AARHUS SCHOOL OF BUSINESS MASTER THESIS MSc in Finance and International Business Sources of Financial Flexibility and their Economic Significance Empirical Evidence from the Financial Crisis 2007-09 Author Academic Supervisor Stefan Hirth, Associate Professor, PhD Department Department of Business Studies Deadline September 1, 2010 Aarhus, August 2010 Total number of pages (including cover page): 86
Declaration of Originality I,, declare that this thesis is my own work and that all sources that I have used or quoted have been acknowledged by means of complete references., August 2010 I
Acknowledgements This Master thesis completes my 2-year Master of Science in Finance and International Business at Aarhus School of Business. My utmost gratitude goes to my academic supervisor, Stefan Hirth, for his constructive and helpful advice and for all the insightful conversations we had to develop the ideas for this thesis. I am also thankful to the Aarhus School of Business as a whole for providing outstanding education in the field of economics. It has been a privilege to study at this institution. Without their resources and wide access to global databases, the empirical part of this thesis would not have been possible. I would also like to thank my family and my friends, who stood beside me and encouraged me constantly during the thesis process. Special thanks go to Sangeeta Iyer, Sylvia Hochmuth, William Tarazona and Benjamin Brandes for proof reading my thesis and providing useful corrections and criticisms., August 2010 II
Abstract Financial flexibility can be viewed as a firm s ability to successfully deal with unexpected events or to take advantage of unforeseen investment opportunities depending on the firm s financial policies and capital structure. This thesis provides a broad overview of the explanatory power of the financial flexibility theory and investigates the issue of different sources of financial flexibility and their economic significance by using a large sample of firms before and after the onset of the Financial Crisis 2007-09. The main objective is to study the effects of financial flexibility on firm s corporate behavior in terms of corporate investment and performance. I measure financial flexibility and classify the sample firms according to their cash and leverage policies by using approaches known from research in the fields of excess cash determination and target leverage estimation. Then, I examine the relationship between different financial flexibility positions, corporate investment and performance and test various hypotheses by applying an empirical difference-in-difference approach including several statistical techniques. I find that the decline in investment expenditures for high cash firms is significantly smaller than for low leverage firms. This finding may be explained by the restriction of capital supply which characterizes the beginning phase of the Financial Crisis 2007-09. Thus, with the onset of the crisis, financially flexible firms that rely more on internal funds have the greatest ability to invest compared to their low leverage counterparts and non-financially flexible firms. Tests about the relationship between financial flexibility and performance do not provide consistent and reliable results. However, this shows that the choice of the right performance measure and the choice of the sample period and periodicity are of major importance. Sophisticated long-term performance studies may provide more reliable results about the relationship between performance and financial flexibility. Keywords: Financial flexibility, corporate investment, corporate performance, cash holdings, capital structure, Financial Crisis 2007-09 III
Table of Contents 1. Introduction... 1 2. Theoretical Analysis... 4 2.1. A Short Introduction to Capital Structure Theory... 4 2.2. The Financial Flexibility Theory in Detail... 6 2.3. Different Sources of Financial Flexibility... 10 2.3.1. Debt... 12 2.3.2. Cash... 14 2.3.3. Other Sources of Financial Flexibility... 20 2.4. The Financial Crisis 2007-09... 21 2.5. Economic Significance Related to the Financial Crisis 2007-09... 23 3. Empirical Analysis... 26 3.1. Hypotheses... 26 3.2. Sampling Procedure and Data... 28 3.3. Empirical Strategy... 31 3.4. Part I: Classification of Sample Firms and Descriptive Analysis... 33 3.4.1. Classification Procedure... 33 3.4.2. Measuring Excess Cash... 34 3.4.3. Measuring Target Leverage... 36 3.4.4. Descriptive Statistics... 38 3.5. Part II: Regression Models... 45 3.5.1. Financial Flexibility and Investment... 45 3.5.2. Financial Flexibility and Performance... 52 3.6. Summary of the Empirical Study and Discussion... 57 4. Conclusion... 64 4.1. Conclusive Remarks... 64 4.2. Limitations of the Thesis... 66 4.3. Suggestions for Future Research... 67 5. Bibliography... 69 6. Appendix... 75 IV
List of Figures Table 1: Summary Statistics I... 30 Table 2: Summary Statistics II... 31 Table 3: Pairwise Mean Comparison for Different Subgroups of Firms... 39 Table 4: Mean Percentage Changes of Key Variables from Pre-crisis to Crisis Period for Different Subgroups of Firms... 41 Table 5: Difference-in-means Estimates of Firm-level Investment and Performance (Pre-crisis vs. Crisis Period) for Different Subgroups of Firms... 43 Table 6: Investment Activity across Different Subgroups of Firms... 46 Table 7: Investment Models... 47 Table 8: Effect on Average Investment of Different Subgroups of Firms... 51 Table 9: Performance across Different Subgroups of Firms... 53 Table 10: Summary of Hypotheses Tests... 65 V
List of Figures Figure 1: Average North American Firm Policies (Boileau and Moyen 2010)... 14 Figure 2: Overview of Motives to Hold Cash... 18 VI
