MARKET FRICTIONS AND ABILITY TO INVEST:

A CASH HOLDING POLICY PERSPECTIVE

Maria-Teresa Marchicaa , Roberto Muraa a

Manchester Accounting and Finance Group Manchester Business School (UK)

ABSTRACT This paper is an original attempt to analyse the effect of different cash holding policies on corporate investment decisions. In a dynamic framework, where firms have both present and future investment opportunities, corporate cash holding may secure the ability to invest in presence of market frictions. We distinguish two groups of companies that differ for their liquidity position relative to the estimated target cash. Our findings show that firms displaying a persistently low cash policy invest less in fixed assets. However, they do not appear to be more exposed to capital markets imperfections than other companies. They seem to have access to alternative sources of funds that enable them to increase non-routine investment and acquisitions in the future. On the contrary, we find that a persistently high cash policy has a strong significant impact on capital expenditures. Cash-rich firms show a significantly lower investment-cash flow sensitivity suggesting that these companies are less exposed to market frictions and to potential overinvestment issues. In addition, a strategy of accumulation of internal funds allows companies to invest more in high growth projects, complete planned acquisitions and increase dividend payment over time.

This draft: January 2008

JEL Classification: G31, G32, D29 Keywords: cash holding policy, investment-cash flow sensitivity, ownership structure, GMM

Address for correspondence: Maria-Teresa Marchica, Manchester Accounting and Finance Group, Manchester Business School, Crawford House, Oxford Road, Manchester, M13 9PL, UK; phone: +44 (0) 161 2750121; fax: +44 (0) 161 2754023; e-mail: maria.marchica@mbs.ac.uk We would like to thank Gabriella Berloffa, Utpal Bhattacharya, Michael Brennan, Annalisa Ferrando, Andrea Fracasso, Chris Gilbert, Jose Guedes, Wei Min Liu, Aydin Ozkan, Ser-Huang Poon, Norman Strong, Roberto Tamborini, Alex Taylor and the participants of the seminars at Manchester Accounting and Finance Group and University of Trento for their helpful comments and discussions. We are grateful also to all the participants at the EFA USA 2007, EFMA 2006 and PFN 2006 meetings. The usual disclaimer applies.

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Electronic copy available at: http://ssrn.com/abstract=1101077

1. Introduction Recently, Almeida et al. (2004) in their empirical analysis of the cash flow sensitivity of cash holding, emphasize the link between demand for liquidity and financing constraints. They suggest that in a dynamic framework where firms have both present and future investment opportunities, and in which cash flows from assets in place may not be sufficient to fund all positive NPV projects, accumulating cash holding would ensure the firms ability to invest. In other words, depending on the firms capacity to raise external finance, hoarding cash may facilitate future investments. This paper is an original attempt to systematically analyse the effects of different cash holding policies on firms investment ability to evaluate more thoroughly the importance of market imperfections on the investment decisions. In the investment literature, to the best of our knowledge, only Fazzari et al. (1988), Devereux and Schiantarelli (1990) and Kadapakkam et al. (1998) include liquidity stock variables in their investment models. They find in general a positive and significant impact of cash stock on capital expenditures for subsamples of firms that are a priori assumed to have less access to external capital markets. Their main objective, however, is to analyse how investment-cash flow sensitivity changes across these sub-samples. On the contrary, we propose the use of cash holding as a clustering criterion and, more in detail, we investigate the link between cash holding strategies and the firms ability to invest. Given their access to external funds, firms may accumulate liquidity in an attempt to improve their ability to invest. Therefore, we argue that it is important to examine the impact of distinct cash holding policies on investment-cash flow sensitivity. Another strand of the literature focuses on how large amounts of cash stock are spent by companies. In particular, Opler et al. (1999) show that firms with large cash reserves tend to keep their liquidity instead of investing it in fixed assets. This reflects a precautionary financial policy. In contrast, Blanchard et al. (1994) and Harford (1999) support the agency view of managerial behaviour, in which managers seek to maximize their own utility when considerable amounts of liquid assets are available in the firm. However, when a persistent behaviour of accumulating liquid assets over time is observed, there is no evidence of such adverse incentives for cash-rich firms (Mikkelson and Partch, 2003). Our study provides a more comprehensive analysis of both low and high cash firms, because different firms cash holding policies may have distinct effects on their investment patterns. Furthermore, in order to avoid our results being affected by temporary lack or abundance of liquid assets, we explore the behaviour of firms over time in order to capture the persistency of cash holding policies, in line with Mikkelson and Partchs (2003) argument. 2
Electronic copy available at: http://ssrn.com/abstract=1101077

In estimating the target cash holding, we take into account two important issues overlooked by previous studies and that may affect the target computation: the endogeneity among the variables included in the cash model and the evolution of the adjustment speed over time. On the one hand, endogeneity may arise for various reasons. Shocks that affect both cash and the determinants of cash may be related to changes in the interest rates or inflation; crosscausality may occur between cash and leverage or cash and managerial ownership. On the other hand, a time-variant adjustment speed is a more appropriate representation of the behaviour of firms that revise their targets year by year and change the adjustment speed towards their target, due to changes either in macro or industry conditions or within the firm itself, or due to the distance from the target itself. In order to mitigate these two problems, we alternatively adopt two techniques: GMM and cross-sections average (CSA). GMM methodology has the advantage of being able to deal with potential endogeneity and individual heterogeneity problems simultaneously, but it does not allow us to compute annual adjustment factors. Therefore, as an alternative method we adopt also the CSA that enables us to deal with the time-variant adjustment speed issue and, to a certain extent, also with endogeneity problems (Rajan and Zingales, 1995). In the first step of our study we estimate firms target cash holdings, by considering firms characteristics that affect their capacity to raise external finance in the presence of transaction costs, agency conflicts and information asymmetry. The lower the ability of a company to raise external funds, the larger its cash holding is expected to be in order to maintain the firms ability to invest. In the second step we test this prediction. We measure the ability to invest by checking firms liquidity position relative to their estimated target cash. We conjecture that firms that persistently deviate from their estimated target cash holdings would exhibit different investment behaviors. More specifically, low cash firms that are persistently below their estimated target cash reserves, are considered less able to invest. This is because, if the estimated target level of cash is determined by the ability to raise external finance, and firms hold less than the desired amount, then their capacity to invest will be hampered. Their investment expenditures are therefore predicted to be lower in level and more sensitive to cash flows than their counterparts. High cash firms, on the other hand, have cash holdings persistently higher than their estimated target. They are expected to be more able to invest. By holding larger amounts of cash firms may reduce some of the costs associated with external funds, and invest in valuable projects whenever they arise. We predict that the investments of such firms will be higher in level and less

sensitive or insensitive to cash flows. We also test the alternative hypothesis that high cash policy is driven by managerial discretion. This is the first study investigating the relation between cash holding policies and investment decisions using UK data. By examining UK data, we provide out-of-sample evidence complementing above work using US data. Our findings show that firms displaying a persistently low cash policy invest less in fixed assets. Nonetheless, they do not seem to be more exposed to capital markets imperfections than other companies as measured by cash flow sensitivity parameter. Robustness checks reveal that PLC firms seem to have access to alternative sources of funds, especially equity capital, that allow them to finance non-routine investment and future acquisitions. On the hand, results report that being a cash-rich firm has a strong positive impact on capital expenditures. Further, a persistently high cash policy seems to decrease the investment sensitivity to cash flow suggesting that this policy may reduce the exposure of companies to market frictions and overinvestment issues. A strategy of accumulation of internal funds allows companies to invest also in high growth projects, complete planned acquisitions and increase the dividend payment. The paper is organized as follows: the subsequent section includes the research design. Section 3 describes the data used in the analysis. In Section 4 we discuss the results. Section 5 presents robustness checks. Conclusions are in Section 6.

2. Research design A number of studies provided different ways to measure high/low cash holding. One of the methods adopted is based on a fixed classification rule for distinguishing between low and high cash firms. Mikkelson and Partch (2003) define cash-rich firms as those having more than 25% of total assets in cash and cash equivalents. Besides the arbitrary decision in choosing the cut-off level, this approach has some other drawbacks. First, it is reasonable to assume that the amount of cash held by one firm is the result of a series of its specific characteristics. For instance, own calculations reveal that levels of cash are significantly different across different sectors. Furthermore, the analysis by Opler et al. (1999) for US companies and Ozkan and Ozkan (2004) for UK firms, demonstrate that firms have indeed a target cash. In addition, an increasing number of work on capital structure decisions corroborate the idea that firms have flexible target of debt (Graham and Harvey, 2001; Bancel and Mittoo, 2004; Brounen et al., 2006). Although in a different area, we could reasonably apply the conclusion reached by Graham and Harvey (2001) to cash holding policy. Consequently, a fixed cut-off approach 4

does not consider the possibility of different targets across firms. Suppose that two firms are classified as cash rich because their actual cash holding is above a pre-defined cut-off level. However, the two companies differ in their target levels. The target cash of one of them is below the cut-off level, while the other one is above the actual amount of cash. In this last case, it would not be correct to define the company as cash rich as its actual amount of liquid assets is below its target. Further, firms tend to change their level of cash holding year by year, depending on changes either in macro or industry conditions in the firms life. Therefore, a fixed cut-off does not account for possible changes of the firms target over time: for the same firm, a fixed cut-off value may be too high in certain years and too low in others. The alternative approach to define cash rich companies, therefore, takes into account the possibility that a firm has a target cash. As consequence, positive deviations from the target represents a way to identify those companies with large amount of accumulate cash. Two different methods have been proposed in this literature. One is to define the target as the time average of the relevant variable (Opler et al., 1999). The implied assumption in this case is that, firms are expected to have, on average, a fixed target over a reasonably long period of time. The other one is to obtain the target for each firm from the fitted values of a specified model for cash holding (Opler et al., 1999; Harford, 1999). Using this second method, the target is more accurate and is more directly related to those factors that are relevant in determining the firms capacity for external finance. Therefore, the first part of our analysis is dedicated to the estimation of a cash model and, in particular, to the investigation of the determinants of cash holdings, in order to estimate the target cash holding for each firm and then, the corresponding deviations.

2.1 Hypotheses on the determinants of cash holding The presence of financial market imperfections increases the cost of external capital, and this may limit firms capacity for external funds. Firms are, then, induced to accumulate more liquid assets in the attempt to mitigate two major problems: being short of liquidity and foregoing valuable projects. The literature suggests that transaction costs and precautionary motives are the main reasons to hold cash (Keynes, 1936). Further, the agency costs of managerial discretion may be another explanation of cash accumulation, as the free cash flow theory implies (Jensen, 1986). Entrenched managers would accumulate cash to pursue their own projects at the shareholders expense. At the same time, they could also avoid the discipline of capital markets.

