How Investment Opportunities Affect Cash Holdings


In recent years the interest of financial researches raised to firms’ cash policy, cash positions; if more accurate they are paying more attention why do firms’ hold so much cash.

These issues have a long history and are the basis of corporate finance. Indeed, from the day to day operations to finance long-term investments, own funds are just the most important source of funding.

In particular, observers have recently serious doubts about the validity of so much cash. This problem has led to important research aimed at clarifying the multifaceted aspects of monetary policy firms. Although the rapid development of significantly enriched our understanding of the factors that stocks of companies the funds, the literature has paid little attention in the form of cash policy’s real impact on the daily activities of firms.

In the 2007-2008 credit crunch business leaders and the media have made the phrase "cash is sovereign" back in vogue. Although the firms internal cash flows decline, the stock markets collapsed and the credit markets nearly frozen, the lack of money has become a reality for many firms. For example, General Motors (GM), based in the U.S. automaker, announced on 7 November 2008 that he could escape from the liquidity, despite the ongoing restructuring process. GM eventually reorganized through bankruptcy, but their fate was to demonstrate the importance of cash holdings. Although the reduction of cash flows, as a rule, inevitable in many industries during the economic downturn, the symptoms can be removed by a sufficient amount of cash as a buffer to the crisis. Nevertheless, for several reasons shareholders do not always want to see the firm to save money and sit on it. The shareholders’ outlook on firm’s cash holdings and the cost they place on it will be examined in this research.

The determinants and consequences of corporate cash holdings have attracted enlarged interest of scientists over the past ten years. One key issue was that the relationship between cash and the value of the company. Broadly speaking, two main factors in the equation of the advantages of liquidity of the company and the agency cost of managerial discretion. Both these arguments have their supporters. For example, Myers and Majluf (1984) argue that costly external financing means that firms must maintain a sufficient cash reserve, which provides liquidity to take advantage of new projects a positive NPV. However, according to Jensen (1986) the agency costs of managerial consolidation means that large amounts of cash should be paid to shareholders to keep managers overinvesting negative NPV projects. Apparently, there is no single truth, which will apply to all companies at once, as the needs of both the firm and its managers are not uniform.

Understanding the value of cash is of interest not only for researchers and scientists, but even more so for practitioners. Equity analysts, financiers and corporate chief financial officers must all be very interesting to know which factors affect the cost of cash holdings in the company and why. Most equity analysts simply add cash to the top of the value of the company, without giving attention from what could be the reason why money should not be evaluated at face value. However, researches show, markets, monetary values in different firms in different ways, and, consequently, analysts may be too - especially if the company has a large amount of liquid assets. For corporate financiers situation is somewhat different, because they often give the conclusion that the value of the target firm is the acquirer, thereby eliminating the influence of the prevailing corporate governance and financial policies. Nevertheless, it can be valuable to understand the value of cash when assessing the market value of the firm. Finally, the financial department of a firm must know why their cash cannot be appreciated at face value, and that they could do if they want. This allows us not only to understand the preferences of shareholders, but perhaps an opportunity to meet them.

Problem Statement

In this research I want to find answers to the questions like:

What is the reason of holding so much cash than needed?

What kind of effects it could cause?

How the financing constraints and investment opportunities together affect the value the shareholders place on cash?

How firm’s investment opportunities affect the marginal value of firm’s cash holdings?

How firm’s the state of external capital markets affect the marginal value of firm’s cash holdings?

1.3 Research objectives

The aim of this work is the approach to the cost of cash holdings of firms in two directions. First, subsequent to Faulkender and Wang (2006), who studied the cross-section changes in the marginal value of corporate cash, which arises from differences in corporate financial policy.

Secondly, inspired by the credit crunch of 2007-2008, I examine how changes in the external capital markets affect the cost of money over time. As far as I know there have not been previous studies on the time changes in the value of cash. There are several reasons why the loan should affect any results related to the company's cash holdings. First, Almeida et al.(2004) show that financially constrained firms maintain a significantly higher proportion of their cash flow, the following adverse macroeconomic shocks than before. This means that the relationship between the preserve cash flow and earnings of the company is dynamic and may change over time. Second, the importance of cash is emphasized in a recession. When a loan is becoming more rationed, the company in which a lot of cash does not need to worry about the inability to finance daily operations. Intuitively, firms with more cash are less likely to be downgraded credit rating and are able to maintain access to capital markets. In addition, these companies can take advantage of the plight of the weaker firms, which may be less liquid assets, through active competitive actions and acquisitions. Thus, it seems appropriate to us a treasure load of cash in good times to be able to strike when the economy turns. Finally, as credit becomes more and more rationed, it also becomes more expensive. This is especially true for financially constrained firms.