1. Introduction In recent years financial flexibility is receiving a growing interest among researchers and became one of the most important determinants in capital structure decisions of financial executives (Graham and Harvey 2001). Classical capital structure theories, such as the trade-off and the pecking order theory, fail to explain the puzzling corporate behavior regarding capital structure decisions of firms. Over the years a theoretical framework has been established that remains to be [ ] the critical missing link for an empirically viable theory in explaining firm behavior with respect to capital structure decisions (DeAngelo and DeAngelo 2007, p.2). The term financial flexibility is defined differently in the financial literature and requires a clear definition in order to use its full explanatory power. Some authors see financial flexibility in preserving borrowing capacity (Mura and Marchica 2009; Myers 1984) and thus considering only debt. However, financial flexibility theory may also explain why firms tend to hoard high amounts of cash even though high economic costs, such as taxes, are normally associated with cash holdings. Thus, not only free debt capacity provides a company with financial flexibility, but also cash. The overall goal of establishing financial flexibility for a firm for both sourcing scenarios is the same: To be able to mobilize financial resources in case of unanticipated shocks, e.g. earnings shortfalls, crises, investment opportunities etc. A current shock to the world economy represents the Financial Crisis 2007-09. The Financial Crisis resulting from consumer defaults on subprime mortgages had remarkable effects on the US financial sector and later on the whole economy. The supply of external capital was radically restricted and companies were forced to rely on internal sources. The changing economic circumstances resulting from the current Financial Crisis creates an exemplary opportunity to examine the effect of different sources of financial flexibility and investigate how firms use different funds in order to attain financial flexibility and what economic significance in terms of real decisions they have. 1
The goal of this thesis is to provide a broad overview of the financial flexibility theory and point out different sources to establish it. In addition, an empirical analysis examines the economic significance of financial flexibility in terms of real corporate investment and performance after the onset of the Financial Crisis 2007-09. Based on the identification of sources of financial flexibility the research question here deals with the extent to which these sources help firms maintain their investment policy and performance at satisfactory levels in the beginning phase of the Financial Crisis 2007-09. Thus the following general hypotheses are the central focus in this thesis: 1) Financially flexible firms are suffering a smaller decline in investments after the onset of the crisis. 2) Financially flexible firms are performing better after the onset of the crisis. 3) Financially flexible firms with high cash balances benefit more from this policy than firms establishing financial flexibility through a low leverage policy, because of the abrupt change in the availability of credits in the beginning phase of the recent Financial Crisis. My study is based on a large sample of US public firms, for which quarterly reported data in the Compustat database is available. The sample period considers one year prior and one year after the onset of the crisis in mid 2007 in order to get the full effect of the shock of capital supply, without being distorted by demand effects that began with a time lag of about one year. The research within this thesis contributes to the existing finance literature in a number of ways. Firstly, this thesis provides a broad overview of different sources of financial flexibility. Here, the focus is particularly on cash holdings, because this potential source has received little attention in the existing financial flexibility literature. Secondly, it ties recent research on capital structure, cash holdings and corporate investment to financial flexibility. Thirdly, the study uses a procedure to classify firms according to their financial flexibility status and source based on regression models know from the research on target leverage ratios and excess 2
cash estimations. Thus, it provides helpful directions for further financial flexibility studies, distinguishing between different sources of financial flexibility. Moreover, it is one of the first papers studying the real effects of financial flexibility in respect to the current Financial Crisis using archival data. Last but not least, it provides an incentive for academics, on the one hand, to further research on the relationship between financial flexibility and the Financial Crisis 2007-09 and for financial managers, on the other hand, to consider the important aspect of financial flexibility in strategic decisions. The remainder of this thesis is structured as follows: In Section 2 a broad overview of the theoretical background is given. This includes a review of relevant literature on financial flexibility and different sources to establish it as well as a short synopsis of the onset of the Financial Crisis 2007-09. Section 3 covers the empirical analysis, where hypotheses are developed, the empirical strategy and data construction will be described and analytical work by applying several tests is done. Finally, section 4 concludes the main results, presents shortcomings of this study and sets suggestions for future research in the field of financial flexibility and its economic significance. 3
2. Theoretical Analysis 2.1. A Short Introduction to Capital Structure Theory One of the most fundamental decisions made by firms is how to finance their assets. Thus, financial policy choice is one of the dominant research areas in finance, though one of the most puzzling (Douglas 2009). The basis for modern capital structure theory forms the capital structure irrelevance proposition by Modigliani and Miller 1958, 1963. Highly theoretical, Modigliani and Miller assume a perfect market, i.e. a market were no market frictions exist e.g. taxes, transaction costs, agency and information problems, bankruptcy costs (cf. DeGennaro and Robotti 2007) and state that in this setting the financing of a firm (its financing mix of equity, debt) is irrelevant to the firm s value. According to Miller and Modigliani, for practical issues a separation of the investment and financing decision is possible (Arslan et al. 2006). However, While the Modigliani-Miller theorem does not provide a realistic description of how firms finance their operations, it provides a means of finding reasons why financing may matter (Frank and Goyal 2007b, p.6). The fundamental findings of Miller and Modigliani provide the basis for looking at the real world where capital market imperfections