Corporate Governance and Cash Holdings - Wiley Online Library

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Corporate Governance and Cash Holdings: Listed New Economy versus Old Economy Firms Yenn-Ru Chen* ABSTRACT Manuscript Type: Empirical Research Question/Issue: This study examines the impact of corporate governance on the cash-holding policies of firms with different investment opportunities. It is difficult to determine the optimal level of cash holdings for “listed new economy” firms (firms in the computer, software, Internet, telecommunications, or networking industries), which require large amounts of capital for investment opportunities with high return potential. Unlike in “old economy” firms, for which investment opportunities are relatively limited, corporate governance in listed new economy firms may create shareholder protections that make investors willing to accept higher levels of corporate cash holdings. Research Findings/Results: By examining American Standard and Poor 1,500 companies, the evidence shows that CEO ownership and board independence affect the cash holdings in listed new economy and old economy firms differently. Specifically, higher managerial cash holdings tend to reduce cash holdings in old economy firms and higher board independence tend to increase cash holdings in listed new economy firms. Theoretical Implications: This study provides empirical support for the association between agency theory and cash theories. Given different firm characteristics, the impact of corporate governance on cash holdings verifies the implication of agency theory in explaining corporate cash policy. Practical Implications: While firms in new economy industries may be eager for more flexible governance codes in order to maintain the freedom of decision making, the evidence from this study suggests that establishing effective governance mechanisms may, in turn, effectively enlarge the degree of freedom for these firms to make timely business decisions. Keywords: Agency Theory, Takeover Defenses, Corporate Control Market, Board of Directors Issues, Ownership Issues

INTRODUCTION

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wo economic theories explain why corporations retain excess cash: trade-off and financial hierarchy theories. These two theories differ mainly in the relationship between investment and cash holdings and in the existence of an optimal level of cash holdings (Kim, Mauer and Sherman, 1998; Opler, Pinkowitz, Stulz and Williamson, 1999; Dittmar, Mahrt-Smith and Servaes, 2003; Ozkan and Ozkan, 2004). In addition, corporate cash holdings can also be explained by agency theory, in relation to these two economic theories.

*Address for correspondence: Department of Accountancy and Graduate Institute of Finance and Banking, National Cheng Kung University, 1 University Road, Tainan, 701, Taiwan. Tel: +886-6-2757575 ext 53425; Fax: +886-6-2744101; E-mail: yrchen@ mail.ncku.edu.tw

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Because a company’s cash-holding policy is a matter of managerial discretion, the level of cash holdings raises concerns about the agency cost of cash flow when managers do not act in the best interests of shareholders, especially in companies that have broad shareholder bases and low managerial ownership (Papaioannou, Strock and Travlos, 1992; Myers and Rajan, 1998). When companies hold excess cash, managers are able to pursue their own interests by spending on unnecessary expenses and unprofitable investments, without market discipline (Jensen, 1986). This, in turn, implies that the agency literature effectively assumes that trade-off theory dominates financial hierarchy theory in explaining corporate cash policy. Corporate governance therefore mitigates this agency problem of free cash flows by lowering the level of cash holdings. It is reasonable to wonder whether trade-off theory is always dominant in explaining corporate cash policy, or © 2008 The Author Journal compilation © 2008 Blackwell Publishing Ltd doi:10.1111/j.1467-8683.2008.00701.x

CORPORATE GOVERNANCE AND CASH HOLDINGS

whether corporate governance has a similar impact on cash holdings when financial hierarchy theory dominates. After all, for capital-intensive firms with high-return investment opportunities, it is difficult to determine an optimal level of cash. Because of their higher business risk, these firms face more difficulty obtaining external financing, which could force them to forgo valuable investment opportunities. Thus, they have strong incentives to retain high levels of cash in order to pursue firm value creation through intensive capital investments, which serves their shareholders best. Accordingly, trade-off theory may not explain cash policies in these firms. Effective corporate governance in this case does not necessarily reduce the level of cash holdings. Instead, shareholders may be willing to accept high levels of cash holdings for capital investments if effective corporate governance can protect their interests. This raises the question of whether the effect of corporate governance on cash holdings differs for firms with and without an abundance of investment opportunities. To understand this aspect, it is necessary to study the relationship between corporate governance and cash holdings for firms competing in the computer, software, Internet, telecommunications, or networking industries – companies referred to as listed new economy firms by Ittner, Lambert and Larcker (2003) and Murphy (2003). The success of listed new economy firms depends highly on the success and uniqueness of their innovations. Thus, they tend to devote capital to research and development (R&D) activities. This requires that listed new economy firms hold more cash. The evidence of Bruinshoofd and Haan (2005) further encourages such investigation of the effect of corporate governance on cash holdings. These authors compare financing behaviors and cash-holding determinants between Information and Communication Technology (ICT) firms and nonICT firms. They show that the former group tends to be smaller, less profitable, and riskier. Such firms use less longterm debt but more short-term debt, and they face higher costs of borrowing and spend more on R&D activities. However, they do not spend more on acquisition activities. Even though financing behavior differs significantly between these two types of firms, Bruinshoofd and Haan (2005) find similar economic determinants of cash holdings between them. We posit that the effect of corporate governance on cash holdings should explain this phenomenon of different financing behavior despite similar economic determinants of cash holdings, given the impact of corporate governance on cash holdings demonstrated in the literature (Ozkan and Ozkan, 2004; Harford, Mansi and Maxwell, 2005). Therefore, it is necessary to examine whether the effects of corporate governance on cash holdings differ between listed new economy firms and traditional manufacturing firms – referred to as old economy firms by Ittner et al. (2003). Empirical results indicate that the investment environments that firms face influence how corporate governance affects corporate cash holdings. Effective governance mechanisms tend to affect cash holdings positively in listed new economy firms but negatively in old economy firms. This is especially evident when evaluating managerial ownership and board independence. In addition to being the first study to examine the relationship between corporate governance and cash holdings

