The increasing trend of corporate cash reserves has attracted the attention of researchers and policy-holders in recent times. Nearly twenty years ago, Dittmar et al.
) identified the existence of US$
1.5 trillion cash reserves in the world’s largest organizations at the end of 1998. In their analysis, Bates et al.
) recognized the US$
2.80 trillion cash reserves in the world’s top 1000 non-financial corporations. Likewise, Opler et al.
) documented US$
1.5 trillion cash reserves in Standard & Poor’s 500 companies. Again, referring to Bates et al.
), they identified cash holding reserves increased by 46% per annum from 1980 to 2006 in U.S. firms. China is now a major provider of liquidity in the global market (see Do et al. 2020
). Since 1996, the M2 of China has surpassed by 75% of the M2 provided by the U.S., Europe, and Japan. In 2009, China’s M2 as measured in U.S. dollars surpassed that of the U.S. for the first time (Caldentey 2017
Cash holding is indeed important for Chinese firms, which until the COVID-19 outbreak was the world’s fastest-growing economy, but this concept also reveals the underdeveloped financial system where firms face obstacles in raising funds externally. In contrast to Western countries, the Chinese financial system is less developed and subject to pronounced agency problems and asymmetric information (Heyman et al. 2003
; Morck et al. 2005
; Vijayakumaran 2017
). Cash retention by Chinese firms has attained a lot of scholarly and business attention. For example, Su et al.
) noted that Chinese listed companies retained large cash reserves from 1998 to 2001. Similarly, Pinkowitz et al.
) documented that Chinese companies’ cash-to-assets ratio was 18.9% during 2000–2003. During this time, U.S. and UK companies’ cash-to-assets ratios amounted to 8.1% and 9.90%, respectively (Ozkan and Ozkan 2004
The self-financing growth of Chinese firms was 17.8% from 1994 to 2006, and in 2006, it reached 665.6 billion, which was almost double the local bank financing (Allen et al. 2007
). Likewise, Zhu and Lu
) reported that the average cash holding in China was 24% from 1998 to 2007, which was higher than that for U.S. companies during that period. Moreover, the Chinese firms managed the informal credit granted by their vendors (banks and/or other financial institutions) to finance growth opportunities (Liu et al. 2020
). Further, Ding et al.
) revealed that Chinese firms retain the funds from their operations, use bank financing and trade credit to finance their business operations (Hu et al. 2016
). Fang et al.
) noted that Chinese firms retain more cash to finance business operations due to the unpredictable long-term capital market. The lower cost of internal financing enhances the ability of Chinese firms to invest more.
In theory, firms maintain cash for productivity purposes or increase returns to shareholders. Internal cash holding provides a low-cost financing option for firms (Subramaniam et al. 2011
). Keynes and Waeger
) argue that internal cash holding reduces the transaction costs of cash holding to readily make funds available for business reasons. The firms also maintain cash to meet unexpected situations in the future or to finance new investment projects or transactions. Likewise, Harford
) states that firms having substantial growth opportunities and high uncertainty of future cash flows will retain more cash.
Conversely, the excess cash balance increases the opportunity cost of cash holding, such as a lower rate of return on liquidity investment and double taxation which negatively affect the firms’ value (Jugurnath et al. 2008
). Additionally, Faulkender and Wang
) explain that additional benefits of cash holding decline with rising levels of cash holding. In their work, Humphery-Jenner and Powell
) suggest that cash-rich companies perform worse than the average industry if they consistently hold cash instead of distributing it to shareholders. The firms want to maintain the best possible cash holding level, where the cost involved is compensated for by cash holding benefits (Nguyen Thanh 2019
). Martínez-Sola et al.
) explain that managers essentially want the best cash holding level to increase the firm’s value and any deviation from it will do damage to the firm value. Moreover, these same authors identify the desired cash holding level by investigating the nonlinear relationship between cash holding and firm value.
