The Value of Surplus Cash

Optimizing financing policy includes deciding how much liquidity a company should carry. In this post we find the value of an extra dollar of cash on the balance sheet.

Academic treatments of appropriate cash levels divide the topic into a number of distinct questions, including

The impact on market cap of an extra $1 of cash
How firm characteristics (growth prospects, governance, etc.) affect the value of cash
The optimal amount of cash a company should hold

The analysis is typically multifactor regression studies, comparing similar firms that differ in their cash holdings. We’ll summarize a few recent studies next.

Pinkowitz and Williamson 2002: $0.27 – $1.76

This the first modern study of the incremental value to market cap of one dollar of cash on the balance sheet. They find that shareholders value cash less for firms with poor growth options, with predictable investment opportunities among several options such as cryptocurrencies with Bitcode Method.

On average, one dollar of cash is worth $0.97.
Growth options are indicated where firms have high sales growth; low (dividend) payouts; and high R&D and or CAPEX spend. They find that cash is valued more for firms exhibiting
- high growth ($1.34 vs. $0.27 for low-growth firms)
- low payouts ($1.21 vs. $0.96)
- high R&D ($1.84 vs. $0.77)
- high CAPEX ($1.55 vs. $0.51)
Predictable investment outlays suggest the company can rely on external capital raises. Where investment opportunities occur without warning, cash on hand is more valuable.
For firms facing distress, a greater proportion of enterprise value accrues to lenders; shareholders of such firms may value additional cash relatively less because they see it contributing to the market value of debt. One dollar is worth $0.23 to distress firms (an Altman’s Z-Score of less than 3.0) vs. $1.60 to non-distressed firms.

The authors studied 9,844 US firms over 1952-1997 excluding financials and utilities.

Faulkender and Wang 2006: $0.94

This is the most-cited study in the last decade on the value of cash. The headline value of $0.94 varies considerably depending on a variety of firm-specific situations.

The authors examined US publicly traded firms 1972-2001. Financial and utility firms were excluded.

Cash and Leverage

The estimated marginal value of cash for a company with no cash and no leverage is $1.47

If the firm has 5% of market cap in cash, the next dollar is worth $1.43; at 15% of market cap in cash, it’s worth $1.36
If the firm has a 10% leverage ratio, the extra dollar is worth $0.14 less to shareholders.

The average firm has 17% of market cap in cash, and 28% leverage; so the extra dollar is worth $0.94.

Cash for Financially Constrained Firms

One dollar of cash is worth $1.04 to a financially constrained firm, but only $0.77 to an unconstrained firm.

The authors define “financially constrained” in four ways:

The value of one dollar for high-payout firms (payout ratio in top 3 deciles) is $0.77 vs. $1.04 for low-payout firms (ratio in bottom 3 deciles)
The value of one dollar for large firms (revenues in top three deciles) is $0.72 vs. $1.09 for small firms
The value of one dollar for the 22% of firms with a public credit rating is $0.73 vs. $1.15 for unrated firms
The value of one dollar for the 9% of firms with a commercial paper rating is $0.46 vs. $1.09 for firms without a CP rating

Cash and Its Use

The use of cash is defined by three “regimes”:

Distributing cash (AKA “cash cows”). Cash for these firms is surplus and incurring an opportunity cost until it is deployed. Among these firms, cash distributed as a dividend is valued $0.13 less than cash distributed via share repurchase, which matches the expected differential investor tax rate at the time of publication. As tax treatment of distribution form changes (which it has in the U.S.), we expect this discount also to change.
Servicing debt. For overlevered firms, who will spend surplus cash on reducing leverage, shareholders will value an extra $1 less because delevering will increase lender value more than shareholder value.
Building dry powder. For firms anticipating a large investment, additional cash reduces the need for incremental external capital raise. The value of $1 of cash may be more than one dollar for such firms.

These firms are identified by examining interest expense coverage ratio and market/book ratio. The latter is a proxy for investment opportunities, where we assume highly valued firms have more valuable growth investments available.

Distributing firms (high coverage and low M/B), an extra dollar is worth $0.53 to market cap
- Among these firms, cash distributed as a dividend is valued $0.13 less than cash distributed via share repurchase, which matches the expected differential investor tax rate at the time of publication. As tax treatment of distribution form changes (which it has in the U.S.), we expect this discount also to change.
For firms servicing debt (low coverage, low M/B), the extra dollar of cash is worth $0.45 to market cap.
For investing firms needing additional external capital to fund investments (low coverage, high M/B), the extra dollar is worth $1.16.

