Corporate Governance, Cash Holdings, and Firm Value: Evidence ...

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Review of Pacific Basin Financial Markets and Policies Vol. 8, No. 4 (2005) 613–636 c World Scientific Publishing Co. and Center for Pacific Basin Business, Economics and Finance Research

Rev. Pac. Basin Finan. Mark. Pol. 2005.08:613-636. Downloaded from www.worldscientific.com by HITOTSUBASHI UNIVERSITY LIBRARY on 12/01/15. For personal use only.

Corporate Governance, Cash Holdings, and Firm Value: Evidence from Japan Qi Luo∗ Department of Industrial Engineering & Management Graduate School of Decision Science and Technology Tokyo Institute of Technology [email protected] Toyohiko Hachiya Department of Industrial Engineering & Management Graduate School of Decision Science and Technology Tokyo Institute of Technology [email protected] This paper presents evidence on cash holdings for Japanese firms listed on the Tokyo Stock Exchange, focusing on the impact of corporate governance factors in cash holdings and the implication of cash holdings to firm value. We find that insider ownership and bank relations of firms play a significant role in determining cash holdings. Our results indicate that foreign stockholders select profitable firms to invest, and these firms have higher levels of cash. We document evidence that cash holdings lead to agency problems and impact firm value negatively, and governance characteristics affect the negative relation between cash holdings and firm value. Keywords: Corporate governance; cash holdings; firm value; Japan.

1. Introduction Cash holdings provide liquidity, which can be both beneficial and costly. One of the main benefits of having large cash reserves in an imperfect capital market is increasing the ability of firms to avoid excessive costs of external

∗

Corresponding author. 613

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614 • Qi Luo & Toyohiko Hachiya

financing. However, according to Jensen (1986), managers of cash-rich firms are subject to more severe agency problems. Opler et al. (1999) examine the determinants of cash holdings for publicly traded US firms. They observe that investment opportunity set, financial distress costs (measured as R&D expenses) and operating uncertainty are positively related to cash holdings. They report that firms with higher cash flows, more capital spending, or higher leverages, tend to hold more cash. In their tests, dividends and firm size are negatively related to cash holdings. After Opler et al. (1999), the decision of corporate cash holdings has drawn a great deal of attention in finance literature. However, empirical investigations of the cash holding decision have so far focused mainly on the role of firm-specific fundamentals in the determination of cash holdings. More recently, very few studies have emphasized the impact of corporate governance in explaining cash holdings. Ozkan and Ozkan (2002) investigate the impact of ownership structure on cash holdings using a sample of UK firms. They provide an evidence of a non-monotonic relationship between managerial ownership and cash holdings. In this paper, we examine the determinants and implication of cash holdings to Japanese firms by testing a sample over the period of 1989–2002. We first investigate the impact of fundamentals on cash holdings as preliminary research. Then, we focus on the role of corporate governance factors in cash holding decision. Moreover, since insiders may hold cash to pursue their own private objects rather than to benefit outside stockholders, we further examine whether the amount of cash holdings leads to agency problems and declines firm value. We discover that insiders tend to hold more cash to benefit their friendly relations with stable stockholders at the expense of minor stockholders. We find that firms with tighter bank relations have better access to external funds and cash holdings are less important to them. Our results indicate that foreign stockholders ex ante select profitable firms to invest, and ex post monitor the firms in which they own stocks to reduce agency conflicts. The remainder of the contents is organized as follows. Section 2 provides our research design. Section 3 describes the data and preliminary research. Section 4 explores the impact of governance factors on cash holdings. Section 5 examines how governance factors affect the relation between cash holdings and firm value. Section 6 concludes this paper.

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Corporate Governance, Cash Holdings, and Firm Value • 615

2. Research Design


2.1. Corporate governance and cash holdings A large amount of literature has been developed to explain the potential conflicts between managers and outside stockholders. The conflicts can stem, for example, from managerial shirking and consumption of perquisites that benefit managers. Another potential agency problem is due to free cash flow the firm generates in excess of the amount required to fund all valuable investment projects (Jensen, 1986). It is claimed that managerial ownership can help align the interests of managers with those of outside stockholders at low levels of managerial ownership. At a certain level of managerial ownership, however, outside stockholders find it difficult to monitor the actions of managers, and management becomes entrenched. As their ownership rises, managers are more capable of shirking and consuming perquisites. Furthermore, at highest levels of managerial ownership, managers are owner-managers and will not be entrenched. Morck et al. (1988) document a non-monotonic relation between managerial ownership and firm value. We predict that the relation between cash holdings and insider ownership changes with increasing levels of insider ownership. At low levels of insider ownership, as their ownership increases, insiders align with outsider stockholders and will adopt efficient management. Thus, insiders will not aim to build up cash and would return excess cash to stockholders in the form of dividends. Since cash is the lowest return assets, we expect that insiders will maintain less cash in the firm as possible when their stakes rise. But with relatively high ownership, insiders are capable of entrenchment and have incentives to increase the amount of cash holdings under their control, because this enables them to spend it as they wish to. Further, at the very highest levels of insider ownership, a pure alignment effect of increased insider ownership appears, and insiders will tend to hold less cash. H1. As insider ownership increases, the level of cash holdings first declines, then increases, and finally falls. In Japan, banks hold both equity and debt stakes in the firms. The main bank is the center of the information flow, provides liquidity to the firms, and reduces costs associated with financial distress. Hence, under the main bank system, if firms can get external funds easily, they would be unlikely to hold cash for precautionary reasons. Firms with higher levels of financial institution ownership might have tighter bank relations and could borrow

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much more from the banks. Consequently, we would expect these firms to hold lower levels of cash.