The trade-off theory sets the optimal cash holding level by balancing the marginal benefits and cost of holding (Kraus and Litzenberger 1973
). However, the ordering hypothesis suggests that marginal benefits can be maximized by using internal financing (Myers and Majluf 1984
). Internal cash flows reduce the agency cost between the capital providers and managers (Hill and Jones 1992
). They also reduce the pressure wrought by external capital providers on managers who seek to look to their own interests and not those of shareholders (Jensen 1986
). Therefore, firms’ marginal benefits of cash holding decrease with higher internal cash holding, and managers choose projects that reflect their own interests but not those providing the funds. It leads to our first research question: does the higher cash holding negatively affect firm value, and does lower cash holding positively influence firm value?
However, what about firms that do not have a sufficient amount of internal cash flows but still have an opportunity to raise funds externally at a reasonable cost? Such firms have lower leverage and can adopt external debt financing at a lower cost to invest in potentially profitable NPV projects. Myers and Majluf
) contend that such firms choose debt financing to procure the investment opportunity, but additional debt financing reduces the marginal benefits of cash holding and leads to external capital providers putting pressure on firms’ investment decisions. Thus, reducing the level of marginal benefits of cash holding and external capital provider pressure forces managers to only invest in viable NPV projects. It raises our second research question: do the lower level of cash holding and the opportunity to raise finance externally at a reasonable cost positively influence firm value?
Recent studies on corporate finance have highlighted the influence of managers’ optimism in decisions made about cash holdings. Optimism is a behavioral bias that is widely discussed in the context of managers’ psychological beliefs and motivations. Nofsinger and Wang
) empirically state the managerial behavioral biases tied up with corporate finance and explain that these biases influence how decisions are arrived at. Optimistic managers are always forecasting positive outcomes and better future performance. They are confident and presume that under their direction all the required work will be accomplished and generate a superior return than the actual return (Tran et al. 2020
). Optimists are convinced that overestimating the return of well-performed firms is justified and assume that the market undervalues their securities. They believe that the issuance of new equity is costly and a firm prefers debt financing, once internally generated funds have been spent (Huang-Meier et al. 2016
; Stephens et al. 2007
). In reality, this generates agency and asymmetric problems.
Mohamed et al.
) explain that a firm’s cash flow volatility increases due to overly optimistic managers. Similarly, Mohamed et al.
) explain that optimistic managers are motivated to invest more with internal financing. This is because optimists are confident that external financing is more expensive than internal cash flows. Mohamed and Shehata
) explain that optimists are even unwilling to invest in profitable projects with smaller internal cash balances. Conversely, optimistic managers are willing to invest more with plenty of internal cash flows and forecast higher future returns, which can lead to investment in overestimated projects (negative NPV) that do not generate an appropriate cash flow to offset the financing cost. It raises our third research question: does managerial optimism in financially unconstrained firms enhance the negative effect of cash holding on firm value, but for cash-constrained firms positively?
When the firms do not have adequate internal cash holding and yet are in a position to generate finance externally, then optimistic managers may take the opportunity of debt financing. However, optimistic managers overestimate the future return and may invest in risky NPV projects. Here, our fourth research question emerges: if a firm has an optimistic manager, does a lower level of cash holding the opportunity to raise finance externally negatively affect firm value? Therefore, this study contributes to the current literature on this topic in various ways. Firstly, it investigates the impact of a non-linear relationship of cash holding on firm value in Chinese manufacturing companies. Secondly, it develops a unique classification scheme to segregate financially constrained and unconstrained firms to reveal the impact of cash holding on firm value in these firms. Thirdly, it contributes by developing a novel technique of earnings forecast errors to measure managerial optimism, in an effort to explain the impact of cash holding on firm value when managerial optimism is evident. To this end, the purpose of this study is to examine the effect of cash holdings on firm value in financially constrained and unconstrained firms. The structure of the rest of this paper is as follows. In the next section, we review important aspects of the literature and research methodologies being used in this area. It also contains the development of our hypothesis in line with the research question. Section 3
contains the selection of the sample being used, the data set, and the choice of research methodology, whereas Section 4
is allocated to the explanation of the results obtained and some important discussions. The final section contains some concluding remarks with reference to managerial and policy implications.
