the effect of corporate governance on cash holdings ...key word: corporate governance, cash...

The Effect of Corporate Governance on Cash Holdings:

Evidence from Hong Kong

BY

WONG Ying Wai

09016031

Accounting Concentration

YANG Zhu

09050450

Accounting Concentration

An Honors Degree Project Submitted to the School of business in Partial Fulfillment of

the Graduation Requirement for the Degree of Bachelor of Business Administration

(Honors)

Hong Kong Baptist University

Hong Kong

April 2013

Supervisor: Dr. O. K. Kent Lee

Acknowledgement

We would like to express our utmost gratitude to our degree project supervisor, Dr. O. K.

Kent Lee for his precious and invaluable guidance and advice on our honors project. We

would like to thank him for his time and support and his care and mercifulness which

enlightened and stimulated us during our project.

We would also like to thank our friends and everyone who has helped and supported

through our research process.

Last but not least, we would like to thank our faculty, School of Business, for giving us

this chance to finish an honors degree project. We have gained valuable experience and

related academic knowledge, as well as to cooperate, and to balance in conducting this

research project.

WONG Ying Wai 09016031

YANG Zhu 09050450

1

Abstract

This study examines the effect of corporate governance on cash holdings by using 160

firm-year observations from 2010 to 2011 from Hong Kong listed companies. The

associate between corporate governance and the cash holdings depends on the size of

the firm. We measure corporate governance with ownership structure of executives and

board effectiveness. Small-sized firms with effective governance mechanisms are found

to have more intention to hold more cash. We document a negative relation between

CEO duality (CEO is the chairman) and cash holdings, and a positive relation between

CEO ownership and cash holdings.

Key word: Corporate governance, Cash holdings, Board of directors, CEO duality,

Ownership.

1. Introduction

It has always been a critical issue to decide an appropriate cash level in a company.

Cash provides liquidity to firms and is an important component of a firm’s assets. Firms

have the incentive to hold cash to ensure the operations, meet obligations, and catch the

good investment opportunities. Cash also acts as a buffer to prevent high opportunity

costs during cash shortage (Opler et al., 1999; Ozkan and Ozkan, 2004). Opler et al.,

(1999) suggest that companies with good investment opportunities and high cash flow

risks tend to hold more cash. The large amount of cash holding, however, may result in

agency problems of free cash flow as managers can get private benefits easily (Jensen,

1986). Weak governance mechanism further triggers managers to hold more cash,

which may cause unwise overinvestment like expensive acquisitions, and subsequently

have negative effect on the shareholders’ benefits (Dittmar et al., 2003; Jensen, 1986).

1.1 Statement of problems

Cash holding is a critical managerial decision to a company. In a perfect financial

market, there is no incentive for companies to hold substantial cash as they can transfer

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assets to cash or get funded at a fair cost in the market immediately when they need

cash. However, the imperfect market because of transaction costs and asymmetric

information provides rationale for companies to reserve cash (Couderc, 2006).

Companies determine the optimal level of cash holdings though trading off costs and

benefits (Kim et al., 1998; Opler et al., 1999). The major two benefits of holding cash

stated by Keynes (1934) relate to the “transaction motive” and the “precautionary

motive”. Companies intend to hold cash in order to reduce the transaction costs of

financing and avoid disposal of assets due to a sudden need of cash. The second benefit

is to ensure companies to have profitable investment opportunities, instead of losing

investment interests due to the lack of cash holdings. Inefficient investment is resulted

from insufficient liquidity. The level of cash holdings is usually associated with growth

opportunities, investment levels, cash flow, research and development expenditure,

company size, leverage, working capitals, and dividend distribution (Kusnadi, 2011).

On the other hand, the conflict of interest may arise between management and

shareholders in the situation that a company hold large amount of cash (Jensen and

Meckling, 1976). The agency theory indicates that entrenched managers (company

executives) prefer to hoard cash rather than distribute dividends to shareholders as

turning cash into personal benefits is relatively easier than getting benefit from other

less liquid assets to managers (Myers and Rajan, 1998).

Dittmar et al. (2003) have also indicated that agency problem are an important

determinant of corporate cash holdings and a strong support has been showed from the

importance of corporate governance in determining cash holdings. Under an effective

corporate governance mechanism, i.e., shareholders’ rights are under good protection,

agency problems can be minimized, and managers can behave in the interests of

shareholders. On the contrary, weak governance, or poor protection for shareholders,

causes an entrenched management, under which the excessive cash is more like ly to be

held.

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However, Harford et al. (2008) explain that companies with poor protection on

shareholders are relatively have small proportion of cash, as managers spend cash

quickly in unnecessary acquisition or investment to benefit themselves in a short term.

Studies have discussed the impact of country- level and company- lever corporate

governance on cash holdings for international firms. Dittmar et al. (2003) find

companies in weak external legal protection hold more cash as a result of the

entrenched management.

In Hong Kong, the external legal protection is strong, so the focus is on the corporate

level. Since prior studies have not examined the relationship of corporate governance

and cash policy in the Hong Kong environment, the availability of data on corporate

governance allows us to examine more in details.

1.2 Objectives of the study

This study is designed to examine the influence of corporate governance mechanisms

on the cash holdings of listed companies in Hong Kong.

- What is the impact of ownership structure on cash holdings level?

- What is the impact of board composition on cash holdings level?

After all, it is worth doing as little empirical studies on effect of corporate governance

on cash holdings have been conducted in Hong Kong. This study can contribute to the

limited literature in Hong Kong environment.

The following section of the paper conducts literature review on prior empirical and

theoretical studies; the third section develops hypothesis; followed by the methodology

and model design; the empirical results are discussed in the fifth section; and the last

section is our conclusion.

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2. Literature review

2.1 Agency problems and cash holdings

Jensen (1986) explained a positive relationship between free cash flow and agency

conflicts. After Opler et al. (1999) had examined several determinants of cash holdings

and specified a tradeoff theory including the impact of agency costs, studies focusing on

agency theory were widely conducted.