I use a sample of around 1000 Malaysian firms for the last decade from 1999 to 2009 to test the hypothesis in Faulkender and Wang (2006), impact of investment opportunities on the value of cash, and the change in value of cash over the economic cycle. The usable observations begin from 1999 because for most of the variables I require a change throughout a fiscal year. The extraordinary state in the financial markets during 2007-2008 allows me to study how it may have impacted the value of cash.

The following terms interchangeably I use in this thesis. First, in a few ways, mainly as cash holdings, cash reserves, or simply cash I refer to firm’s cash holdings. Nevertheless, cash level is used to refer to cash ratio (cash to net assets). Second, I use the value of cash, the marginal value of cash, value of additional cash, value of an extra dollar of cash, and the value the shareholders place on cash while referring to the value of firm’s cash holdings. Third, since most of the previous studies have been done with U.S. data, I discuss the value of a dollar in the introduction. However, my data are from Malaysia, and therefore in the empirical part I am examining the value of a ringgit.

I review the related literature in the next section. Section 3 develops theoretical framework of the study, the main hypothesis, illustrates the methods and details the sample selection.


The literature on market value of cash can be divided into research focus on the benefits of liquidity, or agency costs. The former approaches through the studies of financial policy and corporate decision making of companies, whereas the latter evaluates the degree of agency conflicts on the basis of corporate governance factors. Despite the general division between the two issues, both are at least implicitly always present during the tests and conclusions.

Although much effort has recently been devoted to studying the determinants of cash policy of firms, data on the impact of reserves firms’ cash remains relatively small. However, there are a few notable exceptions. Blanchard, Lopez-de-Silanes and Shleifer (1994), who studied a small sample of companies that received cash windfalls from lawsuits, and Harford (1999), studied the acquisition of the company with unusual cash, the document that managers with weaker incentives to maximize value, tend to spend large amounts of cash is inefficient.

Opler, Pinkowitz, Stulz and Williamson (1999) argue that corporate cash can be attributed to a compromise, the theory of financial hierarchy and agency theory. Kim, Mauer and Sherman (1998) develop a model of compromise and argue that the optimal amount of corporate cash holdings is determined by the tradeoff between lower income and benefits to minimize the need for costly external financing. Almeida, Campello and Weisbach (2004) believe that corporate cash holdings affected by financial difficulties. Pinkowitz and Williamson (2001) believe that the bank authorities can affect the cash holdings of Japanese firms. Faulkender and Wang (2006) consider changes in the marginal value of corporate cash holdings related to differences in corporate financial policy. Foley, Hartzell, Titman and Twite (2006) offer tax-based explanations of corporate cash.

Most of the literature to evaluate the relationship between financial policy and the exact market value cash holding focused on companies in the United States of America (USA) Pinkowitz and Williamson (2004), Faulkender and Wang (2006), and Denis and Sibilkov (2007) all study how the financial characteristics of the company, and the cost of cash to play together. Pinkowitz and Williamson (2004) show that the average market value of the dollar held by a firm at roughly $ 1.20, which indicates that shareholders believe that the benefits outweigh the potential liquidity problems of the agency associated with it. Faulkender and Wang (2006), using different methodologies to find the market value of the dollar at $ 0.94 on average. Their results suggest that the potential costs of institutions, as well as tax effects outweigh the benefits to the average firm. Denis Sibilkov (2007) focus on the financial difficulties of the company and the investment opportunities and find consistent results. Nevertheless, there is significant cross-section changes in the market value of money, thus focusing on the mean values shows only a little about the relationship between fiscal policy and the value of cash.

