The Effect of Corporate Governance on Cash Holdings: Evidence from Hong Kong

Transcription

1 The Effect of Corporate Governance on Cash Holdings: Evidence from Hong Kong BY WONG Ying Wai Accounting Concentration YANG Zhu Accounting Concentration An Honors Degree Project Submitted to the School of business in Partial Fulfillment of the Graduation Requirement for the Degree of Bachelor of Business Administration (Honors) Hong Kong Baptist University Hong Kong April 2013 Supervisor: Dr. O. K. Kent Lee

2 Acknowledgement We would like to express our utmost gratitude to our degree project supervisor, Dr. O. K. Kent Lee for his precious and invaluable guidance and advice on our honors project. We would like to thank him for his time and support and his care and mercifulness which enlightened and stimulated us during our project. We would also like to thank our friends and everyone who has helped and supported through our research process. Last but not least, we would like to thank our faculty, School of Business, for giving us this chance to finish an honors degree project. We have gained valuable experience and related academic knowledge, as well as to cooperate, and to balance in conducting this research project. WONG Ying Wai YANG Zhu

3 Abstract This study examines the effect of corporate governance on cash holdings by using 160 firm-year observations from 2010 to 2011 from Hong Kong listed companies. The associate between corporate governance and the cash holdings depends on the size of the firm. We measure corporate governance with ownership structure of executives and board effectiveness. Small-sized firms with effective governance mechanisms are found to have more intention to hold more cash. We document a negative relation between CEO duality (CEO is the chairman) and cash holdings, and a positive relation between CEO ownership and cash holdings. Key word: Corporate governance, Cash holdings, Board of directors, CEO duality, Ownership. 1. Introduction It has always been a critical issue to decide an appropriate cash level in a company. Cash provides liquidity to firms and is an important component of a firm s assets. Firms have the incentive to hold cash to ensure the operations, meet obligations, and catch the good investment opportunities. Cash also acts as a buffer to prevent high opportunity costs during cash shortage (Opler et al., 1999; Ozkan and Ozkan, 2004). Opler et al., (1999) suggest that companies with good investment opportunities and high cash flow risks tend to hold more cash. The large amount of cash holding, however, may result in agency problems of free cash flow as managers can get private benefits easily (Jensen, 1986). Weak governance mechanism further triggers managers to hold more cash, which may cause unwise overinvestment like expensive acquisitions, and subsequently have negative effect on the shareholders benefits (Dittmar et al., 2003; Jensen, 1986). 1.1 Statement of problems Cash holding is a critical managerial decision to a company. In a perfect financial market, there is no incentive for companies to hold substantial cash as they can transfer 1

4 assets to cash or get funded at a fair cost in the market immediately when they need cash. However, the imperfect market because of transaction costs and asymmetric information provides rationale for companies to reserve cash (Couderc, 2006). Companies determine the optimal level of cash holdings though trading off costs and benefits (Kim et al., 1998; Opler et al., 1999). The major two benefits of holding cash stated by Keynes (1934) relate to the transaction motive and the precautionary motive. Companies intend to hold cash in order to reduce the transaction costs of financing and avoid disposal of assets due to a sudden need of cash. The second benefit is to ensure companies to have profitable investment opportunities, instead of losing investment interests due to the lack of cash holdings. Inefficient investment is resulted from insufficient liquidity. The level of cash holdings is usually associated with growth opportunities, investment levels, cash flow, research and development expenditure, company size, leverage, working capitals, and dividend distribution (Kusnadi, 2011). On the other hand, the conflict of interest may arise between management and shareholders in the situation that a company hold large amount of cash (Jensen and Meckling, 1976). The agency theory indicates that entrenched managers (company executives) prefer to hoard cash rather than distribute dividends to shareholders as turning cash into personal benefits is relatively easier than getting benefit from other less liquid assets to managers (Myers and Rajan, 1998). Dittmar et al. (2003) have also indicated that agency problem are an important determinant of corporate cash holdings and a strong support has been showed from the importance of corporate governance in determining cash holdings. Under an effective corporate governance mechanism, i.e., shareholders rights are under good protection, agency problems can be minimized, and managers can behave in the interests of shareholders. On the contrary, weak governance, or poor protection for shareholders, causes an entrenched management, under which the excessive cash is more likely to be held. 2

5 However, Harford et al. (2008) explain that companies with poor protection on shareholders are relatively have small proportion of cash, as managers spend cash quickly in unnecessary acquisition or investment to benefit themselves in a short term. Studies have discussed the impact of country-level and company-lever corporate governance on cash holdings for international firms. Dittmar et al. (2003) find companies in weak external legal protection hold more cash as a result of the entrenched management. In Hong Kong, the external legal protection is strong, so the focus is on the corporate level. Since prior studies have not examined the relationship of corporate governance and cash policy in the Hong Kong environment, the availability of data on corporate governance allows us to examine more in details. 1.2 Objectives of the study This study is designed to examine the influence of corporate governance mechanisms on the cash holdings of listed companies in Hong Kong. - What is the impact of ownership structure on cash holdings level? - What is the impact of board composition on cash holdings level? After all, it is worth doing as little empirical studies on effect of corporate governance on cash holdings have been conducted in Hong Kong. This study can contribute to the limited literature in Hong Kong environment. The following section of the paper conducts literature review on prior empirical and theoretical studies; the third section develops hypothesis; followed by the methodology and model design; the empirical results are discussed in the fifth section; and the last section is our conclusion. 3

