Abstract
The purpose of this paper is to determine whether the firms follow financial conservatism and leverage conservatism policies, how much this decision has changed after the 87' recession in a decade and what are the factors behind such conservatism. The variables determining the firm as financially conservative or not conservative are statistically tested using logit/probit models for the purpose of providing conclusive evidence of a firm's conservatism. Finally, it is checked if the conservatism policies are dependent on financial distress as well. Results indicate that the number of firms following financial conservatism has risen after that period and is significantly dependent on factors such as market to book ratio and size as well.
Acknowledgement
I am immensely grateful to my professor and supervisor Dr. Leone Leonida for supporting me throughout the dissertation period and guiding me in the right direction. This dissertation would not have been possible without his guidance, encouragement and supervision. I would also like to thank my classmates and friends for all the support and help that they have provided me in all this time. Last but not the least; I would like to thank my parents for always encouraging and supporting me.
1.1 Purpose of the study
The topic effectively deals with one of the relevant issues in today's financial era - Financial Conservatism and Financial Distress. The paper "Determinants of financial conservatism: Evidence from low-leverage and cash-rich UK firms" by Iona, Leonida and Ozkan will serve as the main literature.
By the means of this paper I have tried to justify the reasons as to why a firm follows any kind of conservatism whether cash or leverage. Both the concepts are interdependent to an extent as well as testable enough to draw out conclusions. A comparison between the decades have also been made in this paper to discover that there has been an increase in the number of firms that follow cash conservatism policies, low leverage policies and both of them simultaneously from the period starting from year 1984-87 and 1999-2002. It is also discovered in the actual findings that more cash is maintained than required by the capital structure and level of leverage is maintained lower than that prescribed by the capital structure (Iona, Leonida and Ozkan, 2004). This shows that the firms tend to overshoot the cash targets and undershoot the leverage targets. This could be due to precautionary reasons or other reasons such as managerial discretion as well. Also, it shows that firms are following these two policies at the same time and hence, there exists a connection between the two. Due to this we cannot draw conclusions solely on the basis of their individual analysis and hence need to study them jointly as well. As already much research has been done to prove that firms follow high cash policy or low leverage but not much data is available on the firms following both the policies simultaneously. I have tried to prove this by selecting those firms which have followed high cash policy and low leverage policy at the same time, such firms are classified separately and then regressed against factors such as market to book value, size, profit and dividend policy of the firms and results have been derived to find out their dependence on each of these factors as well.
1.2 Reasons for financial conservatism
The reasons for large cash holdings are varied. The firms which have higher growth opportunities in the near future tend to maintain high cash and low leverage in order to prevent by passing of profitable investment opportunities as and when they occur, this is one of the reasons for firms to maintain higher cash balances. Also the poor performing firms are more concerned about the maintenance of cash balance than the growth firms as they do not have ready access to cash. The second reason owes to agency conflicts and management's conflicts with the shareholders. Managers usually tend to undertake projects which yield quick cash even though they are poor projects and against the welfare of shareholders. Also, due to market imperfections and asymmetric information prevalent in the market, firms tend to follow either high cash or low leverage or both simultaneously as firms want to prevent high agency costs and costly debts. Firms which are already under lot of debt find it harder to raise external money, for this purpose they have two options, either they maintain higher internal funds or keep their external level of debt lower so that as and when some profitable opportunity arises they do not have to forgo it. Higher cash flows enable the firms to take profitable investment opportunities even if they are experiencing a shortfall of funds. Another reason could be the ownership and its impact. Firms which maintain high cash or low leverage quite depends on the manager's discretion as well. Depending on the manager's position in the firm, the manager could deliberately maintain a high cash policy in order to inflate the position of the firm in the eyes of shareholders or for another reason of taking quick cash yielding poor investments in order to increase the size of the firm.
