Do corporate governance mechanisms matter for cash holdings and firm value?

Abstract

This paper examines the relationships between firm-level corporate governance mechanisms and cash holdings; along with their combined effects on firm value for a sample of firms listed in Singapore and Malaysia. Firms with less effective governance attributes are found to be more inclined to accumulate cash than those with more effective governance. The results support the flexibility hypothesis in that an increase in agency conflicts between managers and minority shareholders leads to entrenched managers having more discretion to hoard cash reserves. In addition, the incremental value of holding excess cash is shown to be negative for firms with a single leadership structure, firms with a pyramidal ownership structure, as well as family-controlled firms. The discounts associated with these firms may reflect investors’ recognition of the possibility of managerial entrenchment.

Introduction

Cash and cash equivalents typically constitute an important component of a firm's assets. A recent study has documented an increasing trend in the cash holdings of U.S. firms from 1980 to 2006 (Bates et al., 2009). Earlier studies by Kim et al., 1998, Opler et al., 1999 provide comprehensive reviews of the determinants of corporate cash holdings for publicly listed firms in the U.S. They find that firms trade off the costs and benefits of holding cash in determining their optimal cash balance. In particular, firms’ cash holdings are positively associated with growth opportunities, investment levels, research and development expenditures, cash flow, and cash flow volatility. Cash holdings are also negatively associated with firm size, leverage, net working capital, and a dividend dummy variable.

Several recent studies have examined the role of country-level and firm-level corporate governance in setting corporate cash policy for both the U.S. and international firms, testing an agency cost explanation for cash holdings.¹Dittmar et al. (2003) examine the importance of country-level corporate governance in the determination of corporate cash holdings with an international sample. Using the anti-directors’ rights variable developed by La Porta et al. (1998), they find that firms in countries with weak external legal protection hold proportionately more cash than firms in countries where legal protection is stronger. The results support the flexibility hypothesis in that entrenched managers prefer to hoard cash rather than return excess cash to minority shareholders.

On the other hand, Harford et al. (2008) show that U.S. firms with weak shareholder rights protection, as measured by the G-Index (Gompers et al., 2003), hold relatively small cash balances, as such firms typically spend their cash quickly through acquisitions. Their results are consistent with the spending hypothesis.

This study is designed to examine the relationships between corporate governance mechanisms and firms’ cash holdings in Singapore and Malaysia; along with their combined effects on firm value. While previous studies have extensively examined the consequences of large controlling stakes on firm value, very few studies have examined the interaction between ownership control and board characteristics.

This study examines both board attributes and measures of ownership concentration as proxies for the nature of a firm's internal governance and attempts to better explain the role of the board. The specific proxies investigated are: board leadership structure, board size, board independence, family control, and pyramidal ownership structure. Using a sample of publicly listed firms in Singapore and Malaysia, we test whether these variables are significantly associated with a firm's corporate cash policy. In these two countries, firms’ annual reports are conveniently available from the websites of the stock exchanges, are written in English and contain sufficient useful data on board attributes for analysis. Both Singapore and Malaysia are also described as having strong external legal environment, and both are common law countries which score high on La Porta's anti-directors rights index (La Porta et al., 1997, La Porta et al., 1998).² On the other hand, family control and pyramidal ownership structure are prevalent in both countries. This provides an ideal setting for testing for any significant relationship between agency conflicts and cash holdings.

Our key findings are as follows: first, we show that firms with a single leadership structure (proxied by the CEO-Chairman duality dummy variable) and a small proportion of independent directors on the board tend to hold larger cash reserves. A non-linear relationship is also found between insider ownership and cash holdings. In addition, both the dummy variables representing pyramidal ownership structure and family control are found to be positively related with the size of a firm's cash holdings, and the interaction term between pyramid structure (or family control) and CEO-Chairman duality is also found to be positive and significant.

These findings indicate that managers in firms with a pyramidal ownership structure (which are usually family-controlled firms) and with less effective boards have more discretion in setting corporate cash policies. They have little incentive to distribute any excess cash to minority shareholders, who lack the means to monitor them effectively. Thus, agency conflicts lead to a firm's holding larger cash balances. This reinforces the findings reported by Dittmar et al. (2003).

Our next findings help to clarify significantly the implications of excess cash holdings and governance mechanisms for firm value. We show that the incremental value of holding excess cash reserves is negative for firms with a single leadership structure, as well as for firms with a pyramidal ownership structure and for family-controlled firms. This implies that agency problems might be more severe and the discounts associated with such firms may reflect investors’ recognition of the possibility of managerial entrenchment.

Overall, these findings help to elucidate the relationship between corporate governance and cash holdings by providing more insight into the role of boards and large controlling shareholders in an environment outside the U.S., but with strong external legal protection of investors. Contrary to the conclusions of Harford et al. (2008), the findings of this study are more aligned with the flexibility hypothesis. Although a country's legal system offers some level of protection to minority shareholders, weak governance within a firm remains important in predicting its cash holdings as well as determining the overall impact with excess cash holdings on the firm's value.

The remainder of the paper is organized as follows. Section 2 provides a brief literature review and formally develops the hypotheses on the relationships between internal corporate governance mechanisms, cash holdings, and firm value. Section 3 describes the sample and the variables that we employ in the empirical tests. Section 4 presents the regression models and discusses the implications of the results. Section 5 concludes the paper.