Cash Holdings in German Firms

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1 Cash Holdings in German Firms S. Schuite Tilburg University Department of Finance PO Box 90153, NL 5000 LE Tilburg, The Netherlands ANR: Supervisor: Prof. dr. V. Ioannidou CentER Tilburg University Department of Finance PO Box 90153, NL 5000 LE Tilburg, The Netherlands Abstract: This paper investigates the determinants of cash holdings for public German firms over the period The average cash ratio slightly increases over this period. I find that cash holdings increase with the market to book ratio and industry cash flow volatility. Cash holdings decrease with net working capital, capital expenditures, acquisitions and leverage. The years of the financial and economic crisis, , show an increase in the average cash ratio. This increase is not the result of changed relations between cash holdings and its determinants but, at least partly, by a regime shift in the demand for cash. Consistent with the importance of agency costs, I find some evidence that the value of cash decreased over time during my sample period. This version: February 2012

2 1 Introduction With the financial crisis going forward, the cash piles of businesses are receiving more and more attention. An article on Bloomberg from July 2011 states that U.S. companies are holding about $2 trillion in cash, and the amount keeps growing 1. This phenomenon of increasing cash piles is not only observed in the U.S. but also in Europe. According to another article on Bloomberg, total cash holdings at 466 companies in Europe were $691 billion at the end of September 2010, or 16 percent higher than at the end of 2007, the year the financial crisis began 2. A survey carried out by PricewaterhouseCoopers indicates that German companies had record cash of $171 billion at the end of The issue of cash holdings did not, originally, receive much attention in empirical studies. However, the last decade more studies are examining the evolution and determinants of cash holdings. Opler, Pinkowitz, Stulz and Williamson (1999) (henceforth OPSW) focus on publicly traded U.S. firms in the period. Their findings largely expand the evidence on the determinants of cash holdings. They examine two models in explaining the determinants of cash holdings; the static tradeoff model and the financing hierarchy view. Within the static tradeoff model of holding cash, the costs and benefits of holding cash are weighed. The optimal amount of cash holdings is found when the marginal cost of holding cash equals the marginal benefit of holding cash. The most important cost to holding cash is the lower return earned on it. In fact, if management acts to maximize shareholder wealth, this is the only cost to holding cash. However, since managers are likely to be risk averse and receptive of making purchases for their private benefits, they do not always act in accordance with shareholder wealth maximization. This implies that there exists another cost to holding cash. When the interests of management and shareholders are not fully aligned, management has incentives to engage in wasteful spending, thereby decreasing firm value. The benefits of holding cash can be subdivided into two categories introduced by Keynes (1934): the transaction motive and the precautionary motive (Keynes (1934), In: OPSW (1999)). The transaction motive deals with the costs involved in attracting external funds or having to liquidate assets. By having liquid assets, the firm can use these liquid assets to make payments instead of raising costly funds, thereby saving transaction costs. The precautionary motive describes the benefit of having cash as being able to undertake investments or finance activities when cash flow is too low, relative to investment, and when external funds are not available or are excessively costly. 1 Use It or Lose It Should Be the Rule on Corporate Cash: View, Bloomberg, July 22, Richard Weiss and Francois de Beaupuy, European Companies With $700 Billion Cash Ease Deal Dearth, Bloomberg, November 30, Holger Elfes, German Companies Have Record Cash Pile, Handelsblatt Reports, Bloomberg, May 24,

3 Another theory related to the amount of cash holdings a firm should hold, is the financing hierarchy view. According to this theory there is no optimal amount of cash a firm should hold. The amount of cash a firm holds only depends on the profitability of the firm. OPSW (1999) find evidence supportive of the static tradeoff model. In particular, firms hold more cash when they are smaller, face better investment opportunities, have higher cash flows, have higher capital expenditures and R&D expenditures, have lower net working capital and have more volatile cash flows. Furthermore, firms paying dividends and firms with a higher bond rating hold less cash. They do not, however, find evidence in support of the agency cost motive. In accordance with this finding, Bates, Kahle and Stulz (2009) (henceforth BKS) examine whether agency considerations play a role in explaining the increase in cash holdings but find no support. One possible reason that the agency cost motive is not able to explain cash holdings in these studies is due to the fact that shareholders are well protected in the U.S. and could therefore be able to pursue management to payout excess cash. In order to investigate whether corporate governance problems do play a role in explaining cash holdings, different papers have extended the research on cash holdings to countries with more severe corporate governance problems (see Dittmar, Mahrt Smith and Servaes (2003), Guney, Ozkan and Ozkan (2003) and Ferreira and Vilela (2004)). Dittmar et al. (2003) divide their sample, using the shareholder rights variable from La Porta, Lopez de Silanes, Shleifer and Vishny (1997) (henceforth LLSV(1997)), in a group with countries with good shareholder protection and a group with countries with poor shareholder protection. It turns out that firms in countries with the lowest level of shareholder protection hold more than twice as much cash as firms in countries with the highest level of shareholder protection. With this paper I extend the existing literature in two ways. First, I extensively study the determinants of German cash holdings for the 2000s. Second, I investigate in which way and to what extent the financial crisis has impact on cash holdings for German firms. The comparison between U.S. firms and German firms is interesting because these two countries have very different legal and environmental structures. This paper is, to my knowledge, the first that empirically investigates the impact of the financial crisis on cash holdings. My analyses largely follow the methods used in BKS (2009). The results show that the average cash ratio of public German firms slightly increases over the period I find that cash holdings increase with the market to book ratio and industry cash flow volatility. Cash holdings decrease with net working capital, capital expenditures, acquisitions and leverage. The years of the financial and economic crisis, , show an increase in the average cash ratio. This increase is not the result of changed relations between cash holdings and its determinants but, at least partly, by a regime shift in the demand for cash. Consistent with the importance of agency costs, I find some evidence that the value of cash decreased over time during my sample period. 2