2.1.1 Transaction costs The central idea of the transaction motive of is based on the costs of converting cash substitutes into cash (Keynes, 1936). Firms can procure prompt liquidity in different ways, such as raising funds on external markets, cutting dividends or investment, or selling liquid assets. Nevertheless, all of these are costly. As a consequence, cash might be used as a buffer against the possibility of having inadequate funds to implement valuable projects. The higher the cost of being short of liquidity, the larger the amount of hoarded cash will be. Keynes (1936) defined this situation as the transaction costs motive to hold cash. Leverage is the first cash substitute we include in our cash model. The amount of debt in a firms capital structure may represent its capacity to raise external funds or, in other words, its aptitude for accessing capital markets (John, 1993). From another perspective, Baskin (1987) argues also that a higher proportion of debt to total assets amplifies the costs of investing in liquid assets. All these rationales lead to the prediction of a negative relationship between cash holding and leverage. Nonetheless, at higher levels of debt the probability of financial distress becomes more likely and, thus, the costs of being short of liquidity also increase. Firms with large amounts of debt may therefore save more cash, to reduce their financial distress probability. In order to take into account both of these competing effects of debt on cash policy, we expect the relationship between cash holding and leverage to be U-shaped. We define cash as the ratio of total cash and equivalents to total assets (CASH), while leverage is equal to the ratio of total debt to total assets (LEV). Cash flow is another proxy for the transactions costs of demand for liquidity (Kim et al., 1998). Firms with high cash flows have lower costs of liquidity shortage and, consequently, they have fewer incentives to hold large amounts of cash. Therefore, we predict that cash flow is negatively related to cash. Nonetheless, in line with the view that firms may prefer internal to external capital, we might also expect companies with higher cash flows to accumulate more cash. As a proxy for cash flow (CFLOW) we use the operating profits before tax, interest and preference dividends plus depreciation standardized to total assets as in Kim et al. (1998). On the other hand, if cash flows are uncertain and variable over time, the expected costs of liquidity constraints may become more severe, and lead firms to renounce valuable investment opportunities. There is some empirical evidence that companies with higher cash flow volatility permanently forgo investments, rather than use external capital markets (Minton and Schrand, 1999). Then, cash flow variability is expected to be positively related to cash 6

reserves. We calculate the cash flow variability as the standard deviation of industry cash flow (SIGMA), in line with Opler et al. (1999). For each firm, we compute the cash flow standard deviation for the previous 10 years, when available. We then take the average across sectors of the standard deviations of firm cash flow. We also control for dividend payout as an alternative source of liquid funds. Firms that pay dividends can curtail them to generate funds at lower costs than non-dividend paying companies. In consequence, we predict that the relationship between dividends and cash is negative. Nonetheless, it is also maintained that dividends may be regarded as an efficient instrument to mitigate managers-shareholders conflicts (Easterbrook, 1984). Therefore, cutting dividends may prove costly, by creating a negative reputation amongst external investors. This may imply further difficulties in raising funds in capital markets. To the extent that this argument holds, firms with positive payouts would prefer to accumulate cash rather than reduce payments to shareholders. Dividends (DIV) are defined as the ratio of total dividend pay-out to total assets. Finally, firms with increasing growth opportunities face a higher probability of having to give up better projects under liquidity constraints. So, cash holding is predicted to be positively related to in investment opportunities. As a proxy for growth opportunities we use the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets (MTBV).

2.1.2 Asymmetric information As investors do not have the same information about a company as its managers do, they want to be sure to buy securities that are not overpriced. Even if managers are acting in the shareholders interests, outsiders will tend always to discount the securities price. A higher cost of external capital will thus induce managers not to sell securities and not to invest in some profitable projects (debt/equity rationing). The asymmetric information based models (e.g., Stiglitz and Weiss, 1981; Myers and Majluf, 1984) predict that underpricing problems are more relevant when securities are more information-sensitive, and when information asymmetries are more acute. We consider two types of firms with important asymmetric information problems: firms with high investment opportunities, and small companies. Growth opportunities are likely to increase a firms value when they are realized. However, if the cost of external capital becomes higher, firms may be forced to pass up some of these investments. Therefore, they may tend to accumulate more cash, in the attempt to avoid limitations on the realization of their projects. Another reason to hoard cash stock may be that firms with higher growth 7

opportunities are more likely to suffer higher bankruptcy costs (Harris and Raviv, 1990). This is because growth opportunities are basically intangible assets, and their value may substantially decrease in case of bankruptcy or financial distress. So, as argued before, firms will tend to reduce such a risk by hoarding a larger amount of cash. It has been suggested that small companies are more informationally opaque than larger ones (Petersen and Rajan, 1994). Therefore, they may suffer more borrowing constraints and higher costs of external funds. In addition, smaller firms are less diversified and, consequently, more likely to experience financial distress (Titman and Wessels, 1988). To the extent that size is an inverse proxy for asymmetric information, we would expect a negative relationship with cash. The natural logarithm of total assets is the proxy for size (SIZE).

2.1.3 Agency costs of debt From contracting-cost theory, we derive that managers maximizing shareholders value may have incentives to choose riskier projects than those agreed with bondholders. This would generate a transfer of value from bondholders to shareholders, because the latter would not pay any of the gains from riskier ventures to creditors, yet bondholders would bear part of the risk of failure (asset substitution problem, Jensen and Meckling, 1976). There would be therefore an incentive for bondholders to increase the cost of capital through interest rates, bond indentures or other legal devices. Conversely, a transfer of value from shareholders to bondholders may occur in the presence of outstanding debt in the capital structure of firms. In some states of nature, the benefits accruing to debtholders from a profitable investment project would not give normal returns to shareholders. The higher the outstanding debt, the more selective the managers may be in choosing certain projects. Hence, it is possible for firm to reject positive NPV projects at the expenses of the firm value itself (underinvestment problem, Myers, 1977; Barnea et al., 1980). Companies with high growth opportunities are more likely to be subject to greater agency costs of debt. Therefore, in order to maintain a certain financial flexibility, they will tend to accumulate more cash. As before, since small firms are less diversified and have limited access to capital markets, they may suffer more severe agency costs of debt (Titman and Wessel 1988). We therefore predict an inverse relation between cash and firm size.

2.1.4 Agency costs of equity If there are conflicts between managers and shareholders, managers would tend to accumulate as much cash as possible to pursue their own projects, in line with the free cash 8

flow theory (Jensen, 1986). Cash might be spent in perquisites, but also in projects that equity investors would be unwilling to finance. In addition, managers may also hold excess cash because of their risk aversion. More entrenched managers would tend to hold more cash because they can avoid market discipline and reduce the likelihood of losing their jobs. In their seminal work, Jensen and Meckling (1976) maintain that insider shareholding helps to align the interests of shareholders and managers. Jensen (1993) also argues that many problems arise from the fact that neither managers nor non-manager board members typically own substantial fractions of theirs firms equity. In other words, managers without shares would obtain all the private benefits derived from an expropriation, while managers with a positive amount of equity would receive the private benefits minus the expropriation costs in proportion to their shareholding. Therefore, to the extent that accumulated cash is costly, managers with ownership in the firm would tend to stockpile less cash. In addition, lower expected agency costs due to the alignment between managers and shareholder would decrease the cost of capital and facilitate the firms access to capital markets. This could further, in turn, reduce the accumulation of cash (the incentive-alignment effect). Nonetheless, theoretical predictions by Fama and Jensen (1983) and empirical evidence on ownership and performance (e.g., Morck et al., 1988; McConnell and Servaes, 1995; Lasfer, 2004; Mura, 2007) reveal an non-linear effect associated with increasing managerial ownership. Applying this to the cash holding area, we could argue that at a certain point of their shareholding, managers with increasing voting power and effective control over the firm may become entrenched, and start accumulating excess liquidity in order to keep the flexibility of pursuing their own projects (the entrenchment effect). Part of the previous literature on cash holding has suggested the possibility of a non-linear relationship between cash and managerial ownership. Opler et al. (1999) find a linear relation only, while Ozkan and Ozkan (2004) a cubic one. The extant literature does not provide robust predictions about which of these effects would prevail. For robustness purposes, we investigate whether the impact of managerial ownership on cash in our model is either linear or non-linear. As a proxy for managerial ownership we use the proportion of shares held by executive directors (MAN) and the square values (MAN2) for the non-linear hypotheses. In the cash holding analysis we control also for the effect of blockholding, since managerial discretion is stronger when shareholding is highly dispersed. In a dispersed company, in fact, there are greater free riding problems amongst shareholders: for each atomistic non-managerial owner, the difference between the costs and the benefits of 9

monitoring the incumbent management is so significant that no small shareholder has the incentive to monitor managers and to take the necessary actions to remove them. As Stiglitz (1985) and Shleifer and Vishny (1997) argue, larger shareholders have greater incentives to be involved in the control process than smaller ones, because they can more easily bear the high fixed costs of collecting information on management behaviour. In line with this argument, we would expect a negative relation between cash holding and blockholding. Nonetheless, the presence of a large non-managerial shareholder could in turn also generate other agency costs. Large shareholders, in an attempt to maximize their own wealth, may actively expropriate minority investors (Shleifer and Vishny, 1997), or even collude with managers (Pound, 1988), by pursuing projects that would subtract funds from valuable investments or dividend redistribution. This could also have a negative impact on the cost of capital, because external investors, concerned about holding shares in a majority-controlled company, would demand a higher risk premium. As a result, the effect of ownership by the largest shareholders on cash holding would be positive. Alternatively, a larger amount of cash may allow firms to undertake more growth opportunities which, in turn, may enhance firm value. Large shareholders would benefits from these actions more than others owners due to their more substantial investment in the company and, consequently, they may force companies to accumulate more cash. We use two alternative proxies for blockholding: first, the total ownership of all non-managerial blockholders with more than 3% of shares (BLOCK); and, second, the ownership of the largest non-managerial shareholder (LARGEST). Finally, we also include in the analysis a proxy for the composition of board of directors. Due to the separation between ownership and control, the board of directors is supposed to act on behalf of shareholders, as an important mechanism to monitor top management discretionary behaviour and to ratify important decisions (Hart, 1995). As a consequence, board structure regulation becomes more and more significant. In the UK, in particular, there has been much emphasis on the view that a board of directors becomes more independent as the number of non-executives increases (Cadbury, 1992; Hampel, 1998; Higgs, 2003). With this in mind, we predict that an increasing ratio of non-executives relative to the total number of directors may ensure a better monitoring of management and, in turn, reduce suboptimal amount of cash. However, previous literature has also pointed out possible failures of the internal corporate control mechanisms. Hart (1995) considers that non-executives do not have sufficient financial interests (i.e., firms shareholding) to make them concerned about the companys performance. In addition, the reputation effect in the management labour market may even work in the opposite direction. That is, it may be that only quiet non-executives are selected for board positions. 10

Moreover, Jensen (1993) points out that non-executive directors may lack the necessary expertise to efficiently participate in planning the financial aspects that affect corporate value. Therefore, non-executives may not be efficient monitors and this could lead to higher managerial discretion in the firm and, consequently, higher level of cash holdings. We use the ratio of non-executives to the total number of directors (RATIO) as a proxy for board composition. For clarity, Table 1 summarizes the empirical predictions discussed so far and also those concerning the investment model that we will present later. [INSERT TABLE 1 HERE] Previous studies on cash holding adopted different models specifications. Some of them included economic variables only (i.e., Kim et al., 1998; Harford, 1999), while others estimated a model augmented by some ownership features as well (i.e., Opler et al., Ozkan and Ozkan, 2004)). In order to take into account this variety, we include in our analysis three main specifications: specification 1 refers to the economic model, including proxies for leverage, size, growth opportunities, cash flow, variability of cash flow and dividends. Specification 2 includes models augmented with ownership variables, that is, managerial ownership (in linear and non-linear relation), alternative proxies for blockholding and board composition. Finally, we estimate a third specification which is augmented with two proxies for alternative types of investment, that is, future capital expenditure (CAPEX) and R&D expenses (R&D). This is in order to take into account an endogenous relation between cash holding and investment.

