The Determinants of Corporate Cash Management Policies – Evidence from Around the World

YUANTO KUSNADI City University of Hong Kong

K.C. JOHN WEIHong Kong University of Science and Technology

NTU INTERNATIONAL CONFERENCE ON FINANCETAIPEI

12 Dec 2008

2

Introduction

Increasing attention on the stream of research on corporate cash management policy.

Costs and benefits of holding cash – Keynes (1936), Jensen and Meckling (1976), Myers (1984), Myers and Majluf (1984), and Jensen (1986).

Early studies on determinants of the level of corporate cash reserves: Kim et al. (1998) & Opler et al. (1999).

Corporate governance as an important determinant of cash holdings – Dittmar et at (2003), Dittmar and Mahrt-Smith (2006), Harford et al. (2007), Pinkowitz et al. (2006), and Kalcheva and Lins (2007).

Mixed conclusions!

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Introduction Almeida et al. (2004):

Examining the changes in cash holdings is perhaps a more viable option from theoretical perspectives.

Imperfections in capital markets wedge between internal and external costs of financings.

Constrained firms: higher costs of external financings. Financial flexibility can be achieved by altering

current financial policy to meet future investment needs.

Corporate demand for liquidity can be empirically tested by measuring the marginal propensity to save cash out of current cash flows (the cash-cash flow sensitivity).

4

Introduction

Almeida et al. (2004) (cont’d):

Predict that the cash-CF sensitivity ( ) should be positive and significant only for financially constrained firms.

Better capture the role of financial constraints than the investment-CF sensitivity.

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Introduction

Objectives and Contributions: Examine the role of country-level legal protection

and firm-level financial constraints on international firms’ cash management policy.

First study that documents systematic evidences on the impact of above mentioned factors on both the CF and cash-stock price sensitivities ( ).

Closest paper: Khurana et al. (2006) Role of financial development on cash-cash flow

sensitivity Legal protection should provide the FIRST-ORDER

effect!

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Summary of Results Legal protection of investors is inversely (positively)

related to the cash-cash flow (cash-stock price) sensitivity.

In other words, firms in countries with strong legal protection exhibit lower cash-cash flow and higher cash-stock price sensitivities than firms in countries with weak legal protection.

Financially constrained firms are more likely to experience an increase in both their cash-cash flow and cash-stock price sensitivities than unconstrained firms.

Therefore, our findings emphasize the role of both legal protection and financial constraints on international firms’ cash management policy.

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The role of legal protection: Rights prescribed by regulations and laws + effectiveness of

enforcement. LLSV (1997, 1998, 2002): effect of legal protection LLS (2006): effect of securities laws. Cost of external finance provides an indication of the extent of

shareholder protection afforded by the legal institutions. Chen et al. (2005) and Hail and Leuz (2006): association

with cost of capital. Strong legal protection helps to reduce the constraints faced

by firms in gaining access to the external capital markets firms in these countries should face relatively low costs of external financings and have less incentive to increase their cash holdings to fund future investments!

H1: Predict a negative relationship between legal protection and the cash-cash flow sensitivity.

Hypothesis Development

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The role of legal protection (cont’d): Morck et al. (2000) ; Gelb and Zarowin (2002); Fox

et al. (2003): greater disclosures improves the informativeness conveyed by stock prices and efficiency of capital allocation.

Kusnadi, Titman, and Wei (2008): legal protection is positively associated with the investment-stock price sensitivity.

Strong legal protection: stock prices will be more reflective of the fundamental and potential growth options available to the firms managers have to increase their cash holdings, expecting that they will take on more +ve NPV projects.

H2: Predict a positive relationship between legal protection and the cash-stock price sensitivity.

Hypothesis Development

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The role of financial constraint: Almeida et al. (2004) predict different liquidity policy

for financially constrained vis-à-vis unconstrained firms.

Cash-cash flow sensitivity should be positive and significant only for the constrained firms.

Possible that the effect of firm-level measures of FC (firm size and KZ scores) remains relevant!