4 In order to examine the relations as outlined above, a sample of public German firms is generated for the period This sample is obtained by using the Compustat Global database. The remainder of this paper is organized as follows. Section 2 discusses the existing literature on cash holdings. Section 3 outlines the composition of the data used in my research. Results on the relation between cash holdings and firm characteristics are discussed in Section 4. Section 5 discusses the presence of agency problems. A summary is given in Section 6. 3

5 2 Literature Review This section contains a discussion of the existing theoretical and empirical literature on corporate cash holdings. Empirical literature identifies the static tradeoff model as the main model for determining cash holdings (see, for instance, OPSW, 1999). According to the tradeoff model, three motives can be distinguished in why firms should hold cash. The transaction cost motive A firm in need of money, has the following options to raise funds: (1) raise external funds, (2) liquidate existing assets, (3) reduce dividends or (4) reduce investment (OPSW, 1999). Since these different options are all costly to the firm, the firm can benefit by holding cash. Thus, according to the transaction cost motive, firms that are likely to incur higher transaction costs, hold more liquid assets. The following variables affect the cost of being short of liquid assets and / or the probability of being short of liquid assets: Debt rating Firms having a debt rating are assumed to have better access to the capital markets (OPSW, 1999). Accordingly, firms with a debt rating are expected to hold less cash. Net working capital Shleifer and Vishny (1992) show that firms face substantial transaction costs when forced to sell firmspecific assets. Hence, firms with mostly firm specific assets have higher cash holdings (OPSW, 1999). On the other hand, by having assets that can easily be converted into cash, firms can raise funds at low cost. These assets are seen as cash substitutes. Net working capital is seen as a proxy for cash substitutes (see OPSW (1999), Ferreira and Vilela (2004), and BKS (2009)). In particular, BKS (2009) find that net working capital net of cash explains the most of the change in cash holdings in their sample. Dividends As mentioned above, firms with assets that can cheaply be converted into cash can raise funds at low cost. In the same way, dividend paying firms can raise funds at low cost by lowering dividends paid. Consequently, dividend paying firms are expected to hold less cash (see OPSW (1999) and BKS (2009)). 4

6 However, in contrast with what is predicted by theory, Guney et al. (2003) find that dividend paying firms in Germany hold more cash. Investment opportunities Firms facing cash shortages, have to give up positive NPV projects. When dealing with a cash shortage, an increase in the number of profitable investment opportunities forces the firm to give up profitable projects. More profitable investment opportunities means, holding cash equal, a higher probability of being short of liquid assets. Since the opportunity cost of lost investment is higher for firms with more profitable investment opportunities, they are expected to hold more cash (Dittmar et al., 2003). Size The literature and empirical evidence suggests that the size of a firm plays, for several reasons, a significant role in the determination of cash holdings. Early studies by Frazer (1964) and Vogel and Maddala (1967) suggest that larger firms tend to have lower cash to assets ratios. This is because the fixed costs associated with issuing securities are substantial, thereby preventing small firms from raising external funds. Besides, empirical evidence on economies of scale confirm this relation (Mulligan, 1997). Cash flow volatility When a firm is more uncertain about the cash flows it will incur, the probability of being short of liquid assets will be higher. When faced with adverse cash flow shocks, a firm might possibly be forced to forgo profitable investment opportunities or it may not be able to finance it s daily operations anymore. Adverse cash flow shocks are more likely to occur in states of the world where cash flows are more uncertain. Accordingly, firms with more volatile cash flows hold higher amounts of cash (see, for instance, OPSW (1999) and BKS (2009)). Capital expenditures The relation between capital expenditures and the amount of cash holdings can be either positive or negative. According to Dittmar et al. (2003), if capital spending captures investment demands, cash holdings should be positively related to capital expenditures. On the other hand, BKS (2009) argue that capital expenditures can create assets that can be used as collateral, which increases debt capacity and thus lowers demand for cash. 5