exist and thus make capital structure decisions relevant for maximizing the value of the firm. 1 Subsequent capital structure theories try to incorporate market imperfections in order to find the optimal capital structure that maximizes firm value. In the presence of market frictions there is no perfect substitution between internal and external funds as Miller and Modigliani argue in their proposition (Arslan et al. 2006). Additionally market imperfections constrain corporations from accessing capital markets at any time (Byoun 2008). Frank and Goyal 2007b provide a useful review of the literature on the two mainstreaming, though competitive theories: Trade-off and pecking order theory of capital structure. The trade-off theory is identified by many authors and used as a plausible explanation of how a firm chooses its capital structure (DeAngelo and Masulis 1980; Jensen and Meckling 1976; Kraus and Litzenberger 1973; Myers 1977; Stulz 1990). 1 Modigliani and Miller also extended their model by the effect of taxes and show that the tax deductibility makes debt financing valuable (see Modigliani and Miller 1963). 4
The theory claims that the optimal capital structure of a company is based on balancing the various costs and benefits of alternative leverage plans (Frank and Goyal 2007b). According to the tax deductibility of interest paid on debt, a firm would be best off using 100 percent of debt. Anyway, considering also bankruptcy costs the benefit from the debt tax shield will be partly outweighed (Kraus and Litzenberger 1973). Myers 1984 goes one step further and states that a firm sets a target debt ratio based on balancing tax benefits and distress costs and moves towards this target. Empirical shortcomings of the classical trade-off theory are that many companies maintain low leverage and thus do not fully exploit the tax advantage. Furthermore the leverage rebalancing process is rather slow, contrary to the prediction of the model (DeAngelo and DeAngelo 2007). The pecking order theory is originated in the paper of Myers 1984 which has been motivated by the adverse selection model in Myers and Majluf 1984. Myers theory is based on the argumentation that adverse selection implies that internal resources (e.g. retained earnings) are preferred and firms requiring external capital will seek debt first and utilize equity financing only as a last resort (Denis and McKeon 2009; Frank and Goyal 2007b; Myers 1984). Although the pecking order hypothesis tries to overcome some of the problems related to the trade-off theory it does a poor job explaining why issuing equity is a common phenomenon in practice (DeAngelo and DeAngelo 2007). Today s financial decisions do not strictly follow the pecking order theory or standard trade-off models. Apparently firms tend to borrow less than the dominant traditional theories predict and issue more equity than predicted even though it is declared as the financing mean of last resort (Denis and McKeon 2009; Graham 2000; Minton and Wruck 2001; Mura and Marchica 2009; Strebulaev and Yang 2006). A third theory to try to explain decisions on capital structure emerged: Financial flexibility. The following section examines the theoretical assumptions of the financial flexibility theory in greater detail. 5
2.2. The Financial Flexibility Theory in Detail Financial flexibility is based on an advanced conceptual framework in the overall research field of capital structure theory. I favor rather saying advanced than new, which seems to be a more accurate term as the main assumptions of this theory go back to 1962 where Chandler and Kirkland state that a strategic decision (including capital structure choices) is a matter of (future) uncertainty of external circumstances. Donaldson and Agapos 1971 observe in their pioneering study flexibility in financing of businesses. They find that financial managers do not concentrate on optimizing the use of debt (as predicted by the trade-off theory), but rather on the magnitude of the debt not in use serving as a buffer against unexpected future events. This shows that financial flexibility is not an idea that has emerged within the last decade, but rather is a theory that has been paid less attention compared to trade-off models and the pecking order hypothesis. There is general consent that reality is characterized by uncertainty about future cash flows and investment processes, by financing that is not frictionless and by changes in the supply of capital that affects corporate behavior (see Acharya Viral et al. 2007; Roberts and Lemmon 2007). Already in the 1980s researchers and managers start to realize that tremendous challenges to top management in financing are expected. Their task becomes more and more to enable the firm to get good credit ratings and protect themselves against the sudden financial apocalypse (Wilkins 1980). Wilkins points out that the good old boy relationship of yesteryear, when you left balances with your friendly banker in the hope that he would give you a preference when times were tough have disappeared (Wilkins 1980, p. 105). His statement at that time perfectly matches today s world. There is uncertainty about the future and neither the internal nor the external supply of credit can be guaranteed. In management theory a central role is ascribed to the concept of flexibility. Flexibility is not only important in the area of finance, but also in other functional areas of business, e.g. organizational flexibility, strategic flexibility and operating flexibility (Byoun 2007). Maintaining corporate flexibility plays a major role for the success and survival of organizations and becomes more and more important in 6
