STORY1DETERMINANTSOF CASH HOLDING POLICY OF FIRMSMotivesfor holding cashMyriad of literatureshave debated the matter of contributing factors that affect cash holdingpolicy. These empirical literatures put several explanations in the incentivesof firm to hold cash. Three main reasons were recognized as precautionarypurpose, transaction cost and the wealth of investor.
The first,precautionary purpose is the initial reason for the company to hold more cash. Opleret al. (1999) suggests that managers tend to hold cash as a precautionarymeasure.
In order to protect themselves against adverse shocks, firms hold cashto have easily accessible capital in times when raising capital in the marketis expensive. Opler, Pinkowitz, Stulz, and Williamson (1999) find that firmswith riskier cash flows hold more cash and thereby provide evidence for thismotive. Their findings also support the hypothesis that firms with betterinvestment opportunities will hold more cash, due to higher opportunity cost inthe event of financial distress. Han and Qiu (2007) find that firms that arefinancially constrained have cash holdings that are sensitive to cash flowvolatility. Because future cash flows are not diversifiable, the level of cashincreases when the cash flow volatility rises. Cash is kept as an emergency fundfor the company. A right amount of cash to be held to avoid unanticipatedevents.
These unanticipated events cause many unpredictable consequences thatcompanies have to deal with. Emergencies such as increasing of raw material,labors, falling in marketing demand, loss or theft goods bound the firm to holda certain level of cash. The amount of cash holding relies on the degree ofunpredictability of each event. The higher degree of unpredictability, thehigher level cash need to be held. The second reason for firmholding cash is to reduce the transaction cost.
Following to the study of Myersand Majluf (1984), each company has their own investments in short-term. Due tothe lack of available fund, they tend to raise external fund which is a costlyalternative. High transaction cost is mostly made from informationalasymmetries between firms and external investors. To avoid cost of transaction,the companies maintain much more cash holding to cover their needs ininvesting. In another study, Baumol (1952) and Miller & Orr (1966) pointedout a classic financial model mentioned to the transaction motive.
Their mainpoint is that firm should hold an optimal amount of cash for precautionaryreason such as making certain payment. The optimal amount of cash would beuseful for the firm to save cost. Payment normally is performed in cash. Iffirms hold less cash, they must convert assets to cash in order to make thepayment. The conversion process causes the cost which is considered as a particularform of transaction cost. It is necessary for companies to hold some cash for dayto day business, because inflows and outflows of cash do not always matchperfectly.
By holding appropriate amounts of cash, firms can reduce transactioncosts. As they will have the cash needed to make current payments, they avoidgoing to the market to raise cash, which would be costly. However, holdingexcess cash gives rise to higher opportunity costs, as these cash holdingscould have been used to finance profitable projects. The transaction motiveforesees an optimal level of cash where the opportunity cost of cash equals thecost of holding. The research of Fayele(2004) supports the last reason by considering cash holding serving as apowerful antitakeover defense against hostile bidders. Excess cash balancesoffer potential targets opportunities to counter unfriendly takeover bids. Theseinclude the possibility to repurchase stock as well as the possibility toacquire a competitor of the bidder or the bidder himself.
Muncef Guizani (2017)investigates the determinants of the cash holdings for a sample of Saudi firmsover the period 2006-2014. The paper shows that corporate cash holdings areusually based on three important theories in corporate finance: trade offtheory (Myers, 1977), pecking order theory (Myers and Majluf, 1984) and freecash flow theory (Jensen, 1986). Corporatecash holdings: TheoryTrade-offtheoryTrade-off theorysuggests that companies holding cash set up an optimal level of cash holdings.This level is influenced by balancing the marginal costs and marginal benefits (Opleret al., 1999; Dittmar et al., 2003; Ferreira and Vilela, 2004; Afza and Adnan,2007; Kariuki et al., 2015).
Marginal benefits side of holding cash refer to asthe lower transaction costs, reduction in the likelihood of financial distressand the possibility of implementing investment projects that could not becarried out without these funds owing to the existence of financialconstraints. The marginal benefits are sufficient enough to cover the main costof holding cash which is the opportunity cost of the capital invested in liquidassets. Peckingorder theoryIn the same vein, peckingorder theory suggests that asymmetric information between managers andinvestors makes external financing costly. That means when the internal fund isunder the investment demand, company lending outside sources. The difference inthe amount of outside and inside information of companies leads to informationasymmetry, the main in rising transaction cost. Therefore, firms should financeinvestments first with retained earnings, then with safe debt and risky debt,and finally with equity to minimize asymmetric information costs and otherfinancing costs. Pecking order theory demonstrates that firms do not havetarget cash levels, but cash is used as a buffer between retained earnings andinvestment needs.