H2. The level of cash holdings is negatively related to financial institution ownership. Japanese firms and their corporate stockholders maintain long-term continuous transaction relations, and equity ties are often reciprocated between them (the so-called “cross-stockholdings”). Since the web of crossstockholdings might decline operating risk greatly, firms with higher levels of corporate ownership might have higher business stability and hold less cash. H3. The level of cash holdings is negatively related to corporate ownership. Foreign stockholders are active investors in Japan, and equity returns are their primary objects to hold stakes. Since foreign stockholders may prefer the efficiency of assets heavily, but cash is the lowest return assets, they might limit insiders to build up cash holdings. Therefore, we predict that the level of cash holdings is negatively related to foreign ownership. H4. The level of cash holdings is negatively related to foreign ownership. 2.2. Cash holdings and firm value Myers and Majluf (1984) argue that financial slack can make a firm less likely to give up valuable investment opportunities, which implies that cash holdings might increase firm value. On the other hand, since cash is the lowest return assets, a firm might not be expected to hold too much cash by its outside stockholders. Jensen (1986) argues that outside stockholders may want the firm to distribute its cash because large amount of cash holdings might mainly serve the interests of managers and damage firm value. In this paper, we aim to control factors such as growth opportunities that are linked to the liquidity needs of a firm and examine the potentially negative influence of cash holdings on firm value. At low levels of insider ownership, if insiders align with outside stockholders as insider ownership rises, agency conflicts would decline and the negative influence of cash holdings on firm value would decrease. However, when insider ownership is higher than a certain level, insiders might build up cash for consumption of perquisites and/or making inefficient investment decisions as their stakes rise, which may enlarge the divergence of interests between insiders and outside stockholders. At very highest levels of insider ownership, the negative influence of cash holdings on firm value might fall with increasing levels of insider ownership because of the incentive alignment effect.

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H5. As insider ownership increases, the negative influence of cash holdings on firm value first declines, then rises, and finally falls. For firms with higher levels of financial institution ownership, other things being equal, they might borrow easily from banks with close relations. If firms could obtain external funds cheaply and easily, the existing cash holdings should be less important and might be wasted by insiders. Therefore, we expect to observe that the negative influence of cash holdings on firm value is greater for the firms with higher levels of financial institution ownership. H6. The negative influence of cash holdings on firm value is greater for firms with higher levels of financial institution ownership. As mentioned previously, firms with higher levels of corporate ownership might have lower operating risk and higher business stability. Therefore, these firms are not expected to hold higher levels of cash. It is well accepted that the payment of dividends can lessen the agency costs of holding too much cash. But firms with higher levels of corporate ownership are likely to face fewer requirements for dividends from corporate stockholders and might effectively pay fewer dividends, which may increase the discretionary power of insiders and lead to more severe agency problems. H7. The negative influence of cash holdings on firm value is greater for firms with higher levels of corporate ownership. The main objective of foreign shareholders is to earn as high a return as possible on their equity stakes. Hence, it is expected that firms with large stakes in the hands of foreign stockholders will have a strong incentive to manage their business as efficiently as possible and adopt profit-maximizing policies. In contrast, if a firm has lower levels of foreign ownership, its insiders might face less pressure to pay free cash flow to stockholders and be more likely to use the cash for their own benefits. Therefore, we expect that agency problems are more severe for firms with lower levels of foreign ownership. H8. The negative influence of cash holdings on firm value is greater for firms with lower levels of foreign ownership.

3. Data and Preliminary Research 3.1. Data and variables Our focus is on Japanese non-financial firms listed on the Tokyo Stock Exchange. All financial data come from the Nikkei Corporate Financial Database. Stock price data are taken from the Toyo Keizai Stock Price

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Data Bank. Firms without the data of outstanding stocks are excluded. Also excluded are firms with negative equity or non-positive sales. Consequently, we get a sample of 15,832 firm-year observations over the period of 1989–2002. In this paper, we measure cash holdings as the ratio of cash-on-hand and marketable securities to net assets. We define net assets as total assets minus cash-on-hand and marketable securities, averaged between the beginning and end of the year. The fundamentals we examined are a number of variables, previous studies on which, have shown to affect cash holdings. We use one-year growth rate of sales as a proxy for investment opportunity. We measure operating uncertainty as sales volatility. Sales volatility is the standard deviation of sales scaled by the averaged sales over the past five years. Both sales growth and sales volatility are expected to impact cash holdings positively. We measure cash flow as earnings before taxes plus depreciations, divided by net assets. A positive relation between cash flow and cash holdings is expected because cash flow might be a proxy for profitability and generate higher level of cash holdings. However, a negative influence between them may result from cash flow acting as a substitute of cash holdings. We use the R&D expense-to-net assets ratio as a measure of potential for financial distress costs, which would be positively related to cash holdings. Since small firms might benefit more from cash holdings because they are more likely to face borrowing constraints (Faulkender, 2002), we control for firm size using the natural logarithm of total assets. Total leverage equals to the sum of short-term debt and long-term debt divided by total assets. It is difficult to predict the relation between leverage and cash holdings, because it could be associated with either a build up of cash for payments to lenders or a result of the payments have been made. Capital spending and dividends are cash outflows and may decline cash holdings. But firms with more capital spending may have more investment opportunities and reserve more cash, and firms paying dividends might be profitable and could accumulate more cash. Since we have no access to fixed asset investment, we use the annual change in net fixed assets to which we add back depreciation charges to get a proxy for capital spending. Roughly 5% of the firm-years we examined have negative capital spending using this proxy. Dividend payments are the dividends paid on common stocks. We deflate capital spending and dividends by net assets. Finally, since firms may choose to insure themselves against losses by holding liquid assets besides cash holdings, we use net working capital to

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minus cash-on-hand and marketable securities, and then let it be divided by net assets, as a measure of liquidity asset substitutes.


3.2. Preliminary research: fundamentals and cash holdings Table 1 reports the descriptive statistics for cash holdings and fundamentals. Both the mean (0.224) and median (0.161) of cash holdings are greater than those in Opler et al. (1999). (The mean and median of cash holdings are 0.170 and 0.065 respectively in their Table 1.) This is consistent with the view that Japanese firms usually hold more cash and marketable securities than US firms (Guney et al., 2003; Kalcheva and Lins, 2004; Pinkowitz and Williamson, 1999, 2000 etc.). Table 2 reports the regression results of the impact of fundamentals on cash holdings. We report the result by using the pooled time-series regression with year dummy variables. As a comparison, we also report the result by the Fama–MacBeth (1973) model. The two ways produce similar Table 1.