5. Concluding Remarks
This study examined the influence of cash holdings on firm value in financially constrained and unconstrained firms. The study found that cash holding develops a significant nonlinear relationship with firm value (hypothesis 1). In financially constrained and relatively constrained firms, positive cash holding significantly negatively influences the firm value (hypothesis 2). For financially unconstrained firms, negative cash holding significantly positively influences firm value (hypothesis 3). These results mean that financially constrained firms hold more cash, which negatively influences firm value. Financially unconstrained firms hold less cash, which positively influences firm value. Further, the significant effect of managerial optimism on firm value (hypothesis 4) has been confirmed. In absolutely constrained and relatively constrained firms, the interaction term of (CH × M.Opt) significantly positively affects firm value (hypothesis 5). Meanwhile, the interaction term of (CH × M.Opt) in financially unconstrained firms significantly negatively influences firm value (hypothesis 6). In effect, firms’ cash holding decisions are influenced by managerial optimism biases.
Our results make a unique contribution to generalize cash holding in the context of managerial optimism regarding firm value. We also explained how managerial ownership and personal traits of managers influence their companies’ cash holding decisions. The study employed a unique measure of managerial optimism and reveals the interactive role of cash holding and optimism on firm value. This study is original in that it considered the financial and managerial aspects of cash holding separately to understand the role of firms’ cash levels. Further, this research applies a unique structure to segregate firms into absolutely constrained, relatively constrained, and unconstrained firms. Developed here is a novel way of measuring managerial optimism to investigate the role of cash flows, since the traditional cash level measures do not reflect these futures.
Although we collected data from a large number of manufacturing firms listed on Shehzian Stock Exchange (SSE), we did not cover those firms registered on Shanghai Stock Exchange. Further, the research only used firm-specific characteristics to identify a firm’s financial constraints and ignored industry-specific factors, which are important in determining the financial strength of a firm. Moreover, the research examined manufacturing firms collectively but does not compare different manufacturing sectors and how cash holding affects their firm value. Future research should be undertaken in non-manufacturing industries because of industry-specific characteristics of financial constraints to reveal the impact of cash holding on firm value.
6. Managerial Implications
This study provides important theoretical and managerial implications for manufacturing firms. Theoretically, we documented evidence that a non-linear relationship exists between cash holding and firm value in manufacturing firms operating in China. The results indicated that manufacturing firms’ cash level can serve as a proxy for internal cash-generating ability. One important finding is that financially constrained firms are influenced by long-term cash holding and investment policies. Unconstrained firms have a lower level of cash being held, which positively influences firm value. Financially constrained firms hold more cash, which negatively affects firm value. One possible explanation is that excess cash balance increases the alternative cost of cash holding, so a lower rate of return on liquidity investment and double taxation negatively affect firms’ value. Likewise, the marginal benefits of cash holding decline, when more cash is held. A higher cash level increases the discretionary power of managers to shape investment decisions, and they will invest in projects that best suit their own interests rather than those of capital providers.
In practical terms, this study suggests that constrained firms do not accumulate cash beyond their limit. A company adopts a rational policy about holding cash and proportion of earnings distributed to shareholders. Constrained firms use cash as a tool to overcome financial constraints and invest in value-enhancing projects, while hard cash is only used for uncertain situations. Further, based on the traditional explanation of a firm’s investment decision, this study incorporates the corporate finance behavior approach to explain companies’ investment policies. Managerial optimism has significant explanatory power. Firstly, equity holders must be aware of the behavioral biases of CEOs and their sway over investment policies. The firm’s corporate structure should efficiently overcome any behavioral biases shown by the CEO regarding investment policies. The problem can be minimized by strengthening the board with more independent directors. The stakeholders should encourage the CEO ownership in their firms. This mechanism can help to discipline the firm’s governance structure and ensure the interests of all stakeholders are aligned, and managerial irrationality is reduced. Finally, allegations concerning investment distortions are mainly due to firms’ internal financial characteristics and processes, market imperfections, or corporate governance mechanisms. It is now time to pay attention to managerial behavioral bias and personality characteristics that can also trigger under- and overinvestment problems.