Freecash flow theoryFinally, the free cashflow theory postulates that managers have an incentive to build up cash toincrease the amount of assets under their control and to gain discretionarypower over the firm investment decision. Cash reduces the pressure to performwell and allows managers to invest in projects that best suit their owninterests, but may not be in the shareholders’ best interest. However, neitherthe pecking order theory nor the free cash flow theory suggests that thereexist target cash holding levels while the trade-off theory does. According tothis theory, firms trade off the benefits and costs of holding cash todetermine the target cash reserves, and when the actual cash holdings deviatefrom the target levels, firms tend to adjust their cash reserves to the targetlevel.Determinantsof Cash holding policyPrevious study hasresearch the determinants which affect directly cash holding or liquidityassets of firms.
For example, Kytönen (2005) conducts the empirical study onthe determinants of corporate liquidity holdings for a sample of Finnish firmslisted on Helsinki Stock Exchange. As a result, he found that that firms? size,growth opportunities, opportunity costs, cash flows, efficiency of workingcapital management, leverage, dividend policy and the probability of financialdistress are important in determining liquidity holdings in Finnish firms.Based on study of Guizani M.
(2017), determinantsof cash holding policy includes financial leverage, profitability, capitalexpenditures, dividends payment, growth opportunities, firm size, net workingcapital and cash flow volatility.FinancialleverageThereis a negative correlation between leverage and cash holding Both trade off andpecking order theories predict a negative correlation between leverage and cashholdings. By contrast, Caglayan-Ozkan and Ozkan (2002) and Diamond (1984) showthat debt can be a substitute for cash holdings because of debt relief andmoral hazard. Similarly, according to the pecking order theory, Opler et al.(1999) state that companies use cash to pay debt off, or continue to accumulatecash at target level.
Although companies have the same target level, the moneyis still followed pecking order theory. Free cash flow theory also predicts anegative correlation between leverage and cash holdings as companies whichfunded by external source are not under the supervision thus allow managers tohold higher cash flow. Thereis a positive correlation between leverage and cash holding Contrary to the abovecorrelation, Ferreira and Vilela (2003) argue that trade off theory can alsopredict a positive correlation between leverage and cash holdings as leverageincreases the probability of bankruptcy and therefore companies keep the cashto reduce the probability of financial exhaustion. ProfitabilityThereis a negative relationship between profitability and cash holdings.According to trade offtheory, there is a negative correlation between profitability and cash holdingsbecause profitable companies have sufficient cash flow to avoid ineffectiveinvestment issues (Kim et al., 1998; Caglayan -Ozkan and Ozkan, 2002). Highprofitability reduces the risk of payment and investing for firms. While the firms maintain amount of cashinflow such as profit, cash utility is more flexible through using cash forother firm – level activities.
The same results were found by Almeida et al.(2004) for companies with financial constraint and found by Bates et al. (2009)who also found a negative correlation between profit and cash holdings.Thereis a positive relationship between profitability and cash holdings.According to thepecking order theory, firms tend to retain higher level of liquidity while theyhave higher financial performance.
This is because profitable firms normallyaccumulate the cash flow generated. Consequently, the most profitable companiesshould have more cash to control the investment. There are several valuablestudes that prove this positive relationship. For instance, Opler et al. (1999)argue that there is a positive relationship between cash flows and cash levels.Ferreira and Vilela (2004) and Al-Najjar and Clark (2016) confirm thisargument.
Consequently, there is a positive association between firm’sprofitability and cash holdingsCapitalexpenditures Firms in such capitalintensive industries often need to maintain the required cash over a longerperiod of time because their cash flow cannot be as fast as that of otherindustries.Thereis a negative correlation between capital expenditures and cash holdingsThe pecking ordertheory provides a negative correlation between capital expenditures and cashholdings because capital expenditures clearly reduce the company’s cash directly.Moreover, firms with larger investment expenses have less or no surplus frominternally generated funds to invest in liquid asset reserves, and hence theyhold less liquid assets. Firms which follow risk aversion choose to use theircash for financing short investment instead of using loan.
According to thecontent of this theory, firms rising their demand in invest operation tend touse the cash holdings in order to make the payment or cover the fund shortage. Leeand Song (2007) point to a negative correlation between the cost of capital andcash holdings in companies after the Asian financial crisis. In the same vein,Bates et al. (2009: 1999) argue that ? if capital expenditures create assetsthat can be used as collateral, capital expenditures could increase debtcapacity and reduce the demand for cash ?. The major purpose is to eliminatetransaction cost. Thereis a positive correlation between capital expenditures and cash holdingsConversely, the tradeoffhave a positive correlation between them because high capitalization companieskeep cash at a balance level with the level of transaction costs associatedwith capital and opportunity costs of insufficient financial resources.
This isdue to the content of trade off theory which supposes to balance the marginprofit and margin cost. In studying, Opler et al. (1999) argue that cashholdings increase with the cost of capital.DividendspaymentThereis a negative relationship between dividend payments and CashAccording to thetrade-off theory, the relationship between dividend payments and cash should benegative, since firms that pay dividend can trade off the costs of holding cashby reducing dividend payments (Al-Najjar and Belghitar, 2011). Previous studiessuch as Opler el. (1999) and Drobetz and Gruninger (2007) argue that firms thatcurrently pay dividends can raise funds at low cost by reducing their dividendpayments therefore they don’t need to hold high amounts of cash. In contrast,firms that do not pay dividends need to use the capital markets to raise funds.When firms need cash and have difficulty raising funds, or they are financiallyconstrained because their leverage is special high, they can try to increaseretained earnings by cutting back dividend payments.