Descriptive statistics for cash holdings and fundamentals in the sample.

This table shows the descriptive statistics for cash holdings and fundamentals in the sample. The sample includes 15,832 firm-year observations for Japanese firms listed on the Tokyo Stock Exchange (1989–2002). Cash is the sum of cash-on-hand and marketable securities. Net assets equals to total assets minus cash-on-hand and marketable securities, averaged between the beginning and end of the year. Cash flow is defined as earnings before taxes plus depreciation charges. Sales volatility is defined as the standard deviation of sales scaled by the average sales over the past five years. Capital spending equals to annual change in net fixed assets plus depreciation charges. R&D is research and development expenses, where firm-years do not report this data are considered to be with no R&D expenses. Total leverage is defined as the ratio of total debt to total assets. Dividends are dividends paid on common stocks. Size is defined as the natural logarithm of total assets. Sales growth is one-year growth rate of sales. Net working capital equals to current assets minus current liabilities, and then minus cash-on-hand and marketable securities. N is the number of non-missing observations in the sample for each variable. Variables

Mean

1st Quartile

Median

3rd Quartile

N

Cash/net assets Cash flow/net assets Sales volatility Capital spending/net assets R&D/net assets Total leverage Dividends/net assets Size Sales growth Net working capital/net assets

0.224 0.065 0.091 0.048 0.011 0.593 0.005 11.283 −0.019 −0.018

0.089 0.019 0.047 0.015 0 0.456 0.003 10.343 −0.069 −0.133

0.161 0.062 0.074 0.036 0.002 0.609 0.005 11.099 −0.022 −0.017

0.282 0.108 0.113 0.067 0.013 0.748 0.007 12.101 0.026 0.108

15832 15832 15832 15832 10201 15832 13241 15832 15832 15832

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620 • Qi Luo & Toyohiko Hachiya Table 2.

The impact of fundamentals on cash holdings.

This table shows regression results of the impact of fundamentals on cash holdings. All variables are as defined in Table 1. The dependent variable is cash/net assets. The fullpooled with year dummy regression is run with a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations.


Variables Cash flow/net assets Sales volatility Capital spending/net assets R&D/net assets Total leverage Dividends/net assets Size Sales growth Net working capital/net assets Adjusted R2 N

(1) Full-Pooled with Year Dummy 0.322 (16.074)*** 0.253 (10.388)*** −0.448 (−15.495)*** 0.312 (4.060)*** −0.418 (−36.074)*** 11.815 (31.013)*** 0.005 (4.233)*** 0.117 (7.201)*** −0.287 (−26.468)*** 0.308 15832

(2) Fama–MacBeth Model 0.335 0.272 −0.550 0.274 −0.434 11.667 0.006 0.136 −0.285 0.305 14

(5.740)*** (5.734)*** (−5.700)*** (3.387)*** (−14.877)*** (14.278)*** (3.262)*** (2.582)** (−9.113)***

*, **, ***: Significant at the 10%, 5% and 1% levels, respectively.

results for all fundamentals and have similar adjusted R2 (0.308 versus 0.305). As expected, investment opportunity (measured as sales growth), operating uncertainty (measured as sales volatility) and financial distress costs (measured as R&D expenses) impact cash holdings positively. Our estimation shows that cash holdings are influenced by cash flow positively and by leverage negatively, which is consistent with the evidence in Opler et al. (1999). But our results of the impact of capital spending and dividends on cash holdings are contradictory with those in Opler et al. (1999). We use the annual change in net fixed assets plus depreciation charges as a proxy for capital spending, which is different with Opler et al. (1999) but similar with Pinkowitz and Williamson (1999). Pinkowitz and Williamson (1999) also find that capital spending declines cash holdings and exhibits as a proxy for cash outflow. Opler et al. (1999) and others (Ferreira and Vilela, 2004; Kalcheva and Lins, 2004; Kusnadi, 2003 etc.) use a dividend dummy variable to proxy for dividend policy of firms. Our proxy is dividend deflated by net assets. But, we still get a positive influence of dividends on cash holdings as we use a dividend dummy variable (not reported). The positive relation between dividends and cash holdings might imply that firms paying dividends are profitable.

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We also run the regressions with inclusion of industry dummy variables. The results (not reported) are similar to those in Table 2.


4. Governance Determinants on Cash Holdings The governance factors we examined are the ownerships of insiders, financial institutions, corporate stockholders and foreign stockholders, respectively. Insider ownership, INS, is total ratio of insider stockholdings. Since we have data on the number of financial institution stockholders (and corporate stockholders and foreign stockholders), we measure financial institution ownership as two ways: one is total ratio of financial institution stockholdings, FIS; another is average ratio of financial institution stockholdings, AFIS. AFIS is defined as FIS divided by the number of financial institution stockholders. Similarly, corporate ownership is measured as total and average ratios of corporate stockholdings, CS and ACS, and foreign ownership is measured as total and average ratios of foreign stockholdings, FORS and AFORS. Table 3 shows descriptive statistics for ownership variables and their correlations including cash holdings. Insider ownership, INS, has a mean of Table 3.

Descriptive statistics and correlations for ownership structure.