7 Cash flow Kim, Mauer and Sherman (1998) find evidence for a negative relation between cash flow and the amount of cash a firm holds. They argue that operating cash flow and especially free cash flow provide a ready source of liquidity to meet operating expenditures and maturing liabilities. In contrast, BKS (2009) expect firms with higher cash flow to accumulate more cash. Risk free rate Assets that can be liquidated at low cost are expected to have a lower return to reflect this benefit (see Amihud and Mendelson, 1986). This is called the liquidity premium. Accordingly, this means that there is a cost to holding cash. BKS (2009) argue that the risk free rate is seen as a proxy for the opportunity cost of cash. As the risk free rate declines, holding cash becomes cheaper and so, a negative relation is expected between the risk free rate and cash holdings. The precautionary motive A benefit of holding cash is that it enables firms to finance its activities and pursue profitable investment opportunities when external funds are not available or extensively costly. This motive of holding cash is described by Keynes (1934) and is called the precautionary motive. Within the perspective of the precautionary motive, I can broadly describe two situations in which a firm has a higher precautionary demand for cash. First, in times when it is more likely that a firm will be faced with adverse cash flow shocks, it will hold more liquid assets (BKS, 2009). Second, when outside funds are more costly or not available, firms should rely on internal funds (see, for instance, OPSW (1999) and Dittmar et al. (2003)). The presence and importance of asymmetric information between firm s management and its investors is the main factor making external funds expensive (Myers and Majluf, 1984). The finance literature describes several variables that proxy for the precautionary need of cash. Market to book Since the market to book ratio incorporates growth options, this ratio is seen as a good proxy for the presence of information asymmetries. This is the case because growth options / profitable investment opportunities are intangible in nature and, therefore, harder to value than assets in place. Normally, management has more information about investment opportunities than investors have. Accordingly, investors discount securities issued by the firm in order to protect themselves from paying too much. However, discounting by investors can lead to undervaluation of the firm s securities, making it very 6

8 costly for the firm to attract external capital. As a result, in order to prevent the firm from forgoing profitable investment opportunities, firm s with higher market to book ratios will hold higher amounts of cash (see for example, Dittmar et al. (2003) and BKS (2009)). Besides, firm s with higher market tobook ratios are predicted to have greater financial distress costs, since the value of growth opportunities falls disproportionally in bankruptcy (Ferreira and Vilela, 2004). To avoid bankruptcy, firm s with higher market to book ratios are further expected to hold more cash. R&D expenses Just like the market to book ratio, the extent in which firms engage in research and development can give an indication of the presence and importance of information asymmetries within that firm. R&D expenditures are intangible in nature and, therefore, give rise to information asymmetries. Indeed, several studies show that firms that engage more in research and development hold higher amounts of cash (see, for instance, OPSW (1999), Dittmar et al. (2003) and BKS (2009)). Besides, Opler and Titman (1994) find that highly leveraged firms that engage in research and development suffer the most in economically distressed periods. This is consistent with the theory that firms with specialized products are especially vulnerable to financial distress. To avoid bankruptcy, firm s with higher R&D expenses are further expected to hold more cash. Leverage Highly leveraged firms will find it more difficult to obtain more external funds. Therefore, from a precautionary point of view, it is expected that highly leveraged firms will hold more cash. Holding more cash can serve as a hedge against the higher risks faced by these firms. Indeed, Acharya, Almeida and Campello (2007) find that financially constrained firms with high hedging needs, i.e., if the correlation between operating income and investment opportunities is low, hold more cash. Furthermore, Opler and Titman (1994) show that highly leveraged firms lose substantial market share to their more conservatively leveraged firms in industry downturns, indicating that higher leveraged firms are more subject to financial distress costs. Accordingly, highly leveraged firms are expected to hold more cash. On the other hand, BKS (2009) argue that firms might use cash to reduce leverage when leverage is enough constraining, thereby reducing the probability of experiencing financial distress. In particular, there is strong empirical evidence in favor of a negative relation between leverage and cash holdings (see, for example, OPSW (1999), BKS (2009) and Guney et al. (2003). So, although theoretically seen the relation between leverage and cash holdings is ambiguous, empirical literature provides evidence in favor of a negative relation. 7

9 Size It is well known that, from the perspective of the transaction cost motive, size is an important determinant in the demand for cash. In light of the precautionary motive, size might play a role as well 4. To the extent that smaller firms are assumed to be less well known, information asymmetries arguably are more important to these firms. For this reason, smaller firms are more likely to be financially constrained. In accordance, Almeida, Campello and Weisbach (2004) include the size variable to determine whether a firm is financially constrained and finds that financially constrained firms invest in cash out of cash flow, while unconstrained firms do not. Furthermore, Titman and Wessels (1988) argue that larger firms tend to be more diversified and, therefore, are less prone to bankruptcy. Being less prone to bankruptcy leads to lower financial distress costs and, as a result, larger firms are expected to have a lower precautionary demand for cash. Dividends According to BKS (2009), dividend paying firms are likely to be less risky and, as a result, have greater access to the capital market. Therefore, the precautionary demand for cash is lower for dividendpaying firms. Capital expenditures BKS (2009) argue that capital expenditures could proxy for financial distress costs and / or investment opportunities 5. So, from a precautionary point of view, capital expenditures would be positively related to cash. The agency motive The public corporation is characterized by the division between ownership (shareholders) and control (management). Since management may not always be inclined to act in accordance with the purpose of shareholder wealth maximization, agency costs might arise (Jensen and Meckling, 1976). These agency costs occur in different forms. First, payouts to shareholders reduce the resources under managers control, thereby reducing managers power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital (Rozeff (1982) and Easterbrook (1984), In: Jensen (1986)). Financing projects with cash avoids monitoring by the capital markets (Jensen, 1986). Second, managers prefer to run large firms rather than small ones as, 4 An early study by Frazer (1964) finds a decline in the demand for cash to satisfy the precautionary motive for holding cash as firms increase in size. 5 Kalcheva and Lins (2007) use capital expenditures as a proxy for a firm s potential investment opportunity set. 8