Dittmar and Mahrt-Smith 2007: Good Corporate Governance Doubles the Value of Cash

Good governance encourages optimal management decision making, and can improve the value of surplus cash by ensuring it is put to valuable use. The authors measure governance in two ways:

The market for corporate control is viewed as a strong external force for management discipline. Takeover protections (company bylaws, and various state-level controls) reduce governance effectiveness.
The presence of large shareholders (more than 5% holding) encourages closer oversight of management actions.

The authors studied public U.S. firms for 1990-2003, excluding financials and utilities. They find that, on average, one dollar of cash is worth $1.09:

In well-governed firms (lacking antitakeover provisions), it is worth $1.62
In poorly governed firms, it is worth $0.42

Defining governance by the presence of large institutional block holders reveals an extra dollar is worth

$1.27 to a well-monitored firm
$0.88 to a poorly monitored firm

The authors seek to discover exactly how poor governance reduces the value of cash; for example, do poorly governed firms spend more on acquisitions? They find

Cash accumulation speed does not differ between poorly- and well-governed firms.
Poorly governed firms “dissipate” cash more rapidly than than well-governed firms. It could be that these firms do not focus as much on operating profitability.
- This drives the conclusion that accumulation of excess cash is fueled by external factors (affecting industry members similarly) and that cash use is a discretionary choice that is affected by agency issues and governance structure.
Acquisition spend accounts for some but not all of the cash dissipation by poorly governed firms.

Tong 2008: The Impact of Asset Diversification

Focused firms — those with a single operating segment — may face greater uncertainty in their earnings stream and investment opportunities. This paper tests four hypotheses that offer competing predictions for the impact of asset diversification on the value of cash:

Firm diversification increases the value of cash (for financially constrained firms) because the firm can shift incremental funding to the more profitable segments.
Diversification, which is associated with empire building and cross-subsidization, reduces the value of cash
Diversification (for constrained firms) reduces the value of cash, because segment diversification (uncorrelated revenue sources) increases debt capacity.
Diversification increases the value of cash for shareholders because of investor conflicts: diversification reduces the risk of financial distress (including bankruptcy), so shareholders benefit more from additional cash for diversified firms.

The authors examined publicly traded firms 1998-2005. Financial firms were excluded, yielding a population of 6,867 firms.

The marginal dollar is worth $0.92 to a diversified firm, and $1.08 to a single-segment firm. Whether a firm is financially constrained did change this result.
Of the four hypotheses, the authors choose the second (agency problems: managerial preference for empire building and cross-subsidization) as the best explanation for the overall findings. (This complements the Dittmar and Mahrt-Smith finding that good governance increases the value of cash.)

Martinez-Sola et al. 2010: Optimal Level of Cash

The authors examined 472 publicly traded U.S. industrial firms 2001-2007. Tobin’s Q is the measure of firm value; they confirmed their findings by testing two other value measures: (market cap + debt)/Assets and (market cap)/Equity.

The authors find that there is an optimal cash level that maximizes firm value; and that deviations from this level decrease firm value. They fit a quadratic relationship between cash/assets and value; the relationship is concave, so value initially increases in cash but begins to decline for high levels of cash.

In a separate test the authors find that (positive or negative) deviations from the optimal level of cash reduce firm value.

Denis and Sibilkov 2010: Cash for Financially Constrained Firms

Cash holdings are more valuable to constrained firms because it allows the firms to increase investment; and because marginal investment by constrained firms correlates more highly with value.

The authors studied non-financial, non-utility public U.S. firms 1985-2006. They use the same four proxies for financial constraint as Faulkender and Wang.

The authors find:

Cash is worth more to constrained firms than unconstrained; depending on definition of constraint, cash is worth $0.14-$0.51 more per dollar to constrained firms
Despite this extra value of cash for constrained firms, some of these firms hold relatively little cash. The authors investigate and find that low-cash, constrained firms suffered persistently low and declining free cash flows, rendering the firms unable to build optimal cash reserves. Conversely, firms with valuable investment options can mitigate the adverse effects of financing constraints by retaining free cash flow when available.

Alink 2013: European Firms: $0.76 – $1.14

This paper, a master’s thesis, includes a thorough review of recent literature and findings. To this review the author adds his own study of 7,123 publicly listed European firms for 1998-2012 (excluding utilities and financial firms).

The author found

The marginal value of cash increased when firms held less cash than their industry peers. This supports the concept of an optimal cash level.
- Of four measures of excess cash tested, one married ease of implementation with its ability to generate useful regression results: deducting the industry average cash/assets from the firm’s.
The marginal value of cash has fallen over recent years

Siao and Chou (2012?): The Impact of Managerial Ability

The authors study firms for 1992-2010; they exclude financial firms. Managerial ability is measured four ways:

Number of press citations
Company’s operation efficiency (ratio of output to input)
ROA relative to industry mean
Managerial awards from business journals