The theory claims that organization management should decide on the level of cash holdings by equalizing the marginal benefits of cash holdings with the marginal cost of those holdings. Cash is the least profitable asset in an organization. When a firm has too much cash at hand then the marginal benefit of holding the cash will decrease. The major benefits of holding liquid asset in this case cash according to Opler, Pinkowitz,Stuls and Williamson (1997, p.3-46) are: financing operating and investing activities when alternative sources of funds are not available. Another benefit is that firms do not have to liquidate assets to finance and save on transaction cost to raise funds. Hence from the benefits, the main reasons for organization holding cash is as a precaution when funds are needed and to save on transaction cost. However according to Kim, Mauer and Sherman (1998), the risk of holding cash in an organization is that the organization will not be able to invest and it is likely to be exposed to high taxation. The theory therefore outlines that organizations should have an optimal level on the amount of cash to be held and it should align with the marginal benefits of the cash holdings and the marginal cost of the holdings.
Organization that run on a high information asymmetry hold less cash after controlling for corporate governance, companies with high information asymmetry benefits minimally by holding cash. Organization holding huge amount of cash tend to have managerial problems since the managers may misuse funds of the organization without involving other stakeholders. Information asymmetry plays a key role in the organization has it affects managerial behavior during decision making and other participants to understand the behavior of managers. Higher information asymmetry makes both managers and stakeholders to be concerned about the future of the organization in terms of capital needs. According to Jensen (1986), higher information asymmetry in the organization makes it hard for outsiders to monitor cash flow and interpret managerial actions.
The Agency Cost of Debt
In this case the cost of debt increases when the interest of the shareholders and the management of a public company diverge. In any organization the intentions of bondholders may not be similar to the intentions of the shareholders. The managers of the organization tend to align their decisions to the interest of shareholders in the organization leaving the bond holders alone they therefore use bond indentures as security in case of agency-cost problem. When the organization leaders do things that they are in line with their own interest other than the shareholders then the agency problem arises.
Pecking Order Model
It outlines that information asymmetry between managers and investors make external financing costly. The model suggests that organizations should finance their investments using their savings first instead of seeking for external help. If the savings are not enough then safe debt and risky debt can be used together with equity so as to reduce information asymmetry cost and other expenses. Unlike the trade-off approach firms do not have set levels on cash held, however the cash is used as a shield between retained earnings and investment needs.
Managerial Agency Theory
In organizations with strong cash flows managers should be in a position to decide whether the shareholders interest are met by investing, pursuing acquisition, disbursing the funds to shareholders or holding the cash. Agency problems arises when managers decide to hold cash so that they can use them for their own private interest other than that of shareholders. According to Dittmar and Mahrt-Smith (2007), investors tend to undervalue a company if they know that the manager will easily raise cash in suboptimal manner. Organization lacking governance may be exposed to a scenario whereby managers indulge in value-reducing acquisition and investing in projects which do not bring profits.
The value of cash assets is obtained by dividing the cash held by the companies by total assets. The real size of the organization is obtained by finding the natural logarithm of the total assets held by the organization. Market-to-book ratio is obtained by dividing the price close annual fiscal by book value per share. For the selected companies the R&D/sales is obtained by dividing the research expense by the sales made in the organizations. Cash flow in the organizations is achieved by dividing the negatives of the earnings before interest, depreciation values, total income tax, and the dividends by the total assets of the organizations. Net working capital is achieved by dividing the negatives of total current assets, total current liabilities, cash available and dividing the results by total assets. Capital expenditure is the division of capital expenditure by the total assets. The value for the assets of the organizations is obtained by dividing acquisitions by total assets. Lastly total leverage is obtained by adding the values of total debt in current liabilities and total in long term debt then dividing the value by total assets.
Real size In(22240925.93)=16.92
Market-to-book ratio 0.03036
Net working capital/assets 0.002884
Capital expenditure/assets 0.010318
Total leverage 1.21243
The dependent variable for this case is natural logarithm of cash/assets, which was obtained by dividing the cash held by the companies by total assets. Real size is the natural log of all the asset. All the other variables were obtained has discussed in table 1 above. The cash/asset serves as the dependent variable and the other as independent variable in the regression test. The attached workbook shows the calculations done and the regression output. From the results it is evident that the coefficient value in all the variables is 0, and the t statistics for all the variables is 65535. The larger the organization the lesser the cash held by the organization.
In financial hierarchy model firms with high cash flow tend to have high cash accumulation, the firms tend to also have high market-to-book ratio. Having a high market-to-book ratio contradicts the financial hierarchy model because unlike the way it is expected to be, firms with high market-to-book ratio have less cash. The financial hierarchy model outlines that firms that pay more dividends have less cash, moreover firms which invest more tend to have few resources meaning little cash accumulation. Tradeoff theory also outlines that firms with high cash flow tend to have high market-to-book ratio, the main reason behind it is that the firm is expected to have profits with time of growth.
The financial hierarchy model anticipates that the larger the firm the higher the amount of cash it has since it has stayed in the market for long. According to the financial hierarchy model firms with higher capital expenditure have more cash, this is also in line with those firms with high R&D investment whereby they are expected to have more cash. Tradeoff theory suggest that larger firms tend to have less cash because they spend more on its various sections. Tradeoff theory also outlines that firms with high capital expenditure tend to have less cash accumulation.
The static tradeoff model outlines that firms depends on debts and equity in to finance the organization and its projects. The theory implies that firms are financed using debt and equity, it stresses that when the firm is financed by the debts it has high probability of prospering unlike using tax benefits. When the firm is financed using bankruptcy cost of debt it is likely that the firm will collapse and hence equity is preferred.
Opler, T., Pinkowitz, L., Stulz, R. and Williamson, R., 1999. The determinants and implications of corporate cash holdings. Journal of financial economics, 52(1), pp.3-46.
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