We just discussed the reasons for large cash holdings; similarly there are a number of reasons so as to why following low leverage policy benefits the firms. It is especially beneficial for the shareholder of the firm as debt limits the managerial discretion over free cash flows which ultimately help in monitoring of their behavior. Leverage constraint doesn't allow managers to undertake those opportunities which suffice their own selfish interest and not the combined interest of shareholders and managers. It puts a constraint as managers tend to undertake those opportunities which tend to expand the scale of the firm even if it means undertaking poor value investment and avoiding shareholders concerns. Thus we can say that leverage helps overcoming the overinvestment problem. When a firm follows the high cash and low debt policy together then such firms can be classified as financially conservative firms. All the above mentioned reasons for cash and leverage conservatism are implied for financially conservative firms as well.
The main concern in this paper is to define the financially conservative firms, select the firms from a pool of data which qualify for being financially conservative. For this purpose a number of tests will be conducted mainly 'Logit'/ 'Probit' and regression analysis and the results found out would be hence used to prove whether the firms follow financially conservatism or not and if yes then what are the factors that drive them to take such decision of conservatism. Following that, we study how much the factors such as corporate governance, board composition, executive and non executive shareholders and most importantly 'financial distress' affect the decision making.
For the data analysis I have taken the data for the first four years, that is year 1984-87 and from 1999-2002 and compared the results from the two in order to show the changes in the trend or policies that have occurred between this time span. This will help us to know the impact on firm's conservatism policies at the time of 1987 market crisis and changes 10 years after that.
1.3 Financial Distress: Occurrence and Implication
Financial distress is a situation, as suggested by name, of bad times that occurs when there is a difficulty in honoring the promises to creditors or they get broken. In our hypothesis we have tried to prove that the fear of financial distress is one of the important reasons why firms become financially conservative. And the reason why firms fear financial distress so much is because financial distress is costly. Financial Distress can lead to bankruptcy and bankruptcy incurs a lot of costs. Investors are well aware that levered firms may fall into financial distress and they are concerned about it. This is reflected in the current market value of the securities of the firm. But this cost is not fixed or estimated, rather it depends upon two important factors - what is the probability that the distress will occur and what would be the magnitude of costs incurred incase such a situation arises.
Firms usually maintain the cash balance and leverage level depending upon the capital structure. Capital structure is determined by the tradeoff between tax benefits and costs of financial distress. The risk of distress rises with the debt level in the firm's capital structure and so firms tend to keep their debt level to the minimum so as to avoid any bankruptcy and eventually distress costs.
Bankruptcy occurs when creditors are legally allowed to take over when a firm defaults and bankruptcy costs occur when the process of bankruptcy takes place. It consists of both Direct and indirect costs. Direct costs include legal and administrative costs and indirect costs are nearly impossible to calculate as they cannot be quantified. For example- there is a lot of time and effort which is involved in this whole process.
Thus, in light of all the above points raised we can determine that the firms had enough motivation to save costs on financial distress as it is surely costly and firms as a precautionary measure are cash conservative and leverage conservative. This is the one of the reasons that after the crash of 1987, in the later years we discover more and more firms adopted conservatism policies and there is a rise in the number of firms which are either cash rich or maintain low leverage or both.
Chapter 2
Literature Review
There has not been much empirical research on this topic previously and I have limited background data to research from but I have got help from works by Minton and Wruck (2001), Mikkelson & Partch, Opler (1999) and Jensen (1986) along with the main literature (Iona, Leonida and Ozkan, 2004). Mainly the research has been done to discuss reasons for cash holding or low leverage separately and only one paper has been published discussing the implication of studying both the policies jointly which is also our main literature.
I would start with the discussion of previous empirical works on following high cash policies by the firm and reasons for maintaining low leverage. The first paper by Minton and Wruck brings out some facts clearly regarding the firms that adopt financial conservatism policies and are regarded to be as financially conservative. They are sometimes regarded as being 'under-leveraged', that means that their borrowings are much lower than their capital structure suggests. There are a few main findings with respect to this. First, financially conservative firms mainly follow pecking order policy, but not completely though. Generally these kinds of firms has high funds flow and large cash balances for their operations and investments and they mainly resort to debt financing when the need arises for external funds and then also they do not exhaust their internal funds completely.
