THE JOURNAL OF FINANCE•VOL.LIV,NO.6•DECEMBER1999
Corporate Cash Rerves and Acquisitions
JARRAD HARFORD*
ABSTRACT
Cash-rich firms are more likely than other firms to attempt acquisitions.Stock
return evidence shows that acquisitions by cash-rich firms are value decreasing.
Cash-rich bidders destroy ven cents in value for every excess dollar of cash re-
rves held.Cash-rich firms are more likely to make diversifying acquisitions and
their targets are less likely to attract other bidders.Consistent with the stock
return evidence,mergers in which the bidder is cash-rich are followed by abnormal
declines in operating performance.Overall,the evidence supports the agency costs
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of free cash f low explanation for acquisitions by cash-rich firms.
D ESPIT
E THE IMPORTANCE O
F CASH RESERVES to theories in corporate finance, corporate holdings of cash have received relatively little direct attention in the academic literature.Much of the literature on cash rerves is older and either descriptive or concerned with corporate transaction demand for cash.1 However,the role of cash in the corporation is much broader.In the prence of capital market imperfections deriving from asymmetric information be-tween managers and capital providers,liquidity can take on a strategic role. Managers can increa firm value by managing their cash balances as buffer stocks.The buffer stocks allow the firm to maintain the ability to finance investments even when current cash f lows are insufficient to meet the firm’s investment demands.
Thus,cash rerves provide benefits to equity holders by reducing the underinvestment problem.Managers wishing to avoid the costs associated with external financing in an imperfect information environment find it op-timal to maintain sufficient internal financial f lexibility to allow them to reduce the underinvestment problem.Further,since the equity holders suf-fer the loss from u
nderinvestment,they find it value increasing for manag-ers to maintain the buffer stock of cash.
*University of Oregon.I thank Mike Barclay,George Benston,Jim Brickley,John Chalmers, Larry Dann,Wayne Guay,David Haushalter,Ludger Hentschel,Aditya Kaul,Jon Lewellen, John Long,Rich Luss,Wayne Mikkelson,Mark Mitchell,Megan Partch,Bill Schwert,RenéStulz,Jerry Warner,Jerry Zimmerman,an anonymous referee and minar participants at Emory,Harvard,Indiana,Pennsylvania State,and Southern Methodist Universities,the Uni-versities of Oregon,Pennsylvania,Pittsburgh,and Rochester,and the1998AFA meetings for helpful comments and discussions.
1See,for example,Miller and Orr~1966,1968!,Vogel and Maddala~1967!,and Frenkel and Jovanovic~1980!.However,a contemporaneous paper on corporate liquidity is Opler et al.~1999!.
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1970The Journal of Finance
However,cash rerves have large potential costs in addition to their ben-
efits.The same freedom from external financing that makes cash rerves
valuable to equity holders can be abud by managers.Easterbrook~1984!
posits that frequent trips to the capital markets help control the agency
conf lict between shareholders and managers.Plentiful internal financing
reduces the effectiveness of this control mechanism.Jenn and Meckling ~1976!and Jenn~1986!have emphasized the agency conf lict that exists between owners and managers.Jenn~1986!argues that this conf lict is
most vere in the prence of large free cash f lows,or cash f lows above
what is needed to meet payments to stakeholders and fund positive net prent
value~NPV!projects.Equity holders would prefer that cash above the opti-
mal buffer level of rerves be paid out.However,managers may value the
freedom from monitoring by external capital providers that this capital pro-
vides them.Jenn~1986!notes that acquisitions are a primary method by
which managers can spend cash instead of paying it out to their sharehold-
ers.Managers’desire to reduce their personal undiversified risk or increa
邀请函内容怎么写the scope of their authority may lead them to make investments that are not
value increasing for the shareholders.Since excessive cash rerves are es-
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ntially stockpiled free cash f low,this agency cost of free cash f low should
be vere in cash-rich firms.The main objective of this study is to determine
whether the prence of excess cash leads managers with discretion to make
value-decreasing investment decisions.I focus on acquisitions,which are
large and obrvable outcomes of the investment decision process.
I begin with a brief discussion and examination of how corporations u
cash.Drawing on inventory management and buffer-stock theories of cash
management,a baline model of normal cash rerves is developed.A re-
duced form of the model is estimated using data from porations for
the period1950to1994.I u the model to identify cash-rich firms—firms
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that have accumulated cash rerves above the predictions of the model.