Therefore, firms that arefinancially constrained can only achieve targeted cash flow by cutting dividendpayments. Similarly, Ozkan and Ozkan(2004) argue that these costs can be avoided for firms facing low internalfinancing resources by issuing equity or even reducing payment of dividendsFazzari et al. (1988)observed that “if a company has a shortage of liquid assets, the companycan cope with the shortfall by reducing investment or reducing dividend paymentor by mobilizing outside capital through the issuance of securities or the saleof assets”.Growth opportunities Growth opportunities are opportunities to invest in profitable projects. An investment or project has the potentialto grow significantly that leading to a profit for the investor. New investmentsare often presented to potential investors as growth opportunities. Thereis a positive relationship between growth opportunities and cash holdings.
Based on the trade-offtheory, there is a positive association between growth opportunities and cashholdings. The opportunity cost and financial distress cost should be consideredwhen evaluating the level of growth opportunities. A company investing in a newproject means that it must consider the liquidity of the company’s assets andthe amount of cash held to ensure its ability to pay for incurred during thelife of the project. In case of holding less cash, the opportunity cost due toa lack of liquidity should be more severe for firms with high qualityinvestment project. These firm will also have higher financial distress costs (Williamson,1988) which can make the external financing more expensive (Harris and Raviv,1990). To avoid these costs, these firms normally provide liquidity in ordernot to run the risk of underinvestment in the future. Therefore, to avoid anyshortfall in cash is in accordance with transaction motives of cash (Opler etal.
, 1999). Second motive of avoiding financial distress is consistent withmotive of precaution (Bates et al., 2009). Similarly, the pecking order theoryargues for a positive link between growth opportunities and cash holdings.Firms with higher growth opportunities need higher cash level to cope with anyshortfall in cash. Cashflow volatilityThereis a positive relationship between cash flow volatility and cash holdingsBased on the trade-offtheory, companies with more volatile cash flows face a higher probability ofexperiencing cash shortage due to unexpected cash flow deterioration. Highlevel of volatile cash flows leads firm to forgo some profitable investmentprojects.
Opler et al. (1999) show that uncertainty leads to situations inwhich, at times, the firm has more outlays than expected. In addition, firrmswith unstable cash flow will keep a large amount of cash. Cash is used to makeup for deficits when the cash flow is significant large compared to the cashflow. This explains that the company keeps cash for precautionary motives.Interestingly, Bates et al. (2009) suggest that firms with greater cash flowrisk hold more precautionary cash. Empirically, Saddour (2006) and Ferreira andVilela (2004) argue about a positive link between cash flow uncertainty andcash holdings.
Networking capitalThereis a negative relationship between net working capital and cash holdings.In recently years, researchershave conducted in-depth studies to discover if working capital managementinfluences the level of corporate cash holdings and findings are supportive.Capkun & Weiss (2007) examine the operating assets and cash holdings of USmanufacturing firms in the 1980-2005 periods and find a decrease in operatingassets and an increase in cash holdings. They explain the increase of corporatecash holdings by the reduction in inventory and the increase in accountspayable during the examined period and firms’ manager hold more cash assecurity towards increased exposure to trade credit risk. According to thetrade-off theory, an inverse association exists between cash and net workingcapital.
This is so because net working capital majorly consists of liquidasset cash substitutes. The existence of liquid assets will lead firms to beless reliable on capital markets to obtain cash (Al-Najjar 2013). Previousresearchers like Bates et al. (2009) and Ferreira and Vilela (2004) suggestthat net working capital consists of assets that substitute for cash. FirmsizeThereis a negative relationship between firm size and cash holdingsAs argued by Rajan andZingales (1995), because of diversification, larger firms have more stabilityof cash flow and therefore they have lower probability of being in financialdistress.
It would be easier for these firms to have access to diversifiedfunding sources (Ferri and Jones, 1979), which is often not possible forsmaller one. In a similar vein, Al-Najjar and Belghitar (2011) argue that largefirms are considered to be more diversified than their small counterparts andin turn less prone to bankruptcy related costs. Consequently, they are less likelyto store cash reserves. In line with these arguments, Bates et al. (2009) statethat big firms are more likely to be able to liquidate part of non-core assetsto obtain cash, which reduces the likelihood of encountering financialdistress.
Thereis a positive relationship between firm size and cash holdingsContradicting thetrade-off view, the pecking order theory affirms that cash holdings increasewith firm size, because larger firms are expected to have been more profitablehistorically and thus accumulated more cash. Opler et al. (1999) argue thatlarger firms presumably have been more successful, and hence should have morecash, after controlling for investment.