Secondly, financial conservatism is a transitory policy and findings such as that of Kaplan (1991) have documented this result. With time, most of the financially conservative firms drop their policy of low leverage and financial conservatism and increase their leverage within a short span of time.
Third, the firms tend to stockpile their debt capacity, that is, they maintain low leverage so far that their internal funds are high and their investments are low but as soon as they have more avenues for investment they tend to shift from the pattern and as their internal funds decline they tend to shift towards high leverage. Interestingly, non conservative firms have a different approach, they adopt low leverage when internal funds increase.
Fourth, financial conservatism is not industry based. The financially conservative firms might have some similar characteristics but they are not industry based at all. The general characteristics of financially conservative firms include high book-to market ratio, high internal cash flow and cash balances and low leverage than estimated by optimal capital structure. Also, it says that the financially conservative firms do not necessarily have low tax rate and that tax may play a role but tax consideration cannot be considered as the primary factor while making decision regarding the financial policies of the firm.
Another research regarding reasons and determinants of cash holdings by firms is done by Opler that firms with strong growth opportunities (market to book ratio) and riskier cash flow hold more cash. Also, the firms which have a greater access to capital market i.e. the large firms with credit ratings hold less cash. The paper also suggests that though holding liquid cash holds some disadvantages as liquid asset earns low return and there are some tax disadvantages associated with cash, the benefits outperform the costs. The biggest benefit being, the firm saves on transaction costs as they have readily available cash in hand bringing economies of scale in cash management and also it can fund and immediate investment opportunities serving its precautionary motive.
Jensen's free cash flow theory predicts that firms with excess amount of cash holdings will increase their investment opportunities rather than returning that cash to shareholders, so there is an agency conflict that exists between management and shareholders regarding this issue. Managers have incentives to cause their firms to grow in size by undertaking maximum investment opportunities as it also means control over more resources. Not only this, but in terms of compensation we find that compensation of managers is usually positively related to growth in sales. This may lead managers to become selfish and forget the welfare of the shareholders.
The results reveal that growth opportunities, cash flows, liquid assets, leverage and bank debt are important in determining cash holdings. Firstly they say that as cash provides low cost of financing thus firms hold large amounts of cash. Due to the presence of asymmetric information between firms and external investors (Myers and Majluf, 1984), costly agency problems such as underinvestment and asset substitution (Myers, 1977; Jensen and Meckling, 1976); and transaction costs and other financial restrictions managers try to minimize the costs associated with external financing in imperfect capital markets may find it optimal to maintain sufficient internal financial flexibility.
From the empirical work by Ozkan, we investigate the role of ownership and control structure of firms in determining their cash holdings. We mainly focus on the association between ownership and cash holdings, and the nature of this relationship. Prior research points to the conflicts of interests between managers and shareholders which arise from the separation of ownership and control. On the one hand it is found that managers have incentives to hold cash to serve their own interest and also it is suggested that greater ownership by managers can align the interests of managers and shareholders. If large holdings of cash serve controlling shareholders' interests one would expect firms with controlling shareholders to have higher cash holdings. Also, it is possible that the incentive and the ability to monitor managers changes with the identity of controllers.
This, in turn, implies that the relationship between managerial ownership and cash holdings may depend on the identity of the firm's controlling shareholder. However, the results suggest that board composition and presence of ultimate controllers do not significantly affect cash holdings. But the identity of controllers and the divergence between control rights and cash flow rights seem to matter. Corporate governance has been the focal point in this paper that composition of board members and controlling shareholders and if they have an impact or not. The results indicate that it might be possible that the identity of shareholders could be a significant factor in controlling the managerial ownership over cash holdings and curbing managerial discretion but the composition of board members does not have a significant impact on such a decision. For example firms having families as main controllers tend to hold more cash than those firms having financial institutions as controllers.
The research paper "Do Persistent Large Cash Reserves Hinder Performance" done by Wayne H.Mikkelson and M. Megan Partch serves as the next very important piece of literature in this dissertation. The authors define financial conservatism in terms of high cash holdings. Firms which hold substantial amount of cash balances for a period of five years are defined as financially conservative.