2.2 Target cash and estimation techniques for the cash holding model Although Opler et al. (1999) and Harford (1999) have estimated the target cash from the fitted values of a specified cash holding model, their methodologies have a number of limitations. First, in estimating their cash model they assume that firms adjust immediately to changes in their cash holding targets. Still, market imperfections, such as a delay in the payments by the customers of the company, or, unexpected increases in the growth opportunities, may lead firms not to conform completely to their target, but instead to follow a pattern of partial adjustments (Maddala, 2001). In order to overcome this issue, we allow firms to partially adjust their current cash holding to be closer to their target, as in Ozkan and Ozkan (2004). We estimate, therefore, the following partial adjustment model for cash holding:
k

CASH it = CASH it 1 + k X it + i + t + it
k =1

i = 1, 2...N ; t = 1, 2...T

(1)

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where = (1 ) ; is the adjustment factor, or, in other words, what can effectively be adjusted; i are the firm-specific and t are the time-specific effects; it is a disturbance term which is assumed to be serially uncorrelated with mean equal to zero. OLS and Within Group (WG) estimators are known to be inconsistent and biased, because of the presence of endogeneity of the lagged dependent variable and individual heterogeneity (Arellano and Bond, 1991). These issues advocate the use of an Instrumental Variables estimation technique, in particular the Generalized Method of Moments (GMM-DIFF, or for the sake of brevity, GMM). By including suitable moments of regressors as instruments, GMM estimator has been shown to be more efficient in dealing with the endogeneity problem of both the lagged dependent and all the other regressor (Arellano and Bond, 1991). This is the second issue that previous studies do not address in estimating their cash holding model (Opler et al., 1999; and Harford, 1999). The endogeneity among variables may arise because shocks that affect cash holding are also likely to affect such regressors as cash flow, growth opportunities and leverage choices. For example, changes in the interest rates or inflation rate are likely to impact the value of total assets. Therefore, through total assets these changes affect at the same time cash, cash flow, market-to-book ratio and all the regressors standardized to total assets (Frank and Goyal 2003). Moreover, endogeneity may also derive from cross causality. For instance, the amount of debt in the firms capital structure may influence its cash holding policy; however, leverage itself is also determined by changes in cash holding. In addition, cash holding may be affected by managerial ownership depending on the degree of managers desire to have enough financial flexibility to pursue their own projects. However, it could be the case that managers may be more inclined to hold shares in firms with large amount of cash holding already in place or the potential to hoard it in the near future. The choice of the instrument set is crucial for this kind of technique. The validity of the instruments is tested by the Sargan test of overidentifying restrictions, which tests the null hypothesis of the orthogonality condition of the instruments with the error term. Although the dynamic framework of the cash model and the GMM technique can help us in dealing with the issue of partial adjustment process and the endogeneity among all regressors, there is a problem, overlooked by previous studies. When a target cash model is estimated, there is a possibility of an evolution over time of the adjustment factor towards the target. In a recent survey of capital structure decisions, Graham and Harvey (2001) report that 37% of their respondents have a flexible target of debt, 34% have a somewhat tight range target and only 10% have a strict target, similarly to what documented by Bancel and Mittoo

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(2004) and Brounen et al. (2006). Although their study refers to a different firm policy from the scope of this work, we could reasonably assume that, even for cash-holding decisions, firms tend to change their targets and the adjustment to the targets year by year, depending on changes either in macro or industry conditions or in the firms life. This means that the magnitude of the estimated coefficients in the cash model may change annually. Consequently, the GMM methodology in a panel data framework would not allow us to compute time-variant adjustment factors, because it only provides a fixed adjustment factor () and, fixed coefficients over the entire estimation period. In the attempt to reduce such problem, we decide to adopt as an alternative approach the cross-section average estimation technique (hereinafter CSA), proposed by Rajan and Zingales (1995). This method enables us to deal with the time-variant adjustment factor issue and also, to a certain extent, with endogeneity problems. In particular, in our case we estimate the following equation:
k

CASH i = + k X ki + ui
k =1

(2)

where the dependent variable is in level for each year of the estimation period; all the explanatory variables are averaged over the three years preceding the year of the dependent variable and they are the same as in model (1); uit is the error term. Average values are used in order to moderate the effect of short-term fluctuations or extreme values in one year, and lagging regressors help to partially control for the endogeneity. In particular, CSA may mitigate the effect of contemporaneous correlations between cash and other characteristics of the firm. Estimating a CSA model for each year within the estimation period enables us to compute targets that account for a time-variant adjustment factor for each firm. We are aware of the potential shortcomings of this method. First, we cannot implement a partial adjustment behaviour for cash holding policy, as we can with GMM procedure. Second, the averaged regressors in CSA reduce the variability of data. Consequently, some coefficients may become statistically insignificant simply due to lack of data variability (Wooldridge, 2002). Bearing all these arguments in mind, we decide to estimate 11 overlapping CSA over 1991-2001 period. Then, the annual target is computed from the fitted values of each CSA in each year.

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2.3 Definition of cash holding status and Investment decisions

We derive the target level of cash holding from the fitted values of the GMM (or, alternatively, CSA) estimations which represent what financial theory would predict the level of cash holding of each company to be. After that, we calculate the deviations from the target as the difference between the actual and the estimated target level of cash holding. We define firms as low cash LC (high cash, HC) those with a negative (positive) deviation.1 Finally, a firm is defined as a persistently low (high) cash when we observe at least three consecutive periods in which the firm is classified as LL (HC) prior to the investment decision (PLC3 and PHC3).2 Table 2 Panel A provides an example of how we define PLC3 firms. Because the cash model is estimated in first difference, the first observation is lost (denoted as N/A in the table). Moreover, since we require at least three consecutive observations in which firms are LC to assign the PLC3 status, the first available observation to meaningfully classify PLC firms is the 4th one (corresponding to the 1995 observation in the example). Therefore, in Table 2, the observations corresponding to 1992, 1993, and 1994 are denoted as not available. This explains how, for the investment model, we are left with 3905 observations and 613 firms available. It is worth underlining that, having defined the dummy in this way in the investment model, we will investigate the relation between investment at time t (IKit) and the cash holding status dummies, which define a past behaviour (t-3t-1). This may address the concern that these dummies (and consequently cash) are endogenous to investment. [INSERT TABLE 2 HERE] 2.3.1 Persistent low (high) cash firms and investment decisions In this analysis, we identify persistent low cash firms (PLC) as those that hold below target levels of cash for a number of years. We hypothesize that in imperfect capital markets their ability to invest is limited. This is because, to the extent that desired cash holdings are determined by the firms capacity to raise external finance, lower than target cash holdings could mean that firms will find it difficult to invest. In other words, these firms may have not been able to accumulate the necessary cash to overcome the strong constraints they
For robustness purposes, we also utilized a more stringent definition. We computed the ratio of each (negative and positive) deviation to the corresponding target, in absolute value for standardization purposes. By considering the distribution of this ratio, we identify as LCpct those firms that are above the 25th percentile of the distribution for undershooting firms (negative deviations). Vice versa, HCpct firms are above the 25th percentile of the distribution for overshooting firms (positive deviations). 2 As a robustness purpose, in an alternative definition of persistently low (high) cash firms, we required only two consecutive periods (PLC2 and PHC2). We did the same when we classified companies as LCpct (HCpct). Unreported results show similar findings to what is discussed later in the paper.
1

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experience from external investors. As a consequence, their ability to invest would be hampered. Therefore, we expect that, ceteris paribus, such companies will show a lower level of investment spending relative to others. Moreover, in the earlier literature the sensitivity of investments to cash flow was used to assess the degree of capital market imperfections (Fazzari et al., 1988; Hoshi et al., 1991; Devereux and Schiantarelli, 1990; among many others). However, there is no consensus on the validity of this approach. Following Kaplan and Zingales (1997, 2000), another stream of research shows that the firms able to access capital markets are those with stronger investment-cash flow sensitivity, and that the relationship between investments and internal funds may be biased by measurement problems associated with Tobinsq (Cleary, 1999; Erickson and Whited, 2000). To the extent that investment cash flow sensitivity indeed contains information about financial imperfections, then this sensitivity should increase in PLC firms. This is because these companies may be likely to be more exposed to asymmetric information and contracting problems in the markets. On the other hand, persistently high cash firms (PHC) are those with cash holdings higher than their target. We suppose that their ability to invest in imperfect capital markets increases. Holding larger amounts of cash means reducing the costs of raising external finance, and having the necessary funds to invest in valuable growth opportunities, whenever they occur. Hence, we predict that capital expenditures for such firms should be higher. Furthermore, similar to the argument given above regarding PLC firms, we maintain that investment cash flow sensitivity should decrease for PHC companies, because they are more likely to reduce the impact of capital market imperfections. 3 In contrast to the view that large cash holdings serve shareholders interests, one could argue that higher accumulation of cash may be driven by managerial discretion. In line with the free cash flow theory, entrenched managers would spend the available internal funds to maximize their own utility function, either consuming perquisites or investing in projects with high private benefits. Therefore, the positive impact of high cash holding status may reflect a free cash flow problem rather than a higher ability to invest (Jensen, 1986). To the extent that the managerial discretion hypothesis holds, then the investment cash flow sensitivity should increase for PHC firms. This may be interpreted as evidence for overinvestment problems, and for conflicts with financial markets (e.g., Vogt, 1994; Hadlock, 1998; Goergen and

3 A similar idea to ours is tested in a recent work by Arslan et al. (2006), although the focus of their paper is to investigate how cash holding policy can improve the investment ability of firms during a financial crisis in emerging markets.

15

Renneboog, 2001b; Gugler, 2003). Indeed, the presence of managerial discretion may increase the cost of outside capital, because external investors do not know whether management is raising cash to increase firm value or to pursue its own objectives. Therefore, this asymmetric information cost should be reflected in an increasing investment cash flow sensitivity.

2.4 Investment model

We adopt the q-model specification used by Devereux and Schiantarelli (1990) and Bond et al. (2004) for the investment analysis, augmented by the cash holding status variables. That is, capital expenditures are regressed on Tobins q and cash flow. Also, instead of partitioning the sample into different groups of firms and running separate regressions for each of them, we create dummies for each cash-holding policy status. We include them in the model both as regressors on their own and interacted with cash flow, in the attempt to investigate whether firms with persistent deviations from their target cash have indeed different investment expenditures. Therefore, the augmented models for investment spending become as follows:

IK it = IK it 1 + 1CFK it 1 + 2Qit + 3CASHSTATUSit + 4 ( CASHSTATUSit CFK it 1 ) + i + t + it

(3)

where IK it 1 is the lagged dependent variable to implement the partial adjustment model for capital expenditures; CFK it 1 is a proxy for cash flow, while Qit is a proxy for Tobins q;

CASHSTATUSit refers to both PLC and PHC dummies that are defined over three years
time;4 i is an unobserved firm specific time-invariant effect, t is a time specific firminvariant effect and, finally, it is a disturbance term which is assumed to be serially uncorrelated with mean equal to zero. The interaction terms in the results tables are denominated INTERPLC and INTERPHC for PLC*CFK and PHC*CFK respectively, for brevity reasons. As in Bond et al. (2003), among others in this area, we standardize the main variables in this model with the capital stock (K). We measure the capital stock as total net fixed assets on a replacement cost basis by adopting a standard perpetual inventory method as follows:

K it = Kit 1 (1 ) + I it

(4)

where, for the first observation, the replacement cost is assumed equal to the historic cost of total net fixed assets, adjusted for inflation; is the rate of depreciation assumed to be 0.08. Investment is measured as expenditure in fixed assets (I). The cash flow here is equal to the
In the paper we show results for two separate q-models for the two groups of firms (PLC and PHC). We estimated also models with both cash holding status dummies. Results are in line with what reported here.
4

16

ratio of operating profits before tax, interest and preference dividends plus depreciation of fixed assets to capital stock; while the Tobins q is approximated by the ratio of market value of equity plus total debt, total cash and equivalents to capital stock. Here cash flow and growth opportunities are standardized differently from cash models, in an attempt to mitigate the potential endogeneity issue that may occur by using cash holding status variables as sample-splitting criteria in the investment estimations (Schiantarelli, 1996). For symmetric reasons with the cash model estimations, we estimate the investment model adopting the CSA technique as well. The dependent variable is taken in each year over the same estimation period of the GMM estimations and the explanatory variables are averaged over the three years preceding the investment decision. We are aware that q-models are not without drawbacks. We will discuss the main limits of these models in the section dedicated to the robustness checks.