The other branch of value of cash literature focuses on the effect of corporate governance. For example, Dittmar and Mahrt-Smith (2007) use U.S. data show that the additional $ 1 cash for badly managed companies worth between $ 0.42 to $ 0.88, while good governance doubles the value. Pinkowitz et al. (2006) used a cross-border data and found that an additional $ 1 is associated with an increase in company value of $ 0.29 to $ 0.33, depending on the criteria of corporate governance in countries with weak protection of shareholders, while an additional $ 1 in cash associated with an increase of $ 0.91 to $ 0.95 in the value of the company in countries with good shareholder protection. In addition, Kalcheva and Lins (2003) found that a minority of investors who are not very well protected by applicable discounts for firms in high levels of cash. This is consistent with the findings Fresard and Salva (2009), which show that the value of $ 1 of excess cash of typical non-US companies is U.S. $ 0,58, while it is $ 1.61 for the firms listed in the U.S. through exchanges means that investors discount the value of corporate cash reserves when they are at high risk of turning into private profit.


Theoretical Framework

Here I will talk about the early literature related to the value of cash holdings of the company, as well as provide relevant theory. I begin with outlining the background to understand why firms hold cash. It is necessary to identify with why firms hold cash in order to understand how the shareholders determine the importance they attach to the cash. Then I will present before the relevant studies and conclusions contained in the value of the cash literature.

3.1.1 Cash holding motives

If all firms operating in the world of perfect capital markets, cash holdings will have no value. If the firm was in need of cash for operations or investments, it can raise funds at zero cost.

While there is no liquidity premium in such a world, holdings of liquid assets have no possibility of cost. Consequently, if a company borrows money and invests it in liquid assets, shareholder wealth is unchanged.

Nevertheless, in the real world markets are not perfect and the holding of liquid assets has its costs. Thus, a firm must strike a balance between the marginal cost of holding liquid assets and the marginal benefit of holding these assets.

Here, I present five theories of why firms hold cash and which have been shown in earlier literature. The transaction motive

Transactions motive for holding cash is due to the cost of converting money substitutes into cash. According to Keynes (1936), a company can save on transaction costs by using cash to make payments without liquidation of assets. Miller and Orr (1966) model the demand for cash to finance daily operations, and the required level of cash. The company short of liquid assets has to raise funds in capital markets, liquidate existing assets, reduce dividends and investment, the revision of existing financial contracts, or use a combination of these actions. Since there are both fixed and variable costs in increasing cash, the company must hold a buffer of cash to avoid raising cash often, and thus to avoid the associated fixed transaction costs.

Myers and Majluf (1984) argue that the increase in external financing is more costly than using internal resources in the presence of asymmetric information. Since outsiders know less than the management, they may discount the price of securities more than management was willing to accept. Thus, the management may find it more profitable not to sell securities, and even reduce the investment. For this reason, it may be optimal for companies that conduct a certain level of cash to meet the needs of investment spending. The agency motive

Jensen (1986) argues that entrenched managers have incentives to retain cash rather than an increase in payments to shareholders, even if the firm has limited opportunities for investment. Opler et al. (1999) tender reasons why managers can use the optimal cash policies. First, managers can accumulate funds to pursue their personal interests. Cash allows managers to invest in external capital markets would not be willing to finance. They usually spend one dollar in cash in hand, even if they cannot raise financing from the markets. Consequently, they could make investments that may have a negative impact on the value of the company. Jensen's (1986) free cash flow problem predicts that managers with surplus cash are probably to overinvest. Thus, a one dollar increase in cash holdings of firms can lead to significantly less than one dollar increase in the value of the company. As the outsiders do not know, whether managers are accumulating cash to increase the value of the company or pursue their own goals, the cost of external capital is likely to increase. The tax motive

In recent studies by Foley et al. (2007) shows that U.S. companies which will bear the tax consequences associated with the repatriation of foreign earnings hold a high level of cash. Affiliates referring to the highest tax consequences of repatriating also have the highest level of cash. This means that multinational companies are more likely to accumulate cash. The extent this applies to the Malaysian firms has yet be studied. The theory financing hierarchy