High cash holdings are accompanied by greater investment, particularly R&D expenditures and by greater growth in assets. Such policies support investment without hindering performance. Large cash holdings reduce the disciplinary pressures exerted by debt on managers and managers spend this cash even if profitable investment opportunities are unavailable.
The characteristics of firms with large cash balances are generally consistent with the motives that enhance value. Managers with weaker incentives to maximize value tend to spend large holdings of cash inefficiently. The main objective of the paper is to examine whether large holdings of cash hinder a firms performance. Firms that hold more than 25% of their assets in cash and cash equivalents are defined as cash conservative.
The authors find that firms with substantial amount of cash holdings are better in operating performance than firms which have transitory large cash holdings. Persistent policies of large cash holdings do not hinder performance and do not represent conflicts of interest between managers and stockholders.
Finally and most importantly the empirical work by Iona, Leonida and Ozkan in their paper "Determinants of financial Conservatism: Evidence from low leverage and cash rich UK firms" focuses on those firms which follow persistent cash rich and low leverage policies at the same time. They found some significant results using the data from 1,196 non-financial UK firms and by using Logit/Probit model such as large firms which have an easy access to external finance debt are likely to be less leverage conservative. They also show that there is a positive relationship between low leverage policy and profit of the firms as well as positive with firms market to book ratio.
Chapter 3
Theoretical Framework
In this section I would describe the framework of the paper and any other theoretical explanation which might be useful for understanding the background and the purpose of this research.
3.1 High Cash holding
I would like to begin with the selection of cash variable and what were the criteria that helped us defining the cash variable and set up a binary variable for that. As discussed previously, different researchers have adopted different approaches to define the financial conservatism but the main variables discovered are cash holding or low leverage. We have used the criteria defined by Mikkelson and Partch that a firm could be defined as financially conservative if it holds more than 25 percent of its assets in cash and its equivalents for 5 years. From this, we have taken the criteria 25 percent cash holding for defining our binary variable. Though, we are not restricted to 5 year condition and have segregated our data in two panels, one is from year 1984-87 and other from year 1999-2002 and the firms which consistently hold more than 25 percent of their assets in cash and cash equivalent are taken for the purpose of analysis.
Let us discuss in brief all the benefits for which firms choose to hold more cash and are classified as cash conservative firms. The foremost benefit for holding cash is the saving on transactions cost, thus serving the transactionary motive. The second reason is the precautionary motive, as it is well known that for small firms the external funds could prove to be costly and due to lack of funds sometimes they might have to forego any good investment opportunities that might arise at the same time. Thus, in order o tap the opportunities at the right time it is feasible for the firms to hold substantial amount of cash ready. Results have also shown that capital market imperfections also lead firms to hold more cash than suggested by the capital structure and also smaller firms may have to face agency costs which can prove to be costly. Hence, maintaining enough liquidity helps facing any agency costs. Finally, it is discovered that managerial ownership is also one of the reasons why firms hold cash in their asset base.
3.2 Low Leverage Level
Similarly, we have derived the criteria for defining low leverage firms from the research paper by Minton and Wruck (2001), defining low leverage firms as those firms whose annual ratio of total debt to total assets belongs to the first 20 percent of all firms for the 5 consecutive years. From this, I have defined the binary variable for low leverage firms that those firms whose debt level is below 20 percent at any time follow the policy for low leverage. Similar to the above I have omitted the 5 year persistent policy and instead separated the data in two panels, one for years 1984-87 and another one for years 1999-02. Those firms which follow persistent low leverage policy for these years in a row can be classified as leverage conservative.
I would like to discuss here the benefits of low leverage policy which firms adopt and are classified as leverage conservative. The most important benefit of maintaining low leverage is the avoidance of cost of financial distress. As the cost of distress is felt more by the small firms it is beneficial if they maintain their level of debt to the minimum. Also, due to asymmetrical information prevalent in the capital market, such firms have to incur a very high agency cost. In order to prevent such a cost low debt policy should be maintained. Leverage also helps in curbing managerial discretion as it restricts them for raising more funds for investments that will suffice their selfish motive. Finally, the results show that firms with current growth opportunities should maintain a low level of leverage as existing debt could prevent them from raising additional funds from outside if required and the firms may lose on profitable opportunities. Also additional debt could prove to be very costly as well.
