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
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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
Further, keeping in view the strong competitive environment and fear of “Clones” by others, Intel is constantly required to look for innovative products, which would need more funds for upfront expenditures. In these situations, large cash positions would help Intel to avoid taking loans from outside, and in turn interest costs, by using its own cash balances. A disadvantage of having large cash position would be that cash has an opportunity cost. In other words, Intel could be forgoing profitable investment opportunities. However looking at the data provided in the case, we can see that the cost of holding cash was small as they yield high returns, above 170 bases points above U.S treasury bills, through investing in securities rated above AA. Further, a cash rich company runs the risk of being careless as there may be reduced pressure on the management team to perform better. Observing Intel’s growing performance over a period of time, it seems that currently it has no such problem. However in future, it may become a cause of concern for the company.
Management considering share repurchase program should weigh its benefit of financial discipline, efficient corporate strategy implementation and utilization of tax shield against the downside of cost of financial distress. It’s not the possibility of bankruptcy that causes concerns among equity holders regarding extent of leverage but the direct costs (legal, liquidation, administrative etc.) and indirect costs (deteriorated corporate image, management time and attention, agency costs of value-destructing investment, distress asset sales etc.). Exhibit 4 lists the key assumption inputs of approximating quantitative firm value/ equity value accretion. Levering UST to a larger extent by adding $1,000m does increase firm value.
This step involves short and long term debt equity analysis. The proportion of equity capital depends on the possessing and additional funds will be raised. The choice of the source of funds the company has are the issue of shares and debentures, loans to be taken from banks and financial institutions and public deposits to be drawn in form of bonds. The choice will depend on relative merits and demerits of each source and period of financing. The management of the investment funds is key in allocating that the funds are going in the correct place. The profits that are made can be down in two ways dividend declaration which includes identifying the rate of dividends and retained profits in which the volume has to be decided which will depend upon expansion and diversification of the company. The management of cash is another important function. Cash is needed for all different aspects of the company such as payment of salaries, overhead and bills. All of these are important in a company and how successful the financial aspect is going to be.The financial management practices include capital structure decision, investment appraisal techniques, dividend policy, working capital management and financial performance assessment. A company needs to have well financial in order to be successful. “A company that sells well but has poor financial management can fail.” (Johnston)
they must pay interest payments or risk bankrupting of the firm. It also helps reduce
As a result, holding cash would be essential component of the firm strategy. To develop new products, buy new equipment or expand geographically, firm has to spend money on marketing research, product design, prototype development and so on. Moreover, if a recession hits and the economy start to slow down,
* Taking on debt gives the company the ability to use cash for projects and short term investments.
Furthermore, we choose to use cash as the “plug” for a few reasons. First, the amount of debt Staples holds has been decreasing for the last six years, and the debt-to-equity ratio also has decreased. Meanwhile, as we discussed in the previous Project, Staples tries to maintain its debt-to-equity ratio at a lower level. In this case, we assume that it is not the optimal choice to use debt as the plug, since it will automatically increase the leverage. Second, cash and equivalents owns by Staples is very volatile in the past ten years, so it is not guaranteed that the company will have the ability to pay down more debt if debt is used as the “plug”. Third, as the “plug”, when the company generates more cash, the cash cumulates each year in the
Exhibit 6, 8, and 9 (figures in $ millions) provides selected balance sheet items for Ford, General Motors, and DaimlerChrylser. The given information indicates that Ford carries the highest amount of cash and marketable securities among the three companies. In 1999, Ford had $25,173 of cash and marketable securities while General Motors and Daimler-Chrylser have only $12,140 and $9,163. Comparing at an industry level, we as a team
2. Magnetronics had $7,380 invested in accounts receivables at year-end 1999. Its average sales per day were $133,614 during 1999 and its average collection period was 55.23 days. This represented an improvement from the average collection period of 58.68 days in 1995.
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
From 1993 until the start of 1995, MCI’s stock had outperformed the S&P. However, in 1995, the stock’s performance was poorer than the S&P. With shareholder’s getting restless, the idea of a stock repurchase was being considered. Depending on which option MCI chooses—stock repurchase with debt issuance or open market repurchase program—the message being sent could be different. Let’s consider option one—MCI issues debt and uses the proceeds to repurchase stock. According to the article “Raising Capital: Theory and Evidence” by Clifford Smith, the market would likely react very positively to this leverage-increasing event. Because of the information disparity between a
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
The decision of firms to hold substantial cash reserves has lately been put under the spotlight in the corporate finance
The decision of firms to hold substantial cash reserves has lately been put under the spotlight in the corporate finance
If external financing is required, the “safest” securities, namely debt, are issued first. Although investors fear mispricing of both debt and equity, the fear is much greater for equity. Corporate debt still relatively little risk compared to equity because, if financial distress is avoided, investors receive a fixed return.. Thus, the pecking order theory implies that, if outside financing required, debt should be issued before equity. Only when the firm’s debt capacity is reached should the firm consider equity.