Tuesday, October 04, 2005

Cash Holdings and Governance

What better way to start our look at conference papers than by a paper on Cash Holdings and Corporate Governance by Jarrad Harford, Sattar A. Mansi, and William F. Maxwell that will be in the first session of the FMAs in Chicago.

Short Version:
The authors use a corporate Governance index to examine cash holdings by firms. They report evidence that firms with weaker governance waste the cash faster.

Longer Version:

Is cash good or bad? The correct answer is Yes. It is both. I'll be lazy and quote my dissertation:
"Two theories have been used to explain cash’s role decision making. The first, and more widely accepted model, is an agency costs theory. This agency theory, typically called the “free cash flow problem” and generally credited to Jensen (1986), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions. Not everyone believes this agency cost theory is a good explanation of reality. Skeptics claim that you cannot have too much of a good thing, and cash is a good thing because it allows firms to avoid the 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. "
If you are like me and largely accept the agency cost explanation, then at first glance it may appear surprising that Harford, Mansi, and Maxwell find that firms with poor corporate governance (as measured by the the Investor Research Responsibility Center) have small cash reserves:
"We start with the hypothesis that stronger shareholder rights (weaker manager
rights) will lead to smaller cash holdings, all else equal. However, as noted above, we find the opposite."
Why is this the case? It appears that this finding is because the firms with weak governance spend the money faster!

Again in the author's words:
"...for a given set of firms with high levels of cash, all else equal, the firms with weaker shareholder rights will spend that cash morequickly. Our tests show that this spending is primarily on acquisitions."
That firms with higher agency problems spend the money faster would partially explain why some firms, who probably not coincidentally often have high insider ownership--and thus arguably less severe agency problems--Weis and Microsoft immediately come to mind) for years had consistently high levels of cash and yet did not appear to be adversely affected by their holdings.

A few other tidbits from the paper:

*"The results from the models using GIndex segmented into weak and strong governance firms, suggests that firms with strong management rights hold less cash but firms with strong shareholder rights do not hold more cash than the average firm, which indicates a non-linear relation between GIndex and cash holdings."

* The authors make a good attempt at controlling for the endogeniety problem:
"Although we find that the governance index is negatively related to cash holdings, the OLS regressions may not fully account for potential endogeneity in the sample. Modeling the relation between governance and cash holdings may be problematic if there is an endogenous feedback from cash holdings to governance. That is, cash holdings and the governance index are jointly determined....."
They control for this (at least partially) by using the Granger causality tests using lagged governance scores. The finding?
"We find that the governance index is statistically and significantly related, at the 5% confidence level, related to the future cash holdings of the firm. Firms with strong management rights (high GIndex) shed more cash from one period to the next overall our sample period."
* They also examine cash-rich and non cash-rich firms and report important differences that are tied to acquistion activity:
"For the high-cash sample...both weak and strong governance firms revert toward the normal level of cash for their industry. However, the weak governance firms revert significantly faster. For the increasing cash flow sample, we see that the stronger shareholder firms see an increase in their cash holdings. For the weak governance firm there is no increase in their cash holdings and the difference between firms based on their governance score is significant."
Interesting stuff!

Harford, Jarrad, Sattar A Mansi, and William F. Maxwell. Corporate Governance and Firm Cash Holdings, Working paper, 2005.

Also available on Harford's website.

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