10 in this case, they tend to earn higher salaries and may have more prestige 6. Accordingly, managers might be willing to engage in negative NPV investments, also known as empire building. Third, managers seem to behave in a risk averse way to the detriment of shareholders (Jensen and Meckling, 1976). In order to avoid market discipline, management is inclined to hold excess cash (OPSW, 1999). OPSW (1999) and BKS (2009) examine the impact of agency costs on cash holdings but find no relation. Dittmar et al. (2003) argue that this finding might be due to the fact that their research focuses on the U.S., where shareholders enjoy good legal protection. La Porta, Lopez de Silanes, Shleifer and Vishny (2000) report evidence consistent with this interpretation. To be able to empirically support their interpretation, Dittmar et al. (2003) investigate the impact of agency considerations on cash holdings for a sample of firms from 45 countries. They find evidence supportive of a clear and strong relation between agency conflicts and cash holdings. In particular, firms in countries with the lowest level of shareholder protection hold more than twice as much cash as firms in countries with the highest level of shareholder protection. Consistent with Dittmar et al. (2003), Ferreira and Vilela (2004) show that firms in countries with good shareholder protection and concentrated ownership hold less cash 7. However, their finding of a negative relation between capital market development and cash holdings is contrary to the agency view. Country specific differences between Germany and the U.S. In this paper I will frequently compare my results on the determinants of German cash holdings to the extensive empirical literature on U.S. cash holdings. Before running into that, it is worthwhile to note some country specific differences between Germany and the U.S. which may impact the levels of cash. This section aims to point out these differences. Country s legal structure Legal and institutional characteristics of a country may have significant impact on the cash levels firms hold. For example, Dittmar et al. (2003) show that firms in countries with poor shareholder protection hold up to twice as much cash as firms in countries with good shareholder protection. As a proxy for shareholder rights they use the anti director rights index developed by LLSV (1997). The index ranges from 0 to 5, where a high score indicates good shareholder protection. The U.S. shows a score of 5 on this index whereas Germany only scores a 1 (see LLSV, 1997). Dittmar et al. (2003) suggest that 6 Berk, J. and DeMarzo, P., Corporate Finance. Pearson Education, p Guney, Ozkan and Ozkan (2003) find similar results for firms from Germany, France, UK and Japan. 9

11 shareholders in countries with good shareholder protection, like the U.S., can force managers to return excess funds to them. Accordingly, the agency motive is expected to be more important in Germany than in the U.S. Guney et al. (2003) argue that strong rule of law and creditor protection increase the probability of bankruptcy in financial distress 8. Again, methods developed by LLSV (1997) are used to proxy for quality of law enforcement and creditor protection. The result provided by Guney et al. (2003) suggest that firms in countries with better creditor protection and higher quality of law enforcement have higher cash holdings. The creditor rights index developed by LLSV (1997) shows a score of 1 for the U.S. and a score of 3 for Germany (the index ranges from 0 to 4). The scores on the measure for the quality of law enforcement show little difference; 10 for the U.S. and 9.23 for Germany. Based on the quality of law enforcement and the level of creditor protection I expect German firms to hold more precautionary cash in order to reduce the threat by strong creditors of bankruptcy in financial distress. Ownership structure According to Franks and Mayer (2001), the German market has an insider system. This categorization is based on the concentrated ownership in Germany. Guney et al. (2003) also show that in Germany the ownership of firms is highly concentrated. In opposition to Germany, the U.S. has an outsider system, characterised by it s dispersed ownership of shares. The relation between ownership concentration and cash holdings is ambiguous. Large shareholders are better able to monitor management and could force them to pay out excess funds to the shareholders. On the other hand, large shareholders might be willing to increase the amount of assets under their control to consume private benefits. Related to the ownership structure, Franks, Mayer, Volpin and Wagner (2009) show that family controlled blocks is the most important category of ownership in Germany with 43%. Ozkan and Ozkan (2003) find that U.K. firms having families as ultimate controllers tend to hold more cash than those firms having, for example, financial institutions as controllers. A possible explanation is given by Dittmar et al. (2003), arguing that controlling families force firms to hold more cash in order to avoid the taxes that need to be paid when taking the funds out. Overall, it is hard to predict whether the high level of ownership concentration in Germany has a positive or a negative impact on the amount of cash held by firms. 8 See also Rajan and Zingales (1995). 10