Harford et al. (2008) identified three hypotheses on the relationship between agency

cost and cash holdings. The flexibility hypothesis indicates that increase in agency cost

will result in a high level of cash holdings as managers prefer to hold the cash than to

distribute to shareholders. However, the spending hypothesis predicts highly

autonomous managers are willing to spend the excessive cash on hand on projects that

benefit them the most, and as a result, a low level of cash balance is caused.

Shareholder power hypothesis states if minority shareholders have effective control to

directors, they would allow mangers to hold excess cash to prevent underinvestment.

Dharmastuti and Wahyudi (2013) stated that the knowledge of corporate governance is

mainly derived from agency theory. Corporate governance is the mechanism to

scrutinize the contract between principals (shareholders) and agents (company

executives) (Demsetz, 1983; Fama, 1980). The separation of ownership and control

creates interest conflicts, which further cause information asymmetry and agency costs.

The evidence from Nikolov and Whited (2009) explained that governance is one of the

important factors that affect cash holdings.

2.2 Corporate governance

According to The Organization for Economic Co-operation and Development (OECD)

(1999), corporate governance is “the system by which business corporations are

directed and controlled”. Raithatha and Bapat (2012) had defined that corporate

governance is “overall control of activities in a corporation”.

Prior studies on the relationship between corporate governance and cash holdings had

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controversial results. Dittmar et al. (2003) found that corporate governance affects the

level of cash holding using evidences from 45 countries. Specifically, manager prefers

to hold more cash in countries with poor shareholder protection. In contrast, Harford et

al. (2008) suggested that poor governance results in less cash holdings. However, Early

literatures found that the relationship between cash holdings and firm-level corporate

governance is not significant (Harford, 1999; Opler et al., 1999). Furthermore, Bates et

al. (2009) also concluded that high cash holdings are resulted from preventing high

risks of cash shortage, so that governance plays almost no roles in accumulating cash

reserves.

2.3 Ownership structure and board composition

Board of directors is an important component of corporate governance (Hill and Jones,

1992), especially in large business corporations (Fama and Jensen, 1983a; Williamson,

1983). They are responsible for monitoring the management of the CEO or directors, at

the same time to protect the benefits of shareholders. The internal governance is

commonly measured by the ownership structure, the composition of board members,

including chairman, directors and independent non-executive directors, and internal

auditing etc. (Ho, 2003). In addition, the quality of the governance, especially internal

mechanism, has a close relationship with corporate performance. (Aman and Nguyen,

2008).

The effect of corporate governance on cash holdings has been widely studied

worldwide. Ozkan and Ozkan (2004) investigated the impact of ownership structure to

cash holdings by using UK companies as a sample and expanded the evidence on a

non-monotonic relationship between firm ownership and cash holdings. In the

following part, literatures of different components to measure the corporate governance

are discussed.

2.3.1 Founder CEO

Previous studies showed a positive relationship between founder CEO and firm

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performance. Begley (1995) found that founder is CEO firms have a greater return on

assets than other firms. He (2008) had a similar result that founder-CEO firms have

higher financial performance under a dual leadership structure. These study suggested

that founder-CEOs’ interests are aligned with the company because of their stronger

organizational commitment. Therefore, according to the interest-alignment hypothesis,

shareholders tend to allow directors to accumulate cash and the relation between

founder-CEO and cash holdings is positive related (Chen and Chuang, 2009).

2.3.2 CEO ownership

Chen and Chuang (2009) pointed out that the interest alignment hypothesis is subjected

to the firms’ natures and the investment environment faced by firms. In this study, the

CEO with larger ownership in high-tech firms in US held more cash since the CEO

interest aligned with shareholders and in order to ensure sufficient cash for investment.

In contrast, most studies found a negative relationship between managerial ownership

and cash holdings because interest alignment effect lowers the agency costs, which

provides easier access of external financing due to low information asymmetry. Ozkan

and Ozkan (2004) found that the relationship between director ownership and cash

holdings is non- linear and suggested that the alignment effect of managerial ownership

out weight the entrenchment effect. Alignment effect indicates that the interest between

managers and shareholders are aligned when managers have greater ownership.

However, when the managerial ownership continues to increase, entrenchment effect

overwhelms and relationship between managerial ownership and cash holdings changes

to positive since the director dominates the board and hoard cash for self-interest.

2.3.3 CEO duality

According to Rechner and Dalton (1991), the CEO duality occurs when position of the

CEO and the chairman in the company are held by the same person. First on one side,

the duality creates a strong leadership; on the other side, duality declines the

effectiveness of monitoring the board (Finkelstein and D'Aveni, 1994).

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There were different results on the effect of CEO duality to corporate cash holding from

previous studies. Gill and Shah (2012) studied 166 Canadian listed companies from

2008 to 2010. They found that cash holding is positively affected by CEO duality. One

possible reason is that the CEO/Chairman does not act for the best interests of

shareholders. Research from Drobetz and Grüninger (2007) investigating 156 Swiss

non-financial firms from 1995 to 2004 also concluded the similar result. In contrast,

study documented that duality leads to insider dominance that is similar to family

control (Chen et al., 2005). Under agency theory, ineffective monitoring of board is one

of the reasons for poor governance since there is little monitoring on managers and it is

hard to fire poor performance directors (Carver, 2006). Prior literatures suggest CEO

duality seems to be less effective in corporate governance. Corporate with poor

governance hold less cash as directors spend cash quickly (Harford, 1999). The

underlying reason is found in Dittmar and Mahrt-Smith (2007)’s study that excess cash

holdings decrease the incentive to control cost or improve profit margins, and results in

overinvestment in low margin projects.

On the other hand, Rechner and Dalton (1991) found that there is a negative

relationship between company performance and duality. Meanwhile, other studies

indicated that there is no relation between firm performance and CEO duality (Chaganti

et al., 1985; Daily and Dalton, 1992).