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for listed new economy and old economy firms, this study also contributes to the literature in two ways. First, it provides a new perspective on the effect of corporate governance on cash holdings in relation to economic cash theories (trade-off and financial hierarchy). When firms rely on capital-intensive high-growth opportunities to increase firm value, it is difficult to determine the optimal level of cash holdings. In this case, effective corporate governance ensures investor protection and sufficient funds for investment opportunities. Second, this study offers a solution to the inconsistent behaviors related to corporate financing and cash holdings reported in Bruinshoofd and Haan (2005). The inconsistencies in the evidence in that study are attributable to a concentration on the effects of financial variables, rather than on the impact of corporate governance on cash holdings. This study shows that different characteristics in the two types of firms (new economy and old economy firms) lead to divergent corporate governance, which affects major corporate policies, including cash holdings. The study now reviews the existing literature and develops hypotheses on the effect of corporate governance on the cash holdings of listed new economy firms. Research design and data are described, followed by analysis of results. Conclusions are presented in the final section.

THEORIES AND EMPIRICAL HYPOTHESES Corporate cash-holding policies can be explained by economic and behavioral theory. The former includes trade-off theory and financial hierarchy theory, and the latter is essentially agency theory. The trade-off theory of cash holdings posits that firms have two motives for holding cash: transaction cost and the precautionary motive. The transaction-cost motive suggests that firms hold cash because raising funds in capital markets is more costly than retaining existing cash (because external financing involves fixed costs and variable costs related to the amount of capital raised). The precautionary motive suggests that firms may reduce their investments when they face cash shortages (Kim et al., 1998; Opler et al., 1999; Ozkan and Ozkan, 2004). The size of cash shortages is proportionate to cost because firms must cut investment or raise extra funds. Thus, there will be an optimal level of cash holdings when the marginal cost of cash shortage equals the marginal cost of cash holdings (Opler et al., 1999). The financial hierarchy theory of cash holdings, however, suggests that there is no optimal level of cash holdings. Because of information asymmetry, the cost of external financing for investment projects is higher than the cost of internal financing. Thus, firms tend to use internally generated cash before they seek external financing. This suggests that keeping as much cash as possible on hand is preferable for firms with many investment opportunities, especially for those facing greater challenges in obtaining external financing. According to the agency literature, a higher level of cash holdings provides managers with greater discretion. Papaioannou et al. (1992) suggest that managers tend to retain more cash as a privilege, and Myers and Rajan (1998) argue that managers can obtain more private benefits from

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liquid assets. Opler et al. (1999) also document that managers prefer the control that comes with holding cash rather than paying dividends to stockholders. A key difference between two economic theories (tradeoff and financial hierarchy) is the relationship between investment and cash holdings (Dittmar et al., 2003). Similarly, how agency theory relates to these two economic theories depends on the extent of investment opportunities. When firms (particularly old economy firms) have limited investment opportunities, retaining a high level of cash increases the likelihood of asset expropriation by managers because excess cash may effectively force managers to overinvest and thus damage the interests of shareholders (Easterbrook, 1984; Jensen, 1986; Dittmar et al., 2003). Paying dividends decreases cash holdings and the agency cost of overinvestment (Jensen, Solberg and Zorn, 1992; Kalcheva and Lins, 2004). The level of cash holdings is thus a trade-off between the expected agency costs of overinvestment and the expected return of holding cash for profitable investments. Accordingly, the objective of corporate governance for firms with limited investment opportunities is to ensure that firms maintain appropriate levels of cash, which is more consistent with the trade-off theory of cash holdings. On the contrary, when firms (particularly listed new economy firms) have many investment opportunities available, cash is essential. The success of these firms depends highly on the uniqueness of their business innovations, and thus they tend to devote cash to R&D activities. With special patents, they can commercialize their innovations and maintain competitive positions in dynamic environments (Bahrami and Evans, 1987; Wasserman, 1988). Boyle and Guthrie (2003) argue that holding a high level of cash is necessary for potential investments. Without sufficient internal funds, firms with higher external-financing costs may forgo investment opportunities, lowering firm value and shareholder wealth. To avoid such losses, firms that need more capital for their investment opportunities must retain more cash, especially those facing challenges obtaining external financing. Thus, there may not be an optimal level of cash holdings; cash needs may instead depend on capital needs for investment opportunities. This idea is more consistent with financial hierarchy theory (Opler et al., 1999). To benefit from the high returns of these investment opportunities, shareholders would accept high level of cash holdings in firms with an abundance of investment opportunities if effective corporate governance protects their interests. Therefore, the impact of effective corporate governance on cash holdings will be negative for firms with limited investment opportunities (such as old economy firms), and positive for firms with an abundance of investment opportunities (such as listed new economy firms). Proposition 1: Effective corporate governance mechanisms reduce the level of cash holdings for old economy firms but increase the level of cash holdings for new economy firms. Managerial ownership indicates the level of the interest alignment between managers and outside shareholders, and thus its effect is the mostly investigated in the agency and governance literature. The board of directors is a key internal mechanism of governance, and its independence affects the functions of the board of director in protecting shareholder