12 Liquidity constraints Rajan and Zingales (1995) argue that countries with strong banking sectors have relatively underdeveloped capital markets, representing both the stock market as well the corporate bond market. Germany is characterized as a bank based system, while the U.S. is considered to have a market based system (see Demirguc Kunt and Levine, 1999). The statement by Rajan and Zingales (1995) is empirically supported by LLSV (1997) and Demirguc Kunt and Levine (1999). LLSV (1997) measure the development of the equity market by the ratio of the stock market capitalization held by minorities to gross national product and find significant higher outcomes for the U.S. than for Germany. The development of the credit market is measured by Demirguc Kunt and Levine (1999); they find evidence for a more developed credit market in the U.S. than in Germany. Having less developed capital markets, one would expect German firms to hold more cash than U.S. firms. 11

13 3 Data This section describes the sources and construction of my dataset. The main source of my dataset is the Compustat Global database 9. For the period , I include surviving and non surviving firms incorporated in Germany. This, conditional on having positive book value of total assets and positive sales. Excluded from the sample are financial firms (SIC codes ) because they may hold cash in order to comply with capital requirements (think of Basel agreement). I also exclude utilities (SIC codes ) because they may be subject to regulatory supervision. Below, I describe the variables used in the analyses that will follow. I also add a brief description of how the variable is measured and what relation is expected between the cash ratio and the explanatory variable. Cash ratio The cash ratio is the dependent variable in this research. It is constructed as the amount of cash and marketable securities divided by the book value of total assets. Firm size I use as size measure the logarithm of book assets in 2005 dollars. Firm size is used as a proxy for both the transactions motive as the precautionary motive. Larger firms are assumed to have economies of scale to holding cash. Besides, smaller firms are more opaque to capital markets than larger firms, making it harder for smaller firms to enter the capital markets. So, under both motives, it is expected that smaller firms hold more cash. Market to book ratio I calculate the market to book ratio as the market value of equity 10 plus the book value of total assets minus the book value of equity as the numerator of the ratio and divide this by the book value of total assets. The market to book ratio is used to test all three motives. Within the perspective of the transaction motive, a positive relation is expected between the market to book ratio and cash holdings, as the opportunity costs of a cash flow shortfall are higher for firms with more profitable investment opportunities. The precautionary motive also predicts a positive relationship since firms with a high market to book ratio are thought of having more information asymmetries, making external funds more expensive. In contrast, the free cash flow theory by Jensen (1986) predicts a 9 I explicitly mention when data items are not generated from Compustat Global. 10 Data on the market value of equity is generated from Datastream. 12

14 negative relation, implying low market to book firms to hold higher amounts of cash. The free cash flow theory implies that management is unwilling to pay out cash to shareholders when profitable investment opportunities are not there and in this way increase the assets under their control. Net working capital to assets Net working capital is measured as net working capital minus cash and marketable securities divided by total assets. Net working capital is seen as a cash substitute and thus I expect a negative relation between net working capital and cash holdings. Capital expenditures to assets I measure capital expenditures to assets as the ratio of capital expenditures to the book value of total assets. The relation between capital expenditures and cash holdings is ambiguous. The transaction motive predicts a negative relation as capital expenditures might increase debt capacity and thereby lowering the demand for cash. On the other hand, the precautionary motive predicts a positive relation as capital expenditures can be seen as a proxy for the presence of information asymmetries. Cash flow to assets Cash flow to assets is measured as earnings after interest, dividends and taxes but before depreciation divided by the book value of total assets. Just like net working capital, cash flow could function as a substitute for cash. Therefore, I expect a negative relation between cash flow and the amount of cash a firm holds. R&D to sales R&D to sales is used as a proxy for the presence of information asymmetries and is measured as R&D expenses to sales. I expect R&D to sales and cash holdings to be positively related. Acquisitions to assets I measure acquisitions to assets as acquisitions divided by the book value of total assets. Acquisitions are expected to be negatively related to cash holdings. Industry cash flow volatility I measure industry cash flow volatility as the standard deviation of industry cash flow to assets, computed as follows: For each firm year, I compute the standard deviation of cash flow to assets for the previous three years. I require at least three observations. I then average the firm cash flow standard deviations each year across each 2 digit SIC code. Firms in industries with more volatile cash 13