3. Data
The sample used in this analysis is constructed as follows. In the initial stage, a random sample of around 1100 listed non-financial firms was selected from Datastream constituent lists. Since ownership data were not available in readable-machine format, they were hand-collected from the Price Waterhouse Corporate Register (December issue) for the period 1991-2001. Economic and market value data were downloaded from Datastream from 1969, in order to compute the capital stock variable using the perpetual inventory method. Data on acquisitions were collected from SDC Platinum Database. To be able to follow companies over time from two different datasets, a huge effort went into tracking all the name changes (and also defunct companies) in the period. This information was collected mainly from the London Stock Exchange Yearbook, which reports systematic information on name changes, entries removed from the companies section, companies in liquidation, and companies in receivership and in administration. Moreover, as a further check, the Companies House website was used. This is an online facility that provides various types of information on companies (including name changes). In order to run the empirical analysis, a number of steps were then undertaken. First, the dataset was cleaned of outliers. The ownership part of the dataset was thoroughly inspected in several directions. For example, we double-checked that the sum of all the shares collected did not sum to more than 100. In such cases, we tried to crosscheck the information with other issues of the Hemscott volumes (using either the September edition of the same year or the March edition of the following year) and/or with the London Stock Exchange 17

Yearbook, which also contains some ownership information. When it proved impossible to find coherent information from the different sources of data, this observation was dropped from the sample. After running these tests for the ownership side of the dataset, we also checked for outliers in the economic variables as reported in Datastream. There is no fixed rule for dealing with outliers, so as a general rule of thumb, data were trimmed to the 99% percentile. The trimmed data were then always benchmarked with descriptive statistics reported in other papers. Firms in the public utilities were excluded because of the peculiarities in their operational and regulatory conditions. Also, all missing observations were dropped. Finally, only firms that had a minimum of five consecutive year observations were kept, in order to implement GMM. This is necessary to retrieve asymptotically efficient m2 tests (Arellano and Bond, 1991), which are crucial for assessing the validity of the estimations. The final sample contains 688 firms and 6410 observations, although usable observations vary according to the estimation method.

4. Results
Table 3 shows the descriptive statistics for the main variables used in this work. It reveals that the average firm has 10.4% of total assets in cash reserves. This is similar to Ozkan and Ozkan (2004), who report 9.9% in the period 1995-1998; and to Guney et al. (2006), who report 0.11 in the period 1996-2000. However, for the UK companies in Kalcheva and Lins (2006) the mean ratio is 15%, and in Dittmar et al. (2003) the median cash ratio is 8.1%. The higher mean and median values in these cross-country analyses are most probably due to normalizing cash and marketable securities by total assets minus cash and equivalents, instead of total assets. The same argument holds for the statistics reported by Opler et al. (1999) for US companies, that is, a mean value of 17%. Our companies show a larger amount of cash flow (CFLOW), on average 0.11, than the other UK-based studies. Our average company size (SIZE) is around 11.28, which is in line with the 10.87 reported in Ozkan and Ozkan (2004). We report an average value for market-tobook (MTBV) equal to 1.53 which appears more in line with the US evidence in Opler et al. (1999), 1.53. Statistics for the amount of debt in the capital structure of our sample (LEV), average 0.17, are in line with all the UK evidence. As reported in Table 3, the average capital expenditures (IK) are about 13% which is similar to the reports by Devereux and Schiantarelli (1990) and Bond et al. (2004), at 11.56% and 15% respectively. As far as the other variables in the investment models are concerned, we use two proxies for cash flow and growth opportunities, CFK and Q, which are different 18

from those we employ in the cash models, CFLOW and MTBV. CFK and Q show mean and median values significantly higher than the corresponding cash flow and market-to-book ratios in the cash model because of the different standardization. As far as the ownership variables are concerned, the average ownership by executive directors (MAN) is 8.61%. On average, UK firms in the 1990s had 4 executive and 3.2 nonexecutive directors. Consequently, non-executives are 43.2% of the total number of directors on the board (RATIO). In addition, in the average firm, the largest non-managerial shareholder owns 10.96% of shares, while all shareholders with more than 3% shares (BLOCK) hold more than 32% of the outstanding shares. These findings are similar to what reported by previous UK based studies (e.g., Faccio and Lasfer, 2000; Peasnell et al., 2003). [INSERT TABLE 3 HERE]

4.1 Cash model

We start our analysis by estimating alternative cash models with GMM methodology and then with CSA. Table 4 and 5 show the results. For GMM estimations we report three test statistics: (1) Sargan test of overidentifying restrictions, which is asymptotically distributed as chi-square under the null of instrument validity; (2) m1, first order autocorrelation of residuals, which is asymptotically distributed as standard normal N(0,1) under the null of no serial correlation; and (3) m2, second order autocorrelation of residuals, which is distributed as standard normal N(0,1) under the null of no serial correlation. GMM estimations reveals that the coefficient of the lagged cash holding is positive and significantly different from zero. The reported adjustment coefficient (obtained

from = 1 ) in model 2, for instance, is about 0.41, which seems to provide evidence that the
dynamic nature of our model is not rejected and that firms take about 2/3 years to adjust their cash holdings towards the desired (target) level. [INSERT TABLE 4 HERE]

4.1.1 Transactions costs, asymmetric information and agency costs of debt

As far as the interpretation of economic variables is concerned, in all models (1-5) we detect a significant non-linear relationship between cash holding (CASH) and debt (LEV) in line with our predictions. At lower levels leverage seems to play a substitute role for cash, because it may approximate an increasing firms capacity for external funds. A negative relationship with LEV would be also consistent with the agency costs of equity perspective. In fact, less leverage may imply less control from the external markets and, thus, higher managerial

19

discretion on firms resources. This would, in turn, increase the cash reserves. The result is consistent with both US and UK-based studies. The magnitude of the coefficient of LEV is stable to alternative specifications. Nonetheless, higher levels of debt may lead to an increasing probability of financial distress, which makes liquidity shortage a very expensive condition for firms. Our calculations of the estimated turning point of the quadratic form of LEV reveal that over time firms start hoarding cash when the amount of debt is above 32% of total assets.5 CFLOW is positive and significant in all models. The same positive result is provided by Opler et al. (1999) for the US and by both Dittmar et al. (2003) and Kalcheva and Lins (2004). This is in line with the argument that cash holding is accumulated out of cash flow, rather than the argument that they are substitutes for each other. In addition, variability of cash flow (SIGMA) does not seem to play any role in cash determination, as in Kim et al. (1998) and Ozkan and Ozkan (2004).6 The negative results for SIZE are also in line with our predictions. Larger firms are more likely to be diversified and thus less likely to experience financial distress (e.g., Titman and Wessels, 1988). In addition, they face less borrowing constraints and lower costs of external financing than smaller companies (Fazzari et al., 1988). Previous evidence are similar to ours. The positive, although marginally significant, relation between CASH and MTBV is in line with both the transaction costs hypothesis and the asymmetric information and agency costs of debt arguments. In particular, for firms with greater growth opportunities the costs of being short of funds are expected to be larger than others. As far as dividends are concerned, the negative and significant results in almost all the models in Table 4 seem to be consistent with the argument that dividends is a valuable substitute for cash. This result is in line with the US evidence provided by Opler et al. (1999).

4.1.2 Agency costs of equity

We conducted a number of tests to investigate in detail the role played by ownership and corporate governance structures in determining cash holding. Models 2 and 3 present results on executives ownership (MAN) in two alternative functional forms. MAN is statistically insignificant when included in a linear fashion, while the nonFor example, the inflexion point for the quadratic relation of leverage in Model 2 is calculated as the solution to the following equation: CASH = -0.228LEV + 0.306LEV2. We differentiate CASH with respect to LEV, CASH LEV = 0.228 + 0.306 LEV ; we let CASH LEV = 0 and we solve for LEV. Similarly, we calculate the inflexion point for the quadratic relation of managerial ownership. 6 As a robustness check we use an alternative measure for cash flow variability, defined as the standard deviation of cash flows over the 6 preceding years divided by average total assets calculated in the same 6 years. Unreported results, however, are not different to those presented here.
5

20

linear relation seems highly significant (Models 3-5). The relation with cash holding shows the predicted signs in line with the hypothesis of an alignment effect for lower values of executives shareholding and an entrenchment effect for higher values. This result is different to that in Opler et al. (1999) where only a linear relation is significant and dissimilar to the evidence in Ozkan and Ozkan (2004) for the UK, which reports a significant cubic relationship between board ownership and cash.7 Our calculations of the estimated turning point of the quadratic form of MAN reveal that over time managers start accumulating cash when their ownership is above 34%. In Models 2 and 3 the proxy for blockholding (BLOCK) is negative and significant in line with our monitoring prediction. Large shareholders may provide an efficient monitoring action of managerial behaviour and this would reduce the incentives of managers to accumulate cash reserves for their own interests. Nonetheless, when we substitute BLOCK with LARGEST, this relation disappears, maybe suggesting the necessity to have a large stake in the company to make shareholders able to effectively monitor. Finally, as far as ownership is concerned, RATIO is negative, but insignificant in most of the models (Model 3, 4 and 5). In a different area, this is consistent with Faccio and Lasfer (2000) and Lasfer (2004) who find insignificant improvements in market performance from increasing the number of non-executives in the board. One possible explanation for this result is that non-executives do not have sufficient financial incentives to efficiently monitor executives decisions (Jensen, 1993), here in particular with respect to the cash holding policy. As GMM estimations provide a fixed adjustment factor and fixed estimated coefficients over the entire estimation period, we employ also the CSA method in order to allow the coefficients to vary every year. To this end, we replicated the estimations of the baseline model (Model 3) in CSA for every single year. Results are reported in Table 5. In CSA estimations, regressors are averaged over the three years preceding the year in which the dependent variable is measured. Therefore, we estimate 11 cross-section averages from 1991 to 2001. Comparing CSA and GMM results, we can see a certain degree of consistency among coefficients in terms of signs and significance. The only exceptions are SIZE, which is significant in both estimations, although with opposite signs; and BLOCK and DIV which are significant in GMM and insignificant in all cross-section averages. This may be due simply to differences in the econometric techniques adopted for the two sets of estimations.

For robustness purposes, we also substituted board ownership for executive ownership. In unreported results, this left the significances unchanged.