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interests. Furthermore, external takeover threats play the role of external mechanism disciplining self-interested managers. Thus, this study investigates the effect of corporate governance on corporate cash holdings, particularly with respect to managerial ownership, board independence, and takeover.

Managerial Ownership and Cash Holdings The conflicts of interest between managers and shareholders are mainly due to the separation of ownership and control. Increasing managerial ownership can better align the interests of managers and shareholders (Jensen and Meckling, 1976). A high level of cash reserves provides managers with the discretion to pursue their own interests at the expense of shareholders. Jensen (1986) argues that a high level of managerial ownership reduces the agency problem of cash flows. Therefore, the impact of managerial ownership on cash holdings should be negative. The evidence from UK firms studied by Ozkan and Ozkan (2004) supports this hypothesis. In addition, Opler et al. (1999) employ three dummy variables of managerial ownership to examine the effect of managerial ownership on cash holdings based on the U-shape relationship between managerial ownership and firm value in the literature (Morck, Shleifer and Vishny, 1988; McConnell and Servaes, 1990) for US firms. They find that firms with insider ownership lower than 5 per cent tend to keep more cash, and firms with insider ownership higher than 5 per cent tend to keep less cash. They conclude that the positive relationship between insider ownership and cash holdings for firms with less than 5 per cent managerial ownership is due to managerial risk aversion. Thus, their study suggests that the effect of managerial ownership on cash holdings should be positive for firms with low managerial ownership, and negative for firms with high managerial ownership. However, this hypothesis may not have consistent support because old economy firms possess limited investment opportunities and listed new economy firms have an abundance of them. In addition, listed new economy firms often involve shorter product life cycles and more capital investments than old economy firms (Bahrami and Evans, 1987; Wasserman, 1988), implying that the managers of listed new economy firms are more likely to undertake risky investments than those of old economy firms. That is, managers of listed new economy firms may not be as risk averse as those of old economy firms. Rather, they will take more risks to yield higher returns. Therefore, the impact of managerial ownership on cash holdings for listed new economy firms should be different from that of old economy firms. As contended earlier, effective governance mechanisms are likely to increase cash holdings of listed new economy firms. When the interests of shareholders are protected by effective governance mechanisms, managers of these firms can keep more cash for investment opportunities that in turn increase firm value and shareholder wealth. When managerial ownership aligns the interests of shareholders and managers, the impact of managerial ownership on cash holdings



should be positive for firms with higher managerial ownership in new economy firms. Hypothesis 1: Higher managerial ownership suggests better interest alignment, and thus the relation between CEO ownership and cash holdings should be negative in old economy firms and positive in new economy firms.

Board Independence and Cash Holdings The board of directors is the key internal governance mechanism, and its main functions are to monitor management decisions on behalf of shareholders and to verify the accuracy of information released to shareholders. Independent boards reduce managerial domination, increase the quality of monitoring on managerial opportunisms, and increase the effectiveness of boards in advising business operations (Chahine and Filatotchev, 2008). The impact of board independence on cash holdings has two alternative hypotheses. First, board independence enhances the quality of information disclosure and reduces information asymmetry (Chahine and Filatotchev, 2008). Based on the trade-off theory of cash holdings, higher information transparency makes firms more capable of raising external funds for capital investments. Accordingly, firms in this situation would not need to retain much cash. This hypothesis is, however, not supported by the literature (Ozkan and Ozkan, 2004). Second, board independence reduces shareholders’ concern about insiders pursuing private benefits at the expense of shareholders via board domination. Consistent with the financial hierarchy model in Opler et al. (1999), board independence provides better shareholder protection and thus reduces the agency costs of cash holdings. Accordingly, shareholders are more willing to accept higher cash holdings for firms with more independent boards. Old economy firms experience relatively lower cash flow volatility than listed new economy firms. When the boards of old economy firms effectively protect shareholder capital, the difficulty of obtaining external financing, especially debt financing, will be lower for these firms. Thus, an independent board can reduce corporate cash holdings for old economy firms. On the other hand, board independence may not lower the cost of additional debt financing for listed new economy firms because these firms possess higher operational complexity and cash flow volatility. Even though independent boards can increase the information transparency, the higher uncertainty of cash flow may still deter creditors. Therefore, listed new economy firms must retain high levels of cash holdings. An independent board thus ensures that a company invests its cash appropriately. When managers use cash holdings to increase firm value and shareholder wealth, shareholders are willing to accept higher corporate cash holdings. Hypothesis 2: Board independence shows a positive effect on corporate cash holdings for listed new economy firms and a negative effect for old economy firms.

