Cash Holdings, Working Capital and Firm Value: Evidence from France

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CASH HOLDINGS, WORKING CAPITAL AND FIRM VALUE: EVIDENCE FROM FRANCE Ruta AUTUKAITE* – Eric MOLAY**

Abstract: Although companies deal with day-to-day short term financial decisions, in corporate finance the emphasis is being put on long term financial issues when talking about company’s value. In this paper a sample of French listed companies was chosen to assess the importance of short term financial decisions to company’s value by testing the following hypotheses: an extra euro invested in cash or net working capital is valued less than one euro. Running a panel data analysis, evidences prove that shareholders undervalue cash holdings and net working capital. The results of this paper alert management not to underestimate importance of cash holdings and working capital management; moreover, the results encourage investors to follow company’s actions in this area to maximise their return on investment.

Keywords: cash holdings, profitability, stock return, working capital.

JEL Code: G30 (Corporate Finance and Governance)

* EDHEC – 393 Promenade des Anglais, BP3116, 06202 Nice cedex 3, France (ruta.autukaite@edhec.com) ** University of Nice-Sophia Antipolis (IAE) – 24, av. des Diables Bleus, 06357 Nice cedex 4, France (eric.molay@unice.fr)

Electronic copy available at: http://ssrn.com/abstract=1836900

INTRODUCTION In academic literature, the firm’s total market value is described as the value of all its assets, namely, long term debt and equity. In 1958, Modigliani and Miller showed that in a perfect market capital structure does not matter, that it does not matter how much debt a company carries as long as the business generates sufficient cash flow to make it likely that it will meet its interest obligations. However, in reality firms operate in imperfect capital markets where there are transaction costs, taxes, bankruptcy and agency costs; all these factors make determination of optimal capital structure an important question firms need to solve in order to maximise their value. So the level of long term debt a firm has and the level of shareholders’ equity that is used to finance non-current assets matter, but what about the short term obligations and current assets? Might the level of working capital have an effect on firm’s value, in other words, do investors punish companies if too much money is invested in working capital?

If one thinks well, by managing working capital effectively companies can reduce their dependence on outside funding, and use the released cash for further investments; this will then lead to more financial flexibility. Moreover, by managing working capital, a firm can lower their financing costs as less funds from outside will be needed. In addition, effective management of working capital contributes to the reduced riskiness of a company; consequently, a cheaper financing both from shareholders and lenders can be expected, resulting in lower weighted average cost of capital. Even though Ernst & Young’s working capital report (2009) indicates that companies still have plentiful opportunities to release liquidity from working capital — an aggregate total of up to US$1 trillion for the leading 2,000 corporations in the US and Europe, during the recent challenging economic and financial conditions, companies have been focusing more and more on effective working capital management, that allows them to free the money and at least partially collect funds they need. This practically shows the importance of working capital management nowadays. So both the weak emphasis in the academic literature and the current situation of firms gave a stimulus to go deeper into this topic and analyze the importance of working capital management to firms.

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Electronic copy available at: http://ssrn.com/abstract=1836900

The objective of this paper is to add to the existing literature by finding the relationship between cash holdings, working capital management and firm value of a sample of...
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