Since the cash-rich firms can shed light on the agency conf lict over firm
resources,the rest of the paper examines managers’behavior with respect to
determining whether their cash positions and acquisition decisions can be ex-
plained by the free cash f low hypothesis.The underlying alternative hypoth-
esis is that capital market imperfections are costly enough that firms find it
optimal to save to fund large expenditures,such as a planned acquisition.
I find that the behavior of cash-rich firms is consistent with the predictions洗手的图片
of the free cash f low hypothesis.This conclusion is bad on veral pieces of
evidence.Cash-richness predicts that a firm will become a bidder,even con-
trolling for stock price performance and sales growth.Further,the abnormal
stock price reaction to acquisition bid announcements by cash-rich bidders is
negative and decreasing in the amount of excess cash held by the bidder.I ex-
amine the characteristics of cash-rich bids to explain this result,and find that腿部减肥动作
the proportion of cash-rich firms undertaking diversifying acquisitions is sig-
nificantly higher than the proportion of cash-poor firms doing so.The targets
of cash-rich firms are also significantly less likely to attract other bidders.Con-
sistent with this,the operating performance of the bidder0target combination
in successful cash-rich bids declines significantly following the bid—consistent
Corporate Cash Rerves and Acquisitions1971 with the negative market reaction at the announcement.I conclude that cash-rich firms engage in value-decreasing behavior.Furthermore,the stock mar-ket appears to partially anticipate this behavior,as evidenced by the negative stock market reaction to cash stockpiling.
In the next ction,I provide an overview of the testable hypothes re-garding cash rerves,develop a model of normal cash,and prent descrip-tive statistics on industry cash holdings and cash-rich firms.In Section II,I empirically test the predictions of the free cash f low hypothesis.Section III prents some further tests of the implications of the results of Section II, and Section IV concludes.
I.Corporate Cash Holdings
The largest25percent of financial corporations held$448billion in cash and marketable curities at the end of1995.On average,they held eight percent of their asts in cash rerves~cash and short-term invest-ments!,and98companies held more than$1billion in this form.Relative to total asts,the current levels of liquid holdings are similar to tho in the mid-1980s.Cash reprents20percent or more of the equity value of many well-known companies,such a
s IBM and Chrysler.At this time,we do not understand how corporate managers act when such a large pool of internal financing is at their disposal.
世组词组A.Theory and Hypothes
Jenn~1986!applies agency theory to the conf lict over the disposition of free cash f low.He posits that incompletely controlled managers spend free cash f low on wasteful projects.Additions to cash rerves occur when cash f low is greater than required for the firm’s positive NPV projects.Firms become cash-rich when their managers stockpile free cash f low rather than spending it immediately.What begins as the accumulation of a buffer stock to guard against a downturn can eventually become large enough to afford managers ample discretion in their investment decisions.This,combined with hubris over the good performance needed to generate enough free cash f low to become cash rich,can lead to an agency conf lict over the disposition of the cash rerve.Since excess cash rerves are accumulated free cash f low,Jenn’s free cash f low hypothesis makes a specific prediction about investments made by managers with stockpiled cash:The investments are value decreasing on average.This prediction follows if managers ek to increa the scale and scope of operating asts under their control.How-ever,such a direct form of agency conf lict is not necessary.Cash provides freedom from external due diligence that could si
mply allow managers to make more mistakes than other better monitored firms.
An earlier paper by Lang,Stulz,and Walkling~1991!provides support for the free cash f low hypothesis in explaining acquisitions.They u the ratio of cash f low to asts for low q firms as their proxy for free cash f low and also report“weak”results from using total cash in place of cash f low.This may be
1972The Journal of Finance
Table I
Summary Statistics for Cash Holdings of19Industry Groupings This table prents the median cash rerves~def lated by sales!held by firms in major industry groupings over the period1950to1994.The median market-to-book~M0B!ratios,volatility of cash f lows from operations~CFO!,def lated by sales,and cash f lows from operations,def lated by sales are also prented.CFO Var.is computed as the median coefficient of variation for cash f lows for firms in the industry.The cond panel contains the results of a regression of median industry cash rerves on median cash f low,market-to-book,and cash f low volatility. t-statistics are in parenthes.