6 2. Literature review 2.1 Agency problems and cash holdings Jensen (1986) explained a positive relationship between free cash flow and agency conflicts. After Opler et al. (1999) had examined several determinants of cash holdings and specified a tradeoff theory including the impact of agency costs, studies focusing on agency theory were widely conducted. Harford et al. (2008) identified three hypotheses on the relationship between agency cost and cash holdings. The flexibility hypothesis indicates that increase in agency cost will result in a high level of cash holdings as managers prefer to hold the cash than to distribute to shareholders. However, the spending hypothesis predicts highly autonomous managers are willing to spend the excessive cash on hand on projects that benefit them the most, and as a result, a low level of cash balance is caused. Shareholder power hypothesis states if minority shareholders have effective control to directors, they would allow mangers to hold excess cash to prevent underinvestment. Dharmastuti and Wahyudi (2013) stated that the knowledge of corporate governance is mainly derived from agency theory. Corporate governance is the mechanism to scrutinize the contract between principals (shareholders) and agents (company executives) (Demsetz, 1983; Fama, 1980). The separation of ownership and control creates interest conflicts, which further cause information asymmetry and agency costs. The evidence from Nikolov and Whited (2009) explained that governance is one of the important factors that affect cash holdings. 2.2 Corporate governance According to The Organization for Economic Co-operation and Development (OECD) (1999), corporate governance is the system by which business corporations are directed and controlled. Raithatha and Bapat (2012) had defined that corporate governance is overall control of activities in a corporation. Prior studies on the relationship between corporate governance and cash holdings had 4

7 controversial results. Dittmar et al. (2003) found that corporate governance affects the level of cash holding using evidences from 45 countries. Specifically, manager prefers to hold more cash in countries with poor shareholder protection. In contrast, Harford et al. (2008) suggested that poor governance results in less cash holdings. However, Early literatures found that the relationship between cash holdings and firm-level corporate governance is not significant (Harford, 1999; Opler et al., 1999). Furthermore, Bates et al. (2009) also concluded that high cash holdings are resulted from preventing high risks of cash shortage, so that governance plays almost no roles in accumulating cash reserves. 2.3 Ownership structure and board composition Board of directors is an important component of corporate governance (Hill and Jones, 1992), especially in large business corporations (Fama and Jensen, 1983a; Williamson, 1983). They are responsible for monitoring the management of the CEO or directors, at the same time to protect the benefits of shareholders. The internal governance is commonly measured by the ownership structure, the composition of board members, including chairman, directors and independent non-executive directors, and internal auditing etc. (Ho, 2003). In addition, the quality of the governance, especially internal mechanism, has a close relationship with corporate performance. (Aman and Nguyen, 2008). The effect of corporate governance on cash holdings has been widely studied worldwide. Ozkan and Ozkan (2004) investigated the impact of ownership structure to cash holdings by using UK companies as a sample and expanded the evidence on a non-monotonic relationship between firm ownership and cash holdings. In the following part, literatures of different components to measure the corporate governance are discussed Founder CEO Previous studies showed a positive relationship between founder CEO and firm 5

8 performance. Begley (1995) found that founder is CEO firms have a greater return on assets than other firms. He (2008) had a similar result that founder-ceo firms have higher financial performance under a dual leadership structure. These study suggested that founder-ceos interests are aligned with the company because of their stronger organizational commitment. Therefore, according to the interest-alignment hypothesis, shareholders tend to allow directors to accumulate cash and the relation between founder-ceo and cash holdings is positive related (Chen and Chuang, 2009) CEO ownership Chen and Chuang (2009) pointed out that the interest alignment hypothesis is subjected to the firms natures and the investment environment faced by firms. In this study, the CEO with larger ownership in high-tech firms in US held more cash since the CEO interest aligned with shareholders and in order to ensure sufficient cash for investment. In contrast, most studies found a negative relationship between managerial ownership and cash holdings because interest alignment effect lowers the agency costs, which provides easier access of external financing due to low information asymmetry. Ozkan and Ozkan (2004) found that the relationship between director ownership and cash holdings is non-linear and suggested that the alignment effect of managerial ownership out weight the entrenchment effect. Alignment effect indicates that the interest between managers and shareholders are aligned when managers have greater ownership. However, when the managerial ownership continues to increase, entrenchment effect overwhelms and relationship between managerial ownership and cash holdings changes to positive since the director dominates the board and hoard cash for self-interest CEO duality According to Rechner and Dalton (1991), the CEO duality occurs when position of the CEO and the chairman in the company are held by the same person. First on one side, the duality creates a strong leadership; on the other side, duality declines the effectiveness of monitoring the board (Finkelstein and D'Aveni, 1994). 6