15 flows are expected to hold higher amounts of cash since the probability of being short of liquid assets will be higher. Dividend dummy I include a dividend dummy in my analyses to see whether firms paying dividend indeed hold less cash, as predicted by the transaction motive. The dividend dummy takes a value of one in years when the firm pays a common dividend and a value of zero otherwise. Leverage Leverage is measured as long term debt plus debt in current liabilities divided by the book value of total assets. Leverage is used as a proxy to capture the precautionary demand for cash. I expect to find a negative relation between leverage and cash holdings. Risk free rate The risk free rate is used as a proxy for the opportunity cost of holding cash. A lower risk free rate lowers the opportunity cost of holding cash, thus making it cheaper to hold cash. As a result, a negative relation is expected between the risk free rate and cash holdings. I use 3 month Euribor as the risk free rate 11. Net equity issuance Net equity issuance is measured as equity sales minus equity purchases divided by the book value of total assets. Since attracting funds is costly, firms infrequently raise capital. Because of this, capital raising tends to be lumpy and firms should have higher cash ratios directly after raising capital (BKS, 2009). So, firms with higher net equity issuance are expected to have higher cash holdings. 11 The Euribor rate is generated from Datastream. 14

16 4 Firm characteristics and the cash ratio After merging the data from Compustat with the data from Datastream and dropping the observations from utility and financial firms, the sample includes 6,756 firm year observations and 894 firms. The sample includes surviving and non surviving firms. The sample requires that firms have positive book value of total assets and positive sales. Only firms incorporated in Germany are included. In addition, 46 firms changed their fiscal year end during the sample period which, in each case, resulted in two observations for the same firm concerning the same fiscal year. I removed the observation with the new fiscal year end date since this observation does not reflect full year figures. I require firms to have non missing isin codes in Compustat Global; this is necessary to merge data from Compustat Global with data from Datastream. Observations with missing values on cash and marketable securities, longterm debt and debt in current liabilities are removed from the sample. 4.1 The evolution of the cash ratio and leverage ratios Before examining the determinants in the decision to hold cash, an overview is given of the evolution of the cash ratio and of the leverage and net leverage ratio for the sample period. Table 1 Average and median cash and leverage ratios from 2000 to 2010 The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities (SIC code ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are excluded as well. This yields a panel of 6,756 observations and 894 firms. The cash ratio is measured as cash and marketable securities divided by the book value of total assets. Leverage is defined as long term debt plus debt in current liabilities divided by the book value of total assets. The net leverage ratio is calculated as long term debt plus debt in current liabilities minus cash and marketable securities, divided by the book value of total assets. N stands for the number of firm year observations in each fiscal year. Year N Aggregate Cash Ratio Average Cash Ratio Median Cash Ratio Average Leverage Median Leverage Average Net Leverage Median Net Leverage

17 Table 1 shows the numbers of these ratios for every year in the sample period. Column 2 includes the number of observations per year. The aggregate cash ratio in Column 3 is calculated as the sum of cash and marketable securities per year divided by the sum of total book assets per year for all sample firms. This ratio is 9.3% in 2000 and moderately increases to 10.3% in The average cash ratio, see column 4, shows a comparable trend. From a level of 17.4% in 2000, it increases to 17.9% in A regression of the average cash ratio on a constant and time yields a positive but statistically insignificant time coefficient (see Appendix A, Table A.1). The R square of this regression is 25.9%. The evolution of the average and median cash ratio is graphically pictured in figure 1. From this figure, I observe different trends for the average cash ratio. There is a steep decline from 2000 to 2001, followed by a secular increase to a cash ratio of 18.2% in After a gradual decline until 2008, the cash ratio resumes its uptrend again. If I compare the period with the results found by BKS (2009) for U.S. firms, I find, with the exception of the period from 2000 to 2001, very similar results. From 2000 to 2001, German firms show a dramatic decline in cash ratios whereas U.S. firms show slightly increasing cash ratios. However, from 2001 to 2006, for both countries the trend is clearly upwards and the average cash ratio increases with comparable amounts. Further, a comparison of the level of the average cash ratio shows that U.S. firms, on average, have higher cash ratios than German firms in every year of the period , in a range of 3 to 7 percentage points higher. Figure 1 Evolution of the mean and median cash ratio from 2000 to 2010 The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities (SIC code ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are removed as well. This yields a panel of 6,756 observations and 894 firms. The cash ratio is measured as cash and marketable securities divided by the book value of total assets Mean cash ratio Median cash ratio It would be interesting to investigate the impact of the financial and economic crisis on the cash ratio. Intuitively, the cash ratio should have gone up since there is more uncertainty in periods of crisis, which should be reflected in higher cash flow volatility. In Sections and I will examine the 16