The theory of financing hierarchy implies that there is no optimal amount of cash, based on arguments similar to the hierarchy theory of capital structure (Opler et al. (1999)). According to theory, firms are not willing to issue shares, because it is too expensive because of the asymmetry of information. They sell the debt when they do not have sufficient resources, and when they can do so. When they have sufficient resources to invest in profitable opportunities available, they pay the debt which becomes due, and to accumulate more cash or else. The theory assumes that the cash holdings of firms are less strategic choice but more a result of a dynamic, endogenous process. Investment opportunities and the value of cash

Pinkowitz and Williamson (2004) were the first who studied the market value of cash holdings. They focus on firm’s investment and financing opportunities. They find that the growth of the company have the possibility of a positive attitude to the market value of money. Firms with greater investment opportunities have a higher cost of cash. They also show that firms with higher uncertainty of investment have a higher valuation. In addition, firms in a difficult financial situation have lower valuation on cost. Faulkender and Wang (2006) confirm this conclusion, as they show that firms with lower leverage, a proxy for financial distress, have higher value put on cash. Finally, Pinkowitz and Williamson (2004) argue that access to capital markets does not affect the market value of cash. However, they note that their proxy for access to capital markets, company size may not be perfect. Consequently, Faulkender and Wang (2006) show that the difficulties in obtaining access to capital markets play an important role in the market value of cash. Liu and Chang (2009) show similar proof on the impact of financial constraints on the market value of cash. Faulkender and Wang (2006) also show that the marginal cost of cash reduces with the amount of cash holdings. They argue that this is associated with an increase in the probability distribution of cash to shareholders, and consequently incurring transaction costs and taxation, to reduce the cost of cash.


After I studied the theory of the value of cash holdings, I turn to the empirical predictions. I present hypotheses for the impact of financial policy and investment opportunities on the value of cash. These hypotheses relate to previous work in the field of corporate finance and the value for cash.

Hypothesis 1: The marginal value of cash is decreasing in the level of the firm’s cash position

After Faulkender and Wang (2006), I initially hypothesize that the marginal value of the shareholders place on cash holdings of the company reduces as the level of cash holdings increases. The reasons are based on agency and tax considerations. As firm’s cash level rises it becomes more likely to distribute the cash to shareholders who then as a result incur a dividend tax. In addition, the company with high cash holdings becomes more vulnerable to face agency costs as shareholders begin to worry about the interest and ability of managers to invest in positive NPV projects. Thus, the marginal cost of cash should reduce as the cash level of the company increases.

Hypothesis 2: An extra ringgit of cash holdings is less valuable for shareholders in highly levered firms than in firms with low leverage.

The second hypothesis from Faulkender and Wang (2006), which I test in my Malaysian sample, is the negative relation marginal cost of cash and firm’s leverage. The cost of cash for shareholders in high levered firms is likely to be less than in firms with low leverage as contingent claims analysis predicts that most of the value of these firms is in the hands of debt holders. Additional ringgit is likely to go mostly to increase the value of debt and therefore, the value for shareholders is low.

Hypothesis 3: An extra ringgit of cash holdings is more valuable for shareholders in financially constrained firms.

The last hypothesis which follows Faulkender and Wang (2006) is that the simplicity of accessing to external capital markets should have an impact on the value of cash. Access may be limited for various reasons, but often associated with asymmetric information about the state of the company, which may occur for smaller firms, firms without any credit rating or equity research coverage and the firms that do not pay dividends. These firms can be considered as financially constrained and can be thought of having higher costs in raising external funds. Thus, with its own funds, i.e. cash in hand, should be more valuable to these firms than financially unconstrained firms, which are likely and able to obtain external financing.

Hypothesis 4: An extra ringgit of cash holdings is more valuable for firms with good investment opportunities.

I examine whether firms with better investment opportunities have a higher valuation on their cash holdings than firms with weaker growth potential by following Pinkowitz and Williamson (2004). Pinkowitz and Williamson argue that the main theoretical determinant of the value of cash holding should be the investment opportunity set of the firm. First, liquidity is important, because without liquid assets of the firm will be forced to abandon a positive NPV project (Myers and Majluf (1984)). This should increase the cost of cash as it is expected to increase in value of assets. Secondly, Jensen's (1986) free cash flow problem arises when the firm has a few good opportunities for investment. If a company with sufficient cash reserves has positive NPV investment opportunities, it is likely to use these advantages instead of wasting money on unproductive ventures. Intuition is that when two identical firms except that one has a positive NPV investment opportunities and the other one does not have the opportunity to invest, it is likely that the first firm will spend its cash in ways more valuable to the shareholders.