9 There were different results on the effect of CEO duality to corporate cash holding from previous studies. Gill and Shah (2012) studied 166 Canadian listed companies from 2008 to They found that cash holding is positively affected by CEO duality. One possible reason is that the CEO/Chairman does not act for the best interests of shareholders. Research from Drobetz and Grüninger (2007) investigating 156 Swiss non-financial firms from 1995 to 2004 also concluded the similar result. In contrast, study documented that duality leads to insider dominance that is similar to family control (Chen et al., 2005). Under agency theory, ineffective monitoring of board is one of the reasons for poor governance since there is little monitoring on managers and it is hard to fire poor performance directors (Carver, 2006). Prior literatures suggest CEO duality seems to be less effective in corporate governance. Corporate with poor governance hold less cash as directors spend cash quickly (Harford, 1999). The underlying reason is found in Dittmar and Mahrt-Smith (2007) s study that excess cash holdings decrease the incentive to control cost or improve profit margins, and results in overinvestment in low margin projects. On the other hand, Rechner and Dalton (1991) found that there is a negative relationship between company performance and duality. Meanwhile, other studies indicated that there is no relation between firm performance and CEO duality (Chaganti et al., 1985; Daily and Dalton, 1992) Board size Many studies suggested that company s performance is better when the board size is smaller (Lipton and Lorsch, 1992; Eisenberg, Sundgren and Wells, 1998; Hermalin and Weisbach, 2003; Andres, Azorfra and Lopez, 2005). The reason is that decision making process is more effective in a small board (Yermack, 1996); Lipton and Lorsch, 1992). Gill and Shah (2012) and Kusnadi (2004) indicated that larger board size company has more cash holdings. In contrast, Mak and Li (2001), Kula (2005), and Drobetz and Grüninger (2007) documented that board size has no significant effect on corporate performance. 7

10 2.3.5 Independent director Studies suggested that independent directors can be an effective monitor to the board. Kesner and Dalton (1986) found that outside director is more independent since close relationship do not exist between management team and outsider director. As a result, outside directors perform a better control and monitor function. Weisbach (1988), and Huson, Parrino and Starks (2001) found bad performance manager is likely to be resigned if independent directors take a major seats in the board. According to agency theory, it is expected that non-executive director dominate board are likely to reduce agency cost and hence hold less amount of cash (Ozkan and Ozkan, 2004). However, Chen and Chuang (2009) found a positive relation between outside director and cash holdings since the nature of high-tech firms requires them to hold more cash for future investment. According to Chapter 3 of Hong Kong Listing Rule 1, every board should have at least 3 independent non-executive directors. 3. Hypothesis development This study examines whether and how corporate governance affects the cash holding in Hong Kong listed companies. As discussed above, prior literatures propose different opinions on the effect of corporate governance on cash holdings. Some supported effective governance is positively related to cash, while some argued that it has negative effect on cash holdings. The ownership structure and board attributes influence the board effectiveness and the quality of corporate government. Based on previous literatures, we developed the following hypotheses to test the effect of corporate governance on cash holdings by dividing into individual components of corporate governance. The ownership structure (i.e. Founder CEO, CEO duality, CEO ownership, Chairman ownership, and 1 See HK Listing Rules, Chapter 3: 8

11 non-executive directors ownership) and board attributes (i.e. proportion of independent directors and board size) H1: The presence of founder CEO affects cash holdings positively. H2: The presence of CEO duality either positively or negatively affects cash holdings. H3: CEO ownership is either positively or negatively associated with cash holdings. H4: Chairman ownership is either positively or negatively associated with cash holdings. H5: Non-executive director ownership is negatively. H6: Proportion of independent directors have in board is either positively or negatively associated with cash holdings H7: Board size affects cash holdings positively. 4. Empirical design 4.1 Research methodology The theoretical model of this empirical study follows the generalized method of moment (GMM) estimation procedure from Ozkan and Ozkan (2004) to eases off the endogenous problems, since factors determine the cash holdings affect some of the firm-specific characteristics such as leverage simultaneously, and the effects of the determinants are often delayed to cash in next period. This model is employed by Chen and Chuang (2009) and Kuan et al. (2011) to investigate the determinants of cash holdings in American and Taiwan firms. Our study examines both ownership structures and board attributes as corporate governance proxies, as well as corporate specific 9

12 control factors, to test whether these variables are significantly associated with a firm s corporate cash policy following the GMM model. 4.2 Variables (Appendix A) Subject to data availability and characteristic of Hong Kong companies such as family business and chair duality, we modified some of the variables in the study of Chen and Chuang (2008) on corporate governance and cash holdings in growing high-tech firms listed on NASDAQ. The dependent variable, Cash holdings, is the ratio o f cash or cash equivalent to total assets Governance variables Under ownership structure variables, we design a Founder dummy to check the impact of founders in board, which includes situations where the founder is also the CEO or the chairman in board, or a family of the two. CEOChair dummy is modified to combine the situation of chair duality and where CEO and chairman are families. The share ownership of CEO, the chairman and non-executive directors are denoted with CEOOwn, ChairOwn, and NEDOwn. The shareholding of non-executive directors measures the independency of the board (Chen and Chuang, 2009). Board attributes are proxied by two variables, Board size (BODSize) and Independent Directors Proportion (IndependDir). Companies with large board size have relatively poor corporate governance (Hellman and Puri, 2000; Yermack, 1996). And outside directors enhance the effectiveness of the board in management monitoring and shareholders protection (Core et al., 1999). According to Hong Kong Listing Rules Ch.3 2, the independence is assessed by not more than 1% of company s total issued capital, financial independent to the company, including its related parties, and not connected with any current or former executives in the company. 2 See HK Listing Rules, Chapter 3: 10