18 relation between cash holdings and the crisis years more thoroughly. For now, a look at figure 1 directly confirms the expectation that the average cash ratio went up during the period of the crisis. Whereas the average cash ratio does not give evidence for a clear trend, the median cash ratio does. Starting at a level of 8% in 2000, the median cash ratio increases to 12.5% in The estimated regression of the median cash ratio on a constant and time yields a coefficient on the time trend corresponding to a yearly increase of 0.5% and has a p value below The R square is 84.9% (see Appendix A, Table A.1). Again, the evolution of the median cash ratio during the period highly corresponds with that for U.S. firms as shown by BKS (2009). Although the increase in the median cash ratio for U.S. firms is somewhat higher than for German firms, the pattern is very similar. BKS (2009) were the first to examine the effect of the secular increase in cash ratios on net leverage ratios. They show that the net leverage ratio falls dramatically and even becomes negative at the end of the sample period. They suggest that the decrease in net debt occurs because firms hold more cash rather than because they have less debt. Table 1 contains yearly figures for the cash, leverage and net leverage ratios. Using these numbers, I investigate what the relations are between these variables for German firms. The evolution of the mean and median leverage ratio is drawn in figure 2. Both the mean and median leverage ratio show a secular increase until 2008, after which they start to go down. Figure 2 Evolution of the mean and median leverage ratio from 2000 to 2010 The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities (SIC code ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are removed as well. This yields a panel of 6,756 observations and 894 firms. The leverage ratio is measured as long term debt plus debt in current liabilities divided by the book value of total assets Mean leverage ratio Median leverage ratio Figure 3 pictures the evolution of the mean and median net leverage ratio. Regressions of these variables on a constant and time do not estimate a statistically significant time trend (not reported in a table). By observing the figures of the cash, leverage and net leverage ratios, it can be concluded that movements in the net leverage ratio are the result of changes in the cash ratio as well as leverage ratio, in approximately equal importance. 17

19 Figure 3 Evolution of the mean and median net leverage ratio from 2000 to 2010 The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities ( ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are removed as well. This yields a panel of 6,756 observations and 894 firms. The net leverage ratio is calculated as long term debt plus debt in current liabilities minus cash and marketable securities, divided by the book value of total assets Mean net leverage ratio Median net leverage ratio

20 4.2 Cash ratio by firm size Recently, considerable media attention has been devoted to the large cash piles of some big German companies, like Siemens, Volkswagen, Daimler, BMW and E.ON 12. In the previous section, I observed a slight increase of the average cash ratio over the sample period. To examine whether this increase is caused by the largest firms in the sample, I divide the sample into size quartiles based on the book value of total assets of the prior fiscal year. Figure 4 shows the evolution of the average cash ratio per size quartile over the sample period. Figure 4 Evolution of average cash ratio by firm size quartile from 2000 to 2010 The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities (SIC code ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are removed as well. Missing prior year asset data reduce the panel to 6,524 observations and 888 firms. The cash ratio is measured as cash and marketable securities divided by the book value of total assets. Firm year observations are divided into quartiles based on their prior year book value of total assets Q1: Smallest firm size quartile Q2 Q3 Q4: Largest firm size quartile 12 Holger Elfes, German Companies Have Record Cash Pile, Handelsblatt Reports, Bloomberg, May 24,

21 According to theory and empirical evidence, small firms should hold higher amounts of cash than large firms. As can be read from the figure above, German firms are no different in this; the average cash ratio increases monotonically with firm size. Although the two smallest firm size quartiles retain the highest cash ratios, the gap between the average cash ratio of the smallest firms and the largest firms gets closer towards the end of the sample period. This is due to an increasing average cash ratio for the two largest size quartiles and a decrease for the two smallest size quartiles. To assess whether there are statistically significant trends in the cash ratio for the different size quartiles, I estimate regressions of the average cash ratio on a constant and time for every size quartile (see Appendix A, Table A.2). This regression for the smallest size quartile does not indicate a significant time trend. I do find a significant negative time trend for the second size quartile with a time coefficient corresponding to a yearly decrease of 0.3% and p value below 0.1. The average cash ratios of the largest firms clearly show an upward sloping trend. The estimated regression for size quartile three shows a yearly increase of 0.3% and a p value below The increase of the average cash ratio for the largest firms is found to be highly statistically significant with a yearly increase of 0.4% and p value below From these regressions I conclude that the small increase in the average cash ratio that is observed over the total sample period is accounted for by the largest firms. Furthermore, from figure 4 I observe a dramatic decrease of the average cash ratio for the smallest firms. This decrease, however, is driven by a change in the composition of firms in quartile 1; because of an increase in total assets, more than half of the firms that originally belonged to quartile 1 was divided in quartile 2 or 3 in the year The firms that left quartile 1 represent an average cash ratio of 47.8% and, as a result, the average cash ratio of the quartile with the smallest firms substantially declined from 2000 to Cash ratio by industry cash flow volatility The transaction costs model clearly predicts a positive relation between cash flow volatility and cash holdings since uncertainty leads to situations in which, at times, the firm has more outlays than expected (OPSW, 1999). Empirical evidence on U.S. cash holdings is consistent with this theoretical prediction (see OPSW (1999), Han and Qiu (2006) and BKS (2009)). However, Guney et al. (2003) examine cash holdings of firms from France, Germany, Japan and the U.K. and find only a (positive) relation for Japan. This makes it interesting to investigate how this relation looks like for German firms in my sample period. In order to examine this, I divide the sample into quartiles based on industry cash flow volatility. I measure industry cash flow volatility as follows: for each firm year observation, I calculate the standard deviation of cash flow to assets for the last three years. For each year across each two digit SIC code, I average the cash flow standard deviations. Figure 5 shows the evolution of the average cash ratio for the different quartiles. Remarkably, firms with the largest increase in cash flow volatility show a dramatic decline in average cash ratio, from a level of 31.6% to 13.7%. The other three cash flow volatility quartiles show an increase of the average cash ratio. Regressions on a constant and time show significant time trends for all quartiles (see Appendix A, Table A.3). I conclude that the evidence from the figure and the estimated regressions is in contrast with the transaction costs motive; whereas the transaction costs motive predicts higher cash ratios for firms in industries that face high cash flow volatility, figure 5 provides evidence for the opposite for German firms. 20