the setting of a continuous changing environment and increasing interconnection between markets (Peters 1987; Volberda 1998). According to WordNet, the lexical database for English provided by Princeton University, flexibility is defined as the quality of being adaptable or variable. Bernstein and Wild 1997 define corporate flexibility as the ability to take action to counter unexpected interruption in the business process. More specifically, the finance literature mostly treats financial flexibility as the ability of a corporation to meet its expected future needs. The Financial Standards Board (FASB) uses the term financial adaptability and defines it in its Statement of Principles as the ability to take effective action to alter the amount and timing of its cash flows so that it can respond to unexpected needs or opportunities". Based on Modigliani and Miller 1963, Mura and Marchica 2009 see financial flexibility in the form of maintaining untapped reserves of borrowing power which is closely related to a conservative leverage policy. 2 Arslan et al. 2008 define financial flexibility as the ability of a company to access and restructure its financing at a low cost. According to Byoun 2007 financial flexibility is the degree of capacity and speed at which the firm can mobilize its financial resources in order to take reactive, preventive and exploitive actions to maximize the firm value (Byoun 2007, p. 2). Byoun s definition of financial flexibility seems to be the most complete one, because it recognizes the reactive and preventive as well as the exploitive nature of financial flexibility; reactive and preventive insofar that a firm should be able to react on unexpected shocks (uncertainty) not only when they occur, but also to adjust its financial policies in order to minimize the impact of these shocks (prevention). The exploitive nature results from being able to make use of the uncertainty in competitiveness or environment to rapidly capitalize on rising opportunities (Byoun 2008). Furthermore, Byoun does not limit his definition to only one financial source as Mura and Marchica 2009 do ( borrowing power refers to debt capacity). He sees large positive cash flows, unused borrowing capacities 2 Note that also Modigliani and Miller 1963, p. 442 write in their pioneering article about the need for preserving flexibility due to real world problems by holding a substantial amount of untapped borrowing power. That is their explanation for the fact that firms mostly do not seek to use the maximum amount of debt (according to their theory) in the capital structure. 7
and/or a high amount of liquid assets as potential financial resources to attain financial flexibility (Byoun 2007). Following Byoun s notion of financial flexibility, I propose to refer financial flexibility in the scope of this thesis to the ability of a firm to deal reactively, preven- tively, proactively and exploitively with unexpected shocks, either in the form of negative shocks (e.g. earnings shortfalls, credit supply shock) or in a positive way, e.g. by taking advantage of unforeseen investment opportunities. Flexibility results from optimizing financial policies and capital structure depending on future expectations. Thus, it is future-oriented and a function of uncertainty and enables firms to limit or even avoid financial distress in the face of negative shocks and to readily fund investment when profitable investment opportunities arise (Gamba and Triantis 2007; Mura and Marchica 2009). When market imperfections constrain companies from accessing the capital markets at any time, managers decisions are not based on certain conditions but rather a response to uncertainty (Byoun 2008). At any given point in time, managers and investors face uncertainty about future earnings, investment opportunities, market prices and access to external capital and, thus, give financial managers the incentive to select financial policies which provide the flexibility to respond ex post successfully to unanticipated happenings (DeAngelo and DeAngelo 2007). Therefore, incorporating financial flexibility in the financial strategy ex ante can create valuable options 3 that can be beneficial for the firm ex post in order to deal with future inconsistencies. Financial constraints a firm may face in the future become an important consideration when firms make current financial decisions (Byoun 2008). Hence, financial flexibility is desirable by firms, which demonstrates the importance of the concept. The theoretical approach is highly supported by empirical studies that show that managers are mostly concerned about financial flexibility in their capital structure choices (cf. Bancel and Mittoo Usha 2004; Brounen et al. 2004; Byoun 2007; Gamba and Triantis 2007; Graham and Harvey 2001). 3 To see a detailed examination of the real option approach in relation to the concept of financial flexibility, see Jinlong et al. 2009. The authors apply in their paper the real option approach in order to value financial flexibility. 8
Arslan et al. 2008 examine the effects of financial flexibility on corporate investment and performance using a sample of firms from East Asian countries during a recession and find that financially flexible firms have greater flexibility in taking investment opportunities during tough times and the general performance is better in comparison to non-financially flexible firms. Recently, DeAngelo and DeAngelo 2007 argue that the theory of financial flexibility is a critical missing link in capital structure theory and firm behavior. It can potentially explain the observable corporate debt ratios that are lower than the predicted ones as well as the slow rebalancing process once a target debt ratio is set. DeAngelo and DeAngelo 2007 find that firms have low long run leverage targets and debt issues represent proactive responses to shocks to the firm s investment opportunity set. Furthermore, it may explain why issuing equity is a common form to receive financial resources. Byoun 2007 finds that small firms have lower debt ratios because of additional equity financing which is consistent with the financial flexibility theory and can neither be explained by the pecking order nor the trade-off models. DeAngelo et al. 2010 present a model that generates leverage dynamics that differ radically from those of prior tradeoff models. In their dynamic capital structure model debt serves partly as a transitory financing vehicle and enables firms to meet funding needs associated with anticipated investment shocks. Both, the trade-off and the pecking order theory do not consider the effect of future uncertainty which has apparently effects on capital structure (Jinlong et al. 2009). Mura and Marchica 2009 see the financial flexibility theory as a modified trade-off model where the optimal level of debt for a firm incorporates the ex ante opportunity cost of borrowing. However, not only debt capacity may be a potential driver for financial flexibility. Also liquid assets, primarily cash and cash equivalents, may play a significant role in the theory. Hence, in contrast to standard models of capital structure the flexibility theory recognizes inter-temporal dependencies in financing activity (cf. Denis and McKeon 2009). Gamba and Triantis 2007 investigate the value of financial flexibility considering different sources and find 9