13 4.2.2 Firm-specific control variables Variables related to firm s cash level are considered. Leverage, the ratio of total debts to total assets, measures a company s financial risk, is expected to negatively associate with cash holdings as large cash reserves lower the risk of default and thus reduce the financial risks, Capital expenses (Capex to total assets ratio), and R&D expenses (R&D to total assets ratio) are expected to be positively related to cash holdings as implied by Dittmar et al. (2003) and Boyle and Guthrie (2003) that companies have great investment opportunities prefer to reserve more cash since sufficient internal cash holdings help to prevent foregoing potential investment opportunities. Conversely, the pecking order theory indicates substantial capex drains out the cash of a firm (Daher, 2010). Negative relationship between Capex and cash holdings is found by Bates et al. (2009) and Lee and Song (2007). Prior studies also show that net working capital (working capital net of cash to total assets ratio) is negatively related to cash holdings (Bates et al., 2009; Ferreira and Vilela, 2004; Tong, 2006; Lee and Song, 2007). This is supported by the trade-off theory that networking capitals can be converted to cash easily. The firm size (Size, logarithm of total assets) is positively related to cash holding as indicated by Kalcheva and Lins (2007) and Ozkan and Ozkan (2004). Normally, larger firms intend to hold reserve more cash to maintain the high level and quality of operations and investment chances. On the other hand, a number of studies find an opposite result (Daher, 2010; Drobetz and Grüninger, 2007; Nguyen, 2006) based on the tradeoff theory as large firms benefit from economies of scale, easier access of financing with lower costs (Ferri and Jones, 1979). 4.3 Models development Impact of company ownership structure CASH it = β 0 + β 1 FOUNDER it +β 2 CEO_CHAIR it + β 3 CEOOWN it + β 4 CHAIROWN i t + β 5 NEDOWN it + δ n CONTROL it + ε it Where i denotes firm i and t denotes time t. CONTROL denotes the following financial variables: Cash(t-1), Leverage, NWC, Div Dummy, CapExp, R&D, and Size. 11

14 With this regression equation, our hypotheses can be expressed in terms of the expected signs of the coefficient estimates. H1 β 1 =0, against the alternative β 1 <0 H2 H3 H4 β 2 =0, against the alternative β 2 0 β 3 =0, against the alternative β 3 0 β 4 =0, against the alternative β4 0 H5 β 5 =0, against the alternative β 5 < Effects of corporate board composition CASH it = β 0 + β 6 IND it +β 7 LogBOARD it + δ n CONTROL it + ε it Where IND it denotes proportion of independent directors sit in board, LogBOARD it denotes H6 β 6 =0, against the alternative β 6 0 H7 β 7 =0, against the alternative β 7 > Combined effects of the above two groups of variables CASH it = β 0 + β 1 FOUNDER it +β 2 CEO_CHAIR it + β 3 CEOOWN it + β 4 CHAIROWN i t + β 5 NEDOWN it +β 6 IND it +β 7 LogBOARD it + δ n CONTROL it + ε it The expected signs of the correlation is referred to above expressions. 4.4 Data and Sample selection Sample selection Firstly, we use data 3 of all the listed companies on Stock Exchange of Hong Kong Limited (HKEx) in the reference year 2011 to screen out companies listed on the Main Board of the HKEx. Then we exclude companies that: a. were delisted or newly listed during the year b. were counted as foreign companies (i.e., incorporated overseas AND have the core business outside Hong Kong and China) 3 data package subscribed from HKEx 12

15 c. were controlled by Mainland Government entities or individuals (i.e H-shares companies 4, Red Chip companies 5 ) d. were under the Financial sector (Hang Seng Industry Classification System (HSICS) code: 50) e. were non-ordinary shares or companies lack of available data We exclude 139 H-shares companies 6 and 102 Red Chip companies 7 in order to eliminate the heavy effect of Chinese government on the their corporate governance as most of these companies are state-owned enterprises (SOEs), i.e. the ultimate shareholder is the central or local government in China. However, our sample includes Mainland private enterprises which are incorporated outside of the Mainland and are controlled by Mainland individuals. We consider the government influence on these companies is minimized. Similar to previous studies, banks (Code: 501) and insurance companies (Code: 502) are excluded as a result of different cash holdings requirement to ensure liquidity. In the population of 925 companies, we randomly select 80 companies through MS Excel, and replace companies if one is lack of information. The final sample consists of 160 firm-year observations covered from year 2010 to Table 1 shows the screening process. 4 H-share companies are enterprises that are incorporated in the Mainland which are either controlled by Mainland Government entities or individuals 5 Red chip companies are enterprises that are incorporated outside of the Mainland and are controlled by Mainland Government entities 6 H-share companies list is disclosed on the China Security Regulation Commission s web: _ htm 7 Red Chips companies list is disclosed on 13

