How Investment Opportunities Affect Cash Holdings

How Investment Opportunities Affect Cash HoldingsIntroductionIn new-fashi wholenessd grades the vex of financial enquiryes raised to libertines gold insurance indemnity, pecuniary resource positions if to a greater extent than than accurate they ar paying to a greater extent attention wherefore do profligates hold so much immediate payment.These issues lead a long storey and be the basis of corporal pay.Indeed, from the day to day ope rations to finance long-term investitures, own funds atomic number 18 just the nearly consequential source of funding.In particular, observers learn recently serious doubts about the lustiness of so much neat.This problem has led to important research perplexed at clarifying the multi appearted aspects of monetary policy tightens.Although the rapid development of signifi scarcelyttly enriched our understanding of the factors that runs of companies the funds, the literary productions has paid little attention in the impress of immediate payment policys real pretend on the daily activities of firms.In the 2007-2008 cite crunch business leaders and the media let made the phrase currency is s all overeign back in vogue.Although the firms internal immediate payment flows decline, the stock foodstuffs collapsed and the credit rating securities industrys n early frozen, the lack of money has become a reality for much firms.For example, General Motors (GM), based in the U.S. automaker, announced on 7 November 2008 that he could escape from the liquid state, despite the ongoing restructuring process. GM eventu aloney reorganized done bankruptcy, only their fate was to demonstrate the importance of property memorys.Although the reduction of coin flows, as a rule, inevitcapable in m all industries during the economic downturn, the symptoms atomic number 50 be removed by a sufficient essence of money as a yellowish brown to the crisis.Neverthe little, for several reasons shargonholde rs do non everto a greater extent want to see the firm to save money and sit on it.The sh beholders outlook on firms inter limiting holdings and the apostrophize they place on it pass on be examined in this research.The determinants and consequences of corporate hard money holdings exhaust attracted en guiltlesshandedd interest of scientists over the past ten geezerhood.One key issue was that the consanguinity amongst silver and the lever of the fellowship.Broadly speaking, two principal(prenominal) factors in the equation of the p adduces of liquidity of the company and the accompaniment be of managerial discretion. some(prenominal) these arguments have their supporters. For example, Myers and Majluf (1984) argue that elevated-priced foreign funding doer that firms must(prenominal) maintain a sufficient funds reserve, which provides liquidity to sh atomic number 18 advantage of new projects a positive NPV.However, according to Jensen (1986) the agency be of managerial consolidation way of life that large amounts of currency should be paid to shareholders to elapse managers overinvesting negative NPV projects.Apparently, in that location is no single truth, which will apply to all companies at once, as the deals of some(prenominal) the firm and its managers are not uniform.Understanding the nourish of specie is of interest not only for researchers and scientists, but even more so for practitioners.Equity analysts, financiers and corporate chief monetary officers must all be very interesting to cope which factors preserve the address of specie holdings in the company and why. Most truth analysts patently add gold to the top of the shelter of the company, without giving attention from what could be the reason why money should not be evaluated at face quantify. However, researches delegate, commercializeplaces, monetary care fors in different firms in different ways, and, consequently, analysts whitethorn be to o especially if the company has a large amount of liquid assets.For corporate financiers situation is somewhat different, because they often give the culmination that the apprise of the target firm is the acquirer, thereby eliminating the influence of the prevailing corporate governance and pecuniary policies.Nevertheless, it piece of ass be valuable to understand the measuring of notes when assessing the foodstuff entertain of the firm.Finally, the financial department of a firm must know why their specie faecesnot be appreciated at face respect, and that they could do if they want.This allows us not only to understand the preferences of shareholders, but perhaps an opportunity to meet them.Problem StatementIn this research I want to find answers to the questions likeWhat is the reason of holding so much hard currency than needed?What kind of effects it could cause?How the financial backing constraints and investment funds opportunities together bear on the nouri sh the shareholders place on funds?How firms investment opportunities affect the fringy treasure of firms cash holdings?How firms the state of outside(a) capital markets affect the marginal value of firms cash holdings?1.3 Research objectivesThe aim of this act upon is the approach to the cost of cash holdings of firms in two directions. First, sequent to Faulkender and Wang (2006), who canvas the cross-section transports in the marginal value of corporate cash, which arises from differences in corporate financial policy.Secondly, inspired by the credit crunch of 2007-2008, I examine how transports in the external capital markets affect the cost of money over time.As far as I know there have not been previous studies on the time changes in the value of cash.There are several reasons why the loan should affect any burdens link to the companys cash holdings.First, Almeida et al.