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Meanwhile, firms with entrenched managers often adopt many antitakeover provisions to prevent from being targeted. These antitakeover provisions provide insiders with security of their positions. When managers make selfinterested decisions and decrease shareholder wealth, these provisions protect managers from being replaced by external takeover threats. As a result, the literature often considers that adopting more antitakeover provisions indicates lower shareholder protection (Gompers, Metrick and Ishii, 2003). Agency theory suggests two alternative hypotheses regarding the impact of antitakeover provisions on cash holdings. Fundamentally, agency theory suggests that external takeover threats act as a disciplinary mechanism because firms with high cash holdings are likely to become takeover targets (Jensen, 1986). To avoid being targeted, firms with higher cash holdings are likely to adopt antitakeover provisions. Opler et al. (1999) thus hypothesize a positive relationship between antitakeover provisions and cash holdings, but they find no empirical evidence. Extensively, agency theory suggests that excess cash holdings likely lead to the agency problem of overinvestment and reduce shareholder wealth. The most significant evidence of this argument is reflected on value-decreasing acquisitions. Harford (1999) find that cash-rich firms are more likely to attempt acquisitions and experience lower postmerger performance. Several studies find that firms with high cash holdings are more likely to attempt acquisitions and are less likely to be targeted (Harford, 1999; Faleye, 2004). Thus, with the takeoverdeterrence effect of cash holdings, firms with higher cash holdings are better able to defend against takeover bids. When companies use their cash to defend against takeover bids, there may be a substitution effect between cash holdings and antitakeover provisions. In practice, old economy firms with sufficient cash holdings attempt acquisitions and actively defend against takeover bids. On the other hand, firms with many investment opportunities but few financing resources may seek out mergers with cash-rich firms (Harford, 1999). That is, listed new economy firms may be more willing to merge with other firms for the purpose of improving their own financing positions. Cash holdings in listed new economy firms are more likely for the purpose of financing good investment opportunities rather than defending against takeover bids. Therefore, the hypothesis that firms hold cash to defend against takeover bids is more likely to occur in old economy firms than in listed new economy firms. Hypothesis 3: When antitakeover provisions are considered managerial entrenchment, their effect on cash holdings shall be positive for old economy firms and negative for new economy firms. When cash is used to defend against acquisitions, old economy firms are more likely to hold cash than new economy firms and are thus more likely to exhibit a negative relationship between takeover provisions and cash holdings.

EMPIRICAL DESIGN AND DATA Data and Sample

Takeover Threats and Cash Holdings External takeover threats are considered an external governance mechanism disciplining self-interested managers.


As stated above, the firms are classified as listed new economy or old economy firms based on the studies of Ittner et al. (2003) and Murphy (2003).1 The former are firms in the

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computer, software, Internet, telecommunications, or networking industries, and the latter are in the traditional durable and nondurable manufacturing industries. Financial data and governance data are collected from Compustat and the Governance Research Service of Risk Metrics Group, respectively. The sample covers American Standard and Poor 1,500 firms from 2000 to 2004. There are two reasons to choose the sample after year 2000. First, before 2000, the initial public offering markets were very active, and many new economy firms were able to raise funds easily through the public markets. As a result, cash holding policies are not critical for them. Second, prior studies concentrate on samples before 2000 (Opler et al., 1999; Ozkan and Ozkan, 2004), and thus, this study can provide a comparison with prior studies in explaining corporate cash holdings. Initially, 4,033 firm-year observations are collected from Compustat. By deleting missing financial variables, the sample size is reduced to 3,163 observations. Next, adding the variable of CEO ownership further reduces the sample size to 2,751 observations. Including the variables of board independence narrows the sample size to 1,917 observations. Finally, incorporating the variable of antitakeover index finalizes the sample at 1,815 observations.

Research Design and Variable Definition Several empirical methods examine the effect of corporate governance on cash holdings for listed new economy and old economy firms. First, the Wilcoxon nonparametric twosample test investigates differences in key variables between listed new economy and old economy firms. Second, the effects of corporate governance mechanisms on cash holdings are first examined by ordinary least squares (OLS) regressions. Third, to mitigate the potential endogeneity problems, fixed-effect static panel and the generalized method of moments (GMM) estimations are performed (Dessi and Robertson, 2003; Ozkan and Ozkan, 2004). Last, the effect of corporate governance on cash holdings for listed new economy and old economy firms is examined using GMM estimations. The dependent variable, cash holdings, is defined as the ratio of cash and cash equivalents to total assets. Listed new economy firms are expected to have greater cash holdings than old economy firms. Governance Variables. As stated above, corporate governance includes managerial ownership, board independence, and antitakeover provisions. Fahlenbrach (2004) argues that CEOs in high-technology firms are more influential in decision making. Thus, the CEO ownership (OWN) variable represents managerial ownership and is defined as the percentage of shares owned by CEOs (Papaioannou et al., 1992; Dittmar et al., 2003). Board independence is measured by the common factor of five board variables (affiliated directors, independent outside directors, nominating committee independence, audit committee independence, and compensation committee independence). The presence of more affiliated directors on a board increases the likelihood of managerial expropriation. On the other hand, a board consisting of more independent outside directors is beneficial to shareholders (Core,