Since I have taken the data from year 1984-87 and 1999-2002 and compared the two, I would like to give the background of the UK economy at that time periods and how it had affected the firms at that time and if it had influenced the firms policies about conservatism or not.
We all are aware of the year 1987 crisis and its effect on the market. However; I have compiled a few facts about the UK economy at the time of the 87' crisis. In 1987, the US dollar was in a severe multiyear decline against other currencies but Bretons Woods Treaty saved it. The Fed shifted to a loose monetary policy in late 1987. The housing situation was also deteriorating in that time with the rising concern about potential recession and junk bonds were on a rise. When in 1987, the stock markets crashed there was a huge amount of uncertainty and fear even after recovery that lingered in the investment community. The next year turned out to be a good year with a total return of slightly more than 16% for the S&P 500. After the crash there were predictions about recession or depression Fed acted aggressively in 1987 and injected liquidity into the financial system and helped stabilizing the situation.
Now, business and financial service sector accounts for one third of the UK economy. After the crash in 1987 the financial community in the UK was also affected. The firms were affected adversely by the recession and lot of them could not pursue profitable opportunities due to market condition and a lot of them were under a heavy debt. This is one of the important reasons that could be attributable as to why firms followed high cash policy and also that of low leverage while taking capital structure decision. In such an economic scenario it was very important for the firms to be self sufficient and keep their obligations low as debt have been quite costly at that time to anyone. Small firms and poor performing firms are the ones which are affected the most in such a scenario as there is a money crunch already prevalent and they find it even more difficult and costly to raise cash from external sources and hence are forced to forgo any profitable opportunity that might arise during that time.
One of the main factor we have discussed as a reason for firms being financially conservative is Financial Distress. Conservatism also highly depends on the probability and vulnerability of a firm towards financial distress. Financial distress is a situation when a firm falls short of the money or funds flow and is not able to fulfill its commitment towards its creditors or other parties to whom the firm owes money. Financial distress holds some cost to the company referred to as Cost of financial distress and they are generally bankruptcy and transaction costs. Also, small firms are more likely to be vulnerable towards financial distress and follow conservatism policies as they do not have such an easy access to external funds in raising debt or equity and thus rely mainly on the internal funds and low leverage which they can healthily maintain.
Chapter 4
Empirical Framework
4.1Data and variable description
The data provided for the purpose of the research is the data on an unbalanced panel of 1,195 non-financial UK firms from year 1984 to 2002. The dataset includes data on various factors such as cash balance, leverage, market-to-book, size, profitability, dividend etc.
The description of variables used in the data and for the purpose of the research is as follows:
Cash2: This is the code for the cash variable. This represents the ratio of holdings of cash and cash equivalents to total assets in the firm. Cash holdings are the level of liquid assets held by the firm. This is one of the most important variables which was tested by the means of another binary variable for determining cash conservatism of the firms.
Lev2: This is the code for leverage variable. This represents the ratio of total debts to total assets by the firms. Leverage is the amount of debt holding by the firm. Low leverage is an indicator of the conservatism of the firm. Also, leverage helps in determining a number of results and interpretations about the firm, for example, leverage increases with size of the firms, a possible explanation is that larger firms are better diversified, and have a lower probability of being distressed. Lower expected bankruptcy costs enable them to take on more leverage.
Mtook: This is the variable for Market-to-Book value of the firm. Market to book value shows the value of the company by comparing the book value and the market value. Book value is calculated from the company's historical cost, or accounting value and market value is calculated from its market capitalization. The market to book ratio is generally included a s a proxy of the investment opportunities, we can find out this by replacing market to book with the future growth rate in assets in the level regression and check whether growth rate is negatively related with leverage. There are other potential reasons for such a result as well, such as the shares of firms in financial distress are discounted at a higher rate because distress risk is prized and included (as suggested by Fama and French (1992)).