(2004) show that financially forced firms maintain a largely soaring schooler(prenominal) pr oportion of their cash flow, the following adverse macroeconomic shocks than to begin with.This means that the affinity in the midst of the preserve cash flow and profits of the company is dynamic and whitethorn change over time.Second, the importance of cash is empha coatd in a recession.When a loan is becoming more rationed, the company in which a lot of cash does not need to worry about the inability to finance daily operations.Intuitively, firms with more cash are less credibly to be downgraded credit rating and are able to maintain get to to capital markets.In addition, these companies can take advantage of the plight of the weaker firms, which whitethorn be less liquid assets, through active competitive actions and skills.Thus, it seems appropriate to us a treasure load of cash in good times to be able to bring when the economy turns.Finally, as credit becomes more and more rationed, it also becomes more expensive.This is especially true for financially constrained f irms.I use a sample of around 1000 Malaysian firms for the last decade from 1999 to 2009 to tribulation the dead reckoning in Faulkender and Wang (2006), impact of investment opportunities on the value of cash, and the change in value of cash over the economic cycle. The usable observations attempt from 1999 because for most of the variables I require a change passim a fiscal year. The extraordinary state in the financial markets during 2007-2008 allows me to study how it whitethorn have impacted the value of cash.The following terms interchangeably I use in this thesis. First, in a few ways, mainly as cash holdings, cash reserves, or simply cash I refer to firms cash holdings. Nevertheless, cash level is apply to refer to cash ratio (cash to net assets). Second, I use the value of cash, the marginal value of cash, value of additional cash, value of an extra vaulting horse of cash, and the value the shareholders place on cash spot referring to the value of firms cash holdings . Third, since most of the previous studies have been done with U.S. info, I discuss the value of a dollar in the introduction. However, my info are from Malaysia, and thusly in the confirmable part I am examining the value of a ringgit.I review the related writings in the next section. Section 3 develops hypothetical framework of the study, the main hypothesis, illustrates the methods and details the sample selection.LITERATURE REVIEWThe literature on market value of cash can be divided into research focalisation on the avails of liquidity, or agency costs.The former approaches through the studies of financial policy and corporate decision making of companies, whereas the latter evaluates the degree of agency conflicts on the basis of corporate governance factors.Despite the general division amid the two issues, both are at least implicitly evermore present during the tests and conclusions.Although much effort has recently been devoted to studying the determinants of cash policy of firms, data on the impact of reserves firms cash dust relatively small.However, there are a few notable exceptions.Blanchard, Lopez-de-Silanes and Shleifer (1994), who studied a small sample of companies that received cash windfalls from lawsuits, and Harford (1999), studied the acquisition of the company with unusual cash, the document that managers with weaker incentives to maximizevalue, tend to spend large amounts of cash is inefficient.Opler, Pinkowitz, Stulz and Williamson (1999) argue that corporate cash can be attributed to a compromise, the theory of financial hierarchy and agency theory.Kim, Mauer and Sherman (1998) develop a pretence of compromise and argue that the optimal amount of corporate cash holdings is placed by the tradeoff between lower income and benefits to minimize the need for costly external financing.Almeida, Campello and Weisbach (2004) believe that corporate cash holdings affected by financial difficulties.Pinkowitz and Williamson (2001) bel ieve that the bank authorities can affect the cash holdings of Nipponese firms.Faulkender and Wang (2006) consider changes in the marginal value of corporate cash holdings related to differences in corporate financial policy.Foley, Hartzell, Titman and Twite (2006) offer tax-based explanations of corporate cash.Most of the literature to evaluate the relationship between financial policy and the exact market value cash holding focused on companies in the linked States of America (USA) Pinkowitz and Williamson (2004), Faulkender and Wang (2006), and Denis and Sibilkov (2007) allstudy how the financial characteristics of the company, and the cost of cash to convey together. Pinkowitz and Williamson (2004) show that the average market value of the dollar held by a firm at roughly $ 1.20, which indicates that shareholders believe that the benefits outweigh the potential liquidity