Similar prediction as Almeida et al. (2004) and Khurana et al. (2006)

H3: Predict a positive relationship between financial constraint and the cash-cash flow sensitivity.

Hypothesis Development

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The role of financial constraint (cont’d): Baker et al. (2003), Chen et al. (2007), and

Kusnadi, Titman, and Wei (2008): the presence of financial constraint will further increase the investment-stock price sensitivity.

Financially constrained firms also face difficulties in accessing the external markets need to depend on internal CF

More likely for constrained firms to increase their cash holdings to safeguard against having to make unexpected investments in the future.

H4: Predict a positive relationship between financial constraint and the cash-stock price sensitivity.

Hypothesis Development

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Main Hypotheses Hypothesis 1: Firms in countries with strong legal protection

have cash holdings that are less sensitive to changes in their cash flows than do firms in countries with weak legal protection.

Hypothesis 2: Firms in countries with strong legal protection of investors have cash holdings that are more sensitive to changes in their stock prices than do firms in countries with weak legal protection of investors.

Hypothesis 3: Financially-constrained firms have cash holdings that are more sensitive to changes in their cash flows than do unconstrained firms.

Hypothesis 4: Financially-constrained firms have cash holdings that are more sensitive to changes in their stock prices than do unconstrained firms.

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Data Sample data:

Country-level legal protection measures Firm-level financial data (Worldscope and Datastream)

Legal protection measures: Anti-directors rights (LLSV, 1998) Disclosure requirements, Liablity standards, Private and

public enforcement, Investor protection (LLS, 2006) Firm-level financial data:

Cash holdings, change in cash holdings, short-term debt, total debt, cash flow, capital expenditures, cash dividends, dividends payout, total assets, book value of equity, and market capitalization.

Exclude financial firms; firms with book equity < US$10 million; firms with missing firm-year observations.

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Data

Firm-level measures of financial constraint: Firm size (natural logarithm of total assets) KZ-Index

Use the equally-weighted KZ-Index by resetting the weights of the components for each country.

Unbalanced panel data consisting of 104,283 firm-year observations for 17,009 firms in 43 countries.

Sample period covers 1985-2004.

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Role of Legal Protection

Equation (2):

H1 -- should be negative, ie: legal protection has a decreasing effect on the cash-CF sensitivity

Table 3 confirms our prediction! Equation (3):

H2 -- should be positive, ie: legal protection has an increasing effect on the cash-stock price sensitivity

Table 4 confirms our prediction! Table 5: robustness checks

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Table 3 – Legal Protection and Cash-Cash Flow Sensitivity

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Table 4 – Legal Protection and Corporate Demand for Liquidity

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Role of Financial Constraints

Equation (6):

H3 -- should be negative for SIZE and positive for KZ, ie: financial constraints has an increasing effect on the cash-CF sensitivity

Column (1) of Table 6 confirms our prediction for SIZE (but not KZ)!

Equation (7):

Combining the roles of both legal protection and financial constraints on the cash-CF sensitivity: Column (2) of Table 6 confirms our prediction for SIZE (but not KZ)!

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Role of Financial Constraints

Equation (8):

H4 -- should be negative for SIZE and positive for KZ, ie: financial constraints has an increasing effect on the cash-stock price sensitivity

Combining the roles of both legal protection and financial constraints on BOTH the cash-CF sensitivity and the cash-stock price: Column (3) of Table 6 confirms our prediction for SIZE (but not KZ)!

Table 7: robustness checks

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Table 6 – Role of Financial Constraint

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Table 7 – Robustness Checks

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Conclusion Country-level legal protection and firm-level financial

constraint matter in international firms’ cash management policy.

Strong legal protection eases the constraints faced by firms in raising external financings.

Stock prices of firms in countries with strong legal protection will better reflect the potential growth options.

Presence of financial constraint makes it necessary for firms to stockpile cash reserves, in anticipation of future investment needs.

Practical implications for managers when they decide on the optimal cash management policy that will best suit their firms.