The Determinants of Corporate Cash Management Policies – Evidence from Around the World

1. The Determinants of Corporate Cash Management Policies – Evidence from Around the World YUANTO KUSNADI City University of Hong Kong K.C. JOHN WEI Hong Kong University of Science and Technology NTU INTERNATIONAL CONFERENCE ON FINANCE TAIPEI 12 Dec 2008

2. Introduction • Increasing attention on the stream of research on corporate cash management policy. • Costs and benefits of holding cash – Keynes (1936), Jensen and Meckling (1976), Myers (1984), Myers and Majluf (1984), and Jensen (1986). • Early studies on determinants of the level of corporate cash reserves: Kim et al. (1998) & Opler et al. (1999). • Corporate governance as an important determinant of cash holdings – Dittmar et at (2003), Dittmar and Mahrt-Smith (2006), Harford et al. (2007), Pinkowitz et al. (2006), and Kalcheva and Lins (2007). • Mixed conclusions!

3. Introduction • Almeida et al. (2004): • Examining the changes in cash holdings is perhaps a more viable option from theoretical perspectives. • Imperfections in capital markets  wedge between internal and external costs of financings. • Constrained firms: higher costs of external financings. • Financial flexibility can be achieved by altering current financial policy to meet future investment needs. • Corporate demand for liquidity can be empirically tested by measuring the marginal propensity to save cash out of current cash flows (the cash-cash flow sensitivity).

4. Introduction • Almeida et al. (2004) (cont’d): • Predict that the cash-CF sensitivity ( ) should be positive and significantonly for financially constrained firms. • Better capture the role of financial constraints than the investment-CF sensitivity.

5. Introduction • Objectives and Contributions: • Examine the role of country-level legal protection and firm-level financial constraints on international firms’ cash management policy. • First study that documents systematic evidences on the impact of above mentioned factors on both the CF and cash-stock price sensitivities ( ). • Closest paper: Khurana et al. (2006) • Role of financial development on cash-cash flow sensitivity • Legal protection should provide the FIRST-ORDER effect!

6. Summary of Results • Legal protection of investors is inversely (positively) related to the cash-cash flow (cash-stock price) sensitivity. • In other words, firms in countries with strong legal protection exhibit lower cash-cash flow and higher cash-stock price sensitivities than firms in countries with weak legal protection. • Financially constrained firms are more likely to experience an increase in both their cash-cash flow and cash-stock price sensitivities than unconstrained firms. • Therefore, our findings emphasize the role of both legal protection and financial constraints on international firms’ cash management policy.

7. Hypothesis Development • The role of legal protection: • Rights prescribed by regulations and laws + effectiveness of enforcement. • LLSV (1997, 1998, 2002): effect of legal protection • LLS (2006): effect of securities laws. • Cost of external finance provides an indication of the extent of shareholder protection afforded by the legal institutions. • Chen et al. (2005) and Hail and Leuz (2006): association with cost of capital. • Strong legal protection helps to reduce the constraints faced by firms in gaining access to the external capital markets  firms in these countries should face relatively low costs of external financings and have less incentive to increase their cash holdings to fund future investments! • H1: Predict a negative relationship between legal protection and the cash-cash flow sensitivity.

8. Hypothesis Development • The role of legal protection (cont’d): • Morck et al. (2000) ; Gelb and Zarowin (2002); Fox et al. (2003): greater disclosures improves the informativeness conveyed by stock prices and efficiency of capital allocation. • Kusnadi, Titman, and Wei (2008): legal protection is positively associated with the investment-stock price sensitivity. • Strong legal protection: stock prices will be morereflective of the fundamental and potential growth options available to the firms  managers have to increase their cash holdings, expecting that they will take on more +ve NPV projects. • H2: Predict a positive relationship between legal protection and the cash-stock price sensitivity.

9. Hypothesis Development • The role of financial constraint: • Almeida et al. (2004) predict different liquidity policy for financially constrained vis-à-vis unconstrained firms. • Cash-cash flow sensitivity should be positive and significant only for the constrained firms. • Possible that the effect of firm-level measures of FC (firm size and KZ scores) remains relevant! • Similar prediction as Almeida et al. (2004) and Khurana et al. (2006) • H3: Predict a positive relationship between financial constraint and the cash-cash flow sensitivity.