16 Table 1- Summary of Sample Companies Selection Process Total listed companies on HKEx on 21 Dec ,510 Less companies listed on GEM Board in 2011 (173) Less companies that: New listed (76) Delisted (9) As foreign companies (17) H-shares companies (133) 8 Red Chips companies (101) 9 Financial companies (74) Preferred shares or B-Class shares (2) Total qualified population companies 925 The full list of the sample companies is in Appendix B Governance variables are hand collected from companies annual reports available on website of HKEx 10. According to Part XV of Securities and Futures Ordinance 11 (SFO), Directors and chief executives of a listed corporation must disclose their interests, and short positions, in any shares in a listed corporation (or any of its associated corporations) and their interests in any debentures of the listed corporation (or any of its associated corporations). We calculated the ownership of CEOs, chairs, and non-executive directors as beneficial ownership, instead of deem interests 12 disclosed in annual report. Firm-specific control variables are calculated using financial data including total assets, cash, long-term debts, net working capital, capital expenses, R&D expensed, and common dividend payments collected from Datasteam Company Statistics 8 5 new listed and 1 delisted during 2011 have been counted. 9 1 new listed has been counted. 10 See 11 See 12 Deem interests defined under Part XV of SFO (CAP. 571 S3.5) 14

17 Our sample covers all the industries based on HSICS (no financial sector). Consumer Goods Sector covers most of the companies at 36.3%, followed by Properties & Construction, Services, and Industrial Goods with over 10%. These are in line with the industry distribution of Hong Kong market 13. Table 2- Industry Classification HSICS Code Industry Number of firms Percentage 00 Energy Materials Industrial Goods Consumer Goods Services Telecommunications Utilities Financials Properties & Construction Information Technology Conglomerates A total of 80 samples are included over the periods. Industry classification is based on Hang Seng Industry Classification System (HSICS). (%) The total market capitalization (market cap.) of the sample listed companies is HKD 336, million; it counts only 1.93 % of the total market cap. of listed companies on the Main Board. This results from the exclusion of H-shares and Red Chips, which consist of 23.47% and 21.91% of the equity market in the year of The mean market cap. is HKD 3, million and the median market cap. is HKD million. Comparing to the constituents of Hang Seng Composite Small Cap Index (HSSI), we identify our sample companies substantially smaller, and as small size 13 News release: HKEx Adopts Hang Seng Industry Classification System (2007)

18 companies on average, showing in Table 3. Table 3- Company Market Cap Comparison (HKD in thousands) Sample Companies HHSI Constituents 15 Mean Market Cap. 4,206,486 8,265,418 Median Market Cap. 751,305 5,646,835 The HHSI represent the bottom 5% of total market capitalization of Hang Seng Composite Index, which covers about 95% of the total market capitalization of stocks listed on the Main Board of the HKEx Results and Discussion 5.1 Descriptive Statistics Table 4 shows the descriptive statistics of all the variables. The companies cash consists of 26.54% of total assets on average. This figure is lower than that of the Chen and Chuang (2009) s study on high-tech firms in America which is 34.6%. It can be explained by the fact that high-tech companies with high growing rate face a strong competition environment (Carpenter and Petersen, 2002) and thus tend to hold more cash for future investment opportunities (Chen and Chuang, 2009). Our finding indicates a similar result with Lee and Song (2012) s study of East Asian firms including 536 Hong Kong companies in 2005, with the mean cash holdings of 21.3%. The mean founder dummy of our sample is 51.0%. This reveals around half of sample listed companies have a founder related to the top managers. In addition, 60.0% of the board chairmen and CEOs are the same person on average, which is not highlighted in the US environment. In terms of ownership structure, the CEO owns 19.0% shares of the company while chairman has a higher shareholding of 27.3%. This is similar to the 15 Constituents market caps are collected from Datastream. Currency denoted in Chinese Yuan (CNY) is expressed in HKD with the HKD/CNY exchange rate of on 30 Dec 2011 from Bloomberg. 16 See Benchmark Indexes 16

19 results Brickley et al. (1997) found in the US companies that 8 out 11 firms chairmen have a higher ownership than the CEOs. Non-executive directors, however, have only 2.0% of ownership, which is substantially lower than that in the US high-tech firms with 9.9%. There are 8.2 directors in a board in general. With the mean proportion of independent directors of 41.2%, the number of independent directors in our sample companies counts This is only a little higher than the 3 independent non-executive directors as minimum requirement according to the Hong Kong Listing Rules. The mean financial leverage tells that the long-term debts count 7.7% of total assets in the company. The working capital net of cash is only 0.6% of total assets. Moreover, the mean dividend dummy indicates 58% of our sample companies distribute dividends in our study year. Capital expenditures consist 5.9% of total asset. Furthermore, R&D expenses are only 0.8% of total assets, which is much lower than the 37.3% in the US high-tech companies by Chen and Chuang (2009) due to different business model of sample companies. R&D is crucial to high-tech firms to maintain competitive advantages in the market, while in our sample IT companies count only 6.3%, the majority of companies have little investments in R&D. The average size means the logarithm of total assets is 6.3, which is higher than the 4.6 of the growing high-techs. 17

20 Table 4- Descriptive Statistics Variables (N=160) Mean Std. Maximum 75th Median 25th Minimum Deviation Percentiles Percentiles Dependen variable Cash holdings Governance variables Founder Dummy CEOChair Dummy CEOOwn % ChairOwn % NEDOwn (%) BODSize LogBODSize IndependDir (%) Control variables Leverage NWC Div Dummy CapExp R&D Size The impact of corporate governance on cash holdings This study has three models specifications: model (1) examines the impact of ownership structure; model (2) examines the effects of board variables; and model (3) combines all variables. Table 5 exhibits the empirical results. The adjusted R square in Model summary (Appendix D) shows 56% of the sample data are explained by our model (3). The.000 significance (<0.05) in ANOVA test (Appendix E) demonstrates the independent variables cope with each other well in the model. 18