22 Figure 5 Evolution of average cash ratio by industry cash flow volatility from 2000 to 2010 The figure summarizes the average cash ratio for quartiles of firm year observations sorted by industry cash flow volatility. Cash flow volatility is measured as follows: for each firm year observation, I calculate the standard deviation of cash flow to assets for the last three years. For each year across each 2 digit SIC code, I average the cash flow standard deviations to come up with the industry cash flow volatility. Then, I divide the two digit SIC code industries in my sample into industry quartiles according to the increase in cash flow volatility over the sample period. The sample includes all firm year observations on Compustat Global from 2000 to 2010 with positive book value of total assets and sales for firms incorporated in Germany. Financial firms (SIC code ) and utilities (SIC code ) are excluded from the sample. Observations with missing values on cash and marketable securities, long term debt and debt in current liabilities are removed as well. The panel consists of 6,657 observations and 891 firms. The cash ratio is measured as cash and marketable securities divided by the book value of total assets Q1: Lowest CF volatility quartile Q2 Q3 Q4: Highest CF volatility quartile 21

23 4.3 The average cash ratio for different subsamples Within this section I examine whether the evolution of the average cash ratio during the period can be explained by different subsamples. First, I investigate whether dividend paying firms hold less cash than non dividend paying firms, as theory predicts. Second, I compare average cash ratios between firms with positive net income and firms with negative net income. Third, I focus on the cash holdings of high tech firms versus manufacturing firms. Table 2 shows the average cash ratios for the different subsamples for each year in the sample period. Columns 2 and 3 contain the cash ratios for dividend paying and non dividend paying firms, respectively. For every year in the sample period, the average cash ratio of non dividend paying firms is higher than that for dividend paying firms 13. This is line with both the transaction costs motive and the precautionary motive (see section 2). The average cash ratio for dividend paying firms rises from 9.2% in 2000 to 16.7% in Non dividend paying firms experience a dramatic decline in their average cash ratio. From a level of 24.8% in 2000 it drops to 18.6% in The uptrend for dividend paying firms is statistically significant at the 1% level whereas the downtrend for non dividend paying firms is insignificant (see appendix A, Table A.4). I conclude that the small increase of the average cash ratio for the whole sample during the sample period is the result from the increase of cash holdings of dividend paying firms. In contrast, BKS (2009) show that the average cash ratio of U.S. firms increased for both subsamples during the period Columns 4 and 5 of Table 2 include the average cash ratios for firms with positive net income and firms with negative net income, respectively. Compustat Global misses data on net income. Therefore, I measured net income as ebitda minus interest expenses and taxes. Firm year observations with missing values on one of the variables needed to calculate net income, are removed from the sample. 14 The transaction costs motive describes that positive net income can be seen as a cash substitute and, therefore, firms with positive net income are expected to hold lower amounts of liquid assets. In my sample, firms with positive net income indeed have lower cash holdings than firms with negative net income. This is the case for every year in the sample period 15. The evolution of the average cash ratio for both subsamples suggests that the increase in cash holdings of the total sample occurred in firms with positive net income. Whereas cash holdings increase from 12.4% to 16.2% for firms with positive net income, the average cash ratio declined from 28.9% to 22.2% for firms with negative net income. Again, when comparing with the results for U.S. firms in BKS (2009), I observe that firms in the U.S. with negative net income as well as U.S. firms with positive net income show increasing average cash ratios over the period BKS (2009) find that high tech firms hold on considerably more cash, on average, than manufacturing firms over their sample period. To see whether the increase in cash ratios can be ascribed to firms of one of these industries, I divide the sample into two subsamples; one with high tech firms and one with manufacturing firms. The same method is used as in BKS (2009) to construct the two subsamples. This means that the sample with manufacturing firms consists of all firm year observations with SIC codes that are not high tech firms. BKS (2009) use the definition by Loughran and Ritter (2004) to categorize technology firms; see Appendix B for the SIC codes that make up the subsample consisting of high tech firms. The total number of firm year observations that come from the high tech and manufacturing industry makes up almost two third of the total sample. Therefore, the evolution of the cash ratio in these industries could be an explaining factor in the evolution of the cash ratio for the total sample. The 13 Only the last two years, the difference is not statistically different from zero observations with net income of exactly zero were removed. 15 Except for the year 2009, the differences are statistically different from zero. 22

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