10. Hypothesis Development • The role of financial constraint (cont’d): • Baker et al. (2003), Chen et al. (2007), and Kusnadi, Titman, and Wei (2008): the presence of financial constraint will further increase the investment-stock price sensitivity. • Financially constrained firms also face difficulties in accessing the external markets  need to depend on internal CF • More likely for constrained firms to increase their cash holdings to safeguard against having to make unexpected investments in the future. • H4: Predict a positive relationship between financial constraint and the cash-stock price sensitivity.

11. Main Hypotheses • Hypothesis 1: Firms in countries with strong legal protection have cash holdings that are less sensitive to changes in their cash flows than do firms in countries with weak legal protection. • Hypothesis 2:Firms in countries with strong legal protection of investors have cash holdings that are more sensitive to changes in their stock prices than do firms in countries with weak legal protection of investors. • Hypothesis 3: Financially-constrained firms have cash holdings that are more sensitive to changes in their cash flows than do unconstrained firms. • Hypothesis 4: Financially-constrained firms have cash holdings that are more sensitive to changes in their stock prices than do unconstrained firms.

12. Data • Sample data: • Country-level legal protection measures • Firm-level financial data (Worldscope and Datastream) • Legal protection measures: • Anti-directors rights (LLSV, 1998) • Disclosure requirements, Liablity standards, Private and public enforcement, Investor protection (LLS, 2006) • Firm-level financial data: • Cash holdings, change in cash holdings, short-term debt, total debt, cash flow, capital expenditures, cash dividends, dividends payout, total assets, book value of equity, and market capitalization. • Exclude financial firms; firms with book equity < US$10 million; firms with missing firm-year observations.

13. Data • Firm-level measures of financial constraint: • Firm size (natural logarithm of total assets) • KZ-Index Use the equally-weighted KZ-Index by resetting the weights of the components for each country. • Unbalanced panel data consisting of 104,283 firm-year observations for 17,009 firms in 43 countries. • Sample period covers 1985-2004.

14. Role of Legal Protection • Equation (2): • H1 -- should be negative, ie: legal protection has a decreasing effect on the cash-CF sensitivity • Table 3 confirms our prediction! • Equation (3): • H2 -- should be positive, ie: legal protection has an increasing effect on the cash-stock price sensitivity • Table 4 confirms our prediction! • Table 5: robustness checks

15. Table 3 – Legal Protection and Cash-Cash Flow Sensitivity

16. Table 4 – Legal Protection and Corporate Demand for Liquidity

17. Role of Financial Constraints • Equation (6): • H3 -- should be negative for SIZEand positive for KZ, ie: financial constraints has an increasing effect on the cash-CF sensitivity • Column (1) of Table 6 confirms our prediction for SIZE (but not KZ)! • Equation (7): • Combining the roles of both legal protection and financial constraints on the cash-CF sensitivity: Column (2) of Table 6 confirms our prediction for SIZE (but not KZ)!

18. Role of Financial Constraints • Equation (8): • H4 -- should be negative for SIZEand positive for KZ, ie: financial constraints has an increasing effect on the cash-stock price sensitivity • Combining the roles of both legal protection and financial constraints on BOTH the cash-CF sensitivity and the cash-stock price: Column (3) of Table 6 confirms our prediction for SIZE (but not KZ)! • Table 7: robustness checks

19. Table 6 – Role of Financial Constraint

20. Table 7 – Robustness Checks

21. Conclusion • Country-level legal protection and firm-level financial constraint matter in international firms’ cash management policy. • Strong legal protection eases the constraints faced by firms in raising external financings. • Stock prices of firms in countries with strong legal protection will better reflect the potential growth options. • Presence of financial constraint makes it necessary for firms to stockpile cash reserves, in anticipation of future investment needs. • Practical implications for managers when they decide on the optimal cash management policy that will best suit their firms.