21

In CSA, SIZE is positively related to CASH. This is maybe due to the different ownership structures between small and large firms in line with the argument proposed by Devereux and Schiantarelli (1990). Larger firms tend to have more dispersed ownership. Therefore, the monitoring incentives by non-managerial shareholders would be lower and managerial discretion may be increasing. This would, in turn, determine a higher accumulation of cash holding. However, GMM results show the opposite sign for SIZE, possibly suggesting a prevailing effect of asymmetric information and debt agency costs. This leads us to be cautious in interpreting this relation. Finally, MTBV and RATIO show more significant results in CSA than in GMM estimations. Their signs are consistent with our previous findings. [INSERT TABLE 5 HERE]

4.2 Persistently low (high) cash firms

In the second step of our analysis, after computing the target for each firm, we calculate the deviation of the actual level of cash to the desired one, and, then, the ratios of the deviation to the corresponding target for both undershooting (those with a negative deviation) and overshooting (those with a positive deviation) firms. We identify LC (HC) firms, and we then define persistently low (high) cash firms following the criteria discussed in the methodological section: a firm has to be identified as a LC (HC) cash either for two or three consecutive periods prior to the investment decision year. Table 6 presents tests for differences in mean values of the main variables used in our analysis, for each group of firms and across the entire estimation period. PLC firms seem to use alternative forms of finance to cash more intensely than the control firms, as evidenced by the significantly higher value of leverage (LEV), but, more interesting, of new debt (DEBT ISSUE) and new equity issues (EQUITY ISSUE), suggesting that PLC firms may have a facilitated access to external markets. DEBT ISSUE is defined as the difference between the amount received from issuing debentures, loans, notes, bonds and from other short and long term borrowing and the amount repaid of the same types of debt. This is standardized to total assets. EQUITY ISSUE is the cash proceeds of issues of equity shares to total assets. Moreover, in line with predictions, PHC firms seem to have better growth opportunities than the other group of companies, as indicated by the higher value of marketto-book ratio (MTBV). PHC firms seem on average to be larger than PLC. This is in contrast with the view that larger firms face less severe asymmetric information problems and hence accumulate less cash.

22

Finally, there is mixed evidence in the ownership characteristics. On the one hand, in line with the managerial discretion hypothesis, PHC companies show significantly lower managerial ownership and lower concentration of non-managerial ownership, which may provide the executive directors with greater discretion. On the other hand, they exhibit a significantly higher number of non-executives on the board, probably suggesting tighter monitoring. [INSERT TABLE 6 HERE]

4.3 Investment model

We now move on to the investment model estimations, to verify whether firms with different cash holding policies indeed have different abilities to invest in capital expenditures. Table 7 includes GMM estimations and the results from a pooling of CSAs over the same estimation period. [INSERT TABLE 7 HERE] In general, growth opportunities are significantly related to investment decisions, while cash flow itself seems to play a less relevant role in GMM estimates. This is in contrast to the findings of previous work. The reason for this may lie in the different methodology we adopt. In fact, when we replicate the model as estimated by Bond et al. (2004) in GMM with the same instruments set, our results are in line with theirs. However, in their work, Bond et al. (2004) consider Q an exogenous variable. On the contrary, in the context of our work, we believe that it is a sensible assumption to consider all the regressors as endogenous. Therefore, estimating the investment model without the inclusion of our cash holding status dummies shows that allowing Q to be endogenously determined may be the reason why CFK becomes less significant. As far as the cash holding status variables are concerned, for brevity reason, in all our investment models we report the results for the dummies calculated over the three years preceding the investment decision. Estimates for the other dummies (defined over the two years and with the percentile method) are virtually identical to what reported here. Following our arguments, PLC companies are expected to have a lower ability to invest. In CSA estimations, we find that a policy of persistent low cash holdings has indeed a negative impact on capital expenditures, as evidenced by the strong and significantly negative relationship between PLC3 and capital expenditure. Similar signs, insignificant though, are reported in the GMM estimations. Furthermore, we find that the investment-cash flow sensitivity is insignificant for PLC firms (INTERPLC) in both set of results, although the positive sign is consistent with our

23

prediction: to the extent that investment cash flow sensitivity contains information about financial imperfections, then INTERPLC was expected to be positive and significant, because PLC firms are more likely to be exposed to asymmetric information and contracting problems. The insignificant result we obtain may be consistent with an alternative hypothesis that this particular group of firms has indeed better access to external funds. One could argue that low cash firms are those that do not need to save cash because they are, in the first place, more capable of raising external funds. This could be the case, for instance, for firms that show considerable amounts of new debt or equities issues. Nonetheless, if this argument holds, we would expect more investment in capital stock. Therefore, the negative impact of PLC status on investment expenditures itself seems ambiguous and more difficult to explain within this analysis. On the other hand, PHC firms are expected to be more able to invest. Indeed, it seems that being cash-rich has an impact on capital expenditures. PHC3 appears positive and strongly significant in both sets of results. Furthermore, the sensitivity of investments to cash flow seems to significantly decrease when it interacts with PHC status (INTERPHC3). This result seems to be in line with the prediction suggesting that hoarding cash makes companies more able to invest. The decreasing investment cash flow sensitivity for PHC companies does not appear in line with the overinvestment hypothesis discussed above. This seems to be in line with the conclusions reached by Opler et al. (1999) and Mikkelson and Partch (2003). This is also consistent with the descriptive statistics in Table 6, showing higher growth opportunities for this group of companies. Generally, the agency costs of equity appear less important for firms with valuable investment opportunities.

5. Robustness Checks
Several robustness checks were conducted in the attempt to corroborate our findings and their interpretations. We investigate first whether previous results are robust to: a) different cash models; b) a different approach to define PLC (PHC) firms; c) a different investment specification. Second, we conduct an additional intertemporal descriptive analysis to further investigate the behaviour of the two groups of companies in terms of their alternative spending patterns and alternative sources of funds.

5.1 Alternative cash models

Our cash analysis incorporates a comprehensive set of variables that approximate almost all the capital market imperfections which a company may be exposed to. To test whether our results are dependent on the model of choice, we run (although do not report for brevity) all the 24

analysis for more parsimonious cash model (Specifications 1 above) with only economic variables, and a more complete model (Specifications 3 above) that also includes investment expenditure, both capital and R&D expenditure (Opler et al., 1999). Also, we test these specifications (with the exclusion of ownership information which are not available prior to 1991) on a longer time series (1985-2001) to investigate the degree of dependence of our results from the choice of the time series. The results for both the econometric and the descriptive analysis reveal qualitatively similar figures to those described so far.

5.2 Alternative approach to define PLC (PHC) firms

As we discussed earlier, some previous studies adopted the method based on a fixed classification rule for distinguishing between low and high cash firms. Although we already presented the limits and drawbacks of this methodology, as a robustness check we define the cash holding status dummies setting a benchmark value that separates low cash from high cash firms observing the statistical distribution. For example, Mikkelson and Partch (2003) classify as high cash those companies that hold more than 25% of their assets in cash and equivalents. In a different context from ours, Minton and Wruck (2001) classify firms as low leverage, when their debt ratio is in the bottom 20% of the distribution.. In our paper, we classify firms as LC and HC when they belong to the bottom and top three deciles respectively of the distribution.8 Similarly to what we described above, the results in Table 8 confirm our initial hypotheses. Dummies for firms with less accumulated cash (PLC3) are always negative and significant in CSA set of estimates indicating their less ability to invest. Their cash-flow sensitivity is positive and, contrarily to previous results, significant, in line with the prediction that this group of companies are likely to be more exposed to capital markets imperfections. On the other hand, results on PHC companies are highly significant both with GMM and CSA estimates. Dummies indicating firms with more accumulated cash (PHC3) are always significant and positive, indicating an increased ability to invest. The interaction with cash flow is statistically significant and still negative, which may confirm that these firms are less affected by asymmetric information and agency costs in the capital markets. [INSERT TABLE 8 HERE]

8 Other robustness checks were performed using a 20% and 25% threshold. Alternatively we used the industryadjusted cash distribution to classify companies as LC and HC. Unreported results do not seem to be affected by the choice of the threshold and by the industry-adjusted measure.

25

5.3 Alternative investment model

Estimating q-models of investment is not without problems. A potentially serious issue is that Tobins q will only include future expectations if the conditions indicated by Hayashi (1982) to approximate marginal q with average q hold. In practice, these conditions may not be fulfilled. For instance, in the presence of a stock market bubble, Tobins q would not capture all relevant information about the expected future profitability of current investment. Therefore, cash flow would be positive because of the expectations not captured by Tobins q and not because of the presence of financing frictions (Goergen and Renneboog, 2001). As a result, we replicate all the analysis by estimating the Euler equation to further test the stability of our results (see also Whited, 1992 and Bond and Meghir, 1994):

2 2 IK it = 1 IK it 1 + 2 IK it 1 + 1CFK it 1 + 2 SK it + 3 DK it + 4CASHSTATUSit

+ 5 ( CASHSTATUSit CFK it 1 ) + i + t + it

(5)

In this specification, S represents total sales and D represents total debt. Since both variables are here standardized on capital stock, potential endogeneity issues due to the fact that the cash holding status dummies are generated estimating a cash equation may be mitigated. A representative sample of the results is reported in Table 9 where only GMM estimations are presented. Figures appear to provide strong support for our findings, in particular for companies with large accumulated amount of cash. The PHC dummy is positive and statistically significant and the interaction term is negative and significant in line with our predictions. Results for low cash companies are similar to what report previously confirming that the choice of the investment model does not affect the overall picture of our results. [INSERT TABLE 9 HERE]

5.4 Firm behaviour in time

The second part of our robustness checks is an intertemporal descriptive analysis which tries to shed some light on the following questions: do PLC firms really have access to alternative sources of funds? Do they invest in other than capital expenditures in the future? How do PHC firms employ their positive excess of cash besides investing it in capital expenditure? Figure 1 presents the graphs describing the firms choices and actions in time. We start by defining t=0 as the time when PHC and PLC firms are assigned a value of 1. Then, we analyze their behaviour in terms of both financial and investment decisions before and after this defining moment (from t-2 to t+2). 26

[INSERT FIGURE 1 HERE] In Panel A we plot financing choices by PLC (PHC) companies over time. More in detail, Figure 1a reports cash holding patterns. It is immediately evident that there is a significant difference in absolute levels of cash holdings between PLCs and PHCs. After an initial period of accumulation, PHC firms appear to decrease their total cash holding possibly due to their investment behaviour, represented in Panel B. An opposite pattern, although less marked, appears to hold for PLCs. We can also see, from the next figure, that these

increases/decreases in absolute levels correspond to a decline in the gap between actual and predicted cash (Figure 1b). In other words, both types of firms appear to close the gap with their target cash, as the values for the deviations get closer to zero. However, an interesting feature is that, on average, PHCs appear to stay significantly further from their target than PLC firms. Provided that being off target is expected to be costly for firms, one possible interpretation may be that the cost of overshooting is lower than the cost of undershooting. Figure 1c and 1d provide further interesting facts. On average, PLC firms appear to rely more on debt than PHCs. More in particular, at time t=0, PLC companies show a positive amount of net debt and net equity issue higher than the PHC firms. This could support the interpretation that PLC companies may have no need to accumulate cash, because they have a facilitate access to capital markets, both debt and equity. PHC firms, on the other hand, show a marked increase in leverage from t-1 to t+2 possibly indicating that firms that accumulate cash use debt as complementary source of funds to finance their investment. Further, it appears that with this strategy PHCs use equity issues as little as possible (Figure 1d). Indeed, between t-2 and t+2 they appear to be repurchasing equity rather than issuing. Contrarily, PLCs appear to rely more on issues of equity. Moreover, Figure 1e clearly indicates that PLC firms typically have higher levels of leverage than PHC. Overall PHCs tend to store anywhere between 30 and 50 times more cash than debt; whereas the ratio is in the range 2-4 for PLCs (Figure 1f). Panel B groups plots spending patterns of both PLC and PHC. Figure 1g shows how, prior to t-1, PHC firms appear to invest in fixed assets less then the other group. Nonetheless, between t-1 and t, they experience an important and sudden increase in their investments, which seem to decrease again after t. PLCs, on the other hand, show a steady decreasing level of investment in fixed assets until time t. There is a marginal increase after that. This may support the hypothesis that PHC firms have used their accumulated financial slack to make more investments; whereas the lack of internal resources may have hampered PLCs ability to invest.

