Corporate Financial Policy and the Value of Cash

18364 WordsDec 3, 201074 Pages
THE JOURNAL OF FINANCE • VOL. LXI, NO. 4 • AUGUST 2006 Corporate Financial Policy and the Value of Cash MICHAEL FAULKENDER and RONG WANG∗ ABSTRACT We examine the cross-sectional variation in the marginal value of corporate cash holdings that arises from differences in corporate financial policy. We begin by providing semi-quantitative predictions for the value of an extra dollar of cash depending upon the likely use of that dollar, and derive a set of intuitive hypotheses to test empirically. By examining the variation in excess stock returns over the fiscal year, we find that the marginal value of cash declines with larger cash holdings, higher leverage, better access to capital markets, and as firms choose greater cash distribution…show more content…
For firms whose cash reserves appear to greatly exceed their needs in the foreseeable future, an additional dollar of cash reserves is more likely to be distributed to equity holders through dividends and/or stock repurchases. However, because of the “dividend tax,” only the fraction (1 − τ d ) ends up in the hands of shareholders.3 As such, the marginal value of cash is reduced to (1 − τ d ), which can be significantly below $1. Additionally, if firms use their cash to pay down debt or other liabilities, a small increase in cash reserves partially goes to increasing debt value, not solely to increasing equity value. Thus, the equity market will place a lower value on an additional dollar of cash for high leverage firms relative to the marginal value of cash for a firm with little debt. In contrast, for those firms that need to raise cash from external markets because they have value-enhancing investment opportunities but their internal funds are low, the marginal value of cash should be higher than $1, with the exact amount depending upon the transactions costs (direct or otherwise) that are incurred by accessing the capital markets. Therefore, the marginal value of cash should decline as cash holdings increase because as the cash position of the firm improves, firms become more likely to distribute funds and less likely to raise cash. We also argue that for firms that face greater financing
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