Ebook Corporate Governance and the Value of Cash Holdings
Left to their own devices, managers will waste corporate resources. This is the implication of the extensive literature on agency costs formalized by Jensen and Meckling (1976), but first mentioned by Adam Smith (1776), who explains that due to the separation of ownership and control “negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such companies.” In this paper, we examine the potential value destruction that results from such negligence and profusion and how good corporate governance helps to prevent it.
We do this by focusing on one particular asset: cash. We examine cash for three reasons: first, cash reserves are easily accessible by management with little scrutiny and much of their use is discretionary. Second, firms hold substantial and increasing amounts of cash reserves and the value of these cash holdings represents a significant fraction of all corporate wealth. Lastly, while firm level governance itself is only slowly changing, there is substantial variation in firm level cash holdings over time. This variation in cash allows for statistically powerful tests to examine the effect that governance has on the value and the eventual use of cash reserves in individual firms.
In 2003, the sum of all cash and marketable securities represented more than 13% of the sum of all assets for large publicly traded US firms, reflecting a substantial increase from 5% in 1990. To put the value of these amounts in perspective, the aggregate cash held by publicly traded US firms in 2003 represents approximately 10% of annual US GDP. Although it is optimal for firms to hold some cash to finance day-to-day operations and as a buffer against the cost of externally financing their investments, holding excessive cash resources may have negative value implications if managers use these liquid resources inefficiently. In other words, a dollar may not be worth a dollar if there is a chance that it is going to be wasted. Since good corporate governance is the shareholders’ defense against inefficient use of corporate assets by managers, an important question to ask is: how does corporate governance impact the value and eventual use of cash reserves?
To determine the value effects of governance on cash resources, we employ two methods. First, we follow Faulkender and Wang (2005) and examine how a change in cash holdings leads to a change in the market valuation of a firm. We show that the effect of governance is striking: depending on the measure used, and controlling for other factors, the value of an additional $1.00 of cash for a poorly governed firm is between $0.42 and $0.88. Good governance approximately doubles this value of cash. Second, we estimate and value cash reserves held in excess of those needed for operations and investments, because these resources are most at management’s discretion and thus most at risk of being wasted. We value excess cash with methods employed in Fama and French (1998) and Pinkowitz and Williamson (2004), using market-to-book ratios to estimate the marginal value investors place on a dollar of excess cash. We find again that the market value of excess cash is reduced by approximately one-half when firms have poor governance relative to firms that are well governed.
We then investigate more directly whether poorly governed firms waste cash reserves. We show that a well governed firm has its cash resources better “fenced in”, and that firms with poor corporate governance dissipate excess cash more quickly. In fact, governance has a relatively minor impact on how firms accumulate cash, but it has a significant impact on how firms spend their money. More importantly, we find that firms with both high excess cash and poor governance subsequently experience particularly low operating performance: the accounting returns of a sample of firms that draw down their large excess cash reserves are significantly diminished if the firms have poor corporate governance. This negative impact of excess cash on operating performance is cancelled out if the firm is well governed. These results indicate that either managers subject to agency problems invest their excess cash inefficiently in low return projects, or excess cash reduces the pressures on management to operate efficiently by minimizing costs, improving margins, closely monitoring employees and operations and engaging in other profit enhancing measures. In either case, excess cash leads to sub-optimal performance and good governance can reverse this effect.
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