Friday, July 22, 2005

Corporate Governance Mechanisms and Corporate Cash Holdings by Yuanto Kusnadi

Kusnadi gives us a look at cash holdings and corporate governance from Singapore.

SSRN-Corporate Governance Mechanisms and Corporate Cash Holdings by Yuanto Kusnadi:

Long time readers of my newsletter and/or blog know that my dissertation at Penn State was on High Cash firms. Consequentially, I still am interested in virtually any article on the behavior of firms with high cash.

In fact, I will take from my dissertation to set the Kusnadi paper up:
Two theories have been used to explain cash'’s role in decision making. The first, and more widely accepted is an agency costs theory. This agency theory, which is often called the “free cash flow problem” (Jensen (1986)), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions or use it as a tool to entrench themselves and to block takeovers (Harford 1998)....The alternative view is that cash holdings are good because they allow firms to avoid the transaction costs, mispricing, and delays involved in a security issuance. This second position, called the market friction theory, is widely cited by managers as the reason for holding large cash positions.
Since 1998 (the time of my dissertation), numerous papers have been published that suggest that there is truth in both views.

From Kusnadi: "Dittmar et al. (2003)..., Pinkowitz et al. (2003) and Guney et al. (2004)... find an inverse relationship between shareholder protection and cash holdings."

However, support for the market friction side of the fence can be found from "Mikkelson and Partch (2003) [who] argue that large cash holdings do not necessarily imply negative performance. They find that the operating performance of firms with large, persistent cash reserves is comparable to or even better than the performance of other matched firms."

So it appears cash is still an unsettled issue. Into this discussion comes a new paper by Kusnadi that looks at cash rich firms from Singapore. Maybe not surprisingly, the findings are consistent with both views of the cash (agency cost and market friction).

First the view that cash is good (i.e. there are real market frictions that can be avoided if firms hold more cash):
"size, market-to-book ratio (a proxy for investment opportunities) and capital expenditures (a proxy for investment) are positively related to cash holdings."
Then the bad side (i.e. holding cash is to the benefit of managers and nto to shareholders):
"On the other hand, cash holdings decreases in leverage, tangibility, and a dividend
dummy. As for our governance variables, we demonstrate that firms characterized by largeboards, boards that are dominated by insiders, and low non-management controlling ownership tend to hold higher cash balances. Our findings lend further support to the importance of corporate governance mechanisms in the determination of corporate cash holdings as documented by Dittmar et al. (2003)."
To which I would add, that this once again demonstrates that there is no simple answer to the question of whether cash is good or bad. Like most things, cash can be good or bad, depending on firm specific factors. This firm specificness (which leads to the endogeniety problem) is one of the key factors that make finance so difficult for some people to grasp: there is rarely a single answer.

A worthwhile read!


Kusnadi, Yuanto, "Corporate Governance Mechanisms and Corporate Cash Holdings" (November 2004). EFA 2005 Moscow Meetings Paper.

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