Corporate governance and the value of cash holding

JournalofFinancialEconomics83(2007)599–634Corporategovernanceandthevalueofcashholdings$AmyDittmara,,JanMahrt-SmithbaUniversityofMichigan,701TappanStreet,AnnArbor,MI,48109,USAbUniversityofToronto,105St.GeorgeStreet,Toronto,Ont.,Canada,M5S3E6Received12May2005;receivedinrevisedform18November2005;accepted23December2005Availableonline28November2006AbstractWeinvestigatehowcorporategovernanceimpactsfirmvaluebycomparingthevalueanduseofcashholdingsinpoorlyandwell-governedfirms.Weshowthatgovernancehasasubstantialimpactonvaluethroughitsimpactoncash:$1.00ofcashinapoorlygovernedfirmisvaluedatonly$0.42to$0.88.Goodgovernanceapproximatelydoublesthisvalue.Furthermore,weshowthatfirmswithpoorcorporategovernancedissipatecashquicklyinwaysthatsignificantlyreduceoperatingperformance.Thisnegativeimpactoflargecashholdingsonfutureoperatingperformanceiscancelledoutifthefirmiswellgoverned.r2006ElsevierB.V.Allrightsreserved.JELclassification:G30;G32;G34Keywords:Cashholdings;Corporategovernance;Ownershipstructure;Take-overprovisions;FirmvalueARTICLEINPRESS:10.1016/j.jfineco.2005.12.006$Wearegratefulforcommentsfromthereferee,aswellasSeoungpilAhn,SergeiDavidenko,FrancoisDerrien,CraigDoidge,ArtDurnev,AlexanderDyck,MichaelFaulkender,DavidGoldreich,JarradHarford,LiJin,E.HanKim,BillMaxwell,AdairMorse,JoshuaRauh,MarcelRindisbacher,AmitSeru,HenriServaes,JeremyStein,Rene´Stulz,andseminarparticipantsattheFinancialEconomicsandAccounting2005Conference,NBER2005SummerInstituteCorporateGovernancemeetings,SwedishInstituteofFinancialResearch2005ConferenceonCorporateGovernance,NorthernFinanceAssociation2005AnnualMeetings,UniversityofMannheim,UniversityofMichigan,UniversityofNorthCarolina,UniversityofTexas,UniversityofToronto,andWayneStateUniversity.Correspondingauthor.E-mailaddress:[e-mail](A.Dittmar).1.IntroductionLefttotheirowndevices,managerswillwastecorporateresources.ThisistheimplicationoftheextensiveliteratureonagencycostsformalizedbyJensenandMeckling(1976),butfirstarticulatedbyAdamSmith(1937),whoexplainsthatduetotheseparationofownershipandcontrol,‘‘negligenceandprofusion,therefore,mustalwaysprevail,moreorless,inthemanagementoftheaffairsofsuchcompan[ies].’’Inthispaper,weexaminethepotentialvaluedestructionthatresultsfromsuchnegligenceandprofusionandhowgoodcorporategovernancehelpstopreventit.Wedothisbyfocusingononeparticularasset:cash.Weexaminecashforthreereasons.First,cashreservesareeasilyaccessiblebymanagementwithlittlescrutinyandmuchoftheiruseisdiscretionary.1Second,firmsholdsubstantialandincreasingamountsofcashreservesandthevalueofthesecashholdingsrepresentsasignificantfractionofallcorporatewealth.Lastly,whilefirm-levelgovernanceitselfisonlyslowlychanging,thereissubstantialvariationinfirm-levelcashholdingsovertime.Thisvariationincashallowsforstatisticallypowerfulteststoexaminetheeffectthatgovernancehasonthevalueandtheeventualuseofcashreservesinindividualfirms.In2003,thesumofallcashandmarketablesecuritiesrepresentedmorethan13%ofthesumofallassetsforlargepubliclytradedUSfirms,reflectingasubstantialincreasefrom5%in1990.Toputthevalueoftheseamountsinperspective,theaggregatecashheldbypubliclytradedUSfirmsin2003representsapproximately10%ofannualUSGDP.Althoughitisoptimalforfirmstoholdsomecashtofinanceday-to-dayoperationsandtoprovideabufferagainstthecostofexternallyfinancingtheirinvestments,holdingexcessivecashresourcesmayhavenegativevalueimplicationsifmanagersusetheseliquidresourcesinefficiently.Inotherwords,adollarmaynotbeworthadollarifthereisachancethatitisgoingtobewasted.Sincegoodcorporategovernanceistheshareholders’defenseagainsttheinefficientuseofcorporateassetsbymanagers,animportantquestiontoaskis:howdoescorporategovernanceimpactthevalueandeventualuseofcashreserves?Todeterminethevalueeffectsofgovernanceoncashresources,weemploytwomethods.First,wefollowFaulkenderandWang(2005)andexaminehowachangeincashholdingsleadstoachangeinthemarketvaluationofafirm.Weshowthattheeffectisstriking:dependingonthemeasureofgovernanceused,andcontrollingforotherfactors,thevalueofanadditional$1.00ofcashforapoorlygovernedfirmisbetween$0.42and$0.88.Goodgovernanceapproximatelydoublesthisvalue.Second,weestimateandvaluecashreservesheldinexcessofthoseneededforoperationsandinvestments,astheseresourcesaremostatmanagement’sdiscretionandthusmostatriskofbeingwasted.WevalueexcesscashbyusingmethodsemployedinFamaandFrench(1998),usingmarket-to-bookratiostoestimatethemarginalvalueoffirmattributes.Wefindagainthatthemarketvalueofexcesscashforfirmsthathavepoorgovernanceisapproximatelyone-halfofthevalueofexcesscashforfirmsthatarewellgoverned.Pinkowitz,Stulz,andWilliamson(2006)alsousetheFamaandFrenchmethodologyintheircross-countrystudyofcash,dividendsandgovernance.Theyfindthattheimpactofgovernanceonthevalueofcashisofasimilarorderofmagnitudeasinourstudy.2ARTICLEINPRESS1MyersandRajan(1998)hypothesizethatmoreliquidassetscanleadtoincreasedagencyproblems.2SeealsoPinkowitzandWilliamson(2004)forastudyofthevalueofcashwithoutcontro