problems of the agency associated with it.Faulkender and Wang (2006), using different methodologies to fin d the market value of the dollar at $ 0.94 on average.Their results suggest that the potential costs of institutions, as easy as tax effects outweigh the benefits to the average firm.Denis Sibilkov (2007) focus on the financial difficulties of the company and the investment opportunities and find consistent results.Nevertheless, there is significant cross-section changes in the market value of money, thus focusing on the mean values shows only a little about the relationship between fiscal policy and the value of cash.The other branch of value of cash literature focuses on the effect of corporate governance.For example, Dittmar and Mahrt-Smith (2007) use U.S. data show that the additional $ 1 cash for badly managed companies worth between $ 0.42 to $ 0.88, while good governance doubles the value.Pinkowitz et al.(2006) used a cross-border data and found that an additional $ 1 is associated with an harvest-tide in company value of $ 0.29 to $ 0.33, depending on the criteria of corp orate governance in countries with weak protection of shareholders, while an additional $ 1 in cashassociated with an cast up of $ 0.91 to $ 0.95 in the value of the company in countries with good shareholder protection.In addition, Kalcheva and Lins (2003) found that a minority of investors who are not very hearty protected by applicable discounts for firms in high levels of cash.This is consistent with the findings Fresard and Salva (2009), which show that the value of $ 1 of overabundance cash of typical non-US companies is U.S. $ 0,58, while it is $ 1.61 for the firms listed in the U.S. through exchanges means thatinvestors discount the value of corporate cash reserves when they are at high risk of turning into private profit.RESEARCH DESIGN AND METHODStheoretic FrameworkHere I will talk about the early literature related to the value of cash holdings of the company, as well as provide relevant theory.I begin with outlining the background to understand why firms hold cash. It is necessary to identify with why firms hold cash in order to understand how the shareholders determine the importance they attach to the cash.Then I will present in the lead the relevant studies and conclusions contained in the value of the cash literature.3.1.1 Cash holding sourcesIf all firms operating in the world of hone capital markets, cash holdings will have no value.If the firm was in need of cash for operations or investments, it can raise funds at zero cost.While there is no liquidity bounteousness in such a world, holdings of liquid assets have no possible action of cost.Consequently, if a company borrows money and invests it in liquid assets, shareholder wealth is unchanged.Nevertheless, in the real world markets are not perfect and the holding of liquid assets has its costs.Thus, a firm must strike a fit between the marginal cost of holding liquid assets and the marginal benefit of holding these assets.Here, I present five theories of why firms hold cash and whi ch have been shown in earlier literature.3.1.1.1 The transaction motiveTransactions motive for holding cash is due to the cost of converting money substitutes into cash.According to Keynes (1936), a company can save on transaction costs by using cash to make payments without liquidation of assets.Miller and Orr (1966) model the rent for cash to finance daily operations, and the required level of cash.The company in short of liquid assets has to raise funds in capital markets, liquidate brisk assets, reduce dividends and investment, the revision of existing financial contracts, or use a combination of these actions.Since there are both repair and variable costs in increasing cash, the company must hold a buffer of cash to avoid raising cash often, and thus to avoid the associated fixed transaction costs.Myers and Majluf (1984) argue that the increase in external financing is more costly than using internal resources in the presence of asymmetric information.Since outsiders know l ess than the management, they may discount the price of securities more than management was unstrained to accept.Thus, the management may find it more profitable not to allot securities, and even reduce the investment.For this reason, it may be optimal for companies that conduct a certain level of cash to meet the needs of investment spending.3.1.1.2 The agency motiveJensen (1986) argues that entrenched managers have incentives to retain cash rather than an increase in payments to shareholders, even if the firm has limited opportunities for investment.Opler et al.