21 Table 5- Impact of corporate governance on cash holdings Beta (1) B Beta (2) B Beta (3) B (Constant) (40.872) (33.068) (36.701) Cash(t-1) (0.601)*** (0.638)*** (0.605)*** Governance variables FounderDummy (1.419) (1.35) CEOChairDummy (-6.155)** (-6.313)** CEOOwn % (0.149)** (0.146)** ChairOwn % (-0.023) (-0.029) NonExeDirOwn (%) (-0.061) (-0.064) IndependDir (%) (0.071) (0.077) LogBODSize (-2.126) (-1.149) Control variable Leverage (-0.094) (-0.079) (-0.1) NWC (-0.22)*** (-0.209)*** (-0.221)*** Div Dummy (3.496) (3.466) (3.596) CapExp (-0.082) (-0.068) (-0.088) R&D (-0.112) (-0.022) (-0.05) Size (-4.832)*** (-4.099)** (-4.472)** Significance at the 1% and 5% level is denoted by *** and ** respectively. Our Hypothesis 2 is accepted at 5% significance level, there is significant and negative effect of CEO duality on cash holdings. Companies that the CEO is also the chairman or a family of the chairman tend to hold more cash. Previous study suggested that when CEO and chairman is the same person, which is a single leadership structure, the board would be less effective than dual leadership structure (Kusnadi, 2011). Firms with boards that are large, headed by a chairman who also holds the CEO post, and dominated by insiders tend to be less efficient. Consequently, these firms would be expected to suffer from more severe agency problems and to have less effective corporate governance. Dittmar et al. (2003) documented that firms in countries with poor shareholder protection (which also implies poor governance) hold larger cash balances. As a result, poor corporate governance indicates excess cash holdings. This is in contrary to Ozkan and Ozkan (2004) s finding that single leadership structured firms hold more cash since our sample companies are smaller than those in other studies. 19

22 While this is in line with Chen and Chuang (2009) s study, as similarities between their sample of high-tech firms and ours. Furthermore, other study supported our findings that good governance is associated with relative excessive cash holdings (Liu and Chang, 2009). The possible explanation for our empirical result is found in Harford et al. (2008). That study indicated that week governance holds less cash is due to antitakeover provision. According to Faleye (2004), proxy battle is extracted by poor governance with excess cash holdings. In order to avoid losing position in the board, CEO tends hold less cash. Give the potential penalty of accumulation liquidity, CEO has the incentive to spend cash quickly rather than hold it (Harford et al., 2008). Moreover, companies have chair duality issue more dividends than companies with split roles do in our findings (Appendix C) 17. One possible explanation is that the shareholders are not able to monitor the director effectively when the board is ruled by single director. The agency theory also supported that chair duality has negative effect on corporate performance because the monitoring and control of CEO is compromised. Therefore, firms have less cash holdings as CEO/chairman intends to pay more dividends to maximize his personal benefit rather than considering the benefit of shareholders in terms of long-term operation of the company. On the other hand, positive relationship between the CEO ownership and cash holdings is found. This supports our Hypothesis 3. When the ownership of CEO is higher, the shareholder interests are likely in line with CEO interests. When shareholders interests are well protected, they are more confident to allow corporate have more cash reserves. The sufficient cash holding allows firms to catch potential investment opportunities, especially to small size companies. Ozkan (1996) suggested that small companies are easier to face liquidation problem during financial distress. Whited (1992) and Kim et al 17 We further test the positive relationship between Chairman duality and ratio of dividend to total assets. 5% significance exists. 20

23 (1998) further explained that small firms have higher cost of external financing and borrowing constraints than larger firms. Opler et al. (1999) give evidence that small firms hold larger cash. Thus an effective board acts on behalf of shareholders are willing to ensure a high level of cash holdings. In addition, our finding suggests that there is no significant relationship between Founder CEO, chairman ownership, and non-executive director ownership to cash holdings. H1, H4 and H5 are not supported. For board attributes, we find that both board independence and board size are insignificantly related to cash holdings, H6 and H7 are not accepted. This is inconsistent with Chen and Chuang (2009) that the two variables are positively and significantly related to cash holdings. One possible explanation that no significant effect from proportion of independent directors in board lies behind Chen et al. (2005) s study on 412 public listed companies in Hong Kong. It found that governance composition (i.e. proportion of independent non-executive directors, outsider dominated the board) has little impact on firms performances, especially for small market cap firms. It is implies by the self-selection basis in the selection process of outsider directors. Literatures on the effectiveness of board size are mixed. Larger board size enhances the monitoring, but rigidizes decision-making. Boone et al. (2007) found evidence supporting Harris and Raviv (2008) predicted that larger boards provides optimal monitoring when managers have opportunity to enjoy great private benefit. On contrast, Yermack (1996) found that smaller boards are more efficient. Therefore, it is uncertain whether the board attributes have effect on a firm s cash holdings. 21