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Holthausen and Larcker, 1999). Affiliated directors are directors who have certain relationship with the firm, such as former employees, business partners, financial relationship, interlocking directors, and family members of executives or directors. Independent outside directors are nonemployee directors who are not significantly connected to the firm. That is, independent outside directors are not former employees, are not family members of current or former executives, are not interlocks, are not recipients of charitable funds, and do not provide any professional services to the firm. The related variables are defined as the percentage of board seats held by affiliated directors (AffDir) and independent outside directors (IndependDir). Recently, the profession of corporate board committees has increased in that more firms set up committees within the boards. These committees specialize in nominating executives and directors, ensuring the accuracy of financial statements, and constructing appropriate compensation contracts to executives and directors. Because these committees perform these essential functions that affect shareholder interests directly, their independence becomes critical in protecting shareholder wealth. Following Chhaochharia and Grinstein (2007), we use the proportion of independent directors in these committees. IndependNom represents nominating committee independence and is measured by the proportion of independent directors in nominating committee; IndependAud represents audit committee independence and is measured by the proportion of independent directors in audit committee; and IndependComp represents compensation committee independence and is measured by the proportion of independent directors in compensation committee. Last, the corporate governance index (gindex) of Gompers et al. (2003) is added to further investigate the effect of antitakeover provisions on cash holdings. A higher gindex indicates more antitakeover provisions and implies higher agency costs. It is important to note of the limitations of this proxy. When Gompers et al. created this governance index, they did not justify how this index would reasonably reflect the relative effects among different provisions. By simply counting the number of provisions adopted by corporations, this index may not fairly distinguish the shareholder protection for any two firms with the same value of this governance index. This issue induces an idea for further research. Economic Control Variables. To better assess the effect of corporate governance on cash holdings, empirical models contain some economic control variables that influence cash holdings. Following the study of Opler et al. (1999), cash flow (CF) is defined as earnings before interests, taxes, depreciation and amortization, less interests, taxes and dividends; this is then divided by total assets. Tobin’s Q is a common proxy to measure a firm’s investment opportunity (Lang, Stulz and Walkling, 1991; Doukas, 1995) and is defined as the ratio of the market value of a firm to the replacement cost of its assets. Because the replacement costs of assets are difficult to measure, we estimate Tobin’s q as the ratio of the market value of assets to the book value of assets (MBA) as used in prior studies (Denis, 1994; Chen and Ho, 1997; Chen, Ho, Lee and Yeo, 2000).



In addition, larger firms need more capital to maintain their operations and investment activities. Firm size (Size) is measured by the natural logarithm of total assets. Furthermore, a company’s investment activities can be represented by its R&D expenses and capital expenditures. High R&D expenditure implies a higher level of firm risk, which causes firms to hold more cash to defend against possible losses. Capital expenditure ratio (CapExp), the ratio of capital expenditure to total assets, reflects corporate investment activities. Being used to defend firms against operating losses, net working capital (NWC) is defined as working capital less cash and equivalents, divided by total assets. Similar to Opler et al. (1999), a dividend dummy (Div dummy) variable measures the effect of dividend policy on cash holdings. Dividend dummy equals one if a firm pays dividend in a given year; it is zero otherwise. The leverage variable (LEV) represents a firm’s financial risk, and is defined as the ratio of long-term debts to total assets, following Opler et al. (1999). Large cash reserves can reduce the possibility of bankruptcy. Fama-French beta (FFbeta) is used as the proxy of firm risk and is expected to show a positive effect. The beta of Capital Asset Pricing Model is also employed, but in order to save space, it is not separately reported. Furthermore, if a firm is newly listed, its cash balance may be higher and its demand for additional cash may be lower, regardless of whether it is a listed new economy or old economy firm. Therefore, the variable of listing age is included as a control variable. Even though the literature shows that listed new economy firms have different motives for holding cash than old economy firms, this study argues that what makes firms able to keep cash is the effectiveness of their corporate governance. When investor benefits can be protected by effective governance mechanisms, firms that have high demand for investment capital will be allowed to keep high levels of cash, and firms that do not have many investment opportunities should not retain significant levels of cash. Therefore, even though these economic variables affect corporate cash holdings, the effects may not be different between listed new economy and old economy firms. The evidence of Bruinshoofd and Haan (2005) provides a good example of expectations on the effects of economic control variables.

EMPIRICAL RESULTS AND DISCUSSION Statistics and the Wilcoxon Test Table 1 exhibits the statistics of variables for listed new economy and old economy firms and the p-value of the Wilcoxon two-sample test. The average cash in listed new economy firms accounts for about 33 per cent of total assets, significantly greater than that in old economy firms (12.5 per cent). Even though the average CEO ownership is higher in listed new economy firms, the median value of CEO ownership is higher in old economy firms. In addition, old economy firms adopt more antitakeover provisions than listed new economy firms. Compared with the boards of old economy firms, the boards of listed new economy firms tend to have lower independence. This phenomenon can be explained by the


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idea that listed new economy firms involve more uncertain business operations and management, and the boards with more insiders provide the firms with higher decisionmaking efficiency. Although the boards of new economy firms are associated with more insiders, the committees within the boards still maintain as high independence as in the boards of old economy firms. Furthermore, the independence of compensation committee is even higher in new economy firms than in old economy firms. Consistent with the evidence of Ittner et al. (2003) and Bruinshoofd and Haan (2005), listed new economy firms are smaller and slightly less profitable than old economy firms. In addition, listed new economy firms spend more on investment projects and R&D activities but have less liquidity and leverage than old economy firms. Only 19 per cent of listed new economy firms pay dividends, but 61 per cent of the old economy firms pay dividends. Furthermore, the listed new economy firms are riskier (based on Fama-French beta) and younger than old economy firms.