2.3.4 Board size

Many studies suggested that company’s performance is better when the board size is

smaller (Lipton and Lorsch, 1992; Eisenberg, Sundgren and Wells, 1998; Hermalin and

Weisbach, 2003; Andres, Azorfra and Lopez, 2005). The reason is that decision making

process is more effective in a small board (Yermack, 1996); Lipton and Lorsch, 1992).

Gill and Shah (2012) and Kusnadi (2004) indicated that larger board size company has

more cash holdings. In contrast, Mak and Li (2001) , Kula (2005), and Drobetz and

Grüninger (2007) documented that board size has no significant effect on corporate

performance.

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2.3.5 Independent director

Studies suggested that independent directors can be an effective monitor to the board.

Kesner and Dalton (1986) found that outside director is more independent since close

relationship do not exist between management team and outsider director. As a result,

outside directors perform a better control and monitor function. Weisbach (1988), and

Huson, Parrino and Starks (2001) found bad performance manager is likely to be

resigned if independent directors take a major seats in the board. According to agency

theory, it is expected that non-executive director dominate board are likely to reduce

agency cost and hence hold less amount of cash (Ozkan and Ozkan, 2004). However,

Chen and Chuang (2009) found a positive relation between outside director and cash

holdings since the nature of high-tech firms requires them to hold more cash for future

investment.

According to Chapter 3 of Hong Kong Listing Rule1, every board should have at least 3

independent non-executive directors.

3. Hypothesis development

This study examines whether and how corporate governance affects the cash holding in

Hong Kong listed companies. As discussed above, prior literatures propose different

opinions on the effect of corporate governance on cash holdings. Some supported

effective governance is positively related to cash, while some argued that it has negative

effect on cash holdings.

The ownership structure and board attributes influence the board effectiveness and the

quality of corporate government. Based on previous literatures, we developed the

following hypotheses to test the effect of corporate governance on cash holdings by

dividing into individual components of corporate governance. The ownership structure

(i.e. Founder CEO, CEO duality, CEO ownership, Chairman ownership, and

1 See HK Listing Rules, Chapter 3:

http://www.hkex.com.hk/eng/rulesreg/listrules/mbrules/documents/chapter_3.pdf


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non-executive directors ownership) and board attributes (i.e. proportion of independent

directors and board size)

H1: The presence of founder CEO affects cash holdings positively.

H2: The presence of CEO duality either positively or negatively affects cash holdings.

H3: CEO ownership is either positively or negatively associated with cash holdings.

H4: Chairman ownership is either positively or negatively associated with cash

holdings.

H5: Non-executive director ownership is negatively.

H6: Proportion of independent directors have in board is either positively or negatively

associated with cash holdings

H7: Board size affects cash holdings positively.

4. Empirical design

4.1 Research methodology

The theoretical model of this empirical study follows the generalized method of

moment (GMM) estimation procedure from Ozkan and Ozkan (2004) to eases off the

endogenous problems, since factors determine the cash holdings affect some of the

firm-specific characteristics such as leverage simultaneously, and the effects of the

determinants are often delayed to cash in next period. This model is employed by Chen

and Chuang (2009) and Kuan et al. (2011) to investigate the determinants of cash

holdings in American and Taiwan firms. Our study examines both ownership structures

and board attributes as corporate governance proxies, as well as corporate specific

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control factors, to test whether these variables are significantly associated with a firm’s

corporate cash policy following the GMM model.

4.2 Variables (Appendix A)

Subject to data availability and characteristic of Hong Kong companies such as family

business and chair duality, we modified some of the variables in the study of Chen and

Chuang (2008) on corporate governance and cash holdings in growing high- tech firms

listed on NASDAQ. The dependent variable, Cash holdings, is the ratio o f cash or cash

equivalent to total assets.

4.2.1 Governance variables

Under ownership structure variables, we design a Founder dummy to check the impact

of founders in board, which includes situations where the founder is also the CEO or the

chairman in board, or a family of the two. CEOChair dummy is modified to combine

the situation of chair duality and where CEO and chairman are families. The share

ownership of CEO, the chairman and non-executive directors are denoted with

CEOOwn, ChairOwn, and NEDOwn. The shareholding of non-executive directors

measures the independency of the board (Chen and Chuang, 2009).

Board attributes are proxied by two variables, Board size (BODSize) and Independent

Directors Proportion (IndependDir). Companies with large board size have relatively

poor corporate governance (Hellman and Puri, 2000; Yermack, 1996). And outside

directors enhance the effectiveness of the board in management monitoring and

shareholders protection (Core et al., 1999). According to Hong Kong Listing Rules

Ch.32, the independence is assessed by not more than 1% of company’s total issued

capital, financial independent to the company, including its related parties, and not

connected with any current or former executives in the company.

2 See HK Listing Rules, Chapter 3:



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4.2.2 Firm-specific control variables

Variables related to firm’s cash level are considered. Leverage, the ratio of total debts to

total assets, measures a company’s financial risk, is expected to negatively associate

with cash holdings as large cash reserves lower the risk of default and thus reduce the

financial risks, Capital expenses (Capex to total assets ratio), and R&D expenses (R&D

to total assets ratio) are expected to be positively related to cash holdings as implied by

Dittmar et al. (2003) and Boyle and Guthrie (2003) that companies have great

investment opportunities prefer to reserve more cash since sufficient internal cash

holdings help to prevent foregoing potential investment opportunities. Conversely, the

pecking order theory indicates substantial capex drains out the cash of a firm (Daher,

2010). Negative relationship between Capex and cash holdings is found by Bates et al.

(2009) and Lee and Song (2007). Prior studies also show that net working capital

(working capital net of cash to total assets ratio) is negatively related to cash holdings

(Bates et al., 2009; Ferreira and Vilela, 2004; Tong, 2006; Lee and Song, 2007). This is

supported by the trade-off theory that networking capitals can be converted to cash

easily. The firm size (Size, logarithm of total assets) is positively related to cash holding

as indicated by Kalcheva and Lins (2007) and Ozkan and Ozkan (2004). Normally,

larger firms intend to hold reserve more cash to maintain the high level and quality of

operations and investment chances. On the other hand, a number of studies find an

opposite result (Daher, 2010; Drobetz and Grüninger, 2007; Nguyen, 2006) based on

the tradeoff theory as large firms benefit from economies of scale, easier access of

financing with lower costs (Ferri and Jones, 1979).

