Impact of Financial Policies on Marginal Value of Cash

Based on textbook finance, corporate financial policies are split into three major areas: financing decisions, budgeting decisions, and financial decisions. The financing and budgeting decisions had been exhausted in the financial literature. The third area, financial decisions was not as well highlighted. Though this issue is of extreme important for both corporate management and shareholders. Graham and Harvey (2001) mentioned a survey of American and European CFOs asserting that financial flexibility is the most important driver behind corporate capital structure decisions. On the other hand, shareholders are highly concerned about the cash that firms holds. Hanson (1992), Smith and Kim (1994) warn of excess cash holdings. They think this may be interpreted as a value destruction symptom. Other researchers confirmed Hanson and Kim for the cost associated with cash accumulation (such as Kim et al (1998), Faulkender (2004), Hartzell, Titman and Twite (2005)).

Furthermore, little academic attention has been put into studying the marginal cost of cash holdings. Brealey and Myers (1996) assert that liquidity valuation is still one of the 10 unsolved problems in finance. Let alone the marginal value of liquidity or accumulated cash in corporate reserves. Kim, Mauer, and Sherman (1998) look at the correlation between financing decisions and optimal liquidity at the firms based on the costs and benefits of holding liquid reserves. The optimal investment liquidity is an increasing function of cost of external financing in addition to return and variance of future cash flows. Sapriza and Zhang (2004) analyze the effects of financial constraints on the value of the firm and found out that financial constraints reduce the firm value. 

Billett and Garfinkell (2004) observe that firms, with low access cost to external financing, do not face a compelling demand for internal liquidity. This is echoed in the work of Faulkender and Wang (2006) that suggests that the marginal value of cash holding depends highly on the usage of this cash whether it would be distributed to equity holders, service debt, or just sits idle in the corporate coffers until it is needed. As a result, the marginal value of cash is an inverse function of holdings size, leverage, but has a direct relation with cost of access to capital markets. By choosing stock repurchase over dividends, firms would increase the marginal value of its cash holdings. 

 Hennessy and Whited (2005) consider an optimal dynamic capital structure and they suggest that the marginal value of debt is higher if it is used to avoid costly equity issuance instead of distributing it to equity holders. Acharya, Almeida, and Campello (2007) study the marginal value of cash as well and examine its value when investment opportunities are coined with low cash flow states or high cash flow states. 

Similar to Billett et Garfinkell (2004), Gamba and Triantis (2008) uses a simulated dynamic model to analyze the optimal liquidity policies of a company and the associated effects on the firm value. For the latter, they think that the marginal value of liquidity depends on the current investment and financing decisions for a company and on the inter-temporal link between current decisions and forward looking estimations of needs for cash. 

Faulkender and Wang (2006) [FW06] and Gamba and Triantis (2008) [GT08] are similar in their research objective as both concentrates on the effects of financial policies on the value of firms. In addition, they both have consistent findings as they assert that the marginal value of corporate liquidity is: 

1. higher for companies with less cash holdings 
2. higher for companies with more investment opportunities 
3. higher for companies with tougher external financing constraints 

From a methodological point of view, FW06 derive and test their intuitive hypotheses empirically while GT08 simulates a dataset (10000 firms for 60 years) based on base care parameters implied from Hennessy and Whited (2005). GT08 dynamic model is able to capture frictions effects such as the impact of income taxes and distress costs. They mention also that the model is flexible enough to include other friction elements such as the effect of fixed cost of debt issuance. 

FW06 examine the marginal value of cash based on three cash regimes found in Hennessy and Whited (2005) in order to facilitate qualitative predictions for the cross section variations of cash marginal value. They argue that their methodology for firm valuation considering its characteristics is better than FF 98 because FW06 incorporates time varying risk factor instead of cross sectional variation only with FF 98. Another reason for the methodological superiority is the choice of the dependent variable. FW06 uses equity returns instead of market to book ratio as the former is easier to observe and measure. They do not regress the excess equity return on the yearly change in cash holdings only, but also on the incremental profitability, financing policy and investment policy. To test their hypotheses empirically, FW06 use a dataset of 82187 firm-years observations over three decades (1971 – 2001). 

Although, the dynamic model of GT08 is able to incorporate friction costs, I would like to note that FW06 follows a more rigorous methodology as they have used empirical tests and robustness tests. 

As a potential literature contribution: 

1. It is possible to extend FW06 model to incorporates more friction elements and see how much this would affect the marginal valuation. GT08 argue that distress costs highly affect the marginal value of cash. 
2. The FW06 model can be tested with Canadian data a well to see whether the country specific factors would affect the marginal liquidity valuation. 
3. Replicating GT08 model with empirical data (Either US or Canadian data) and robustness tests might also be a new contribution. 
4. Incorporating the agency cost into either model would be an asset as well because several studies in the literature mentioned the big impact of agency problems on financial policies within the firm and this would surely affect the marginal valuation of cash.