that the value depends on the cost of external financing and the level of corporate and personal tax rates that determine the effective cost of holding cash. This provides also the basis for argumentation in the scope of this thesis. DeAngelo and DeAngelo 2007 note that corporations can develop various sources of financial flexibility through the preservation of debt capacity, cash accumulation and equity payouts. In normal times firms preserve their capacities by maintaining either low debt ratios in order to have the option to borrow in abnormal periods or hold abnormal high amounts of cash in order to be e.g. resistant against future earnings shortfalls (Byoun 2007). In summary, beginning with the Miller and Modigliani theorem the theories of capital structure decision became more and more realistic by considering market imperfections and trying to understand real corporate behavior. The trade-off theories are based on trading-off the costs and benefits of leverage decisions whereas the competitive thinking of the pecking order says that corporations prioritize sources of financing from internal generated capital to equity. Nowadays, the theory around financial flexibility goes back to both, elements from the pecking order and the trade-off theory, incorporates future uncertainty that corporations face and tries to shed light on the capital structure and cash holding puzzle. By maintaining financial flexibility firms may be able to successfully react on investment opportunities even if negative external shocks influence the economic situation. However, managers and researchers are still waiting for a general accepted theory that explains corporate financial structure decisions. 2.3. Different Sources of Financial Flexibility Firms have different options to finance their investments, basically through debt, equity issues or internal funds (Boileau and Moyen 2010; Jinlong et al. 2009). Because financial flexibility is closely related to meet future investment needs, the same instruments and / or options apply for attaining financial flexibility. The current literature shows that debt is the primary source of financial flexibility whereas cash and other sources have been paid less attention. Here begins the purpose of this thesis. The current literature on financial flexibility mostly investigates ei- 10
ther debt or cash as a potential instrument. The empirical findings are ambiguous: Denis and McKeon 2009 show that unused debt capacity is an important source of financial flexibility. However, they have little evidence that firms use outstanding cash balances as a source of financial flexibility. In contrast, others find that controlling leverage and liquidity policies separately can increase firm value relative to controlling only the net level of debt (Gamba and Triantis 2007). Hence, large cash balances may influence the level of financial flexibility, increase future funding capacity and the firm s ability to undertake new investment opportunities (Acharya Viral et al. 2007). This paper aims to shed more light on the puzzling aspect of financial policies where many firms that employ debt financing simultaneously hold large cash balances (Gamba and Triantis 2007). These so called hybrid forms also seem to be a common form of financial flexibility, whereas it is important to distinguish between various sources and not only considering net debt by deducting the firm s amount of cash from the value of outstanding debt as traditional valuation approaches used to do (Acharya Viral et al. 2007; Boileau and Moyen 2010). Different combinations of debt and cash may lead to significantly different firm values although they produce the same net debt level (Gamba and Triantis 2007). The combinations may reason from diverse firm, industry and country specific characteristics (which determine the presence of financing frictions) and the sources perform differently in respect to the optimization of investment under uncertainty. Furthermore, cash allows management to make investments that the capital market is not willing to finance. As a consequence, the concepts of debt and cash as funding sources have to be treated separately and cash is not accepted to be the same as negative debt for management (Opler et al. 1999). This indicates the importance of a dynamic management of debt and cash (Acharya Viral et al. 2007). The following section will summarize current findings about the various instruments or sources (primary focus on debt and cash balances) to acquire financial flexibility by investigating the benefits and costs of holding debt and cash respectively. In addition, the review reveals that cash and debt can be used as hedging tools available to a large universe of firms (cf. Acharya Viral et al. 2007). In or- 11
der to form an empirical model that classifies financially flexible firms a deeper understanding about different debt-levels and cash-ratios is necessary. 2.3.1. Debt The use of debt as a financing source is based on four main motivations (Denis and McKeon 2009): 1) undertake investments, 2) increase in net working capital in order to guarantee the daily business, 3) cover reductions in operating profitability and 4) use debt as payout to shareholders. According to the traditional trade-off theory the optimal amount of debt in a firm s capital structure is determined by trading off the costs (distress costs) and benefits (benefit from tax shield) of holding debt. Based on this idea, a firm is able to set its best capital structure policy. The trade-off models assume a certain longterm leverage ratio. Deviations from this target will be rebalanced relatively fast. However, empirically observed debt ratios differ significantly from theoretically predicted leverage. Obviously, firms carry less debt than the classical trade-off theory would suggest. Based on the idea of a trade-off model, it stands to reason that important costs, which reduce the optimal amount of