4.3 Models development

4.3.1 Impact of company ownership structure

CASHit = β0 + β1FOUNDERit +β2CEO_CHAIRit + β3CEOOWNit + β4CHAIROWNi t +

β5NEDOWNit + ∑δnCONTROLit + εit

Where i denotes firm i and t denotes time t. CONTROL denotes the following

financial variables: Cash(t-1), Leverage, NWC, Div Dummy, CapExp, R&D, and Size.

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With this regression equation, our hypotheses can be expressed in terms of the expected

signs of the coefficient estimates.

H1 β1=0, against the alternative β1

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c. were controlled by Mainland Government entities or individuals (i.e H-shares

companies4, Red Chip companies5)

d. were under the Financial sector (Hang Seng Industry Classification System

(HSICS) code: 50)

e. were non-ordinary shares or companies lack of available data

We exclude 139 H-shares companies 6 and 102 Red Chip companies 7 in order to

eliminate the heavy effect of Chinese government on the their corporate governance as

most of these companies are state-owned enterprises (SOEs), i.e. the ultimate

shareholder is the central or local government in China. However, our sample includes

Mainland private enterprises which are incorporated outside of the Mainland and are

controlled by Mainland individuals. We consider the government influence on these

companies is minimized.

Similar to previous studies, banks (Code: 501) and insurance companies (Code: 502)

are excluded as a result of different cash holdings requirement to ensure liquidity.

In the population of 925 companies, we randomly select 80 companies through MS

Excel, and replace companies if one is lack of information. The fina l sample consists of

160 firm-year observations covered from year 2010 to 2011. Table 1 shows the

screening process.

4 H-share companies are enterprises that are incorporated in the Mainland which are either controlled

by Mainland Government entities or individuals 5 Red chip companies are enterprises that are incorporated outside of the Mainland and are controlled

by Mainland Government entities 6 H-share companies l ist is disclosed on the China Security Regulation Commission ’s web:

http://www.csrc.gov.cn/pub/csrc_en/affairs/OverseasListing/OverseasListedCompanies/201203/t2012

0331_208037.htm 7 Red Chips companies l ist is disclosed on

http://www.hkex.com.hk/eng/stat/smstat/chidimen/cd_rcmb.htm

http://www.csrc.gov.cn/pub/csrc_en/affairs/OverseasListing/OverseasListedCompanies/201203/t20120331_208037.htmhttp://www.csrc.gov.cn/pub/csrc_en/affairs/OverseasListing/OverseasListedCompanies/201203/t20120331_208037.htmhttp://www.hkex.com.hk/eng/stat/smstat/chidimen/cd_rcmb.htm

14

Table 1- Summary of Sample Companies Selection Process

Total listed companies on HKEx on 21 Dec 2011 1,510

Less companies listed on GEM Board in 2011 (173)

Less companies that:

New listed (76)

Delisted (9)

As foreign companies (17)

H-shares companies (133)8

Red Chips companies (101)9

Financial companies (74)

Preferred shares or B-Class shares (2)

Total qualified population companies 925

The full list of the sample companies is in Appendix B

Governance variables are hand collected from companies’ annual reports available on

website of HKEx10. According to Part XV of Securities and Futures Ordinance 11 (SFO),

Directors and chief executives of a listed corporation must disclose their interests, and

short positions, in any shares in a listed corporation (or any of its associated

corporations) and their interests in any debentures of the listed corporation (or any of its

associated corporations). We calculated the ownership of CEOs, chairs, and

non-executive directors as beneficial ownership, instead of deem interests12 disclosed

in annual report.

Firm-specific control variables are calculated using financial data including total assets,

cash, long-term debts, net working capital, capital expenses, R&D expensed, and

common dividend payments collected from Datasteam.

4.4.2 Company Statistics

8 5 new listed and 1 delisted during 2011 have been counted.

9 1 new listed has been counted.

10 See http://www.hkexnews.hk/listedco/listconews/advancedsearch/search_active_main.aspx

11 See http://www.sfc.hk/web/EN/rule-book/sfo-part-xv-disclosure-of-interests/

12 Deem interests defined under Part XV of SFO (CAP. 571 S3.5)

http://en-rules.sfc.hk/en/display/display_main.html?rbid=3527&element_id=3007

http://www.hkexnews.hk/listedco/listconews/advancedsearch/search_active_main.aspxhttp://www.sfc.hk/web/EN/rule-book/sfo-part-xv-disclosure-of-interests/http://en-rules.sfc.hk/en/display/display_main.html?rbid=3527&element_id=3007

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Our sample covers all the industries based on HSICS (no financial sector). Consumer

Goods Sector covers most of the companies at 36.3%, followed by Properties &

Construction, Services, and Industrial Goods with over 10%. These are in line with the

industry distribution of Hong Kong market13.

Table 2- Industry Classification

HSICS Code Industry Number of firms Percentage

(%)

00 Energy 2 1.5

05 Materials 8 10.0

10 Industrial Goods 9 11.3

20 Consumer Goods 29 36.3

30 Services 11 13.8

35 Telecommunications 2 2.5

40 Utilities 1 1.3

50 Financials - -

60 Properties & Construction 12 15

70 Information Technology 5 6.3

80 Conglomerates 1 1.4

A total of 80 samples are included over the 2010-2011 periods. Industry classification

is based on Hang Seng Industry Classification System (HSICS).

The total market capitalization (market cap.) of the sample listed companies is HKD

336,518.88 million; it counts only 1.93 % of the total market cap. of listed companies

on the Main Board. This results from the exclusion of H-shares and Red Chips, which

consist of 23.47% and 21.91% of the equity market in the year of 201114.