Logass: This is the variable for the size of the firm. It represents the logarithm of total assets in constant prices. Size of the firm has proven to be a very important and significant factor in our empirical analysis and is negatively related with conservatism, that is, the bigger the firm the less conservative it is ought to be due to better fund raising opportunities and investment opportunities.
Profit2: This is the variable for the profitability of the firm and represents the ratio of earnings before interest and tax payments to total assets. It could be used as a proxy for the profitability of the firms and it used in our analysis.
Dividend: This is the variable for the dividend of the firms as suggested by name. It represents the ratio of dividend payments to total assets. It is used in our analysis to figure out if dividend payments have a relation with firms being cash or leverage conservative.
Now I would like to discuss the binary variables which I have chosen for the purpose of my research. I have chosen three variables in total. The first one is 'cash rich' which is the binary variable for firms that have 25% of their assets in cash and cash equivalents. It takes value 1 if it suffices the above condition and 0 if not.
Similarly, 'Low lev' is the binary variable which takes values as 1 and 0 respectively for the firms that have debt holding of less than 20%.
The third and the most important binary variable taken is 'CRLL' which uses results by combining the previous two variables, that is, it takes value 1 if the firm is both cash and leverage conservative and 0 otherwise.
4.2 Methodology
Our methodology consists of a series of steps. We have used binary variables and empirical results are calculated using the binary discrete choice Logit and Probit models. Firstly, the group of firms which are cash conservative are determined by placing the appropriate condition and use of binary dummy variable 'cash rich' in order to differentiate cash rich firms from the non cash rich ones. Similarly, leverage conservative firms are defined and determined using another binary dummy variable 'low lev' for the same purpose of differentiating leverage conservative firms from non conservative ones. Then, the firms which are both cash and leverage conservative are separated from the pool of data using another binary dummy variable 'crll' and which combines the above two conditions. We obtain three datasets defining cash rich firms, low leverage firms and firms following both policies jointly.
After determining the dummy variables for the three files, the data is now sort on the time basis. For the purpose of my research I have formed two panels, one from year 1984-1987 and the other one from year 1999-2002 in order to compare the results between the two time periods and what differences have occurred in the span of a decade. After forming the panels, it is of utmost importance that only those firms are selected which are consistently cash rich or leverage conservative for all the four years in both the panels. The rest of the firms are eliminated. This is important in order to maintain the consistency of the data so that results are not affected by exceptions as if any firm has a large value in some particular variable but only for two out of four years it can significantly affect the results without giving a true picture.
Thus, for this purpose data from only those firms would be used which are consistent in all the four years of both the panels in all the three datasets. After selecting and sorting the required firms from the pool of data, we will now test the dummies against the actual variables and which will help us prove the hypothesis in the research. Each set is tested using logit analysis with the other variables, for example the cash rich variable for cash rich firms are tested against market to book, leverage, size, profitability and dividends. Similarly, the leverage conservative firms are tested against cash, market to book, size, profitability and dividends the results are obtained.
For the purpose of statistical testing we are using the Logit and the Probit models. Logit and Probit models are used for binary choices as they explain a (0/1) dependent variable i.e. given a choice between the two if one will happen, other will not. For example, (y=1) or not (y=0). For this purpose Logit and Probit models are perfect as they represent discrete binary choices in estimations. They are generally estimated by the method of maximum likelihood. We can say that a different and more appropriate economic treatment is used which is more suitable for the purpose than the standard least squares regression technique. These models postulate some relation between nonlinear functions of the observed probabilities and unknown parameters of the model an attention is paid to economic interpretation of parameters.
The quantitative model used here is one with one variable kept as dependent and the factors affecting it as independent and then the estimated parameters are used to calculate the target level of Cash and leverage (dependent variables) for each firm in each year.
In order to check if the variables we have chosen are significant and relevant to the issue we have taken some help from the previously researched data and for the rest we have carried out a robustness check. For that purpose, the selected variables are tested against the chosen data for different time periods for all the three categorized firms. The results derived are consistent with our hypothesis and therefore the parameters I have chosen for the study are significant enough to serve our purpose.