debt, are ignored in such models. The concept of financial flexibility suggests that firms carry little debt because otherwise they must sacrifice valuable financial flexibility in terms of unused debt capacity (DeAngelo and DeAngelo 2007). Empirical findings support this theoretical view. Corporations reserve borrowing power to finance future investment or growth opportunities. The utilization of debt capacity today makes a firm more vulnerable against future investment distortions (e.g. Byoun 2007; Goldstein et al. 2001). Denis and McKeon 2009 find that observed dynamics in debt ratios are primarily based on the firm s opportunity set rather than being a reflection of traditional trade-off or pecking order considerations. Apparently the uncertainty about future development and happenings plays a major role, much greater than firstly expected. Studies show that the level of uncertainty is negatively correlated with the firm s debt ratio (Chung 1993; Jinlong et al. 2009). The optimum debt level reflects the option to use debt capacity if needed. Then, ex post, firms may move away from this target debt level to e.g. fund profitable investment. Since options 12
have value from an option theory perspective, financial flexibility is likely to have value as well (DeAngelo and DeAngelo 2007; DeAngelo et al. 2010). However, the rebalancing process, caused by the temporary ex post deviation from the low leverage level is rather slow, which is shown by several leverage rebalancing studies (see DeAngelo and DeAngelo 2007; DeAngelo et al. 2010; Fama and French 2002; Roberts and Lemmon 2007). Some authors try to explain the observed debt ratio phenomenon by splitting up the debt into two separate parts (cf. DeAngelo et al. 2010; Mura and Marchica 2009). According to this idea a company s leverage ratio consists of both permanent and transitory components. The permanent component is the firm s long run target, whereas the transitory part is determined by the firm s funding needs and represents deliberate but temporary deviations from the (permanent) leverage targets. Generally speaking, the costs of external funds, such as debt, are costs resulting from asymmetric information (moral hazard, agency costs), distress costs and transaction costs and make outside funds more costly. Distress costs occur when firms cannot meet promises to creditors and are unable to access the capital market (Acharya Viral et al. 2007; DeAngelo and DeAngelo 2007). Usually, the creditor requires a premium for the credit risk of debt. Transaction costs result from the transaction associated with the debt issuance as well as from compensation for the time value of money (Mello and Parsons 2000). By considering the uncertainty factor as in the financial flexibility theory, the optimal debt level balances ex ante the tax shield against distress costs and against the opportunity cost of borrowing now rather than preserving the option to borrow later when funding needs arise caused by unanticipated earnings shortfalls or new investment opportunities (DeAngelo et al. 2010). The cost of maintaining financial flexibility by not fully using a firm s debt capacity is that the company gives up a part of the tax shield. This shows that the financial flexibility theory creates a trade-off-situation between the costs and the benefits of acquiring financial flexibility. 13
2.3.2. Cash In the beginning of the upcoming idea of financial flexibility the academic world agreed on that unused debt capacity dominates as a source of financial flexibility. A plausible explanation is that the firm pays taxes on interest earned on cash, whereas unused debt capacity is untaxed (DeAngelo and DeAngelo 2007). However, firm s behavior shows a significant trend in hoarding cash. Within the last 30 years the average cash-to-assets ratio by US firms has doubled (see Figure 1) and from a theoretical perspective the average firm could pay back all debt obligations, but does not (Bates et al. 2008; Riddick and Whited 2009). 0,5 0,4 0,3 0,2 0,1 0 1980 1990 2000 Cash/Assets Debt/Assets Figure 1: Average North American Firm Policies (Boileau and Moyen 2010) It seems to be a paradoxical situation and one may ask oneself why firms hoard so much cash. Recently, the issue of corporate saving has received much attention and many authors pursue the question and find several reasons for the enormous increase in firm s cash balances (cf. Riddick and Whited 2009). Plausible reasons may be classified into matters resulting from a changing firm and matters resulting from a changing environment. Lasting changing firm characteristics, such as riskier cash flows, fewer inventories and accounts receivables and increasing research and development activities are reasons caused by internal corporate development (Bates et al. 2008). Bates et al. 2008 and Han and Qiu 2007 find that risk (meas- 14
ured by cash flow volatility) is positively correlated with the cash ratio and show that firms adjust cash holdings as a response to changes in cash flow volatility. The increased idiosyncratic risk is the main determinant of the rise of cash holdings in recent decades (Bates et al. 2008; Boileau and Moyen 2010). Also the changing external environment (macroeconomic conditions), i.e. primarily through an increasing global competition is a potential determinant for the riskier setting where the firm is operating in. On the one hand, cash may be used as a security against this increased risk, which helps the firm to be financially flexible. On the other hand, authors interpret the hoarding of cash in a negative way and argue high cash holdings not to be a signal of being financially unconstrained, but rather being constrained in terms of not having access to external capital (Hovakimian 2009). Hovakimian 2009 claims that firms do not have to hoard cash as long as they have sufficient access to external capital markets. However, considering a situation as the capital supply shortage as a result of the Financial Crisis 2007-09, cash holdings may be valuable even for firms that do not face problems rising external funds in normal times. According to the theory of cash holdings, several costs and benefits can be identified. Assets that can be easily liquidated have lower transaction costs. Lower returns reflect this benefit. However, holding cash reserves imply