Regression Analysis Table 2 reports the effect of corporate governance on cash holdings in OLS estimations. Model (1) investigates the impact of CEO ownership; model (2) adds in the factor variable of board independence; and model (3) incorporates the effect of antitakeover index. The positive coefficient of the new economy dummy (newecon) variable indicates that listed new economy firms tend to keep more cash than old economy firms. The coefficient of the newecon variable is significant in all models (t = 12.49, p < .001 in model (1); t = 11.85, p < .001 in model (2); t = 2.28, p < .05 in model (3)). In addition, the relations between control variables and cash holdings are consistent with the results of prior studies (Opler et al., 1999; Ozkan and Ozkan, 2004). In model (2), where the common factor of board independence is included, the coefficient of OWN is significantly positive (t = 2.09, p < .05) and that of OWN-square is negative but insignificant. The negative impact of OWN interaction with the newecon variable becomes marginal, significant at only 10 per cent level, while the coefficient of OWN-square interaction with the newecon variable is still significantly positive (t = 2.14, p < .05). The positive relation in old economy firms is consistent with the evidence of Opler et al. (1999), suggesting that managers in these firms keep more cash for risk-aversion reasons. Nevertheless, the negative coefficient of OWN interaction with the newecon variable is not consistent with the expectation, which may be due to the endogenous relation among corporate decisions and thus a further analysis is necessary. The board independence variable does not show significant effect on cash holdings, but its interaction with newecon is significantly positive (t = 2.40, p < .05), indicating that the impact of board independence on cash holdings is significantly different between new economy and old economy firms. This finding is consistent with Hypothesis 2 that new economy firms with higher board independence are more likely to hold more cash for their investment opportunities. In model (3), where gindex is added to the equation, the negative gindex variable confirms that cash holdings play an

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September 2008 6.53 .94 12.39 14.63 23.15 14.83 16.30 2.46 .07 1.34 1.39 .05 .21 .12 .15 .02 .49 .56 20.60

.13 2.20 .01 11.54 71.49 84.41 92.91 92.39 10.06

2,194

2,194 1,575 1,575 1,575 1,575 1,575 1,575 1,492

2,194 .09 2,194 2.02 2,194 7.34 2,194 .05 2,194 .06 2,194 .10 2,194 .21 2,194 .01 2,194 .61 2,194 1.06 2,194 26.64

.15

.12 2.19 8.20 .06 .05 .18 .30 .02 1.00 1.31 36.00

1.12 .84 18.18 83.30 100.00 100.00 100.00 12.00

.17

.09 1.60 7.21 .04 .02 .10 .20 .01 1.00 1.02 21.00

.31 .24 10.00 75.00 100.00 100.00 100.00 10.00

.06

.06 1.27 6.32 .02 .00 .02 .09 .00 .00 .76 10.00

.09 -.48 .00 62.50 66.70 100.00 100.00 8.00

.02

Mean Standard 75th Median 25th deviation Percentile Percentile

2.62 -.06 11.88 68.62 83.65 92.12 93.65 8.32

.33

557 .09 557 2.82 557 7.25 557 .05 557 .14 557 .02 557 .13 557 .00 557 .19 557 1.38 557 16.02

557 342 342 342 342 342 342 323

557

N

.09 2.17 1.63 .05 .12 .13 .19 .02 .40 .49 13.75

5.74 .87 12.21 13.67 24.10 15.57 14.78 2.47

.22

.13 3.52 8.09 .07 .20 .09 .21 .00 .00 1.70 19.00

2.16 .65 16.67 80.00 100.00 100.00 100.00 10.00

.50

.09 2.12 7.01 .03 .13 .02 .04 .00 .00 1.35 12.00

.26 .11 11.11 70.00 100.00 100.00 100.00 8.00

.30

.05 1.44 5.99 .02 .05 -.06 .00 .00 .00 1.07 7.00

.05 -.54 .00 60.00 66.70 100.00 100.00 7.00

.14

.37 .00 .99 .96 .00 1.00 1.00 1.00 1.00 .00 1.00

.70 .99 .17 1.00 .59 .79 .05 1.00

.00

p-value of Wilcoxon test (new Mean Standard 75th Median 25th old > 0) deviation Percentile Percentile

New economy

This table exhibits descriptive statistics of variables for our sample from 2000 to 2004. Cash holdings is the ratio of cash and equivalents to total assets. Own is the percentage of shares owned by CEOs. BOD independence is a common factor of affiliated directors, independent outside directors, nominating committee independence, audit committee independence, and compensation committee independence. AffDir and IndependDir represent the percentages of directors who are in affiliated members and independent outsiders, respectively. IndependNom, IndependAud, and IndependComp represent the proportion of independent directors in the committee of nominating, audit, and compensation, respectively. The gindex variable is the governance index number estimated based on Gompers et al. (2003). CF is the ratio of cash flow to total assets. MBA is the market-to-book value of assets. Size is the natural log of total assets. CapExp is the ratio of capital expenditure to total assets. R&D is the ratio of R&D expense to net sales. NWC is the ratio of net working capital to total assets. LEV is the ratio of long-term debt to total assets. Div dummy is a dummy variable that equals one if a firm pays dividends in a given year. FFbeta is the Fama-French beta. Listing age is the years that a firm has been listed on an exchange.