The mean market cap. is HKD 3,756.13 million and the median market cap. is HKD

751.31 million. Comparing to the constituents of Hang Seng Composite Small Cap

Index (HSSI), we identify our sample companies substantially smaller, and as small size

13

“News release: HKEx Adopts Hang Seng Industry Classification System” (2007) http://202.66.146.82/regbod/hk/hkex/press/p071211a.pdf

14 http://www.hkex.com.hk/eng/stat/statrpt/factbook/factbook2011/Documents/FB_2011.pdf

http://202.66.146.82/regbod/hk/hkex/press/p071211a.pdfhttp://www.hkex.com.hk/eng/stat/statrpt/factbook/factbook2011/Documents/FB_2011.pdf

16

companies on average, showing in Table 3.

Table 3- Company Market Cap Comparison

(HKD in thousands) Sample Companies HHSI Constituents15

Mean Market Cap. 4,206,486 8,265,418

Median Market Cap. 751,305 5,646,835

The HHSI represent the bottom 5% of total market capitalization of Hang Seng

Composite Index, which covers about 95% of the total market capitalization of stocks

listed on the Main Board of the HKEx16.

5. Results and Discussion

5.1 Descriptive Statistics

Table 4 shows the descriptive statistics of all the variables. The companies’ cash

consists of 26.54% of total assets on average. This figure is lower than that of the Chen

and Chuang (2009)’s study on high-tech firms in America which is 34.6%. It can be

explained by the fact that high-tech companies with high growing rate face a strong

competition environment (Carpenter and Petersen, 2002) and thus tend to hold more

cash for future investment opportunities (Chen and Chuang, 2009). Our finding

indicates a similar result with Lee and Song (2012)’s study of East Asian firms

including 536 Hong Kong companies in 2005, with the mean cash holdings of 21.3%.

The mean founder dummy of our sample is 51.0%. This reveals around half of sample

listed companies have a founder related to the top managers. In addition, 60.0% of the

board chairmen and CEOs are the same person on average, which is not highlighted in

the US environment. In terms of ownership structure, the CEO owns 19.0% shares of

the company while chairman has a higher shareholding of 27.3%. This is similar to the

15

Constituents ’ market caps are collected from Datastream. Currency denoted in Chinese Yuan (CNY) is

expressed in HKD with the HKD/CNY exchange rate of 1.2339 on 30 Dec 2011 from Bloomberg. 16

See Benchmark Indexes http://www.hsi.com.hk/HSI-Net/static/revamp/contents/en/dl_centre/brochures/hsci_E.pdf

http://www.hsi.com.hk/HSI-Net/static/revamp/contents/en/dl_centre/brochures/hsci_E.pdf

17

results Brickley et al. (1997) found in the US companies that 8 out 11 firms’ chairmen

have a higher ownership than the CEOs. Non-executive directors, however, have only

2.0% of ownership, which is substantially lower than that in the US high-tech firms

with 9.9%.

There are 8.2 directors in a board in general. With the mean proportion of independent

directors of 41.2%, the number of independent directors in our sample companies

counts 3.38. This is only a little higher than the 3 independent non-executive directors

as minimum requirement according to the Hong Kong Listing Rules.

The mean financial leverage tells that the long-term debts count 7.7% of total assets in

the company. The working capital net of cash is only 0.6% of total assets. Moreover, the

mean dividend dummy indicates 58% of our sample companies distribute dividends in

our study year. Capital expenditures consist 5.9% of total asset. Furthermore, R&D

expenses are only 0.8% of total assets, which is much lower than the 37.3% in the US

high-tech companies by Chen and Chuang (2009) due to different business model of

sample companies. R&D is crucial to high-tech firms to maintain competitive

advantages in the market, while in our sample IT companies count only 6.3%, the

majority of companies have little investments in R&D. The average size means the

logarithm of total assets is 6.3, which is higher than the 4.6 of the growing high-techs.

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Table 4- Descriptive Statistics

Variables (N=160) Mean Std.

Deviation

Maximum 75th

Percentiles

Median 25th

Percentiles

Minimum

Dependen variable

Cash holdings 26.5 18.6 96.5 36.5 24.3 11.8 0.7

Governance variables Founder Dummy 0.51 0.50 1.00 1.00 1.00 0.00 0.00

CEOChair Dummy 0.60 0.49 1.00 1.00 1.00 0.00 0.00

CEOOwn % 18.94 21.20 74.07 31.96 10.15 0.00 0.00

ChairOwn % 27.30 21.05 74.07 38.47 25.45 9.34 0.00

NEDOwn (%) 1.99 8.00 60.00 0.21 0.00 0.00 0.00

BODSize 8.18 2.25 18.00 9.00 8.00 7.00 5.00

LogBODSize 0.90 0.11 1.26 0.95 0.90 0.85 0.70

IndependDir (%) 41.23 8.94 60.00 44.44 42.86 33.33 20.00

Control variables

Leverage 7.68 15.78 117.48 9.12 0.98 0.00 0.00

NWC 0.58 24.05 57.75 14.25 1.76 -9.87 -172.64

Div Dummy 0.58 0.50 1.00 1.00 1.00 0.00 0.00

CapExp 5.95 11.36 125.01 7.07 2.89 0.80 0.00

R&D 0.77 2.93 30.00 0.12 0.00 0.00 0.00

Size 6.29 0.64 8.50 6.61 6.23 5.80 5.08

5.2 The impact of corporate governance on cash holdings

This study has three models specifications: model (1) examines the impact of ownership

structure; model (2) examines the effects of board variables; and model (3) combines all

variables. Table 5 exhibits the empirical results. The adjusted R square in Model

summary (Appendix D) shows 56% of the sample data are explained by our model (3).