24 5.3 The effect of founder relationships In the sample, around half of founders sit in the board as the chairman, or involve in management as the CEO, or have a close relationship as a family of the two. In the other words, founders tend to have a great influence on decision making and business operation. With great passion to the company they established initially, founders with managerial influence are likely to act in the interest of a long-term benefit for the company. This study analyzes the differences of effects that corporate governance has on cash holdings between firms with an active executive founder and firms with the leader teams have little relationship with the founder. By examining the interactions of Founder dummy with other governance factors, we check the influence of a close founder on the relation between corporate governance and cash holdings. Table 6 shows the results that positive relationship of CEO ownership and negative effect of chair duality follow the H2 and H3. However, no significance is found from the impact of a close founder on enhancing the relation between corporate governance and cash holdings. 22

25 Table 6- Impact of founder CEOs on the relation between corporate governance and cash holdings Beta B Beta B Beta B (Constant) (39.702) (27.647) (27.928) Cash(t-1) (0.592)*** (0.644)*** (0.6)*** Governance variables FounderDummy (1.292) (0.034) (1.411) CEOChairDummy (-6.137)** (-5.975)** CEOOwn % (0.156)** (0.138)** ChairOwn % (-0.017) (-0.017) NonExeDirOwn (%) (-0.107) (-0.096) IndependDir (%) 0.02 (0.042) 0.03 (0.062) LogBODSize (1.471) (2.384) Control variable Leverage (-0.11) (-0.073) (-0.112) NWC (-0.22)*** (-0.203)*** (-0.208)*** Div Dummy (3.102) (3.05) (2.597) CapExp (-0.088) (-0.051) (-0.088) R&D (-0.14) (0.015) (-0.021) Size (-4.644)*** (-3.546)* (-3.475)* FdummyCEOChair (1.404) (1.644) FdummyCEOOwn (0.15) (0.542) FdummyChairOwn (-0.597) (-0.425) FdummyNEDOwn (-0.741) (-0.368) FdummyIndpendDir (-1.585) (-1.84) FdummyLogBODSize (0.388) (0.508) 5.4 Effect of firm characteristics The cash holdings are perfectly and positively related to that in prior year. In addition, working capital net of cash is perfectly and negatively affects the cash holdings. This is consistent to prior studies and is explained by trade off theory with the high liquidity of working capital. Meanwhile, firm size is negatively related to cash holding at 5% significance level. Tradeoff theory is applied as large firms benefit from economies of scale, easier access of financing with lower costs. Small companies have the intention to hold more cash. This implies that the small-sized sample companies with good corporate governance have a higher cash level. 23

26 However, leverage, capital expenses, R&D expenses, and the decision of whether to pay dividends have no significant influence on cash holdings in small size firms. 6. Conclusion In this study, we analyze a sample of 80 listed Hong Kong companies for two years from 2010 to 2011, and examine the effect of effective corporate governance on cash holdings in Hong Kong. We develop three models in the first group. The first model tests the impact of ownership structure, as a measurement of corporate governance, on cash holdings. The second examines the impact of board attributes on cash holdings. And the third combines all variable to test the effect on cash holdings. The other group of models further reviews the influence of funder CEOs on the relation between corporate governance and cash holdings. The random selected sample consists of small-sized firms. And the empirical analysis shows a negative relationship between CEO duality and cash holdings; while CEO ownership positively affects cash holdings. Separate of CEO and the chairman improved the board effectiveness. Higher CEO ownership aligns the shareholders interests with the managers. Both factors reflect effective corporate governance. The results from the small-sized listed companies in Hong Kong are in line with Chen and Chuang (2009) s study on growing high-tech companies that a corporate cash level and governance effectiveness is positively related. Small-sized firms prefer to hold more cash to avoid underinvestment and the potential consequence of being acquired due to proxy fight. In conclusion, our results suggest that effective corporate governance has a positive effect on cash holdings in small firms. Further research need to be done in order to inspect the different effects of corporate governance on cash holdings associate with firms in different sizes. 24

27 Appendix Appendix A- Definitions of variables Name Description Dependent variables Cash holdings Ratio of cash and cash equivalents to total assets Independent variables Governance variables Founder dummy Dummy variable = 1 if the Founder is the CEO or the Chairman or a family of the two ChairCEO dummy Dummy variable = 1 if Chairman of company is the company s CEO or a family of the CEO CEOOwn (%) ChairOwn (%) NonExeDirOwn (%) BODSize Percentage of shares owned by CEOs Percentage of shares owned by the Chair Percentage of shares owned by non-executive directors Total number of directors on a firm s board Log (BODSize) IndependDir (%) Proportion of independent non-executive directors on the board Control variables Leverage (%) R&D (%) NWC (%) Size Div dummy Ratio of long-term debt to total assets Ratio of R&D expenses to total assets Ratio Working capital net of cash to total assets The logarithm of total assets Dummy variable = 1 if a company pays dividend in a given year 25