27

To further investigate this argument, we analyze the value of the non-routine investments in Figure 1h. Non-routine investments, or spikes, are those capital expenditures that are larger in value than what appears to be the norm in the firms life (Mayer and Sussman, 2004). To identify these spikes, we proceed as follows. First, we identify investments over a period of three years of data. We calculate the average value of investments only in the extreme years, excluding the central one (i.e., (It-1 + It+1)/2). This would represent the norm investment. Then, we define a spike if the investment value in the central year t is at least twice the average of these two extremes.9 Once these spikes have been identified, we plot their average value for the two groups of firms. Figure 1h indicates how, between t-1 and t+1, PHC firms experience non-routine investments in a larger magnitude than other companies. This further supports the idea that PHC firms make extraordinary capital expenditures after having reinforced their capacity to use internal funds finance. The increase in non-routine investments seems important also for PLC companies after time t. However, with this analysis we cannot determine whether this result is due to the marginal increase in cash holding or to the positive net equity issues at time t+1. The subsequent graphs describe the use of funds alternative to the capital expenditure. Figure 1i indicates that PHC firms have higher growth options than their counterparts. This may partially explain why PHCs tend to store much more financial slack than PLCs. In line with Myerss argument (1977), firms with more growth opportunities are those more exposed to agency costs of debt issues, such as underinvestment problems. Similarly, Myers-Majluf (1984) pecking order theory shows how asymmetric information between insiders and outsiders determines the degree of capital rationing for high quality companies. As previously discussed, to avoid passing up valuable investment opportunities, high growth companies seem to accumulate more cash as a buffer against potential market imperfections. Furthermore, this may provide a rationale for the difference in total debt we just observed. According to Jensen (1986) firms with low growth options are more exposed to the problem of free cash flow. Managers can exercise more discretion over spending patterns when investment opportunities are limited. In this context, external debt may provide a protection of shareholders interest, as indeed the higher level of leverage by PLC companies shows. The difference in growth options is further expressed in Figure 1j where R&D expenditure patterns are plotted. It is evident how PHC firms tend to invest significantly in R&D while PLCs show a sharp decreasing pattern in time.

The same exercise was performed using five rather than three years and delivers similar conclusions.

28

Further analysing spending patterns, our data suggest that PHC firms tend to pay more generous and increasing dividends to their equity holders (1k), similarly to the evidence reported by Opler et al. (1999); while PLC companies tend, at the most, to marginally decrease them. We take into account also spending in acquisitions (Figure 1l). From our calculations it results that about 25% of our PLC companies completed at least one acquisition process in the year in which we analysed their capital expenditure (time t). Similarly, among the identified PHC firms our calculations reveal that about 40% of them has completed at least one acquisition process at time t. Furthermore, the total value of acquisitions completed by PHC companies is more than double of that by PLC firms. However, looking at the total value of the undertaken acquisitions Figure 1l shows that PLC firms increase their acquisitions only in the future, from t+1 on. On the other hand, PHC companies tend to dedicate an increasing part of their investment money to acquiring other companies.10 This preliminary investigation appears in line with Harford (1999) findings on acquisitions patterns for US cash rich firms. He interpreted this result as evidence of managerial discretion. Further analysis on our sample should be done on this issue, but this would be beyond the scope of our work. However, Gregory (2005) recently finds no support for the managerial discretion hypothesis of acquisitions when analysing a large dataset of UK takeovers. He provides evidence that acquirers with high free cash flow perform better than acquirers with low free cash flow, even in the long run. Overall, the results in this section seem to support the hypothesis that firms can benefit from a larger availability of slack. Accumulated cash allows firms to invest not only in fixed assets but also in high growth projects that the capital market would not be willing to finance. In addition, it may help them to build a positive reputation with external investors through the signal of larger dividend payouts. Finally, it contributes to complete planned acquisitions. On the other hand, firms that accumulate less cash invest less both in tangible and intangible assets and pay out less dividends. However, by accumulating more cash in the future and issuing new equity they can afford to increase their future non-routine capital expenditure and their acquisitions.

6. Conclusions

10

We also looked at acquisitions paid in cash for more than 50% of the total value. Results do not change substantially. This may be because more than 80% of firm-year observations over our estimation period indeed show a payment in cash for more than half of the entire cost of the acquisition.

29

This work empirically investigates how cash holding policies influence investment decisions in a large sample of publicly traded UK companies from 1991-2001, on the assumption that cash holdings facilitate firms ability to invest in imperfect capital markets. Our study contributes to the literature on corporate investment on several grounds. First, we measure the ability of companies to invest by assessing their liquidity position with respect to their target cash. Then, we investigate how deviations from the targets affect both the amount of investment expenditures and the sensitivity of investments to cash flow. Contrary to previous research, we aim to provide a more comprehensive analysis of the investment behaviour of both cash-rich and cash-poor companies. Second, in estimating the target cash holding, we take into account two important issues that may potentially bias the target computation: the endogeneity among variables and the evolution of the target over time. Therefore, we adopt two alternative techniques, dynamic GMM and cross-sections average (CSA), in an attempt to mitigate such problems and calculate more accurate targets. Third, thanks to the availability of a rich data set of both economic and ownership variables, we are able to estimate the influence of ownership characteristics on the target cash computation and investment models in a panel data framework. Finally, our study may shed more light on the relation between cash holding policy and investment expenditures for UK firms. The results reported in our work are robust to several different analyses we ran. They reveal that those firms showing persistently low cash policy invest less, but, contrary to our predictions, they do not seem to be more exposed to capital markets imperfections than other companies. Robustness checks provide support to the interpretation that PLC firms have access to alternative sources of funds, in particular equity, although there is some evidence of increase in future capital expenditure and, at most, in planned acquisitions. On the other hand, our analysis reveals that a policy of accumulating cash holding significantly affect the investment decisions of the companies. PHC firms invest significantly more in capital expenditure. Furthermore, a persistently high cash policy seems to decrease the investment sensitivity to cash flow suggesting that this policy may reduce the exposure of companies to capital market imperfections. In addition, a strategy of accumulation of internal funds allows companies to invest both in fixed assets and in high growth projects, complete planned acquisitions and increase the dividend payouts.

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35

Table 1. Summary of empirical predictions.

This table shows the empirical predictions of the major theories tested in the work and the proxy variables used to test the predictions. Panel A include all the predictions for the cash model; Panel B summarizes the expected impacts of cash holding status dummies (PLC/PHC) on both the amount of capital expenditures (IK) and the investment cash flow sensitivity (ICFS). LEV is measured by the ratio of total debt to total assets; LEV2 is LEV squared; CFLOW is defined as the ratio of operating profits before tax, interest and preference dividends plus depreciation to total assets; SIGMA is equal to the average across sectors of the standard deviations of firm cash flow computed over the previous 10 years, when available; SIZE is equal to the natural logarithm of total assets in 1989 prices; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; DIV is the ratio of total payment dividend to total assets; CAPEX is equal to the capital expenditures standardized to total assets; R&D is equal to the expenditure in intangible assets (mainly R&D) standardized to total assets; MAN is equal to the percentage of ownership held by executive directors; LARGEST is the percentage of ownership held by the first non-managerial shareholder; RATIO is equal to the proportion of non-executives to total number of directors; PLC is a dummy equal to 1 if a company is identified as persistently low cash firm; PHC is a dummy equal to 1 if a company is identified as persistently high cash firm; IK is defined as the ratio of investment to capital stock; ICFS is the investment cash flow sensitivity.

Control variables LEV LEV2 CFLOW SIGMA SIZE MTBV DIV MAN MAN2 CAPEX R&D BLOCK LARGEST RATIO

Panel A. Cash model hypotheses Transaction costs Asymmetric Agency costs information of debt negative positive negative/positive positive negative negative positive positive positive negative/positive negative

Managerial discretion

positive/negative positive positive positive negative/positive negative/positive negative/positive Panel B. Investment model hypotheses Low ability to invest High ability to invest negative positive positive negative

Overinvestment

PLC firms PHC firms

IK ICFS IK ICFS

positive positive

Table 2. Examples for cash holding status dummy.

This table includes an example of how we generate the persistently low cash dummy (PLC3). Deviation represents the difference between the predicted target cash and the actual value; LC stands for low cash; PLC3 is a dummy equal to 1 if a firm is low cash for three consecutive years, as shown in the table, and 0 otherwise.

Firm A Firm A Firm A Firm A Firm A Firm A Firm A Firm A Firm A Firm A Firm A

Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Persistently low cash status dummy: an example Deviation LC PLC3 status N/A N/A N/A < 1 N/A < 1 N/A < 1 N/A < 1 1 > 0 1 > 0 0 < 1 0 < 1 0 < 1 0 < 1 1

36

Table 3. Descriptive statistics.

This table shows the sample characteristics for 652 firms over the period 1989-2002. CASH is defined as the ratio of total cash and equivalents to total assets; LEV is measured by the ratio of total debt to total assets; CFLOW is defined as the ratio of operating profits before tax, interest and preference dividends plus depreciation to total assets; SIGMA is equal to the average across sectors of the standard deviations of firm cash flow computed over the previous 10 years, when available; SIZE is equal to the natural logarithm of total assets in 1989 prices; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; DIV is the ratio of total payment dividend to total assets; CAPEX is equal to expenditure in fixed assets to total assets; R&D is the ratio of expenditure in total intangible assets to total assets; IK is defined as the ratio of investment to capital stock; CFK is measured by the ratio of cash flow to capital stock; Q is equal to the market value of assets to capital stock; MAN is equal to the percentage of ownership held by executive directors; BLOCK represents the percentage of shares held by all nonmanagerial shareholders with more than 5% of shares; LARGEST is the percentage of ownership held by the first non-managerial shareholder; TOTEXEC is equal to the total number of executives directors; TOTNONEX is the total number of non-executive directors; RATIO is equal to the proportion of non-executives to total number of directors.

Variable CASH LEV CFLOW SIGMA SIZE MTBV DIV CAPEX R&D IK CFK Q MAN BOARD BLOCK LARGEST TOTEXEC TOTNONEX RATIO

Mean 0.104 0.174 0.113 0.068 11.287 1.530 0.027 0.070 0.023 0.129 0.384 3.6 8.614 10.947 32.10 10.961 4.153 3.210 0.432

Std.Dev. 0.122 0.133 0.112 0.057 1.850 0.882 0.022 0.104 0.070 0.128 0.445 4.475 14.019 15.634 19.31 10.964 1.722 1.654 0.146

25th Percentile 0.018 0.066 0.066 0.031 9.975 0.998 0.013 0.023 0 0.059 0.180 1.192 0.154 0.365 16.52 0 3 2 0.333

Median 0.064 0.161 0.117 0.051 11.040 1.294 0.025 0.049 0 0.111 0.284 2.032 1.483 3.6734 30.76 9.58 4 3 0.429

75th Percentile 0.145 0.253 0.173 0.084 12.453 1.767 0.037 0.090 0.011 0.180 0.457 3.958 11.199 15.323 46.03 15 5 4 0.5

37

Table 4. Two-step robust GMM estimations for cash model.