Panel A:Summary Statistics Sorted by Cash0Sales Ratio
Industry Cash0Sales M0B CFO Var.CFO
Wholesale0.031 1.6310.0390.016 Airlines0.034 1.4940.0480.042 Auto Manufacturing0.038 1.4990.0350.054 Construction0.044 1.3560.0390.043 Retail0.046 1.9960.0250.030 Tobacco0.046 1.3920.0260.086 Food0.049 1.6950.0270.056 Utility0.049 1.4490.0540.135 Basic Materials0.054 1.1640.0400.066 Lumber,Paper and Pulp0.058 1.4430.0320.070 Transportation0.064 1.4170.0400.074 Petroleum0.074 1.3670.0420.094 Equipment Manufacturing0.081 2.0090.0560.050 Recreation0.101 2.0280.0880.072 Service0.121 2.6400.0740.044 Chemical0.142 2.9290.0650.042 Agriculture,Fishing and Mining0.195 1.8950.1760.116 Computer0.199 3.0000.0890.000 Financial Services0.325 1.2870.0640.130 Panel B:Regression to Explain the Cash0Sales Ratios in Panel A
Independent Variable All Industries Excluding Financials
InterceptϪ0.112Ϫ0.075***
~Ϫ1.363!~Ϫ4.288!
Cash f low from operations0.9290.165
~
美食的英文1.658!~1.119!
M0B0.0600.054
~1.529!~6.575!*** Volatility of cash f low from operations0.6870.809
~1.267!~9.386!*** Number of obrvations1918
Adjusted R20.360.94
***Significant at the1percent level.
becau they do not control for the widely differing levels of“normal”cash across companies documented here~in Table I,below!and in Opler et al.~1999!.The definition of excess cash ud here adjusts for the differences.Lang et al.~1991! show that firms with good investment opportunities~high q firms!and high
Corporate Cash Rerves and Acquisitions1973 current period cash f low do not suffer from free cash f low problems.In con-trast,I find that once firms have accumulated a large stock of cash from pre-vious cash f low,both high and low q firms exhibit agency costs with respect to this accumulated f
ree cash f low.That is,in accumulating more than a normal level of cash,the firms have demonstrated that they have more cash f low than they need for their good investments,regardless of how many good invest-ments they have to begin with.
The natural alternative to the free cash f low hypothesis is that managers are reluctant to distribute funds becau capital market imperfections make it costly for them to replace the funds later if they need them~Myers and Majluf~1984!!.Hanson~1992!and Smith and Kim~1994!find support for Myers and Majluf in that there are gains to an acquisition when firms with financial problems combine with firms with financial slack.Under this mar-ket imperfection hypothesis,cash-rich firms are no more likely to make bad investments than are other firms.
Distinguishing between the market imperfection and free cash f low hy-pothes requires identification of firms with excess cash rerves.Finan-cial theory implies that the value of holding cash rerves varies across firms.Therefore,if two firms have the same cash rerves,one may be cash-rich while the other may have an amount appropriate for its expected fi-nancing demands.A baline model of cash holdings rooted in financial theory is employed to identify cash-rich firms.In the following subction,I discuss such a benchmark of normal cash holdings to u in tests of the hypothes.
B.Empirical Overview and Description of the Model of Normal Cash
Firm characteristics that affect the value of cash rerves to the firm can be identified by considering cash rerves as primarily buffer stocks.Three factors driving the value of cash rerves are the degree of information asym-metry faced by the managers and the volatility and level of the firm’s cash f lows.I u the market-to-book ratio of equity as an empirical proxy for the degree of information asymmetry between external capital providers and managers in a given industry.Firms in an industry with a high average market-to-book ratio derive most of their value from growth opportunities and intangibles,such as human capital and ongoing rearch~Smith and Watts~1992!and Bizjak,Brickley,and Coles~1993!!.The firms can be expected to find it more difficult to certify the value of a particular project than firms that derive most of their value from asts-in-place.2
Table I prents descriptive statistics for cash in the COMPUSTAT panel ~1950to1994!.Throughout this paper,cash is defined as cash and short-term investments~COMPUSTAT item#1!.In addition to reporting wide vari-ation in cash rerves by industry groupings,Table I confirms the expected
2Market-to-book has also been ud by authors as a proxy for good management~Morck, Shleifer,a
nd Vishny~1988a!,Lang,Stulz,and Walkling~1989!!.For the purpos of Table I, however,using an industry-level value should mitigate this dual-proxy problem.That is,the average industry market-to-book should be driven primarily by the characteristics of the asts and growth opportunities of the industry.