Dependent variable Cash holdings Explanatory variables Own BOD independence AffDir IndependDir IndependNom IndependAud IndependComp gindex Control variables CF MBA Size CapExp R&D NWC LEV DIV Div dummy FFbeta Listing age

N

Old economy

TABLE 1 Statistics Description: Listed New Economy versus Old Economy Firms

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437

TABLE 2 The Effect of Corporate Governance on Cash Holdings – OLS Model (1)

Intercept Explanatory variables newecon Own Own-sq BOD independence gindex newecon ¥ own newecon ¥ own-sq newecon ¥ BOD independence newecon ¥ gindex Control variables CF MBA Size CapExp R&D NWC LEV Div dummy FFbeta Listing age No. of observations Adjusted R2

Model (2)

Model (3)

Coefficient

t-statistics

Coefficient

t-statistics

Coefficient

t-statistics

.393

22.69***

.356

18.76***

.390

16.96***

.098 .001 -1E-05

12.49*** 2.16* -1.31

.101 .002 -2E-05 .003

11.85*** 2.09* -1.95 1.01

-.009 4E-04

-3.37*** 3.62***

-.007 3E-04 .018

-1.94 2.14* 2.40*

.061 .002 -2E-05 .005 -.004 -.008 3E-04 .014

2.28* 1.76 -1.71 1.46 -2.88** -2.09* 2.42* 1.78

.004

1.35

-.082 .026 -.027 -.510 .385 -.264 -.225 -.045 .020 2E-04 1,815 57.92%

-1.57 10.27*** -11.50*** -7.48*** 14.25*** -10.23*** -11.30*** -6.88*** 4.04*** 1.08

-.170 .029 -.030 -.524 .197 -.297 -.215 -.055 .026 2E-04 2,751 54.72%

-4.14*** 16.41*** -14.37*** -9.49*** 13.69*** -13.59*** -13.17*** -9.39*** 5.64*** 1.20

-.078 .026 -.027 -.506 .380 -.257 -.221 -.051 .020 2E-04 1,917 58.62%

-1.62 10.98*** -12.03*** -7.68*** 15.25*** -10.16*** -11.55*** -8.00*** 4.04*** 1.24

This table shows the determinants of cash holdings in OLS regressions. Cash holdings is defined as the ratio of cash and equivalents to total assets. The newecon variable equals one if a firm is in a new economy industry. Own is CEO ownership. BOD independence is a common factor of affiliated directors, independent outside directors, nominating committee independence, audit committee independence, and compensation committee independence. The gindex variable is the governance index, estimated based on Gompers, et al. (2003). CF is cash flow. MBA is the market-to-book ratio of assets. Size is the natural log of total assets. CapExp is capital expenditure. R&D is R&D expense. NWC is net working capital. LEV is long-term debt ratio. DIV dummy equals one if a firm pays dividends in a given year. FFbeta is the Fama-French beta. Listing age is the years that a firm has been listed on an exchange. *p < .05, **p < .01, ***p < .001. OLS, ordinary least squares.

important role in defending external takeover bids (t = -2.88, p < .01); on the other hand, its interaction with the newecon variable is insignificantly positive, indicating that the role of cash in defending external takeover bids is slightly lower in listed new economy firms than in old economy firms.

Endogenous Issue The issue of endogeneity has been widely discussed in the literature because many corporate decisions are endogenously determined, either simultaneously or contemporaneously. To mitigate endogeneity problems, we perform both static panel and dynamic panel estimations (Dessi and Robertson, 2003; Ozkan and Ozkan, 2004).


Table 3 shows the results of the fixed-effect static-panel estimations. As in Table 2, model (1) investigates the impact of CEO ownership; model (2) adds in the factor variable of board independence; and model (3) incorporates the effect of antitakeover index. The results are similar to those in Table 2. Furthermore, Ozkan and Ozkan (2004) argue that transaction and adjustment costs could delay adjustment in cash holding policy, and they thus adopt GMM regressions to estimate cash-holding determinants. In addition, Harford et al. (2005) identify that the gindex variable is related to firms’ future cash holdings based on the Granger causality test. Accordingly, even though static-panel estimations can mitigate heterogeneity, the contemporaneous endogenous

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438

TABLE 3 The Effect of Corporate Governance on Cash Holdings – Static Panel Model (1)

Intercept Explanatory variables newecon Own Own-sq BOD independence gindex newecon ¥ own newecon ¥ own-sq newecon ¥ BOD independence newecon ¥ gindex Control variables CF MBA Size CapExp R&D NWC LEV Div dummy FFbeta Listing age Fixed effect Adjusted R2

Model (2)

Model (3)