tax disadvantages. Interest income from cash and cash equivalents is taxed twice, firstly, at the corporate level and secondly, when it generates income for shareholders (Opler et al. 1999). A third cost related to cash holdings and probably the most controversial one are agency costs and the resulted managerial abuse of cash (DeAngelo et al. 2010). Opler et al. 1999 cannot find strong evidence for an important impact of agency costs on cash holdings. They justify their finding by saying when a firm runs into difficulties, excess cash allows management to finance losses. Consequently, it is not surprising that management is not as concerned about hoarding cash as shareholders are. However, other authors claim that agency costs make internal funds expensive and having excess cash may lead to value decreasing decisions (see DeAngelo and DeAngelo 2007; Dittmar and Mahrt-Smith 2007; Faulkender and Wang 2006; Gamba and Triantis 2007; Pinkowitz et al. 2006). Agency costs of managerial discretion occur because management may hold cash 15
to pursue its own objectives at shareholders expense resulting from a risk aversion of management and the flexibility to pursue objectives (Opler et al. 1999). Surely, hoarding cash can be costly and to some extent also agency costs play a role. However, agency problems totally fail to support the explanation for the rise in cash holdings in recent decades (Bates et al. 2008; Boileau and Moyen 2010; Opler et al. 1999). Much of the prior work on cash holdings focus on the dark side of cash, whereas the observable increase in global cash holdings may be one indication for the existence of a bright side of cash. According to firms behavior in respect to their cash balances the benefits of holding cash must outweigh the costs. The finance literature identifies four motives for firms to hold cash. The main motives go even back to Keynes 1936. In his pioneering paper he identifies two reasons that are still today of major importance. Firstly, firms save transaction costs (Keynes 1936). Companies that hold cash avoid the costs of being short liquid assets and thus meet current and ongoing liquidity needs (Boileau and Moyen 2010). Transaction costs incur e.g. when a firm converts non-cash financial assets into cash (Bates et al. 2008; Opler et al. 1999). In particular, transaction costs arise when a firm either raises funds in the capital markets (e.g. debt issuance costs), liquidates existing fixed assets, renegotiates existing financial contracts or a combination of these actions (Opler et al. 1999). The transaction cost motive is closely related to the liquidity motive, which is based on meeting current liquidity needs (present-based) and states that it is more expensive to alter investment, dividend, debt and equity policies than accumulating cash in order to meet liquidity requirements (Boileau and Moyen 2010). Secondly, high cash balances provide firms the flexibility if other sources of funding are not available or too costly. Thus, liquid assets may be used to finance activities and investments. This is closely related to the precautionary motive, which is, contrary to the transaction cost mechanism, more concerned about the firm s future. It presents the predominantly approach to understand the corporate demand for cash (Byoun 2008). The precautionary saving theory by Keynes 1936 implies that firms behave prudently and hold cash as a buffer to protect against 16
adverse shocks. The precautionary motive results from two potential sources: firstly, the increased risk and secondly, liquidity constraints (Boileau and Moyen 2010). An increase in idiosyncratic risk raises the need for self-insurance against anticipated shocks due to limited diversifiability (Dreze and Modigliani 1972; Han and Qiu 2007). Carroll and Kimball 2001 find that the introduction of liquidity constraints augments the precautionary saving motive. Theoretically, financially unconstrained firms have no incentive to hold cash due to precautionary reasons (Han and Qiu 2007). A realistic view, though, implies that currently unconstrained firms may engage in precautionary saving if they believe in some future risk that constraints may bind (Carroll and Kimball 2001). The importance of the precautionary motive is supported by several empirical findings. Opler et al. 1999 find evidence for the view that management accumulates excess cash if it has the opportunity to do so and therefore it seems that the precautionary motive for cash holdings is excessively strong. Duchin et al. 2010 find also an important precautionary saving role for seemingly excess cash and Bates et al. 2008 argue that it has a high explaining power in explaining the recent increase in cash holdings. Closely related to the precautionary saving motive is the hedging motive of cash balances. Classical hedging instruments help firms to avoid situations where firms have to access capital markets to raise external capital due to e.g. cash flow shocks. Often, hedging with classical instruments (e.g. derivatives) is expensive. Additionally, firms face many risks that they cannot hedge or are reluctant to hedge with classical derivatives (Bates et al. 2008). Especially future cash flow risk cannot be fully hedged in the market (Han and Qiu 2007). Thus, companies are expected to hold liquid assets as a hedging instrument (cf. Opler et al. 1999). Arslan et al. 2006 find empirical evidence on a hedging role of cash. Excess cash secures investments against cash flow deficits and income shortfalls. The relatedness between precautionary cash holdings and cash as a hedging instrument make cash holdings motivated by general prudence about the future a substitute to classical hedging instruments. Opler et al. 1999 find that the precautionary motive is increased when asymmetric information or agency costs make it difficult for corporations to raise external capital. This finding raises a third motive mentioned in the economic and finance 17