This table shows descriptive statistics for ownership structure variables and their correlations including cash holdings. INS is the insider ownership, which is the fraction of stockholdings by insiders. FIS is total ratio of financial institution stockholdings, which is the fraction of stockholdings by financial institution stockholders. CS is total ratio of corporate stockholdings, which is the fraction of stockholdings by corporate stockholders. FORIS is total ratio of foreign stockholdings, which is the fraction of stockholdings by foreign stockholders. AFIS is average ratio of financial institution stockholdings, which equals to the total ratio of financial institution stockholdings divided by the number of financial institution stockholders. ACS is average ratio of corporate stockholdings, which equals to the total ratio of corporate stockholdings divided by the number of corporate stockholders. AFORIS is average ratio of foreign stockholdings, which equals to the total ratio of foreign stockholdings divided by the number of foreign stockholders. The correlation results are Pearson coefficients. Panel A: Total ratio of stockholdings Correlations

Descriptive Statistics Variable Mean Median Std Dev

Cash/Net Assets

INS FIS CS FORIS

0.164*** 1 0.039*** −0.208*** 1 −0.036*** −0.187*** −0.661*** 1 0.111*** −0.022*** 0.200*** −0.333***

0.028 0.333 0.295 0.054

0.005 0.329 0.261 0.025

0.059 0.153 0.174 0.075

INS

FIS

CS

FORIS

1

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(Continued )

Panel B: Average ratio of stockholdings Correlations


Descriptive Statistics Variable Mean Median Std Dev

Cash/Net Assets

AFIS 0.008 ACS 0.002 AFORIS 0.001

−0.003 0.106*** −0.039*** −0.015 0.035*** 0.062***

0.006 0.001 0.001

0.005 0.003 0.003

INS

AFIS 1 0.245*** 0.122***

ACS 1 0.095***

AFORIS

1


0.028 and a median of 0.005, which is fairly low and skew. We notice that financial institutions and corporate stockholders are major stockholders for Japanese firms; the means of FIS and CS are 0.333 and 0.295, respectively. Moreover, FIS and CS are highly correlated and the coefficient is negative (−0.661). The next set of regressions examines the relation between ownership variables and cash holdings. We control for fundamentals examined previously and include annual dummy variables to incorporate any macroeconomic effects that may impact the results. The pattern of the estimated coefficients on fundamentals is almost the same as in Table 2 in all regressions. For simplicity, the estimated coefficients on control variables are not reported.

4.1. Insider ownership and cash holdings Panel A of Table 4 shows the regression results of the impact of insider ownership on cash holdings. Column 1 shows the linear regression results. The estimated coefficient on INS is positive (0.191) and significant at 1% level (t-value is 6.635). In order to examine whether there exists any nonlinear relation between insider ownership and cash holdings, we re-run the regressions by including the squared and cubic terms of insider ownership, INS2 and INS3 , as additional explanatory variables. In column 2, the estimated coefficient on INS2 is positively significant, while the estimated coefficient on INS is insignificant. In column 3, the estimated coefficients on INS and INS3 are positive, the coefficient estimate on INS2 is negative, and all are significant at 1% level. These results suggest that insider ownership increases cash holdings at whole levels of insider ownership.

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Table 4.

The impact of insider/stable ownership on cash holdings.

This table shows the regression results of the impact of insider/stable ownership on cash holdings. INS is as defined in Table 3. INS 0% to 16.3% is insider ownership if insider ownership is less than 16.3%, and 16.3% if insider ownership is greater than 16.3%. INS over 16.3% is 0 if insider ownership is less than 16.3%, and insider ownership minus 16.3% if insider ownership is greater than 16.3%. STBL is stable ownership, which is the fraction of stockholdings by insiders, financial institutions and corporate stockholders. STBL 0% to 70.7% is stable ownership if stable ownership is less than 70.7%, and 70.7% if stable ownership is greater than 70.7%. STBL over 70.7% is 0 if stable ownership is less than 70.7%, and stable ownership minus 70.7% if stable ownership is greater than 70.7%. The dependent variable is cash/net assets. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations. Variables

(1)

(2)

(3)

(4)

Panel A: The impact of insider ownership on cash holdings INS INS2 INS3 INS 0% to 16.3% INS over 16.3% Adjusted R2 N

0.191 (6.635)***

0.310 15832

0.009 (0.151) 0.635 (3.386)***

0.391 (3.862)*** −2.386 (−3.582)*** 4.879 (4.727)***

0.311 15832

0.313 15832

0.091 (1.983)* 0.380 (5.248)*** 0.310 15832

Panel B: The impact of stable ownership on cash holdings STBL 0.045 (3.179)*** 0.345 (3.914)*** 0.355 (1.234) −0.244 (−3.445)*** −0.262 (−0.508) STBL2 0.011 (0.036) STBL3 STBL 0% to 70.7% STBL over 70.7% 0.309 0.309 0.309 Adjusted R2 N 15832 15832 15832

0.086 (4.386)*** −0.007 (−1.757)* 0.309 15832


We get a turning point, INS = 16.3%, by the result in column 3 and run piecewise linear regression. In column 4, the piecewise linear regression result confirms that insider ownership increases cash holdings at whole levels of insider ownership. There is no evidence supporting the idea that insider ownership decreases cash holdings at low levels or the very highest levels of insider ownership. Our hypothesis 1 has only been supported partially. The Japanese governance system explains our results. Financial institutions and corporate stockholders are stable stockholders in Japan. They have other relations, such as lending and having commercial trade ties with firms in which they own stocks. It is commonly argued that stable stockholders own their stocks primarily to cement and grow stable business relations rather than to earn returns on their stakes. Since cash holdings may contribute to their stable and friendly relations, stable stockholders might

