Corporate cash holdings: An empirical investigation of UK companies Aydin Ozkan* University of York, UK Neslihan Ozkan University of Liverpool, UK Abstract This paper investigates the empirical determinants of corporate cash holdings for a sample of UK firms over the period 1984-1999. We present evidence of the significant relation between managerial ownership and cash holdings. The results also suggest that the way in which managerial ownership exerts influence on cash holding decisions differs between firms with ultimate controllers and those that are widely-held. The results reveal that growth options of firms, cash flows, liquid assets, leverage and bank debt are important in determining cash holdings.
In contrast, there is much less evidence that larger firms hold less cash. Our analysis also suggests that unobserved firm heterogeneity and endogeneity are crucial in analysing the cash structure of firms. JEL classification: G3; G32 Keywords: Cash holdings; Ownership structure; Firm heterogeneity; Panel data. Department of Economics and Related Studies, University of York, Heslington, York, YO10 5DD, UK.
E-mail: ao5@york. Introduction Why do firms hold large amounts of cash and cash equivalents? Various explanations have been put forward in an attempt to provide some answers to this question. One major explanation is that cash provides low cost financing for firms. According to this view, raising external finance costs more in the presence asymmetry of information between firms and external investors (Myers and Majluf, 1984); costly agency problems such as underinvestment and asset substitution (Myers, 1977; and Jensen and Meckling, 1976); and adjustment costs and other financial restrictions.
Therefore, managers trying to minimize the costs associated with external financing in imperfect capital markets may find it optimal to maintain sufficient internal financial flexibility. However, there are also potential adverse effects of cash holdings. Central to this view is the argument that agency conflicts existing between shareholders and managers can be most severe when firms have large free cash flows (Jensen, 1986). Managers can pursue their own interests at the expense of shareholders and cash serves the interests of managers more than those of shareholders in this respect.
Recently the investigation of cash holdings of firms has gained a great deal of attention in the empirical literature. An important strand of this literature has focused on the determinants of corporate holdings of cash. 1 For example, Kim et al. (1998) analyse the determinants of cash holdings for a sample of US companies.
They report that firms facing higher costs of external financing and having more volatile earnings and firms with relatively lower returns on assets have significantly larger proportions of liquid assets to total assets. For similar firms, Opler et al. (1999) provide evidence that firms with strong growth opportunities and riskier cash flows, and small firms hold larger amounts of cash. Finally, in a related paper, Pinkowitz and Williamson (2001) examine the cash holdings of firms from the United States, Germany, and Japan.
In addition to finding which are similar to those in Opler et al. (1999) 1 The other important strand of this literature examines the relationship between cash holdings and corporate performance. See, for example, Harford (1999), Mikkelson and Partch (2002), and also Opler et al. 2 they document that the monopoly power of banks in Japan has a significant impact on cash balances of Japanese firms.
The purpose of our paper is to contribute to this literature by examining the empirical determinants of cash holdings for a sample of UK companies over the period 1984-1999. The UK and US are often described as being similar with respect to ownership and control structures of companies. They are also characterised as having similar institutional and legal framework. It is, however, our view that there are distinct features of the corporate governance system in the UK, which may lead to different inferences than those in the US with regard to the cash holding behaviour of firms.
To take an example, to the extent that large cash holdings serve managers’ interests, it is more likely in the UK that cash holdings will increase with managerial shareholdings. This is because, as we will argue, managers in the UK appear to entrench themselves considerably against external market discipline. As a first contribution to this literature, we investigate the role of ownership structure in determining corporate policies on cash holdings. More specifically, we first empirically analyse the nature of the relationship between managerial ownership and cash holdings.
Furthermore, we investigate whether the presence of ultimate controllers in the firm has a significant impact on the amount of cash it holds. In addition, we extend our analysis by addressing the potential interactions between managerial ownership and ultimate controllers. In particular, we examine the extent to which the presence and identity of the controlling shareholder affect the managerial behaviour towards cash holdings. We argue that the presence of a controlling shareholder can affect cash holding decisions of firms.
For instance, if large holdings of cash serve controlling shareholders’ interests one would expect to observe higher cash holdings in firms with controllers. Also, to the extent that the incentive and ability to monitor managers change with the identity of controllers, the relationship between managerial ownership and cash holdings may depend on who the firm’s ultimate controller is. Our second contribution is that, distinct from previous empirical studies, the analysis of this paper explicitly deals with the endogeneity problem in testing the cash holdings hypotheses. We think that the endogeneity issue in this context is important for several 3 reasons.
First, it is highly likely that observable as well as unobservable shocks affecting cash holdings can also affect some of the firm-specific characteristics such as market value of equity. Second, it is possible that observed relations between cash and its potential determinants reflect the effects of cash on the latter rather than vice versa. To control efficiently for the potential endogeneity problem we utilise panel data and the Generalised Method of Moments (GMM) estimation procedure, the combination of which allows us to optimally choose instruments as well as to deal with firm heterogeneity. Our last contribution lies in the dynamic analysis of the cash holding decision.