The .000 significance (

19

Table 5- Impact of corporate governance on cash holdings

Beta (1) B Beta (2) B Beta (3) B

(Constant)

(40.872)

(33.068)

(36.701)

Cash(t-1) 0.624 (0.601)*** 0.663 (0.638)*** 0.628 (0.605)***

Governance variab les

FounderDummy 0.038 (1.419)

0.036 (1.35)

CEOChairDummy -0.163 (-6.155)** -0.167 (-6.313)**

CEOOwn % 0.171 (0.149)** 0.167 (0.146)**

ChairOwn % -0.027 (-0.023) -0.032 (-0.029)

NonExeDirOwn (%) -0.026 (-0.061) -0.028 (-0.064)

IndependDir (%) 0.034 (0.071) 0.037 (0.077)

LogBODSize -0.012 (-2.126) -0.007 (-1.149)

Control variab le

Leverage -0.08 (-0.094) -0.067 (-0.079) -0.085 (-0.1)

NWC -0.284 (-0.22)*** -0.271 (-0.209)*** -0.287 (-0.221)***

Div Dummy 0.093 (3.496) 0.092 (3.466) 0.096 (3.596)

CapExp -0.05 (-0.082) -0.042 (-0.068) -0.054 (-0.088)

R&D -0.018 (-0.112) -0.004 (-0.022) -0.008 (-0.05)

Size -0.167 (-4.832)*** -0.142 (-4.099)** -0.155 (-4.472)**

Significance at the 1% and 5% level is denoted by *** and ** respectively.

Our Hypothesis 2 is accepted at 5% significance level, there is significant and negative

effect of CEO duality on cash holdings. Companies that the CEO is also the chairman

or a family of the chairman tend to hold more cash. Previous study suggested that when

CEO and chairman is the same person, which is a single leadership structure, the board

would be less effective than dual leadership structure (Kusnadi, 2011). Firms with

boards that are large, headed by a chairman who also holds the CEO post, and

dominated by insiders tend to be less efficient. Consequently, these firms would be

expected to suffer from more severe agency problems and to have less effective

corporate governance. Dittmar et al. (2003) documented that firms in countries with

poor shareholder protection (which also implies poor governance) hold larger cash

balances. As a result, poor corporate governance indicates excess cash holdings. This is

in contrary to Ozkan and Ozkan (2004)’s finding that single leadership structured firms

hold more cash since our sample companies are smaller than those in other studies.

20

While this is in line with Chen and Chuang (2009)’s study, as similarities between their

sample of high-tech firms and ours.

Furthermore, other study supported our findings that good governance is associated

with relative excessive cash holdings (Liu and Chang, 2009). The possible explanation

for our empirical result is found in Harford et al. (2008). That study indicated that week

governance holds less cash is due to antitakeover provision. According to Faleye (2004),

proxy battle is extracted by poor governance with excess cash holdings. In order to

avoid losing position in the board, CEO tends hold less cash. Give the potential penalty

of accumulation liquidity, CEO has the incentive to spend cash quickly rather than hold

it (Harford et al., 2008).

Moreover, companies have chair duality issue more dividends than companies with split

roles do in our findings (Appendix C) 17 . One possible explanation is that the

shareholders are not able to monitor the director effectively when the board is ruled by

single director. The agency theory also supported that chair duality has negative effect

on corporate performance because the monitoring and control of CEO is compromised.

Therefore, firms have less cash holdings as CEO/chairman intends to pay more

dividends to maximize his personal benefit rather than considering the benefit of

shareholders in terms of long-term operation of the company.

On the other hand, positive relationship between the CEO ownership and cash holdings

is found. This supports our Hypothesis 3. When the ownership of CEO is higher, the

shareholder interests are likely in line with CEO interests. When shareholders’ interests

are well protected, they are more confident to allow corporate have more cash reserves.

The sufficient cash holding allows firms to catch potential investment opportunities,

especially to small size companies. Ozkan (1996) suggested that small companies are

easier to face liquidation problem during financial distress. Whited (1992) and Kim et al

17

We further test the positive relationship between Chairman duality and ratio of dividend to total assets. 5% significance exists.

21

(1998) further explained that small firms have higher cost of external financing and

borrowing constraints than larger firms. Opler et al. (1999) give evidence that small

firms hold larger cash. Thus an effective board acts on behalf of shareholders are

willing to ensure a high level of cash holdings.

In addition, our finding suggests that there is no significant relationship between

Founder CEO, chairman ownership, and non-executive director ownership to cash

holdings. H1, H4 and H5 are not supported.

For board attributes, we find that both board independence and board size are

insignificantly related to cash holdings, H6 and H7 are not accepted. This is inconsistent

with Chen and Chuang (2009) that the two variables are positively and significantly

related to cash holdings.

One possible explanation that no significant effect from proportion of independent

directors in board lies behind Chen et al. (2005)’s study on 412 public listed companies

in Hong Kong. It found that governance composition (i.e. proportion of independent

non-executive directors, outsider dominated the board) has little impact on firms’

performances, especially for small market cap firms. It is implies by the self-selection

basis in the selection process of outsider directors.

Literatures on the effectiveness of board size are mixed. Larger board size enhances the

monitoring, but rigidizes decision-making. Boone et al. (2007) found evidence

supporting Harris and Raviv (2008) predicted that larger boards provides optimal

monitoring when managers have opportunity to enjoy great private benefit. On contrast,

Yermack (1996) found that smaller boards are more efficient.

Therefore, it is uncertain whether the board attributes have effect on a firm’s cash

holdings.

22

5.3 The effect of founder relationships

In the sample, around half of founders sit in the board as the chairman, or involve in

management as the CEO, or have a close relationship as a family of the two. In the

other words, founders tend to have a great influence on decision making and business

operation. With great passion to the company they established initially, founders with

managerial influence are likely to act in the interest of a long-term benefit for the

company. This study analyzes the differences of effects that corporate governance has

on cash holdings between firms with an active executive founder and firms with the

leader teams have little relationship with the founder. By examining the interactions of

Founder dummy with other governance factors, we check the influence of a close

founder on the relation between corporate governance and cash holdings. Table 6 shows

the results that positive relationship of CEO ownership and negative effect of chair

duality follow the H2 and H3. However, no significance is found from the impact of a

close founder on enhancing the relation between corporate governance and cash

holdings.