Coefficient

t-statistics

Coefficient

t-statistics

Coefficient

t-statistics

.406

22.37***

.357

18.16***

.377

15.73***

.101 .002 -2E-05

12.73*** 2.58*** -1.49

.103 .002 -2E-05 .003

11.87*** 1.69 -1.86 .82

-.010 .000

-3.62*** 3.79***

-.008 3E-04 .016

-2.13* 2.45* 2.03*

.059 .002 -2E-05 .004 -.003 -.009 4E-04 .013

2.07* 1.69 -1.85 1.25 -2.18* -2.43* 2.84** 1.58

.005

1.51

-.076 .024 -.025 -.461 .383 -.255 -.237 -.045 .019 2E-04 year 58.84%

-1.43 9.26*** -10.32*** -6.66*** 14.05*** -9.68*** -11.20*** -6.68*** 3.79*** .98

-.169 .030 -.031 -.484 .196 -.288 -.208 -.054 .025 2E-04 year 55.19%

-4.05*** 16.78*** -14.46*** -8.55*** 13.68*** -12.97*** -12.56*** -9.22*** 5.3*** 1.25

-.064 .025 -.026 -.468 .384 -.251 -.233 -.050 .018 2E-04 year 59.72%

-1.30 9.70*** -11.20*** -6.99*** 15.34*** -9.81*** -11.75*** -7.80*** 3.77*** 1.26

This table exhibits cross-sectional time-series regression estimates of cash holding determinants with fixed year effect. Cash holdings is defined as the ratio of cash and equivalents to total assets. The newecon variable equals one if a firm is in a new economy industry. Own is CEO ownership. BOD independence is a common factor of affiliated directors, independent outside directors, nominating committee independence, audit committee independence, and compensation committee independence. The gindex variable is the governance index, estimated based on Gompers et al. (2003). CF is cash flow. MBA is the market-to-book ratio of assets. Size is the natural log of total assets. CapExp is capital expenditure. R&D is R&D expense. NWC is net working capital. LEV is long-term debt ratio. DIV dummy equals one if a firm pays dividends in a given year. FFbeta is the Fama-French beta. Listing age is the years that a firm has been listed on an exchange. *p < .05, **p < .01, ***p < .001.

problem remains. Therefore, following Ozkan and Ozkan (2004), the first-difference specification of GMM estimates is used to reexamine the effect of corporate governance on cash holdings; results are reported in Table 4. As in Table 2, model (1) investigates the impact of CEO ownership; model (2) adds in the factor variable of board independence; and model (3) incorporates the effect of antitakeover index. All models in Table 4 treat the lagged cash as endogenous and thus an instrument variable is employed, and all explanatory and control variables are endogenous in all models. In all models, the coefficient of lagged cash is positive and significant, showing that corporate cash is serially related. Thus, the estimations of GMM provide more meaningful analysis to examine the effect of corporate gov-

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ernance on cash holdings. The results in Table 4 show that the effect of corporate governance is more significant in dynamic-panel than in static-panel estimations, and that the effect of corporate governance on cash holdings is different between listed new economy and old economy firms. Because the results in all models are similar, the following discussion is based on the results of model (3). CEO ownership shows a negative and significant effect on cash holdings (t = -3.91, p < .001) that is consistent with Hypothesis 1, but its interaction with newecon variable is not significant as is in Table 3. This finding suggests that the effect of CEO ownership is not significantly different between listed new economy and old economy firms when all variables are considered endogenous. In addition, the



439

TABLE 4 The Effect of Corporate Governance on Cash Holdings – Dynamic Panel (GMM) Model (1) Coefficient Intercept Explanatory variables Cash holding (t-1) newecon Own Own-sq BOD independence gindex newecon ¥ own newecon ¥ own-sq newecon ¥ BOD independence newecon ¥ gindex Control variable CF MBA Size CapExp R&D NWC LEV Div dummy FFbeta Listing age No. of firms Sargan test (p-value of chi-square)

Model (2)

t-statistics

Coefficient

Model (3)

t-statistics

Coefficient

t-statistics

.009

7.01***

.009

7.87***

.011

8.83***

.272 .075 -.002 3.E-06

9.03*** 1.87 -2.63** .21

.307 .031 -.002 6.E-06 -.007

10.63*** .95 -2.96** .58 -2.01*

.221 -.002 -.003 2.E-05 -.018 .001 -.006 5.E-04 .024 -.004

7.92*** -.04 -3.91*** 1.98* -3.22** .26 -1.09 2.72* 3.60*** -.52

-3.E-04 3.E-04

-.04 1.38

-.003 4.E-04 .015

-.46 2.10* 2.50*

.056 .004 .019 -.208 .078 -.347 .013 -.047 .000 -.001

1.12 1.05 5.61*** -3.26*** 4.16*** -13.37*** .43 -5.16*** -.06 -2.09*

.104 .010 .014 -.239 .086 -.389 .027 -.052 .009 -.001

1.96* 3.17*** 4.52*** -3.94*** 4.62*** -16.75*** .93 -6.40*** 1.95* -1.28

.025 .017 .018 -.251 .119 -.448 .022 -.062 .002 -.001

.66 5.24*** 3.91*** -4.38*** 6.61*** -19.30*** .77 -6.92*** .51 -1.81

447 111.90

(