This table presents GMM regressions for cash holding model. In GMM estimations all the regressors are dated at time [t], except for the lagged dependent variable at [t-1]. CASH is defined as the ratio of total cash and equivalents to total assets; LEV is measured by the ratio of total debt to total assets; LEV2 is LEV squared; CFLOW is defined as the ratio of operating profits before tax, interest and preference dividends plus depreciation to total assets; SIGMA is equal to the average across sectors of the standard deviations of firm cash flow computed over the previous 10 years, when available; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; DIV is the ratio of total payment dividend to total assets; MAN is equal to the percentage of ownership held by executive directors; MAN2 is equal to MAN to the power of two; MAN3 is equal to MAN to the power of three; BLOCK represents the percentage of shares held by all non-managerial shareholders with more than 5% of shares; BOARD is equal to he percentage of ownership held by all directors; LARGEST is the percentage of ownership held by the first non-managerial shareholder; RATIO is equal to the proportion of non-executives to total number of directors; CAPEX is equal to expenditure in fixed assets to total assets; R&D is the ratio of expenditure in total intangible assets to total assets. GMM is the model in the first differences with levels dated [t-2] of all regressors as instruments. In GMM model time dummies are included. Asymptotic standard errors robust to heteroskedasticity are used in all the estimations. Sargan test is a test of overidentifying restrictions, distributed as chi-square under the null of instrument validity; m1 and m2 are test statistics for first and second order autocorrelations in residuals, respectively, distributed as standard normal N(0,1) under the null of no serial correlation.

CASHt-1 LEV LEV2 CFLOW SIGMA SIZE MTBV DIV MAN MAN2 BLOCK LARGEST RATIO

Predictions + + -/+ + + -/+ -/+

(1) Coeff. 0.581*** [0.000] -0.228*** [0.000] 0.306*** [0.002] 0.066* [0.070] -0.509 [0.270] -0.006* [0.074] 0.007 [0.110] -0.375*** [0.000]

(2) Coeff. 0.589*** [0.000] -0.232*** [0.000] 0.307*** [0.002] 0.070* [0.060] -0.655 [0.150] -0.007* [0.098] 0.007 [0.123] -0.372*** [0.000] 0 [0.200]

-/+ -/+ -/+

-0.000* [0.088]

(3) Coeff. 0.576*** [0.000] -0.243*** [0.000] 0.324*** [0.001] 0.077** [0.041] -0.453 [0.312] -0.008** [0.043] 0.006 [0.175] -0.386*** [0.000] -0.002*** [0.001] 0.000*** [0.002] -0.000* [0.053]

(4) Coeff. 0.583*** [0.000] -0.243*** [0.000] 0.326*** [0.000] 0.080** [0.032] -0.409 [0.366] -0.007* [0.057] 0.007* [0.082] -0.386*** [0.000] -0.002*** [0.000] 0.000*** [0.000]

(5) Coeff. 0.577*** [0.000] -0.246*** [0.000] 0.356*** [0.000] 0.133*** [0.001] -0.027 [0.951] -0.006 [0.173] 0 [0.907] -0.331*** [0.000] -0.001** [0.012] 0.000*** [0.010] -0.000* [0.095]

0.009 [0.449]

-0.004 [0.768]

0 [0.382] -0.006 [0.597]

CAPEX R&D No. of firms No. of obs Sargan test m1 m2 688 6410 253.381 -9.069*** -0.2551 688 6410 252.215 -9.058 0*** -0.1401 688 6410 243.848 -9.047 0*** -0.1645 688 6410 245.298 -8.967 0*** -0.05757

-0.004 [0.713] 0.04 [0.330] -0.011 [0.915] 688 6410 325.786 -9.055*** -0.156

* significant at 10%; ** significant at 5%; *** significant at 1%.

38

Table 5. CSA estimations for cash model.

This table presents cross-sectional regressions for the cash holding model (3). The estimation period for CSA is 1989-2001 with a total of 11 cross-section averages. The dependent variable is CASH, measured in each year from 1991 to 2001, while the regressors are averaged over the three years preceding the year of the dependent variable. In all CSA industry dummies are included. CASH is defined as the ratio of total cash and equivalents to total assets; LEV is measured by the ratio of total debt to total assets; LEV2 is LEV squared; CFLOW is defined as the ratio of operating profits before tax, interest and preference dividends plus depreciation to total assets SIGMA is equal to the average across sectors of the standard deviations of firm cash flow computed over the previous 10 years, when available; SIZE is equal to the natural logarithm of total assets in 1989 prices; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; DIV is the ratio of total payment dividend to total assets; MAN is equal to the percentage of ownership held by executive directors; LARGEST is the percentage of ownership held by the first non-managerial shareholder; RATIO is equal to the proportion of non-executives to total number of directors. Asymptotic standard errors robust to heteroskedasticity are used in all the estimations. P-values are reported in parentheses.

LEV LEV2 CFLOW SIGMA SIZE MTBV DIV MAN MAN2 BLOCK RATIO Const

cs91 cs92 -0.427*** -0.772*** [0.000] [0.000] 0.433*** 1.087*** [0.002] [0.000] 0.072 0.154* [0.341] [0.092] 0.223 -0.847 [0.149] [0.464] 0.006* 0.009* [0.083] [0.058] 0.020*** 0.036*** [0.000] [0.007] 0.582 0.263 [0.256] [0.624] -0.001* -0.001 [0.078] [0.134] 0.000* 0.000* [0.056] [0.068] 0 0 [0.969] [0.891] -0.023 -0.04 [0.446] [0.236] 0.044 0.16 [0.366] [0.381] 770 0.173 617 0.276

cs93 cs94 -0.285*** -0.506*** [0.000] [0.000] 0.079*** 0.726*** [0.001] [0.000] -0.027 0.066** [0.584] [0.017] -0.025 -0.391 [0.929] [0.235] 0.006* 0.002 [0.099] [0.665] 0.053*** 0.033*** [0.000] [0.000] 0.422 0.609 [0.316] [0.149] 0 -0.003*** [0.972] [0.006] 0 0.000*** [0.931] [0.008] 0 0 [0.741] [0.617] -0.019 -0.084** [0.556] [0.017] 0.023 0.144** [0.716] [0.010] 796 0.235 650 0.249

cs95 cs96 cs97 -0.183*** -0.567*** -0.391*** [0.000] [0.000] [0.000] 0.038*** 0.673*** 0.126*** [0.002] [0.000] [0.000] -0.006 -0.049 -0.154*** [0.857] [0.236] [0.001] -0.138 -1.069** 0.078 [0.317] [0.017] [0.634] 0.001 0.006* 0.002 [0.836] [0.070] [0.623] 0.031*** 0.033*** 0.016*** [0.001] [0.002] [0.006] 0.459 0.432 0.43 [0.198] [0.287] [0.106] -0.002** -0.002** -0.003*** [0.013] [0.016] [0.002] 0.000** 0.000** 0.000*** [0.013] [0.011] [0.003] 0 0 0 [0.590] [0.743] [0.879] -0.03 -0.089*** -0.075** [0.376] [0.008] [0.029] 0.101** 0.168*** 0.161*** [0.049] [0.006] [0.001] 875 0.183 692 0.247 911 0.252

cs98 -0.704*** [0.000] 0.807*** [0.001] -0.149** [0.030] 0.634 [0.374] 0.006 [0.122] 0.025*** [0.000] 0.428 [0.208] -0.001 [0.451] 0 [0.228] 0 [0.483] -0.044 [0.281] 0.042 [0.595] 649 0.223

cs99 cs00 cs01 -0.275*** -0.477*** -0.156*** [0.000] [0.000] [0.003] 0.038*** 0.633*** -0.046 [0.000] [0.004] [0.163] -0.135** -0.062 -0.152* [0.027] [0.349] [0.082] -0.036 -0.387 0.425* [0.834] [0.436] [0.059] 0.001 -0.004 -0.006 [0.868] [0.289] [0.128] 0.024*** 0.015*** 0.011** [0.000] [0.006] [0.014] 0.107 0.345* 0.400* [0.618] [0.064] [0.093] 0 -0.001 0 [0.892] [0.439] [0.716] 0 0 0 [0.901] [0.545] [0.743] 0 0 0.001 [0.457] [0.798] [0.131] -0.068* -0.057 0.053 [0.091] [0.158] [0.305] 0.139** 0.227*** 0.105* [0.015] [0.004] [0.091] 767 0.229 506 0.144 628 0.223

Obs R-2

* significant at 10%; ** significant at 5%; *** significant at 1%.

39

Table 6. Test for difference in means between PLC and PHC firms.
This table shows the tests for difference in means between PLC and PHC companies over a number of variables that characterized these two groups of firms. Tests are run for the entire estimation period 1991-2001. PLC firms are those companies that have persistently low cash, that is, low cash for three consecutive years preceding the year in which investment decisions are made. Vice versa, PHC firms are those companies that show high cash for three consecutive years preceding the year in which their investment decisions are made. LEV is measured by the ratio of total debt to total assets; DEBT ISSUE is equal to the ratio of net debt issued in each year to total assets; EQUITY ISSUE is the ratio of net equity issued in each year to total assets; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; R&D is the ratio of expenditure in total intangible assets (research and development, goodwill, patents, trade marks, deferred charges, formation expenses and concessions) to total assets; SIZE is equal to the natural logarithm of total assets in 1989 prices; DIV is the ratio of total payment dividend to total assets; ACQUISITIONS is equal to the total value of completed acquisitions in million of sterling; MAN is equal to the percentage of ownership held by executive directors; LARGEST is the percentage of ownership held by the first non-managerial shareholder; BOARD represents the total number of directors in the board; RATIO is equal to the proportion of non-executives to total number of directors.

1994-2001 LEV DEBT ISSUE EQUITY ISSUE MTBV R&D SIZE DIV ACQUISITIONS MAN BLOCK RATIO PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC PHC PLC 0.173 0.186 -0.003 0.005 0.005 0.018 1.753 1.291 0.005 0.005 12.256 10.749 0.038 0.022 98.686 33.434 7.166 9.656 31.587 33.701 0.449 0.431

p-value 0.0739 * 0.0379 ** 0.0005 *** 0.000 *** 0.7266 0.000 *** 0.000 *** 0.000 *** 0.000 *** 0.0221 ** 0.000 ***

***, **, * significance level at 1%, 5% and 10% respectively.

40

Table 7. GMM and CSA results for investment model.

