Corporate Financial Policy and the Value of Cash
THE JOURNAL OF FINANCE • VOL. LXI, NO. 4 • AUGUST 2006
Corporate Financial Policy and the Value of Cash
MICHAEL FAULKENDER and RONG WANG∗ ABSTRACT
We examine the cross-sectional variation in the marginal value of corporate cash holdings that arises from differences in corporate financial policy. We begin by providing semi-quantitative predictions for the value of an extra dollar of cash depending upon the likely use of that dollar, and derive a set of intuitive hypotheses to test empirically. By examining the variation in excess stock returns over the fiscal year, we find that the marginal value of cash declines with larger cash holdings, higher leverage, better access to capital markets, and as firms choose greater cash distribution via dividends rather than repurchases.
WHAT VALUE DO SHAREHOLDERS PLACE ON THE CASH THAT FIRMS HOLD, and how does that value differ across firms? While an extensive literature attempts to estimate the value of adding debt to a firm’s capital structure, the search for estimates of the value of additional cash has not received nearly as much attention. This is a non-trivial oversight considering that corporate liquidity enables firms to make investments without having to access external capital markets, and to thereby avoid both transaction costs on either debt or equity issuance and information asymmetry costs that are often associated with equity issuances. Moreover, corporate liquidity reduces the likelihood of incurring financial distress costs if the firm’s operations do not generate sufficient cash f low to service obligatory debt payments. Corporate liquidity comes at a cost, however, since interest earned on corporate cash reserves is often taxed at a higher rate than interest earned by individuals. Furthermore, cash may provide funds for managers to invest in projects that offer non-pecuniary benefits but destroy shareholder value (Jensen and Meckling (1976)). Given the extent to which the literature examines the effect
Corporate Financial Policy and the Value of Cash
MICHAEL FAULKENDER and RONG WANG∗ ABSTRACT
We examine the cross-sectional variation in the marginal value of corporate cash holdings that arises from differences in corporate financial policy. We begin by providing semi-quantitative predictions for the value of an extra dollar of cash depending upon the likely use of that dollar, and derive a set of intuitive hypotheses to test empirically. By examining the variation in excess stock returns over the fiscal year, we find that the marginal value of cash declines with larger cash holdings, higher leverage, better access to capital markets, and as firms choose greater cash distribution via dividends rather than repurchases.
WHAT VALUE DO SHAREHOLDERS PLACE ON THE CASH THAT FIRMS HOLD, and how does that value differ across firms? While an extensive literature attempts to estimate the value of adding debt to a firm’s capital structure, the search for estimates of the value of additional cash has not received nearly as much attention. This is a non-trivial oversight considering that corporate liquidity enables firms to make investments without having to access external capital markets, and to thereby avoid both transaction costs on either debt or equity issuance and information asymmetry costs that are often associated with equity issuances. Moreover, corporate liquidity reduces the likelihood of incurring financial distress costs if the firm’s operations do not generate sufficient cash f low to service obligatory debt payments. Corporate liquidity comes at a cost, however, since interest earned on corporate cash reserves is often taxed at a higher rate than interest earned by individuals. Furthermore, cash may provide funds for managers to invest in projects that offer non-pecuniary benefits but destroy shareholder value (Jensen and Meckling (1976)). Given the extent to which the literature examines the effect
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