Corporate Financial Policy and the Value of Cash

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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 of these same frictions on capital structure, it is surprising that the value implications of holding cash in the presence of these frictions have not been similarly explored.1 ∗ Faulkender and Wang are at the Olin School of Business, Washington University in St. Louis. We thank Luca Benzoni, Murillo Campello, Gerald Garvey, Robert Goldstein, Todd Milbourn, Mitchell Petersen, Robert Stambaugh (the editor), Rene Stulz, Rohan Williamson, an anonymous referee, the associate editor, and seminar participants at Washington University in St. Louis and the 2004 Western Finance Association Annual Conference for helpful comments. 1 There has been some work that estimates the value implications of excess cash flow. For instance, Hanson (1992) and Smith and Kim (1994) both find that bidding firms with high excess free cash f low exhibit low excess stock returns around merger announcements. Their estimated coefficients can be interpreted as the value destruction associated with high levels of excess free cash f low.

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Recent empirical studies of corporate cash holdings (e.g., Opler et al. (1999), Harford (1999)) examine the cross-sectional variation in the level of cash holdings related to the above theoretical benefits and costs.2 Consistent with the hypothesized effects, they find that firms with stronger growth opportunities, riskier cash f lows, and more limited access to capital markets hold higher cash balances. Now that we understand the characteristics that determine how much cash firms hold, we move to the question of what value the market places on the cash holdings of firms and how that value varies cross-sectionally. In generating empirical predictions, we argue that the value (to the equity holder) of one additional dollar of cash reserves should vary considerably depending upon whether that dollar is more likely to go to: (1) increasing distributions to equity via dividend payments or share repurchases, (2) decreasing...
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