28 Appendix B- Sample Company List Stock HSICS Company Name Market Cap. Code Code 4 Wharf (Holdings) Ltd. 106,326,581, Cathay Pacific Airways Ltd. 52,398,809, Evergrande Real Estate Group Ltd. 47,956,999, Uni-President China Holdings Ltd. 16,737,419, China Zhongwang Holdings Ltd. 14,380,775, Lee & Man Paper Manufacturing Ltd. 11,770,953, Haitian International Holdings Ltd. 10,661,280, Hi Sun Technology (China) Ltd. 5,667,671, SITC International Holdings Co. Ltd. 5,200,000, Greatview Aseptic Packaging Co. Ltd. 3,467,360, Tian Teck Land Ltd. 2,967,073, Real Nutriceutical Group Ltd. 2,855,269, Soundwill Holdings Ltd. 2,392,013, Regal Hotels International Holdings Ltd. 2,353,333, Sinolink Worldwide Holdings Ltd. 2,053,845, Oriental Watch Holdings Ltd. 2,031,372, Besunyen Holdings Co. Ltd. 1,971,132, International Elite Ltd. 1,968,083, Sijia Group Co. Ltd. 1,864,869, Golden Meditech Holdings Ltd. 1,760,536, Tian Shan Development (Holding) Ltd. 1,740,000, Pico Far East Holdings Ltd. 1,685,561, Oriental Ginza Holdings Ltd. 1,604,584, Embry Holdings Ltd. 1,603,908, Heng Tai Consumables Group Ltd. 1,454,766, China Starch Holdings Ltd. 1,392,902, Get Nice Holdings Ltd. 1,342,042, DaChan Food (Asia) Ltd. 1,336,414, Global Sweeteners Holdings Ltd. 1,237,344, Chuang's Consortium International Ltd. 1,169,091, Victory City International Holdings Ltd. 1,133,382, China Mining Resources Group Ltd. 1,032,682, Water Oasis Group Ltd. 932,022, Carpenter Tan Holdings Ltd. 925,000, Datronix Holdings Ltd. 915,200, Pegasus International Holdings Ltd. 898,761, Shenzhen High-Tech Holdings Ltd. 854,240, China Infrastructure Investment Ltd. 853,982,

29 1155 Centron Telecom International Holding Ltd. 848,991, Lisi Group (Holdings) Ltd. 755,473, Goldpoly New Energy Holdings Ltd. 747,136, Changfeng Axle (China) Co. Ltd. 736,000, Kingmaker Footwear Holdings Ltd. 724,722, China Flavors and Fragrances Co. Ltd. 687,654, Sinoref Holdings Ltd. 660,000, CCT Tech International Ltd. 654,139, Cinderella Media Group Ltd. 641,184, Champion Technology Holdings Ltd. 619,453, China-Hongkong Photo Products Holdings Ltd. 616,829, Hybrid Kinetic Group Ltd. 614,221, Moiselle International Holdings Ltd. 581,187, China Titans Energy Technology Group Co. Ltd. 564,400, Lerado Group (Holding) Co. Ltd. 532,905, Rainbow Brothers Holdings Ltd. 517,302, Chinney Investments, Ltd. 490,717, Chevalier Pacific Holdings Ltd. 475,019, Scud Group Ltd. 469,560, AV Concept Holdings Ltd. 425,792, Kingwell Group Ltd. 423,560, China Environmental Technology Holdings Ltd. 410,835, Wang On Group Ltd. 404,545, Sino Resources Group Ltd. 348,578, Ford Glory Group Holdings Ltd. 328,500, Hing Lee (HK) Holdings Ltd. 302,998, China Kangda Food Co. Ltd. 298,734, China Boon Holdings Ltd. 297,451, Asia Cassava Resources Holdings Ltd. 252,000, China Agrotech Holdings Ltd. 242,329, China Best Group Holding Ltd. 216,418, Group Sense (International) Ltd. 200,009, Kenford Group Holdings Ltd. 197,516, Topsearch International (Holdings) Ltd. 190,386, Infinity Chemical Holdings Co. Ltd. 190,000, Asia Tele-Net And Technology Corporation Ltd. 164,188, e-kong Group Ltd. 161,510, Art Textile Technology International 157,130,

30 Co. Ltd. 243 QPL International Holdings Ltd. 141,964, Daisho Microline Holdings Ltd. 136,869, Shun Cheong Holdings Ltd. 131,983, China Properties Investment Holdings Ltd. 61,402, Appendix C- regression result on testing linear relationship between Div/TA and Chair duality Coefficients a Model Unstandardized Coefficients Standardized Coefficients B Std. Error Beta t Sig. (Constant) CEOChairDummy a. Dependent Variable: Div/Total Assets The 5% significance level demonstrates the existence of chair duality increase the dividend pay. This demonstrates a lower cash level after higher dividend payment in firms with chair duality. Appendix D- Model Summary (combined model) CASH it = β 0 + β 1 FOUNDER it +β 2 CEO_CHAIR it + β 3 CEOOWN it + β 4 CHAIROWN i t + β 5 NEDOWN it +β 6 IND it +β 7 LogBOARD it + δ n CONTROL it + ε it Model Summaryb N R R Square Adjusted R Square Std. Error of the Estimate a Appendix E ANOVA b Model Sum of Squares df Mean Square F Sig. Regression a Residual Total

31 a. Predictors: (Constant), Cash(t-1), FounderDummy, CEOChairDummy, CEOOwn %, ChairOwn %, NonExeDirOwn (%), IndependDir (%), LogBODSize, Leverage, NWC, Div Dummy, CapExp, R&D,,Size, b. Dependent Variable: Cashholdings Appendix F 29