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have a greater preference for cash holdings and make insiders hold more cash. Since stable stockholders act as semi-insiders in Japan, their ownership might serve as an alternative proxy for insider ownership. As a complementary test, we examine the relation between cash holdings and stable ownership. Stable ownership, STBL, is the fraction of stockholdings by insiders, financial institutions and corporate stockholders. The results of the impact of stable ownership on cash holdings are reported in Panel B of Table 4. In column 1, the stable ownership is positively related to cash holdings in the linear regression, which is similar to that in Panel A. In column 2, the estimated coefficient on STBL is positive but the estimated coefficient on STBL2 is negative, which suggests the relation between stable ownership and cash holdings turns from positive to negative as stable ownership is over a turning point. We calculate the turning point, STBL = 70.7%, by the result in column 2 and run piecewise linear regression. The piecewise linear regression result in column 4 indicates that, the relation between stable ownership and cash holdings is positive as stable ownership is below 70.7%, and then negative as stable ownership is above 70.7%. Since Japanese firms usually maintain their target levels of stable ownership in the 40–70% range, and the turning point is rightly around the level of 70%, we infer that insiders move from entrenchment to alignment as stable ownership increases. More specifically, under 70% stable ownership, as stable ownership rises, insiders tend to hold more cash to benefit their friendly relations with stable stockholders at the expense of minor stockholders. When insiders and stable stockholders own more than 70% stakes and their ownership further increases, stable stockholders push insiders to adopt efficient management and then cash holdings decline. 4.2. Financial institution ownership and cash holdings Table 5 reports the regression results of the impact of financial institution ownership on cash holdings. In column 1, total ratio of financial institution stockholdings, FIS, is used as an explanatory variable, and we observe its negative effect on cash holdings, which is marginally significant at 10% level. This result is consistent with our expectation that firms with tighter bank relations can borrow easily and maintain lower levels of cash holdings. Since average ratio of financial institution stockholdings, AFIS, is likely to reflect the relation between a firm and its main banks, we hope for a more profound negative relation between AFIS and cash holdings. However,

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Corporate Governance, Cash Holdings, and Firm Value • 625 Table 5.

The impact of financial institution ownership on cash holdings.

This table shows the regression results of the impact of financial institution ownership on cash holdings. FIS and AFIS are as defined in Table 3. Bank debt is the sum of short-term bank debt and long-term bank debt, and total debt is the sum of short-term debt and long-term debt. The dependent variable is cash/net assets. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations.


Variables FIS AFIS Bank debt/total debt Adjusted R2 N

(1)

(2)

(3)

−0.024 (−1.777)* 0.671 (1.661)* 0.308 15832

0.308 15832

−0.197 (−19.25)*** 0.324 15832


column 2 shows a positive relation between them. We interpret that this result is associated with the monopoly power of main banks in Japan, which is argued by Pinkowitz and Williamson (1999). On one hand, a main bank may persuade a client firm to over-borrow and hoard cash by its influence on the firm. On the other hand, since the firm’s cash holdings are deposited at the bank, the bank can lend funds to the general market again. This situation can only occur if the bank have monopoly power and, thus, can induce such behavior in the firm. Since firms with tighter bank relations might borrow much more from banks, we use bank-debt ratio as a proxy for bank relations of firms and examine its effect on cash holdings. Column 3 reports a strong negative relation between bank-debt ratio and cash holdings, which is expected if firms were using bank borrowing as a substitute of cash. 4.3. Corporate/foreign ownership and cash holdings In Table 6, columns 1 and 2 report the regression results of the impact of corporate ownership on cash holdings. Both total and average ratios of corporate stockholdings, CS and ACS, have no significant impact on cash holdings. This suggests that corporate stockholders act as “silent partners” and do not influence the cash holding decision of insiders, which is consistent with the idea that corporate stockholders are stable stockholders. The regression results of the impact of foreign ownership on cash holdings are reported in columns 3 and 4 of Table 6. Contradictory to our hypothesis 4, we observe a positive relation between foreign ownership (measured as

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The impact of corporate/foreign ownership on cash holdings.

This table shows the regression results of the impact of corporate/foreign ownership on cash holdings. CS, ACS, FORIS and AFORIS are as defined in Table 3. The dependent variable is cash/net assets. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations.


Variables CS ACS FORIS AFORIS Adjusted R2 N

(1)

(2)

(3)

(4)

0.013 (1.289) 0.568 (0.970) 0.048 (1.923)* 0.308 15832

0.308 15832

0.308 15832

1.603 (2.491)** 0.309 15832


either total or average ratio of foreign stockholdings, FORS or AFORS) and cash holdings. One plausible explanation for this result lies in the ex ante selection of foreign stockholders. Foreign stockholders might prefer to select profitable firms to invest, and these firms perform well and accumulate more cash. 5. The Impact of Cash Holdings on Firm Value This section tests our hypotheses on the implication of cash holdings to firm value. Our proxy for firm value is Tobin’s Q. It equals to the market value of total assets divided by the book value of total assets. Market value of total assets equals to the market value of equity plus the book value of interestbearing liabilities. Book value of total assets equals to the book value of equity plus the book value of interest-bearing liabilities. Table 7 shows that both the mean and median of Tobin’s Q are greater in the 4th quartile of cash holdings than in the 1st quartile of cash holdings, and the correlations between Tobin’s Q and cash holdings are positive in each quartile of cash holdings and the full sample. The univariate analysis suggests that the amount of cash holdings is value enhancing for Japanese firms. In Table 8, we report the estimations of the impact of cash holdings on firm value by the full-pooled regression with year dummy variables and by the Fama–MacBeth (1973) model. Since our purpose is to examine the potential agency conflicts resulting from cash holdings, we control for fundamentals that are linked to the liquidity needs of firms in the regressions.

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Corporate Governance, Cash Holdings, and Firm Value • 627 Table 7.

Univariate analysis for the relation between cash holdings and firm value.

This table shows the univariate analysis results for the relation between cash holdings and firm value. Tobin’s Q equals to the market value of total assets divided by the book value of total assets. Market value of total assets equals to the market value of equity plus the book value of interest-bearing liabilities. Book value of total assets equals to the book value of equity plus the book value of interest-bearing liabilities. The p-value is generated from a difference test for the means (t-test) or medians (z-test) of Tobin’s Q corresponding to the 1st and 4th quartiles of cash holdings. The correlation results are Pearson coefficients.


Cash/Net Assets Firm Value Tobin’s Q Mean Median Correlation

1st Quartile 2nd Quartile 3rd Quartile 4th Quartile Full Sample p-Value 1.309 1.138 0.053***

1.494 1.268 0.023*

1.635 1.357 0.031**

1 .779 1.489 0.017*

1.554 1.293 0.122***

0.000*** 0.000*** —


Table 8.