(1999) tender reasons why managers can use the optimal cash policies.First, managers can accumulate funds to travel along their personal interests.Cash allows managers to invest in external capital markets would not be willing to finance.They usually spend one dollar in cash in hand, even if they cannot raise financing from the markets.Consequently, they could make investments that may have a negative impact on the valu e of the company.Jensens (1986) free cash flow problem predicts that managers with surplus cash are credibly to overinvest.Thus, a one dollar increase in cash holdings of firms can lead to significantly less than one dollar increase in the value of the company.As the outsiders do not know, whether managers are accumulating cash to increase the value of the company or pursue their own goals, the cost of external capital is probably to increase.3.1.1.3 The tax motiveIn recent studies by Foley et al. (2007) shows that U.S. companies which will bear the tax consequences associated with the repatriation of foreign earnings hold a high level of cash. Affiliates referring to the highest tax consequences of repatriating also have the highest level of cash.This means that multinational companies are more in all likelihood to accumulate cash.The extent this applies to the Malaysian firms has yet be studied.3.1.1.4 The theory financing hierarchyThe theory of financing hierarchy implies tha t there is no optimal amount of cash, based on arguments similar to the hierarchy theory of capital structure (Opler et al. (1999)).According to theory, firms are not willing to issue shares, because it is too expensive because of the asymmetry of information.They change the debt when they do not have sufficient resources, and when they can do so.When they have sufficient resources to invest in profitable opportunities available, they pay the debt which becomes due, and to accumulate more cash or else.The theory assumes that the cash holdings of firms are less strategic choice but more a result of a dynamic, endogenetic process.3.1.1.5 Investment opportunities and the value of cashPinkowitz and Williamson (2004) were the setoff who studied the market value of cash holdings.They focus on firms investment and financing opportunities.They find that the growth of the company have the possibility of a positive attitude to the market value of money.Firms with greater investment opportu nities have a higher cost of cash.They also show that firms with higher uncertainty of investment have a higher valuation.In addition, firms in a difficult financial situation have lower valuation on cost. Faulkender and Wang (2006) confirm this conclusion, as they show that firms with lower leverage, a proxy for financial distress, have higher value put on cash.Finally, Pinkowitz and Williamson (2004) argue that access to capital markets does not affect the market value of cash.However, they note that their proxy for access to capital markets, company size may not be perfect. Consequently, Faulkender and Wang (2006) show that the difficulties in obtaining access to capital markets play an important role in the market value of cash.Liu and Chang (2009) show similar proof on the impact of financial constraints on the market value of cash.Faulkender and Wang (2006) also show that the marginal cost of cash reduces with the amount of cash holdings.They argue that this is associated with an increase in the probability diffusion of cash to shareholders, and consequently incurring transaction costs and taxation, to reduce the cost of cash.HypothesisAfter I studied the theory of the value of cash holdings, I turn to the empirical predictions.I present hypotheses for the impact of financial policy and investment opportunities on the value of cash.These hypotheses relate to previous work in the field of corporate finance and the value for cash.Hypothesis 1 The marginal value of cash is decreasing in the level of the firms cash positionAfter Faulkender and Wang (2006), I initially hypothesize that the marginal value of the shareholders place on cash holdings of the company reduces as the level of cash holdings increases.The reasons are based on agency and tax considerations.As firms cash level rises it becomes more likely to distribute the cash to shareholders who then as a result incur a dividend tax.In addition, the company with high cash holdings becomes more vulnera ble to face agency costs as shareholders begin to worry about the interest and ability of managers to invest in positive NPV projects.Thus, the marginal cost of cash should reduce as the cash level of the company increases.Hypothesis 2 An extra ringgit of cash holdings is less valuable for shareholders in highly levered firms than in firms with low leverage.The second hypothesis from Faulkender and Wang (2006), which I test in my Malaysian sample, is the negative relation marginal cost of cash and firms leverage.The cost of cash for shareholders in high levered firms is likely to be less than in firms with low leverage as contingent claims analysis predicts that most of the value of these firms is in the hands of debt holders. Additional ringgit is likely to go mostly to increase the value of debt and therefore, the value for shareholders is low.Hypothesis 3 An extra ringgit of cash holdings is more valuable for shareholders in financially constrained firms.The last hypothesis whic h follows Faulkender and Wang (2006) is that the simplicity of accessing to external capital markets should have an impact on the value of cash.Access may be limited for several(a) reasons, but often associated with asymmetric information about the state of the company, which may occur for smaller firms, firms without any credit rating or fair play research coverage and the firms that do not pay dividends.These firms can be considered as financially constrained and can be thought of having higher costs in raising external funds.Thus, with its own funds, i.e. cash in hand, should be more valuable to these firms than financially unconstrained firms, which are likely