This table presents GMM and cross-sectional estimates predicting capital expenditures decisions with cash status dummies computed from the baseline Model 3 of cash holding. The estimation period for GMM is 1994-2001, depending on the availability of cash holding status dummies. In GMM estimations CFK, cash holding status dummies and the interaction terms are dated at [t-1], while Q at time [t]. GMM is the model in the first differences with levels dated [t-2, t-3] of all regressors as instruments. In GMM model time dummies are included. Asymptotic standard errors robust to heteroskedasticity are used in all the estimations. P-values are reported in parentheses. CSA estimates are in pooling over the 1994-2001 with a total of 8 overlapping panels. The regressors in CSA are averaged over the three years preceding the year of the dependent variable. In all CSA industry dummies are included. IK is defined as the ratio of investment to capital stock; CFK is equal to the ratio of cash flow to capital stock; Q represents the ratio of market value of assets to capital stock; PLC3 is a dummy equal to 1 if a company is identified as low cash firm for three consecutive years and 0 otherwise; PHC3 is a dummy equal to 1 if a company is identified as high cash firm for three consecutive years and 0 otherwise; INTERPLC3 is the interaction term between PLC and CFK; INTERPHC3 is the interaction term between PHL and CFK. Sargan test is a test of overidentifying restrictions, distributed as chi-square under the null of instrument validity; m1 and m2 are test statistics for rst and second order autocorrelations in residuals, respectively, distributed as standard normal N(0,1) under the null of no serial correlation.

IK IK t-1 CFK Q PLC3 INTERPLC3 PHC3 INTERPHC3 Const Predictions + + + + + (a) 0.095*** [0.007] 0.072 [0.183] 0.013*** [0.000] -0.005 [0.782]

GMM (b) (c) 0.092** 0.095*** [0.010] [0.007] 0.07 0.078 [0.298] [0.169] 0.013*** 0.013*** [0.000] [0.000] -0.03 [0.466] 0.078 [0.448] 0.044** [0.011]

CSA (d) 0.088*** [0.008] 0.132** [0.015] 0.013*** [0.000] (e) (f) (g) (h)

0.067*** [0.000] 0.006*** [0.000] -0.017*** [0.000]

0.068*** [0.000] 0.006*** [0.000] -0.015** [0.050] 0.004 [0.835]

0.072*** 0.070*** [0.000] [0.000] 0.006*** 0.006*** [0.000] [0.000]

0.125*** [0.000] -0.222*** [0.000] 0.081*** [0.000] 0.081*** [0.000] 3905 0.071

0.007* [0.095] 0.01 [0.558] 0.075*** 0.076*** [0.000] [0.000] 3905 0.07 3905 0.07

0.010** [0.028]

Obs R-2 Sargan test m1 m2

3905 78.75 -9.948*** -0.0148

3905 96.3 -9.533*** -0.1478

3905 59.738 -6.193*** -1.78

3905 68.211 -6.25*** -1.873

3905 0.071

* significant at 10%; ** significant at 5%; *** significant at 1%.

41

Table 8. GMM and CSA results for investment model using the fixed cut-off approach.
This table presents GMM and cross-sectional regressions predicting capital expenditures decisions with cash status dummies computed from the fixed classification method. The estimation period for GMM is 1994-2001, depending on the availability of cash holding status dummies. In GMM estimations CFK, cash holding status dummies and the interaction terms are dated at [t-1], while Q at time [t]. GMM is the model in the first differences with levels dated [t-2, t-3] of all regressors as instruments. In GMM model time dummies are included. Asymptotic standard errors robust to heteroskedasticity are used in all the estimations. P-values are reported in parentheses. CSA estimates are in pooling over the 1994-2001 with a total of 8 overlapping panels. The regressors in CSA are averaged over the three years preceding the year of the dependent variable. In all CSA industry dummies are included. IK is defined as the ratio of investment to capital stock; CFK is equal to the ratio of cash flow to capital stock; Q represents the ratio of market value of assets to capital stock; PLC3 is a dummy equal to 1 if a company is identified as low cash firm for three consecutive years and 0 otherwise; PHC3 is a dummy equal to 1 if a company is identified as high cash firm for three consecutive years and 0 otherwise with the fixed classification method; INTERPLC3 is the interaction term between PLC and CFK; INTERPHC3 is the interaction term between PHL and CFK. Sargan test is a test of overidentifying restrictions, distributed as chi-square under the null of instrument validity; m1 and m2 are test statistics for rst and second order autocorrelations in residuals, respectively, distributed as standard normal N(0,1) under the null of no serial correlation.

IK IK t-1 CFK Q PLC3 INTERPLC3 PHC3 INTERPHC3 Const Predictions + + + + + (m) 0.095*** [0.000] 0.070* [0.081] 0.030*** [0.000] -0.017* [0.100]

GMM (n) (o) 0.087*** 0.090*** [0.000] [0.000] 0.066 0.058 [0.134] [0.157] 0.031*** 0.029*** [0.000] [0.000] -0.023 [0.277] 0.008 [0.923] 0.050*** [0.000]

CSA (p) 0.084*** [0.000] 0.072* [0.065] 0.030*** [0.000] (q) (r) (s) (t)

0.094*** [0.000] 0.011*** [0.000] -0.018*** [0.000]

0.086*** [0.000] 0.011*** [0.000] -0.028*** [0.000] 0.040* [0.058]

0.092*** 0.101*** [0.000] [0.000] 0.011*** 0.011*** [0.000] [0.000]

0.086*** [0.003] -0.143* [0.070] 0.065*** [0.000] 0.067*** [0.000] 8730

0.020*** 0.034*** [0.000] [0.000] -0.041** [0.027] 0.058*** 0.056*** [0.000] [0.000] 8730 8730

Obs R-2 Sargan test m1 m2

6722 207.774 -11.33*** -1.63

6722 240.367 -11.24*** -1.762

6722

6722

8730

0.085
213.306 241.573 -11.331*** -11.385*** -1.39 -1.568

0.091

0.071

0.073

* significant at 10%; ** significant at 5%; *** significant at 1%.

42

Table 9. Euler Equation Results.

This table shows the GMM results for the investment model with the cash status dummies computed from the baseline Model 3 of cash holding. The estimation period for GMM is 1994-2001, depending on the availability of cash status dummies. GMM is the model in the first differences with levels dated [t-2, t-5] of all regressors as instruments. In GMM model time dummies are included. Asymptotic standard errors robust to heteroskedasticity are used in all the estimations. P-values are reported in parentheses. Sargan test is a test of overidentifying restrictions, distributed as chi-square under the null of instrument validity; m1 and m2 are test statistics for rst and second order autocorrelations in residuals, respectively, distributed as standard normal N(0,1) under the null of no serial correlation. IK is defined as the ratio of investment to capital stock; CFK is equal to the ratio of cash flow to capital stock; SK is equal to the ratio of total sales to capital stock; DK is equal to the ratio of total debt to capital stock; PLC3 is a dummy equal to 1 if a company is identified as low cash firm for three consecutive years and 0 otherwise; PHC3 is a dummy equal to 1 if a company is identified as high cash firm for three consecutive years and 0 otherwise; INTERPLC3 is the interaction term between PLC and CFK; INTERPHC3 is the interaction term between PHL and CFK.

IKt-1 (IKt-1)2 lCFK S/Kit-1 (D/Kit-1)2 PLC3 INTERPLC3 PHC3 INTERPHC3

(i) 0.118* [0.068] -0.037 [0.843] 0.147** [0.021] 0 [0.998] 0.003 [0.504] -0.01 [0.611]

GMM (j) 0.102* [0.099] -0.011 [0.947] 0.120* [0.091] 0.002 [0.872] -0.001 [0.853] -0.017 [0.750] 0.029 [0.823]

(k) 0.123* [0.058] -0.049 [0.794] 0.145** [0.025] 0.001 [0.955] 0.002 [0.579]

(l) 0.121* [0.051] -0.052 [0.761] 0.213*** [0.003] 0 [0.958] 0.004 [0.360]

0.054*** [0.002]

0.131*** [0.005] -0.210** [0.028] 3905 108.774 -4.995*** -1.603

Observations Sargan test m1 m2

3905 93.661 -5.16*** -1.661

3905 113.324 -5.286*** -1.825

3905 93.239 -5.16*** -1.649

* significant at 10%; ** significant at 5%; *** significant at 1%.

43

Figure 1. Firm behaviour in time.

These figures are constructed with the cash status dummies derived from the baseline cash model (Model 3). Firms are divided in two categories here: PLC are firms that at some point in time are identified with PLC=1 (they are separated from those firms that are always low-cash for the entire period); PHC are firms that at some point in time are identified with PHC=1 (they are separated from those firms that are always high-cash for the entire period). At time t the capital expenditures of PLC (PHC) firms are examined after a period of low (high)-cash policy. The analysis of the trends for each firm characteristic is conducted before and after this defining moment (from t-2 to t+2). CASH is defined as the ratio of total cash and equivalents to total assets; Deviation represents the difference between the actual and predicted level of leverage for each firm; Net Debt Issued is the ratio of net debt issued in each year to total assets; Net Equity Issued represents the ratio of net equity issued in each year to total assets; Leverage is defined as the ratio of total debt to total assets; Cash-Leverage ratio is equal to the ratio between cash and leverage; IK is defined as the ratio of investment to capital stock; Spike Value is defined over a pattern of 3 years of investment data. The average value of investments is calculated in the extreme years. Thus, there is a spike in this pattern only if the investment value in the central year is at least twice the average of the extremes; MTBV is the ratio of book value of total assets minus book value of equity plus market value of equity to book value of assets; R&D is the ratio of expenditure in total intangible assets to total assets; Dividends is the ratio of total payment dividend to total assets; Acquisitions is equal to the total value of completed acquisitions in million of sterling.

Panel A. Sources of Funds

a. CASH
0.3 0.08

b. DEVIATION

0.25

0.06

0.2

0.04

PLC 0.15 PHC 0.02 PHC 0.1 0 t-2 0.05 -0.02 t-1 t t+1 t+2 PLC

0 t-2 t-1 t t+1 t+2 -0.04

44

Figure 1. Firm behaviour in time. Panel A (continued).

c.NET DEBT ISSUED
0.006 0.02 0.018 0.005 0.016 0.004 0.014 0.003 PLC 0.002 PHC 0.008 0.001 0.006 0 t-2 -0.001 t-1 t t+1 t+2 0.004 0.002 0 -0.002 t-2 t-1 t t+1 t+2 0.012 PLC 0.01 PHC

d. NET EQUITY ISSUED

e. LEVERAGE
0.2 0.18 50 0.16 0.14 40 0.12 PLC 0.1 PHC 0.08 0.06 0.04 10 0.02 0 t-2 t-1 t t+1 t+2 20 30 60

f. CASH-LEV RATIO

PLC PHC

0 t-2 t-1 t t+1 t+2

45

Panel B. Uses of funds

g. IK
0.14 0.25

h. SPIKEVALUE

0.12 0.2 0.1

0.08 PLC PHC 0.06

0.15 PLC PHC 0.1

0.04 0.05 0.02

0 t-2 t-1 t t+1 t+2

0 t-2 t-1 t t+1 t+2

i. MTBV
0.008 1.8 0.007

j. R&D

1.6

1.4

0.006

1.2 0.005 1 PLC PHC 0.8 0.003 0.6 0.002 0.004 PHC PLC

0.4

0.2

0.001

0 t-2 t-1 t t+1 t+2 0 t-2 t-1 t t+1 t+2

46

Figure 1. Firm behaviour in time. Panel B (continued).

k. DIVIDENDS
0.05 0.045 0.04 0.035 0.03 PLC 0.025 PHC 0.02 40 0.015 30 0.01 20 0.005 10 0 t-2 t-1 t t+1 t+2 0 t-2 t-1 t t+1 t+2 50 PHC 100

l.ACQUISITIONS

90

80 70

60 PLC

47