Sources of Financial Flexibility and their Economic Significance literature: the agency motive. Dittmar et al. 2003 find evidence across countries that firms hold more cash in countries with greater agency problems. Saying exist- to authors ar- ing agency costs are a motive for firms to hold cash is in contrastt guing agency costs make cash more costly (as previously identified). However, it may depend on specific country and firm characteristics, whether agency costs associated with cash hoardings or agency costs associated with rising external funds are higher. A fourth motive considers taxes, also in contrast to many authors arguing taxes make internal funds costly. Foley et al. 2007 find that firms that incur higher tax costs when repatriating earnings hold significantly more cash. This tax-based ex- tax foreign planation for cash holdings results from the fact that many countries income of firms but thesee taxes can be deferred until earnings are repatriated. This creates an incentive to retain earnings abroad. Thus, cash holdings are, in part, a consequence of the tax costs associated with repatriating foreign income. 1. Transaction Cost Motive / Liquidity Motive 2. Precautionary Motive / Hedging Motive 3. Agency Cost Motive 4. Tax Motive Figure 2: Overview of Motives to Hold Cash As seen previously, cash holdings play an important and independent role in the optimization of financial policies (Acharya Viral et al. 2007). Arslan et al. 2006 in- expendi- vestigate the role of cash reserves in determining corporate investment tures and find that high cash reserves increase the ability of firms to undertake profitable investment opportunities. Thus, cash balances indeed affect investment policy and provide firms self-insurance against states in which the firm does not have sufficient funds to pay its contractual obligations or invest in positive NPV 4 projects (Campello et al. 2009b). This is the idea behind attaining financial flexibili- 4 NPV = Net Present Value 18
ty and therefore cash and cash equivalents present a second important source of financial flexibility. A large empirical literature on cash holdings has emerged in recent years and reports the importance of cash in obtaining financial flexibility and reducing the underinvestment problem resulting from not being financially flexible. Faulkender and Wang 2006 find that the marginal value of cash is higher for constrained firms and for firms with high growth options. Denis and Sibilkov 2010 investigate the effect of cash holdings on investment and find higher levels of financial slack make value increasing projects possible. The level of cash holdings seems to vary across firms depending on their characteristics. Companies holding more cash are characterized by 1) strong growth opportunities, 2) risky activities, 3) small in size, 4) limited access to capital markets and 5) bad credit ratings (Opler et al. 1999). Similar findings by Faulkender and Wang 2006 and Gamba and Triantis 2007 show that the marginal value of liquidity is higher for firms with 1) lower liquidity, 2) greater investment opportunities and 3) higher external financing constraints. These findings suggest that there is no single optimal level of cash applying to all companies. The optimal level of cash is determined by many factors subject to change continuously and over time. Riddick and Whited 2009 show that an inter-temporal trade-off between interest income taxation and the cost of external finance determines optimal cash balances held by a company and find that the firm s optimal level of cash increases with the cost of external finance. Focusing on the trade-off between costs and benefits of holding cash, it seems to be straightforward to find the optimal level of cash. However, due to a complex environment and many interconnecting influencing factors, it remains for future research to tie in with existing models of optimal cash balances and incorporate recent empirical findings. The Financial Crisis 2007-09 may shed further light on this issue. Nevertheless, it is not the focus of this thesis to focus on an optimal cash holding model; there is room for further research, though. However, within the empirical analysis of this report there will be further discussion about existing findings on the determination of the optimal level of cash balances. 19
In summary, cash holdings potentially increase financial flexibility. Consistent with the high explanation power of the benefits of cash holdings, a cash-rich portfolio outperforms a cash-poor portfolio by about 15 percentage points (Duchin et al. 2010). Cash balances enable corporations to forestall distress and default. This growing importance should be taken into consideration when evaluating and assessing corporate financing decisions. 2.3.3. Other Sources of Financial Flexibility In the previous section cash has been discussed as a potential and important source of financial flexibility. Cash and cash equivalents represent internal liquidity. Another form of liquidity, external liquidity, is represented by credit lines. Similarly to debt, lines of credit can be seen as options on liquidity that can be strategically exercised when financial markets fail (Campello et al. 2009b). They function as a kind of insurance policy against liquidity shortages and correspond to an effective way of transferring current resources to bad future states (Acharya Viral et al. 2007; Holmstrom and Tirole 1998). Since credits are expensive in bad states of the economy, it makes sense to seek insurance. The results of Campello et al. 2009b describe the use of credit lines during the Financial Crisis 2007-09 and suggest that companies reduce the use of credit lines when internal liquidity is available, consistent with a cost hedge between these two forms of liquidity. The negative correlation between cash holdings and lines of credit indicates a substitution between these two sources and imply that credit lines are primarily used when internal funds are low. However, Campello et al. 2009b find that during the crisis the average size of the available lines of credit did not change much, but they observe a significant variation in the use of lines of credit across different companies. Other less significant sources of financial flexibility, which are rarely mentioned in the finance literature are dividends paid. DeAngelo and DeAngelo 2007 argue that dividends are preferable to short term debt payments because they constrain managerial discretion (by limiting cash accumulation) and build future financial flexibility by establishing a reputation for returning cash to equity holders (Douglas 2009). However, this theoretical view is not consistent with firm beha- 20