23

Table 6- Impact of founder CEOs on the relation between corporate governance and

cash holdings

Beta B Beta B Beta B

(Constant)

(39.702)

(27.647)

(27.928)

Cash(t-1) 0.614 (0.592)*** 0.668 (0.644)*** 0.623 (0.6)***

Governance variab les

FounderDummy 0.035 (1.292) 0.001 (0.034) 0.038 (1.411)

CEOChairDummy -0.162 (-6.137)** -0.158 (-5.975)**

CEOOwn % 0.178 (0.156)** 0.158 (0.138)**

ChairOwn % -0.02 (-0.017) -0.02 (-0.017)

NonExeDirOwn (%) -0.046 (-0.107) -0.041 (-0.096)

IndependDir (%) 0.02 (0.042) 0.03 (0.062)

LogBODSize 0.009 (1.471) 0.014 (2.384)

Control variab le

Leverage -0.094 (-0.11) -0.062 (-0.073) -0.095 (-0.112)

NWC -0.285 (-0.22)*** -0.262 (-0.203)*** -0.269 (-0.208)***

Div Dummy 0.083 (3.102) 0.081 (3.05) 0.069 (2.597)

CapExp -0.054 (-0.088) -0.031 (-0.051) -0.054 (-0.088)

R&D -0.022 (-0.14) 0.002 (0.015) -0.003 (-0.021)

Size -0.161 (-4.644)*** -0.123 (-3.546)* -0.12 (-3.475)*

FdummyCEOChair 0.071 (1.404) 0.083 (1.644)

FdummyCEOOwn 0.008 (0.15) 0.029 (0.542)

FdummyChairOwn -0.032 (-0.597) -0.023 (-0.425)

FdummyNEDOwn -0.04 (-0.741) -0.02 (-0.368)

FdummyIndpendDir -0.085 (-1.585) -0.099 (-1.84)

FdummyLogBODSize 0.021 (0.388) 0.027 (0.508)

5.4 Effect of firm characteristics

The cash holdings are perfectly and positively related to that in prior year. In addition,

working capital net of cash is perfectly and negatively affects the cash holdings. This is

consistent to prior studies and is explained by trade off theory with the high liquidity of

working capital. Meanwhile, firm size is negatively related to cash holding at 5%

significance level. Tradeoff theory is applied as large firms benefit from economies of

scale, easier access of financing with lower costs. Small companies have the intention

to hold more cash. This implies that the small-sized sample companies with good

corporate governance have a higher cash level.

24

However, leverage, capital expenses, R&D expenses, and the decision of whether to pay

dividends have no significant influence on cash holdings in small size firms.

6. Conclusion

In this study, we analyze a sample of 80 listed Hong Kong companies for two years

from 2010 to 2011, and examine the effect of effective corporate governance on cash

holdings in Hong Kong. We develop three models in the first group. The first model

tests the impact of ownership structure, as a measurement of corporate governance, on

cash holdings. The second examines the impact of board attributes on cash holdings.

And the third combines all variable to test the effect on cash holdings. The other group

of models further reviews the influence of funder CEOs on the relation between

corporate governance and cash holdings.

The random selected sample consists of small-sized firms. And the empirical analysis

shows a negative relationship between CEO duality and cash holdings; while CEO

ownership positively affects cash holdings. Separate of CEO and the chairman

improved the board effectiveness. Higher CEO ownership aligns the shareholders

interests with the managers. Both factors reflect effective corporate governance. The

results from the small-sized listed companies in Hong Kong are in line with Chen and

Chuang (2009)’s study on growing high- tech companies that a corporate cash level and

governance effectiveness is positively related. Small-sized firms prefer to hold more

cash to avoid underinvestment and the potential consequence of being acquired due to

proxy fight.

In conclusion, our results suggest that effective corporate governance has a positive

effect on cash holdings in small firms. Further research need to be done in order to

inspect the different effects of corporate governance on cash holdings associate with

firms in different sizes.

25

Appendix

Appendix A- Definitions of variables

Name Description

Dependent variables

Cash holdings Ratio of cash and cash equivalents to total assets

Independent variables

Governance variables

Founder dummy Dummy variable = 1 if the Founder is the CEO or the

Chairman or a family of the two

ChairCEO dummy Dummy variable = 1 if Chairman of company is the

company’s CEO or a family of the CEO

CEOOwn (%) Percentage of shares owned by CEOs

ChairOwn (%) Percentage of shares owned by the Chair

NonExeDirOwn (%) Percentage of shares owned by non-executive directors

BODSize Total number of directors on a firm’s board

Log (BODSize)

IndependDir (%) Proportion of independent non-executive directors on

the board

Control variables

Leverage (%) Ratio of long-term debt to total assets

R&D (%) Ratio of R&D expenses to total assets

NWC (%) Ratio Working capital net of cash to total assets

Size The logarithm of total assets

Div dummy Dummy variable = 1 if a company pays dividend in a

given year

26

Appendix B- Sample Company List

Stock

Code Company Name Market Cap.

