The impact of cash holdings on corporate efficiency
LE3 .A278 2016
Bachelor of Business Administration
Currently, corporations are choosing to hold an increasing amount of their total assets in cash and cash equivalents. This increase has caught the interest of the academic world as research tries to create theories to explain why firms are choosing to increase the level of cash on their balance sheet. Michael Jensen proposed a n explanation in 1986. He stated that management will increase the level of cash holdings in order to pursue their own interests instead of the interests of shareholders. When this occurs, firm value is destroyed and the cash is wasted. Alternative theories have emerged that try to explain this phenomenon. The transaction cost theory is based on the foundation that a firm will increase their cash holdings to reduce the transaction costs of converting non-liquid assets into cash. The precautionary theory states that a firm will increase their cash holdings to protect themselves from shocks to their cash flow and from economic ncertainties. Finally, the tax motive describes how a firm may choose to increase the level of cash to avoid taxes associated with moving cash from one country to another. Jensen’s theory implies that an increase in cash will decrease the firm’s efficiency. This hypothesis was tested in the current study using return on invested capital (ROIC) as the measure of efficiency. It was found that an increase in cash actually increases the ROIC, and therefore the hypothesis is rejected. Robustness tests were conducted to add additional control variables but the findings remained consistent . The data provides some support for the alternative theories, but further research is needed to fully explain why the association between cash and ROIC is positive.
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