The impact of cash holdings on firm value.

This table shows the regression results of the impact of cash holdings on firm value. The dependent variable is Tobin’s Q defined in Table 7. Cash holdings and fundamentals are as defined in Table 1. The full-pooled with year dummy regression is run with a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations. Variables

(1) Full-Pooled with Year Dummy

(2) Fama–MacBeth Model

Cash/net assets Cash flow/net assets Sales volatility Capital spending/net assets R&D/net assets Total leverage Dividends/net assets Size Sales growth Net working capital/net assets Adjusted R2 N

−0.421 (−12.832)*** 1.469 (17.668)*** 0.516 (5.124)*** −0.519 (−4.286)*** 4.652 (14.675)*** 0.061 (1.223) 38.769 (23.979)*** −0.015 (−2.931)*** 0.534 (7.993)*** −0.313 (−6.855)*** 0.351 15832

−0.424 1.583 0.473 −0.675 4.308 0.049 38.213 −0.028 0.608 −0.329 0.152 14

(−4.029)*** (6.674)*** (1.938)* (−2.181)** (6.760)*** (0.559) (15.578)*** (−0.861) (6.485)*** (−4.614)***


By controlling a variety of factors, we observe a negative relation between cash holdings and firm value, which suggests that cash holdings lead to agency problems and decline firm value. Cash flow and dividends, which are highly related to operating performance, impact the firm value positively.

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The effects of R&D and size have the same sign as in Morck (1988). Sales growth is positively related to the firm value, which is true since investment opportunity set is a part of the firm value. It’s interesting that capital spending declines firm value, which may suggest that the investment decisions of firms are inefficient. Next, we examine whether governance characteristics affect the relation between cash holdings and firm value. To do this, we segment full samples by various governance characteristics and use a series of interactive dummy variables in our regressions, which take the form of:

F Vi,t = α +

J

γj (Dj × Cashi,t) +

j

+

T

δt (Y earDt ) + εi,t

k

βk (F undamentalsi,t )k

k=1

(1)

t=1

where the Fundamentals i,t variables are fundamentals defined above (K = 9), YearD t are year dummy variables for 1989–2001 (T = 13), and i and t are indexes for firm and year respectively. The cash variable is interacted with dummy variables indicated by the Dj s. Dj s serve to segment samples by a particular governance characteristic. In most cases, we segment samples into quartiles and J = 4. While for insider ownership and stable ownership, in order to obtain interpretable results, we segment the samples into deciles and thus J = 10. Additionally, since the levels of insider ownership are very skew, we segment samples by certain levels of insider ownership (J = 7). We also segment samples by certain levels of stable ownership (J = 5), because we attempt to detect how target levels of stable ownership affect the relation between cash holdings and firm value. A more detailed introduction for the grouped levels of insider ownership and stable ownership is in the notes to Table 9. In Eq. (1), we not only restrict the estimation to a single intercept, but also require that the coefficients on all control variables are the same. We do this way because our interest is the estimated coefficients on cash holding variables interacted. We can certainly examine separate regressions for various sub-samples. However, if we run the estimation on only a subset of the data, we are discarding the full information of our database. In the following, for ease of presentation, we only report the estimated coefficients on the interaction terms.

The impact of cash holdings on firm value with increasing levels of insider/stable ownership.

Stake at the Deciles 0.082% 0.139% 0.205% 0.305% 0.471% 0.831% 1.734% 3.706% 8.309% 73.892%

Grouping Dummies

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

0–1% 1–5% 5–10% 10–15% 15–20% 20–25% > 25% — — —

Range

N 9932 3291 1315 564 296 194 240 — — —

Levels of Stakes

Insider Ownership

50.146% 56.635% 60.532% 63.675% 66.659% 69.583% 72.527% 75.809% 80.078% 100%

Stake at the Deciles

40%< 40–50% 50–60% 60–70% >70% — — — — —

Range

469 1077 2930 5237 6119 — — — — —

N

Levels of Stakes

Stable Ownership

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Panel A: Grouped levels of insider/stable ownership

This table shows the impact of cash holdings on firm value with increasing levels of insider/stable ownership. Dj (j = 1, 2, 3, . . . , 10) equals to 1 for an observation at the j decile of insider or stable ownership, and 0 otherwise. Dj (j = 1, 2, 3, . . . , 7) equals to 1 for an observation if the insider ownership is in the range of below 1% (j = 1), 1–5% (j = 2), 5–10% (j = 3), 10–15% (j = 4), 15–20% (j = 5), 20–25% (j = 6), or above 25% (j = 7), and 0 otherwise. Dj (j = 1, 2, 3, . . ., 5) equals to 1 for an observation if the stable ownership is in the range of below 40% (j = 1), 40–50% (j = 2), 50–60% (j = 3), 60–70% (j = 4), or above 70% (j = 5), and 0 otherwise. In Panel B, the dependent variable is Tobin’s Q defined in Table 7. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations.

Table 9.


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0.376 (3.886)*** −0.105 (−0.173) −0.188 (−2.096)** −0.682 (−8.403)*** −0.736 (−9.043)*** −0.545 (−6.586)*** −0.400 (−7.341)*** −0.618 (−9.444)*** −0.454 (−8.331)*** −0.369 (−7.052)*** 0.356 15832

(1)

(2) −0.389 (−9.083)*** −0.528 (−11.085)*** −0.462 (−8.207)*** −0.085 (−1.049) −0.314 (−2.307)** −0.463 (−3.635)*** −0.625 (−6.608)*** — — — 0.352 15832


(D1) × (Cash/net assets) (D2) × (Cash/net assets) (D3) × (Cash/net assets) (D4) × (Cash/net assets) (D5) × (Cash/net assets) (D6) × (Cash/net assets) (D7) × (Cash/net assets) (D8) × (Cash/net assets) (D9) × (Cash/net assets) (D10) × (Cash/net assets) Adjusted R2 N

Variables

(Continued)

−0.509 (−6.540)*** −0.330 (−4.238)*** −0.602 (−7.586)*** −0.593 (−7.789)*** −0.529 (−6.842)*** −0.552 (−8.618)*** −0.684 (−10.586)*** −0.575 (−9.288)*** −0.491 (−7.741)*** 0.116 (2.028)** 0.357 15832

(3)

−0.740 (−6.340)*** −0.306 (−3.064)*** −0.397 (−6.475)*** −0.545 (−11.929)*** −0.353 (−9.357)*** — — — — — 0.352 15832

(4)

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Panel B: Regression results

Table 9.