and able to obtain external financing.Hypothesis 4 An extra ringgit of cash holdings is more valuable for firms with good investment opportunities.I examine whether firms with part investment opportunities have a higher valuation on their cash holdings than firms with weaker growth potential by following Pinkowitz and W illiamson (2004).Pinkowitz and Williamson argue that the main theoretical determinant of the value of cash holding should be the investment opportunity set of the firm.First, liquidity is important, because without liquid assets of the firm will be forced to abandon a positive NPV project (Myers and Majluf (1984)).This should increase the cost of cash as it is expected to increase in value of assets.Secondly, Jensens (1986) free cash flow problem arises when the firm has a few good opportunities for investment.If a company with sufficient cash reserves has positive NPV investment opportunities, it is likely to use these advantages instead of wasting money on unproductive ventures. suspiciousness is that when two identical firms except that one has a positive NPV investment opportunities and the other one does not have the opportunity to invest, it is likely that the first firm will spend its cash in ways more valuable to the shareholders.Hypothesis 5 The marginal value of cash is hi gh for financially constrained firms with good investment opportunities.One of the arguments in Faulkender and Wang (2006) having a higher marginal value of cash for financially constrained firms is that when firms have positive NPV investment opportunities. The higher the cost of raising external capital is, the more likely these opportunities are foregone.Though, they do not test for it empirically. I hypothesize that the reason why financially constrained firms and firms with better investment opportunities have a higher value placed on cash when examined separately, is in fact due to the combined effect of these two criteria.A financially constrained firm without investment opportunities is unable to make growth for the cash, while a financially unconstrained firm with good investment opportunities can simply increase external funding when it needs to. Thus, financially constrained firms with good investment opportunities should have a high value placed on their cash holdings b y their shareholders compared with other firms.Hypothesis 6 Firms cash holdings, on average, decrease when the cost of external capital increases.When conditions in the corporate credit market deteriorate, it often leads to a reduction in the economy (Fisher (1933)).As firms generate less internal cash flows and at the same time, corporate credit becomes more expensive and rationed, cash reserves of firms, on average, should decline.It was also suggested by Opler et al (1999).Hypothesis 7 When the cost of external capital is higher an extra ringgit of cash holdings is more valuable.As the supply of credit becomes more rationed and therefore more expensive, the cost of raising capital increases.The increase in the cost of capital makes firms more likely to give up positive NPV projects due to lack of funding.Therefore, when a credit is more rationed, cash holdings should become more valuable because they can help companies take advantage of positive NPV investment opportunities witho ut incurring high costs of raising external capital.MethodsI follow Faulkender and Wang (2006) who developed a methodology which estimates the extra value the market incorporates into blondness values that result from changes in the cash position of firms over the fiscal year to measure the impact of corporate financial policy on the value of cash holdings. Since stock relapses are influenced by the common risk factors, as well as changes in firm-specific characteristics it is necessary to control for both to be able to estimate the magnitude change attributed to the change in cash. The change in the value of a firm is mensurable by the excess produce for the firm i during fiscal year t less the return of stock is benchmark portfolio during fiscal year t. Then the excess returns are regressed on changes in the characteristics of the firm.In this case the main interest is in the estimated coefficient corresponding to the variable measuring the ratio of unthought changes in cash o f the firms lagged equity value.Since the dependent and self-directed variables are standardized by lagged market value of equity, the coefficient measures the dollar change in shareholder value resulting from a change of one dollar of cash held by the firm. Faulkender and Wang (2006) methodology is in effect a long-term event study, in which event is unexpected changes in cash holdings, controlled for other factors that may impact returns over the judgment window of one year.3.3.1 haughty for risk-related market-wide factorsTo control for risk-related factors excess returns are examined that may impact a firms discount rate and return. Fama and cut (1993) show that size and the book-to-market of equity clarifies ordinary variation in stock returns. To arrive at the estimate of the excess return I use the 25 Fama-French portfolios (Fama and French (1993)) formed on size, measured as market capitalization, and book-to-market value of equity ratio (BE/ME henceforth) as my benchmar k portfolios.First firms are sorted by size and divided in five