Hypothesis 5: The marginal value of cash is high for financially constrained firms with good investment opportunities.

One of the arguments in Faulkender and Wang (2006) having a higher marginal value of cash for financially constrained firms is that when firms have positive NPV investment opportunities. The higher the cost of raising external capital is, the more likely these opportunities are foregone.

Though, they do not test for it empirically. I hypothesize that the reason why financially constrained firms and firms with better investment opportunities have a higher value placed on cash when examined separately, is in fact due to the combined effect of these two criteria. A financially constrained firm without investment opportunities is unable to make return for the cash, while a financially unconstrained firm with good investment opportunities can simply increase external funding when it needs to. Thus, financially constrained firms with good investment opportunities should have a high value placed on their cash holdings by their shareholders compared with other firms.

Hypothesis 6: Firms’ cash holdings, on average, decrease when the cost of external capital increases.

When conditions in the corporate credit market deteriorate, it often leads to a reduction in the economy (Fisher (1933)). As firms generate less internal cash flows and at the same time, corporate credit becomes more expensive and rationed, cash reserves of firms, on average, should decline. It was also suggested by Opler et al (1999).

Hypothesis 7: When the cost of external capital is higher an extra ringgit of cash holdings is more valuable.

As the supply of credit becomes more rationed and therefore more expensive, the cost of raising capital increases. The increase in the cost of capital makes firms more likely to give up positive NPV projects due to lack of funding. Therefore, when a credit is more rationed, cash holdings should become more valuable because they can help companies take advantage of positive NPV investment opportunities without incurring high costs of raising external capital.


I follow Faulkender and Wang (2006) who developed a methodology which estimates the extra value the market incorporates into equity values that result from changes in the cash position of firms over the fiscal year to measure the impact of corporate financial policy on the value of cash holdings. Since stock returns are influenced by the common risk factors, as well as changes in firm-specific characteristics it is necessary to control for both to be able to estimate the magnitude change attributed to the change in cash. The change in the value of a firm is measured by the excess return for the firm i during fiscal year t less the return of stock i’s benchmark portfolio during fiscal year t. Then the excess returns are regressed on changes in the characteristics of the firm. In this case the main interest is in the estimated coefficient corresponding to the variable measuring the ratio of unexpected changes in cash of the firm’s lagged equity value. Since the dependent and independent variables are standardized by lagged market value of equity, the coefficient measures the dollar change in shareholder value resulting from a change of one dollar of cash held by the firm. Faulkender and Wang (2006) methodology is in effect a long-term event study, in which event is unexpected changes in cash holdings, controlled for other factors that may impact returns over the assessment window of one year.

3.3.1 Controlling for risk-related market-wide factors

To control for risk-related factors excess returns are examined that may impact a firm’s discount rate and return. Fama and French (1993) show that size and the book-to-market of equity clarifies ordinary variation in stock returns. To arrive at the estimate of the excess return I use the 25 Fama-French portfolios (Fama and French (1993)) formed on size, measured as market capitalization, and book-to-market value of equity ratio (BE/ME henceforth) as my benchmark portfolios.

First firms are sorted by size and divided in five size groups, and then firms are sorted by BE/ME ratios and divided in five BE/ME quintiles for each year. Then I group every firm into one of

BE/ME portfolios and 25 size based on the intersection between the BE/ME and size independent sorts. Firm’s excess return is calculated by subtracting the firm i’s benchmark portfolio return during fiscal year t from the firm i’s stock return during fiscal year t. The fiscal year, or yearly, returns are calculated using the monthly returns. Hence, the dependent variable for the baseline regression is


where ri,t is the stock return for firm i during fiscal year t and is stock i’s benchmark portfolio’s return during the corresponding fiscal year t.

3.3.2 Controlling for firm-specific factors

It is necessary to control for variables that could be correlated with both change and returns in cash holdings to be able to examine how much the change in cash holdings impacts the change in equity value. Hence, in addition to change in cash should be regressed the excess stock return over the fiscal year on changes in a firm’s profitability, investment policy, and financing policy.