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5.1. Insider/stable ownership, cash holdings and firm value Panel A of Table 9 describes the grouped levels of insider ownership and stable ownership. We find that inter decile range of insider ownership rises from 0.08% to 65.59% with increasing levels of insider ownership, and most observations (9,932 of 15,832) are in the 0–1% insider ownership range. We also find that the levels of stable ownership are fairly high, and there are only 469 of 15,832 observations in the range of less than 40% stable ownership. In Panel B of Table 9, column 1 reports the estimation result as we segment samples into deciles by insider ownership. We find that the estimated coefficients on cash holdings are negative, except when insider ownership is at the 1st decile. The negative influence of cash holdings on firm value increases from the 1st decile to the 5th decile of insider ownership. However, the trend of the negative influence of cash holdings on firm value is not clear when insider ownership rises from the 6th decile to the 10th decile. Column 2 of Panel B reports the regression result as we segment samples by certain levels of insider ownership. We find that the negative influence of cash holdings on firm value first has no clear trend as insider ownership increases. From the 10–15% insider ownership range, the negative influence of cash holdings on firm value rises with increasing levels of insider ownership. In Sec. 4, we present that insider ownership increases cash holdings at whole levels of insider ownership. Consistently, we might expect that the negative influence of cash holdings on firm value increase as insider ownership rises. However, this hypothesis is only held for a part of our observations. One possible reason for this might be the behavior of insiders to benefit stable stockholders. In Panel B of Table 9, column 3 reports the estimation result as we segment samples into deciles by stable ownership. As stable ownership rises from the 1st decile to the 7th decile, the negative influence of cash holdings on firm value has no clear trend. We find that, as stable ownership rises from the 7th decile to the 9th decile, the negative influence of cash holdings on firm value falls, and it turns into positive at the 10th decile of stable ownership. This confirms our prior inference that insiders move to alignment as stable ownership is over a turning point (STBL = 70.7%, which is rightly at the 7th decile of stable ownership). Column 4 of Panel B reports the regression result as we segment samples by certain levels of stable ownership. The estimated negative coefficient on cash holdings is the largest (0.740) when stable ownership is below 40%,

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which is difficult to be assessed because the distribution of observations in this range is very skew. In the 40–70% stable ownership range, we find that the negative influence of cash holdings on firm value rises as stable ownership increases. This is consistent with our prior inference that, when the level of stable ownership is below 70%, insiders hold more cash to benefit their friendly relations with stable stockholders as stable ownership rises. The negative influence of cash holdings on firm value declines as stable ownership further increases above the 70% level, which is also what we would expect because stable stockholders would exhibit alignment incentives and push insiders to adopt efficient management as their ownership reaches very highest levels. 5.2. Financial institution ownership, cash holdings and firm value In Table 10, we segment samples by total and average ratios of financial institution stockholdings and bank debt ratio respectively, and expect the negative influence of cash holdings on firm value is greater for firms with higher levels of total or average ratio of financial institution stockholdings, or higher levels of bank debt ratio. The results of our estimation are shown in columns 1–3, respectively. As expected, the negative influence of cash holdings on firm value is greater for firms with tighter bank relations in all three specifications. This is consistent with the idea that financial institutions are stable stockholders and do not monitor the firms in which they own stocks. Otherwise, agency conflicts should be reduced for firms with higher bank relations under the monitoring, and the negative influence of cash holdings on firm value should be less for these firms. We should stress on the result in column 2. In Sec. 4, our interpretation for the positive relation between average ratio of financial institution stockholdings and cash holdings is associated with the over-borrowing of firms under the monopoly power of main banks, which would damage firm value heavily. Here, we find that the estimated coefficient on cash holdings is positive for firms at the 1st quartile of average ratio of financial institution stockholdings, suggesting that cash holdings are very important for firms with fewer bank relations. As average ratio of financial institution stockholdings rises from the 2nd to the 4th quartile, we find that cash holdings decline firm value monotonically with the increasing bank power. This result firmly supports our hypothesis.

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Corporate Governance, Cash Holdings, and Firm Value • 633 Table 10. The impact of cash holdings on firm value with increasing levels of financial institution ownership.


This table shows the regression results of the impact of cash holdings on firm value with increasing levels of financial institution ownership. Dj (j = 1, 2, 3, 4) equals to 1 for an observation at the j quartile of total or average ratio of financial institution stockholdings, or bank debt/total debt, and 0 otherwise. The dependent variable is Tobin’s Q defined in Table 7. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations. Variables (D1) × (Cash/net assets) (D2) × (Cash/net assets) (D3) × (Cash/net assets) (D4) × (Cash/net assets) Adjusted R2 N

(1)

(2)

(3)