HSICS

Code

4 Wharf (Holdings) Ltd. 106,326,581,178 800

293 Cathay Pacific Airways Ltd. 52,398,809,699 304

3333 Evergrande Real Estate Group Ltd. 47,956,999,160 601

220 Uni-President China Holdings Ltd. 16,737,419,250 204

1333 China Zhongwang Holdings Ltd. 14,380,775,024 52

2314 Lee & Man Paper Manufacturing Ltd. 11,770,953,680 53

1882 Haitian International Holdings Ltd. 10,661,280,000 100

818 Hi Sun Technology (China) Ltd. 5,667,671,250 702

1308 SITC International Holdings Co. Ltd. 5,200,000,000 304

468 Greatview Aseptic Packaging Co. Ltd. 3,467,360,000 204

266 Tian Teck Land Ltd. 2,967,073,900 601

2010 Real Nutriceutical Group Ltd. 2,855,269,880 205

878 Soundwill Holdings Ltd. 2,392,013,975 601

78 Regal Hotels International Holdings

Ltd. 2,353,333,083 302

1168 Sinolink Worldwide Holdings Ltd. 2,053,845,443 601

398 Oriental Watch Holdings Ltd. 2,031,372,397 301

926 Besunyen Holdings Co. Ltd. 1,971,132,719 205

1328 International Elite Ltd. 1,968,083,000 305

1863 Sijia Group Co. Ltd. 1,864,869,750 53

801 Golden Meditech Holdings Ltd. 1,760,536,811 205

2118 Tian Shan Development (Holding) Ltd. 1,740,000,000 601

752 Pico Far East Holdings Ltd. 1,685,561,405 305

996 Oriental Ginza Holdings Ltd. 1,604,584,152 601

1388 Embry Holdings Ltd. 1,603,908,150 203

197 Heng Tai Consumables Group Ltd. 1,454,766,904 204

3838 China Starch Holdings Ltd. 1,392,902,880 53

64 Get Nice Holdings Ltd. 1,342,042,788 302

3999 DaChan Food (Asia) Ltd. 1,336,414,200 204

3889 Global Sweeteners Holdings Ltd. 1,237,344,660 204

367 Chuang's Consortium International Ltd. 1,169,091,264 601

539 Victory City International Holdings Ltd. 1,133,382,865 203

340 China Mining Resources Group Ltd. 1,032,682,390 52

1161 Water Oasis Group Ltd. 932,022,372 301

837 Carpenter Tan Holdings Ltd. 925,000,000 202

889 Datronix Holdings Ltd. 915,200,000 100

676 Pegasus International Holdings Ltd. 898,761,000 203

106 Shenzhen High-Tech Holdings Ltd. 854,240,605 601

600 China Infrastructure Investment Ltd. 853,982,102 601

27

1155 Centron Telecom International Holding

Ltd. 848,991,825 350

526 Lisi Group (Holdings) Ltd. 755,473,957 202

686 Goldpoly New Energy Holdings Ltd. 747,136,492 203

1039 Changfeng Axle (China) Co. Ltd. 736,000,000 100

1170 Kingmaker Footwear Holdings Ltd. 724,722,711 203

3318 China Flavors and Fragrances Co. Ltd. 687,654,814 204

1020 Sinoref Holdings Ltd. 660,000,000 100

261 CCT Tech International Ltd. 654,139,940 701

550 Cinderella Media Group Ltd. 641,184,000 303

92 Champion Technology Holdings Ltd. 619,453,376 702

1123 China-Hongkong Photo Products

Holdings Ltd. 616,829,040 202

1188 Hybrid Kinetic Group Ltd. 614,221,420 201

130 Moiselle International Holdings Ltd. 581,187,800 203

2188 China Titans Energy Technology Group

Co. Ltd. 564,400,000 100

1225 Lerado Group (Holding) Co. Ltd. 532,905,214 202

33 Rainbow Brothers Holdings Ltd. 517,302,500 202

216 Chinney Investments, Ltd. 490,717,656 601

508 Chevalier Pacific Holdings Ltd. 475,019,034 204

1399 Scud Group Ltd. 469,560,567 202

595 AV Concept Holdings Ltd. 425,792,093 703

1195 Kingwell Group Ltd. 423,560,620 100

646 China Environmental Technology

Holdings Ltd. 410,835,786 400

1222 Wang On Group Ltd. 404,545,971 601

223 Sino Resources Group Ltd. 348,578,845 2

1682 Ford Glory Group Holdings Ltd. 328,500,000 203

396 Hing Lee (HK) Holdings Ltd. 302,998,344 202

834 China Kangda Food Co. Ltd. 298,734,120 204

922 China Boon Holdings Ltd. 297,451,561 305

841 Asia Cassava Resources Holdings Ltd. 252,000,000 53

1073 China Agrotech Holdings Ltd. 242,329,565 53

370 China Best Group Holding Ltd. 216,418,705 2

601 Group Sense (International) Ltd. 200,009,726 202

464 Kenford Group Holdings Ltd. 197,516,700 202

2323 Topsearch International (Holdings) Ltd. 190,386,000 100

640 Infinity Chemical Holdings Co. Ltd. 190,000,000 53

679 Asia Tele-Net And Technology

Corporation Ltd. 164,188,409 100

524 e-Kong Group Ltd. 161,510,000 350

565 Art Textile Technology International 157,130,990 203

28

Co. Ltd.

243 QPL International Holdings Ltd. 141,964,107 703

567 Daisho Microline Holdings Ltd. 136,869,479 100

650 Shun Cheong Holdings Ltd. 131,983,880 302

736 China Properties Investment Holdings

Ltd. 61,402,582 601

Appendix C- regression result on testing linear relationship between Div/TA and

Chair duality

Coefficientsa

Model

Unstandardized Coefficients

Standardized

Coefficients

t Sig. B Std. Error Beta

(Constant) .006 .008 .768 .444

CEOChairDummy .021 .011 .155 1.974 .050

a. Dependent Variable: Div/Total Assets

The 5% significance level demonstrates the existence of chair duality increase the

dividend pay. This demonstrates a lower cash level after higher dividend payment in

firms with chair duality.

Appendix D- Model Summary (combined model)

CASHit = β0 + β1FOUNDERit +β2CEO_CHAIRit + β3CEOOWNit + β4CHAIROWNi t +

β5NEDOWNit +β6INDit +β7LogBOARDit + ∑δnCONTROLit + εit

Model Summaryb

N R R Square Adjusted R Square Std. Error of the Estimate

160 .774a .599 .560 12.316

Appendix E

ANOVAb

Model Sum of Squares df Mean Square F Sig.

Regression 32798.071 14 2342.719 15.446 .000a

Residual 21992.893 145 151.675

Total 54790.964 159

29

a. Predictors: (Constant), Cash(t-1), FounderDummy, CEOChairDummy, CEOOwn %, ChairOwn

%, NonExeDirOwn (%), IndependDir (%), LogBODSize, Leverage, NWC, Div Dummy, CapExp,

R&D,,Size,

b. Dependent Variable: Cashholdings

Appendix F

30

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