Summary of literature view of Internal Corporate Governance and Corporate Cash Holdings

As you all know, investments in cash are essential for corporations. Up to now, the transactions cost is
attracted a lot of scholars’ attention and they assumed transactions cost is the major determinant of
cash level, they think that firms will hold more cash if they have benefit with marginal cost.

(Opler and others 1999) consider two board explanations to give more evidences on the determinants
of cash holdings: the tradeoff theory and the financing hierarchy theory. Based on the tradeoff theory,
firms give up the costs and benefits of holding cash to get the optimal cash levels. Besides that, they
consider the transactions costs, the asymmetric information and the agency cost of external financing
as the determinants of cash holdings. In term of the financing hierarchy theory, based on the pecking
order theory of capital structure, there is no optimal cash level. Moreover, (Opler and others 1999)
analyze the tradeoff and hierarchy aspects of cash holdings as mentioned above for all firms on the
Compustat database from 1952 to 1994. The result of that analysis is that smaller firms will hold more
cash and have lower net working capital if their investment and R&D expenditures is high and they
have better investment opportunities. In this tradeoff model, both transactions cost, and asymmetric
information are important determinants. But there is still no one gives significant evidence on the
impacts of corporate governance on cash holdings.

(Mikkelson and Partch 2003) point out that the ownership structure of both firms in which one hold
large cash reserves and the one have normal cash levels is the same. But his analysis is opposite with
Harford’s analysis (Harford 1999) which mainly focused on the effect of cash holdings on the
acquisition of that firm. In Harford’s work, the companies which have a high cash level are likely to
attempt acquisitions, and those companies tend to pay a higher price for the acquisition, but their
operating performance after acquisitions is worse than others. Therefore, the agency costs matter
when managers want to hold more cash.

The reason for there is little proof to suggest that agency costs matter in cash holdings is most of the
research focus on the US, but there is good protection for shareholders. So, shareholders in the US can
claim managers to give them surplus funds. Through this paper, by using international data, the
impacts of corporate governance on cash holdings could be clearer. The main reason for using data
over the world is that the variation in agency costs of equity between countries is likely to be at least
as considerable as the variation between companies in a given country. If the analysis is based on
data from one country, the importance of corporate governance can be biased.

As a result of the research, Dittmar, Mahrt-Smith and Servaes find out that firms in low-level
shareholder protection countries hold more 25% cash reserves than the one in high-level shareholder
protection. This 25% can increase to 70% if they control the development of capital market.
Moreover, when they done with shareholder rights, if debt markets are more developed, the
proportion of cash in company will raise which is consistent with agency cost theory. Based on this
evidence, they also point out that firms tend to raise cash levels when their market-to-book ratios and
R&D expenditures is higher. Moreover, larger firms have lower cash levels while profitable firms
have higher ones, and because net working capital can convert to cash easily so, the higher net
working capital firms have, the lower cash level firms hold. Thus, working capital and cash are
substitutes. 

In addition, they conduct two more tests to verify that agency cost has an important effect on firms’
cash level. The first test is about the dependence of shareholder rights on cash holdings to investment
opportunities. The interpretation of this test is that managers hold more cash because shareholders
cannot compel them to give back the excess funds, so managers can ignore shareholders’ interest to
make decisions. With low-level shareholder protection countries, it may be more expensive to
external financing. This leads managers to decide to hold more cash for good opportunities which can
occur in the future. On the other hand, because the transactions cost is not the main factor affect on
cash holdings so that if the agency problem has an impact on cash holdings, managers tend to ignore
investment opportunities when there is low shareholder protection. Therefore, in lower agency
conflict countries, investment opportunities and cash is stronger tie. 

The second test is based on the research of (RAJAN and ZINGALES 1995). Dittmar, Mahrt-Smith
and Servaes use their measure of outside financing to distinguish between transactions cost and
agency cost. Firms in industries that depend on external finance have more cash. In addition, the
unconcern for external finance is the cause of agency problems in cash holdings. 

In conclusion, the corporate governance is important determinants of cash holdings all over the world,
but there is not many scholars prove the effect of agency costs on cash holdings outside the US.
(RAJAN and ZINGALES 1995) provide some statistical data of cash holdings of the G-7 countries in
1991, especially, Japanese firms hold a double amount of cash than other countries. (Pinkowitz and
Williamson 2001) focuses on this huge cash level in Japan, and they find out that corporate cash
holding decrease as bank power weakened overtime. 

References:

Harford, Jarrad. 1999. ‘Corporate Cash Reserves and Acquisitions’, Journal of Finance, 54.6: 1969–
97 <https://doi.org/10.1111/0022-1082.00179>

Mikkelson, Wayne H., and M. Megan Partch. 2003. ‘Do Persistent Large Cash Reserves Hinder
Performance?’, The Journal of Financial and Quantitative Analysis, 38.2: 275
<https://doi.org/10.2307/4126751>

Opler, Tim, Lee Pinkowitz, René Stulz, and Rohan Williamson. 1999. ‘The Determinants and
Implications of Corporate Cash Holdings’, Journal of Financial Economics, 52.1: 3–46
<https://doi.org/10.1016/s0304-405x(99)00003-3>

Pinkowitz, Lee, and Rohan Williamson. 2001. ‘Bank Power and Cash Holdings: Evidence from
Japan’, Review of Financial Studies, 14.4: 1059–82 <https://doi.org/10.1093/rfs/14.4.1059>

RAJAN, RAGHURAM G., and LUIGI ZINGALES. 1995. ‘What Do We Know about Capital
Structure? Some Evidence from International Data’, The Journal of Finance, 50.5: 1421–60
<https://doi.org/10.1111/j.1540-6261.1995.tb05184.x>