−0.243 (−5.292)***

0.128 (2.373)**

−0.300 (−8.388)***

−0.433 (−9.239)***

−0.395 (−8.186)***

−0.532 (−9.418)***

−0.496 (−9.147)***

−0.562 (−12.985)***

−0.968 (−14.468)***

−0.588 (−12.109)*** −0.627 (−12.490)*** 0.352 15832

0.358 15832

−0.672 (−9.516)*** 0.355 15832


5.3. Corporate ownership, cash holdings and firm value In columns 1 and 2 of Table 11, we segment samples by total and average ratios of corporate stockholdings, respectively. We find that the negative influence of cash holdings on firm value is greater for firms with lower levels of corporate ownership, which is inconsistent with our hypothesis 7. We suspect this result might be confused by the influence of financial institution ownership. In order to maintain their target levels of stable ownership, firms should decrease their financial institution ownership as their corporate ownership rises, or vice versa. Since the negative influence of cash holdings on firm value is greater for firms with higher levels of financial institution ownership, on the opposite, the negative influence of cash holdings should be greater for firms with lower levels of corporate ownership. We suggest there exists no mechanism that corporate ownership affects the relation between cash holdings and firm value, because we find no significant impact of corporate ownership on cash holdings in Sec. 4. 5.4. Foreign ownership, cash holdings and firm value In column 3 of Table 11, we segment samples by total ratio of foreign stockholdings. We find that the estimated coefficients on cash holdings are

assets) assets) assets) assets)

−0.375 (−8.261)*** −1.302 (−8.480)*** −0.485 (−9.549)*** 0.038 (0.822) 0.351 15832

(1)

(2) −0.594 (−10.671)*** −0.518 (−11.467)*** −0.496 (−10.167)*** −0.174 (−3.658)*** 0.353 15832


(D1) × (Cash/net (D2) × (Cash/net (D3) × (Cash/net (D4) × (Cash/net Adjusted R2 N

Variables

−0.656 (−9.171)*** −0.815 (−15.820)*** −0.596 (−13.418)*** −0.047 (−1.121) 0.360 15832

(3)

−0.528 (−8.692)*** −0.516 (−8.624)*** −0.422 (−8.402)*** −0.382 (−10.175)*** 0.351 15832

(4)

This table shows the regression results of the impact of cash holdings on firm value with increasing levels of corporate/foreign ownership. Dj (j = 1, 2, 3, 4) equals to 1 for an observation at the j quartile of total or average ratio of corporate stockholdings, or foreign stockholdings, and 0 otherwise. The dependent variable is Tobin’s Q defined in Table 7. The regressions are run with fundamentals defined in Table 1 and a year dummy variable for each year from 1989–2001 (not reported). Estimated t-statistics appear in parentheses after the coefficient estimates. N is the number of observations.

The impact of cash holdings on firm value with increasing levels of corporate/foreign ownership.

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Table 11.




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significantly negative as total ratio of foreign stockholdings is at the 1st, 2nd and 3rd quartiles. As total ratio of foreign stockholdings is at the 4th quartile, the impact of cash holdings on firm value is insignificant, reflecting there exist few agency conflicts as foreign stockholders own large stakes of firms. In column 4, we use average ratio of foreign stockholdings to segment samples and report the regression result. We find that the estimated negative coefficient on cash holdings is the largest (0.528) at the 1st quartile of average ratio of foreign stockholdings. This is consistent with our expectation that agency conflicts are severe in the absence of active monitoring. As average ratio of foreign stockholdings rises from the 1st quartile to the 4th quartile, the negative influence of cash holdings on firm value falls monotonically, suggesting agency conflicts decline with the increased monitoring power of foreign stockholders. 6. Conclusions We examine the role of corporate governance factors on cash holdings and the impact of cash holdings on firm value for Japanese firms listed on the Tokyo Stock Exchange. We find that insiders tend to hold more cash to contribute their friendly relations with stable stockholders. Firms with higher levels of financial institution ownership hold less cash, but some of them are over-borrowing under the monopoly power of main banks. Our results suggest that foreign stockholders select profitable firms to invest, and these firms perform well and maintain higher levels of cash holdings. We document evidence that cash holdings lead to agency problems and impact the firm value negatively. We find that insiders collude with stable stockholders and hold excess cash to consume the interests of minor stockholders. We discover that cash holdings cause more severe agency conflicts for the firms who have closer bank relations. The negative influence of cash holdings on firm value declines as foreign ownership rises, which results from the active monitoring of foreign stockholders on the firms in which they own stocks. In this study, the governance factors we examined are mainly the ownership structure of firms. The ownership variables might be relevant with each other (for example, financial institution ownership and corporate ownership are highly correlated in our database). To deal with this problem, we test the impact of ownership variables on cash holdings separately. In future research, it is better to get more comprehensive data and explore the role of governance factors on corporate cash holdings more sharply.

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References Fama, EF and JD MacBeth (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81, 607–636. Faulkender, M (2002). Cash holdings among small businesses. http://papers.ssrn. com. [2 April 2002]. Ferreira, MA and A Vilela (2004). Why do firms hold cash? Evidence from EMU countries. http://papers.ssrn.com/ [20 June 2004]. Guney, Y, A Ozkan and N Ozkan (2003). Additional international evidence on corporate cash holdings. http://papers.ssrn.com/ [21 June 2003]. Jensen, MC (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323–329. Kalcheva, I and KV Lins (2004). International evidence on cash holdings and expected managerial agency problems. http://papers.ssrn.com/ [20 January 2004]. Kusnadi, Y (2003). Corporate cash holdings and corporate governance mechanisms. http://papers.ssrn.com/ [23 December 2003]. Morck, R, A Shleifer and RW Vishny (1988). Management ownership and market valuation: An empirical analysis. Journal of Financial Economics, 20, 293–315. Myers, SC and NS Majluf (1984). Corporate financing and investment decisions when firms have investment information that investors do not. Journal of Financial Economics, 13, 187–221. Opler, T, L Pinkowitz, R Stulz and R Williamson (1999). The determinants and implications of corporate cash holdings. Journal of Financial Economics, 52, 3–46. Ozkan, A and Ozkan O (2002). Corporate cash holdings: An empirical investigation of UK companies. http://papers.ssrn.com/ [13 March 2002]. Pinkowitz, L (2000). The market for corporate control and corporate cash holdings. Working Paper, http://papers.ssrn.com/ [23 May 2000]. Pinkowitz, L and R Williamson (1999). Bank Power and Cash Holdings: Evidence from Japan. http://papers.ssrn.com/ [24 January 1999].

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