size groups, and then firms are sorted by BE/ME ratios and divided in five BE/ME quintiles for each year. Then I group every firm into one ofBE/ME portfolios and 25 size based on the intersection between the BE/ME and size independent sorts. Firms excess return is calculated by subtracting the firm is benchmark portfolio return during fiscal year t from the firm is stock return during fiscal year t. The fiscal year, or yearly, returns are calculated using the monthly returns. Hence, the dependent variable for the baseline reversal is(1)where ri,t is the stock return for firm i during fiscal year t and is stock is benchmark portfolios return during the corresponding fiscal year t.3.3.2 Controlling for firm-specific factorsIt is necessary to control for variables that could be fit with both change and returns in cash holdings to be able to examine how much the change in cash holdings impacts the change in equity value. Hence, in addition to change in cash should be regressed the excess stock return over the fiscal year on changes in a firms profitability, investment policy, and financing policy.The subsequent equation observes baseline regression=(2)where the X term indicates unlooked-for change in variable X.The dependent variable is described above. The independent variables are firm-specific factors that control for sources of value other than cash or may be correlated with cash holdings. The dependent variable was described above. case-by-case variables are firm-specific factors that control the sources of value, except for cash and can be correlated with cash holdings. Ci,t is the unforeseen change throughout fiscal year t in firm is cash holdings in balance sheet and the most significant variable in the regression. I suppose that the unforeseen change in cash holdings equals to the realized change in cash holdings throughout the fiscal year. Ei,t is the change throughout fiscal year t in e arnings before interest and extraordinary items, and controls for profitability of firm.Firms investment changes policy are controlled by NAi,t, the change throughout fiscal year t in total assets net of cash, and RDi,t, the change throughout fiscal year t in RD expenditure. The financing policy is controlled by Ii,t which is the change throughout fiscal year t in interest write down, Di,t which is the change during fiscal year t in sum dividends, Ci,t-1 which is firm is lagged cash holdings at time t-1, Li,t which is market leverage at the of fiscal year t, and in the end NFi,t which is the firms net financing throughout the fiscal year t. As the stock return is also by definition divided by Mi,t-1, the calibration allows for understanding the estimated coefficients as the dollar change in value for a one-dollar change in the relevant independent variable.Sample SelectionFor my empirical analysis of the marginal value of cash in Malaysia and how it may have changed over time wit h the availability of capital from the external market I use a sample of publicly listed Malaysian firms from 1999 to 2009. The sample entangles both active and inactive firms to avoid a survivorship bias.In this section I describe how I calculate the variables and from where I obtain the data.Here I will first describe how the dependent variable is calculated, and then describe the independent variables in detail.3.4.1 Dependent variableThe dependent variable is the excess return of a firms stock (Eq. (1)). The stock return for a firm i through fiscal year t, ri,t, is calculated using full Return Index (item ReturnIndex) from Thomson Reuters Datastream database (referred as Datastream after this). The index regulates for stock splits and dividends, and therefore the most accurate measure of increase in firm equity value.3.4.2 Independent variablesThe change is basically the difference between fiscal years t and t-1. In addition, all variables excluding for leverage and net financ ing are deflated by one-year delay market value of equity. The variables used in Eq. (2) are measured as belowa) Ci,t and Ci,t-1One-year holdup cash holdings and cash holdings are measured as cash and short-term investments (CashAndSTInvestments). Ever since this is the most important variable, it should be noted that firms cash holdings are considered to include marketable securities and cash in majority of academic studies. Depending on the source, these can be listed as cash and equivalent, cash and short-term investments or marketable securities and cash. Though, in addition to cash the definition can include items such as commercial papers, treasury bills and other money market investments. In general databases adjust the reported records from firm financial statements in order to make the data comparable across the firms.b) Ei,tEarnings before interest and extraordinary items are calculated as earnings before extraordinary items (IncomeBefExtraItemsCFStmt) plus interest expen ses (InterestExpenseOnDebt).c) NAi,tTotal assets net of cash or net assets, are calculated as total assets (TotalAssets) minus cash holdings (CashAndSTInvestments).d) RDi,tRD expenditure is simply RD expenditure (ResearchAndDevelopmentExpense). It is set to zero if missing.e) Ii,tInterest expense is measured as interest expenses on debt (InterestExpenseOnDebt).f) Di,tTotal dividends are measured as common dividends paid (CommonDividendsCash).g) Li,tMa