The subsequent equation describes baseline regression:



where the ΔX term indicates unforeseen change in variable X.

The dependent variable is described above. The independent variables are firm-specific factors that control for sources of value other than cash or may be correlated with cash holdings. The dependent variable was described above. Independent variables are firm-specific factors that control the sources of value, except for cash and can be correlated with cash holdings. ΔCi,t is the unforeseen change throughout fiscal year t in firm i’s cash holdings in balance sheet and the most significant variable in the regression. I suppose that the unforeseen change in cash holdings equals to the realized change in cash holdings throughout the fiscal year. ΔEi,t is the change throughout fiscal year t in earnings before interest and extraordinary items, and controls for profitability of firm.

Firm’s investment changes policy are controlled by ΔNAi,t, the change throughout fiscal year t in total assets net of cash, and ΔRDi,t, the change throughout fiscal year t in R&D expenditure. The financing policy is controlled by ΔIi,t which is the change throughout fiscal year t in interest expense, ΔDi,t which is the change during fiscal year t in sum dividends, Ci,t-1 which is firm i’s lagged cash holdings at time t-1, Li,t which is market leverage at the of fiscal year t, and finally NFi,t which is the firm’s net financing throughout the fiscal year t. As the stock return is also by definition divided by Mi,t-1, the standardization allows for understanding the estimated coefficients as the dollar change in value for a one-dollar change in the relevant independent variable.

Sample Selection

For my empirical analysis of the marginal value of cash in Malaysia and how it may have changed over time with the availability of capital from the external market I use a sample of publicly listed Malaysian firms from 1999 to 2009. The sample includes both active and inactive firms to avoid a survivorship bias.

In this section I describe how I calculate the variables and from where I obtain the data.

Here I will first describe how the dependent variable is calculated, and then describe the independent variables in detail.

3.4.1 Dependent variable

The dependent variable is the excess return of a firm’s stock (Eq. (1)). The stock return for a firm i through fiscal year t, ri,t, is calculated using Total Return Index (item ReturnIndex) from Thomson Reuters Datastream database (referred as Datastream after this). The index regulates for stock splits and dividends, and therefore the most accurate measure of increase in firm equity value.

3.4.2 Independent variables

The change is basically the difference between fiscal years t and t-1. In addition, all variables excluding for leverage and net financing are deflated by one-year holdup market value of equity. The variables used in Eq. (2) are measured as below:

a) Ci,t and Ci,t-1

One-year holdup cash holdings and cash holdings are measured as cash and short-term investments (CashAndSTInvestments). Ever since this is the most important variable, it should be noted that firm’s cash holdings are considered to include marketable securities and cash in majority of academic studies. Depending on the source, these can be listed as cash and equivalent, cash and short-term investments or marketable securities and cash. Though, in addition to cash the definition can include items such as commercial papers, treasury bills and other money market investments. In general databases adjust the reported records from firm financial statements in order to make the data comparable across the firms.

b) Ei,t

Earnings before interest and extraordinary items are calculated as earnings before extraordinary items (IncomeBefExtraItemsCFStmt) plus interest expenses (InterestExpenseOnDebt).

c) NAi,t

Total assets net of cash or net assets, are calculated as total assets (TotalAssets) minus cash holdings (CashAndSTInvestments).

d) RDi,t

R&D expenditure is simply R&D expenditure (ResearchAndDevelopmentExpense). It is set to zero if missing.

e) Ii,t

Interest expense is measured as interest expenses on debt (InterestExpenseOnDebt).

f) Di,t

Total dividends are measured as common dividends paid (CommonDividendsCash).

g) Li,t

Market leverage is defined as the market debt ratio and calculated as total debt (STDebtAndCurPortLTDebt+TotalLTDebt) over the summation of the market value of equity and total debt.

h) NFi,t

Net financing is total equity issuance (SaleOrIssuanceOfStockCFStmt) minus repurchases (PurchOfComAndPfdStkCFStmt) plus debt issuance (LTDebtIssuanceCFStmt) minus debt redemption (LTDebtReductionCFStmt).

i) Mi,t-1

One-year holdup market value of equity is used to decrease the firm-specific factors except leverage and measured as the market value of equity (MarketValue).