Peer Effects on Corporate Cash Holdings

1. Peer Effects on Corporate Cash Holdings YiwenChen YuanchenChang Department of Finance National Chengchi University

2. Introduction Motivation of this studies • U.S. companies are sitting on an enormous and growing pile of cash. • Cash reserve plays an important strategic role. • This paper offers a new perspective to examine cash holdings.

3. Introduction Figure I: U.S. companies are sitting on an enormous and growing pile of cash. Why do U.S. firms hold so much more cash than they used to? (BKS, 2009 JF)

4. Introduction Demand function for cash holdings • If left unmonitored, entrenched managers may waste free cash flows (Jenson, 1986) • Deep pockets argument (Fresard, 2010 JF). • Smooth R&D expenditures (Brown and Petersen, 2011, and Shin and Kim, 2011). • → Cash reserve plays an important strategic role like a preemptive weapon !

5. Introduction Hypothesis • Firm tend to mimic the cash holding decisions of their industry counterparts. • Firms that are financially constrained and have higher R&D expenditures exhibit more pronounced cash mimicking tendencies.

6. Introduction Empirical findings • The ratio of cash to total assets is significantly influenced by peer firms’ average cash holdings. • The peer firm effect on cash holdings is not only directly through channel of peer firms’ cash holdings, but also indirectly through their competitors' characteristics. • Firms that are financially constrained and have higher R&D expenditures tend to mimic cash holdings of their rivals.

7. Introduction Contributions • Prior studies do not consider the peer firm effects on cash holding and thus under-estimate the need for it. • Imitation is a common form of behavior that arises in a variety of business domains, we recognizes the interactions among firms.

8. Data and Summary Statistic Data • Sample: • manufacturing firms (SIC code: 2000-3999): because firms with high cash holdings concentrate in this sector as shown in Figure I. • Data source: • annual accounting data from Compustat database • monthly returns from CRSP • portfolio returns from Ken French’s website • Period: • from 1980 to 2011

9. Methodology and variable construction Baseline Regression where the indices i, j, and t correspond to firm, industry, and year, respectively. • y: cash and short-term investment divided by book asset • X:

10. Methodology and variable construction Endogeneity (simultaneity) issues • If firms’ cash holding decisions are influenced by one another, then it can be argued either that causes or that causes . • Solution: • Instrument variable (TSLT)

11. Methodology and variable construction Instrumental Variable • A valid instrumental variable must satisfy the relevance and exclusion conditions. • Instrumental Variable: lagged idiosyncratic stock returns of peer firms (PIDIO-ijt)(Following Leary and Roberts, 2012)

12. Methodology and variable construction Instrumental Variable Calculation Estimate coefficients (4-factor model) Compute expected returns Annual actual return – annual expected return The industry average excluding the i observation

13. Results Table VI: Cash Holding Regression

14. Results Table VI: Cash Holding Regression

15. Results Table VII: Cash Holding Regression of High/Low R&D Expenditure Subsample

16. Results Table VIII:Cash Holding Regression of High/Low Sale Subsample

17. Conclusion • When managers make their decisions on cash holdings, they will take the average of industry cash holdings into consideration. • The peer firm effect on cash holdings is not only directly through channel of peer firms’ cash holdings, but also indirectly through their competitors' characteristics. • Firms with higher R&D expenditure or more financial constraints exhibit more pronounced mimicking tendencies.

18. Thanks!