We incorporate the view that market imperfections such as adjustment costs may prevent firms from adapting to new circumstances. We utilise a partial target-adjustment model that allows for the possibility of delays in response of firms in adjusting their cash holdings. We are not the first to investigate the question whether firms have target cash holdings. Opler et al.
(1999), for example, estimate different target-adjustment models relating the firm’s actual cash holdings to its target cash holdings. Their results provide evidence that firms have target cash levels. Our dynamic analysis is an attempt to complement rather than substitute the analysis of Opler et al. Our model incorporates all the firm-specific factors described in the paper as relevant in determining cash holdings.
More importantly, in estimating the target-adjustment model we also control for unobservable fixed effects as well as time effects. To the extent that these effects are significant in the underlying target cash model and not controlled for, estimated coefficients of the target-adjustment model will be biased. As noted above, the approach adopted in our dynamic analysis also controls for the potential biases that may arise from endogeneity of regressors as well as random measurement errors. Our analysis reveals that ownership structure of firms plays an important role in determining levels of cash UK companies hold.
We find evidence for the non-monotonic relationship between managerial ownership and corporate cash holdings. In addition, the nature of the relationship changes with the presence of ultimate controllers. We also provide evidence of significant dynamic effects in the determination of firms’ cash holdings. Moreover, there is evidence that cash flow and growth opportunities of firms exert a positive 4 influence on cash holdings.
There is significant evidence for the negative impact of liquid assets. The results also suggest that higher cash holdings are associated with lower levels of bank debt and leverage in firms’ capital structure. The paper is organised as follows. In Section 2 we briefly discuss the main features of the ownership and control structures of companies in the UK as distinct from the US.
Section 3 reviews the relevant theory and derives the empirical hypotheses. Section 4 describes the alternative estimation methods used in the paper. Section 5 describes the construction of the data set. Section 6 presents the empirical results and finally Section 7 offers our conclusions.
UK Institutional Features Companies in both the UK and US are often described as being similar with respect to their ownership structures and as characterised as having similar regulatory systems. For example, both the UK and US are often described as “market-oriented” countries with similar capital markets and financial institutions.2 Also, the type of ownership and control structures in both countries are described as “outsider” systems in which ownership is dispersed amongst a large number of outside investors. However, there exist important differences in the corporate governance system and in the patterns of share ownership, which makes the conduct of an analysis of cash holdings of UK companies interesting. The main features of the prevailing corporate governance system in the UK as distinct from those in the US can be summarised as follows.
First, the concentration of institutional stock ownership is higher in the UK than in the US. Nestor and Thompson (2000) report that financial institutions in the UK hold 68 percent of the all shareholdings in 1994 as compared to 46 percent in the US in 1996. Goergen and Renneboog (2001) argue that financial institutions adopt a passive stance towards disciplining firms’ management. This, in turn, 2 The so-called market-oriented countries include Canada, United Kingdom and United States; and the bank oriented countries include France, Germany, Italy and Japan.
See for a detailed discussion, for example, Hoshi et al. 5 coupled with significant shareholdings by directors, further increases in the power of directors and creates its own type of agency problems, i. high managerial discretion. They argue that the passive stance of financial institutions is mainly due to the fact that they are not major players from the agency perspective.
Goergen and Renneboog (2001) report that the average of the largest shareholding owned by financial institutions is only 5.5 percent for their sample of firms in 1992. We also report in Section 5 that 6.5 percent of non-financial firms in the UK is controlled by widely-held financial institutions at the 20 percent ultimate control threshold for a sample of 780 firms. Also, we find that the average value of control rights of the largest controlling financial institution is 20. This compares with the average values of 38.67 percent for those firms that are ultimately controlled by widely-held corporations and families respectively.
Second, managerial discretion is higher in the UK. Franks et al. (2001) report that higher shareholdings by insiders in the UK lead to entrenchment rather than disciplining management. There are several potential reasons for this.
For example, they argue that substantial directors shareholdings enable managers to hinder monitoring activities sought by other shareholders such as restructuring the firm’s board. They also argue that in the UK the role of non-executive directors is quite different from that in the US. Non-executive directors have a more advisory role rather than performing a disciplinary function.3 Moreover, they claim that stronger minority investor protection in the UK discourages coalition of shareholders. This, in turn, coupled with less fiduciary obligations on directors but stricter rights issue requirements strengthen the discretionary managerial power.4 Finally, there is also a divergence of empirical evidence regarding the disciplining role of takeovers.
Franks and Mayer (1996), in contrast to the findings of Martin and McConnell (1991) for the US companies, provide evidence that takeovers do not work as a corporate governance mechanism for disciplining poor managers in the UK. 3 In addition, the board structure of UK companies is also different from that of US companies. Vafeas and Theodorou (1998) find an average of 39 percent non-executive directors on UK boards, representing a majority of executive directors.