We have derived the results by looking at the coefficient signs, the value of t-probabilities from the tests and the descriptive statistics results. Results from all the empirical and statistical analysis are discussed in the next chapter.
Chapter 5
Results
In this section, I will present the results from the empirical analysis and descriptive statistics derived. We have found out significant relationships among dummy and other variables used for the purpose of analysis.
Results for TABLE 1
The table 1(a) shows the result for the cash rich firms from 1984-87. This table shows the results of before the 87' stock market crisis occurred and we can see that the results from our variables are not significant. As we can see that this has happened before the crisis we can say that the firms were not concerned about the cash conservatism or any such policies. Also I have tested cash rich firms keeping as constant against variables such as low leverage, market-to-book, profitability, dividends and size of the firm and by looking at the coefficients the results derived are as follows-
There is a negative relation between the constant and the first variable that is low leverage indicating that the cash rich firms tend to have lower levels of debt. Market-to-book ratio can be used as a proxy for the availability of investment opportunities to a firm and it has a negative relationship with the constant, we can say that firms before recession were not concerned by this factor as it is insignificant as well. Also, there is a negative relationship with the size of the firm, indicating that the cash richer the firm is, lower is it size. In other words, a small firm would be more inclined towards holding cash balance rather than a big size firm as it is difficult for a small firm to raise external cash and it suffers with the problem of higher debt and agency costs. Larger firms are subject to less severe asymmetric information problems and greater access to capital markets leading to a lower level of optimal cash.
On the other hand, on comparing the results with Table 1(b) which gives us the result for the sample years 1999-2002 that is almost a decade later, we have found out some important results. It is to be noticed that in the long run, factors like leverage, market-to-book ratio and size tend to become significant. Also, one can notice that the coefficient of market-to-book variable is positive which means that firms with better investment opportunities tend to hold more cash. It is worth noting that even in the long run, after a decade; factors like profit and dividend are insignificant. Though by looking at the coefficients we can say that profitable firms are tend to be cash rich and the relation with dividend is unclear.
Table 1(c) is basically showing the results for cash rich firms with all the years taken into consideration,
Results for TABLE 2
This result can be seen as an analogy of the previous result where the cash rich firms are tested for whether they are also following low leverage and high market-to-book values as in this result we find again a positive relationship between the low leverage and cash rich and market-to-book variables, that is a firm following low leverage policy is also cash rich and has high investment opportunities. Also, size has a negative relationship indicating that smaller the firm higher are the chances of following low leverage policy and vice versa as the result came out to be of negative relationship. But the results are somewhat non synchronized when we include the profit factor. When profit is included the market to book variable becomes negative and when profit is excluded then market to book gives a positive result. This could be probably because of the reason that when profits are taken into picture then the firm will take profitable opportunities becomes obvious.
INSERT TABLE 3
Finally on combining both the cash rich and low leverage factor, we segregated the firms and then tested them against all the variables and this result proves our hypothesis and cash rich firms are low leverage firms with high market-to-book but the smaller the firm more conservative it is likely to be.
We can also conclude that there exists a positive relation between leverage and value for low growth firms (low market to book value as it is a proxy of this variable) and a negative relation between leverage and value for high growth firms.
A second reason for the market to book ratio to be negatively correlated with leverage stems from the tendency for firms to issue stock when their stock price is high relative to earnings.
Chapter 6
Summary and Conclusion
In the conclusion I would like to summarize all the main findings of my research. Firstly, the results clearly shows that there has been an increase in the number of firms which have been following cash conservatism policies low leverage policies and both of them jointly between the period 1984 and 2002. The number of cash rich firms has risen by 2.43%, similarly firms that maintain significantly low leverage have increased by 0.96% and the number of firms following both the policies has increased by 2.11%. This increase can be attributable to a number of reasons.
Firms could have become more cash and leverage conservative due to recession of 1987 and that is the reason we can see an increase in the number of firms that have chosen to become financially conservative. It would have been feasible to hold cash to meet any unexpected event or contingencies. Though the percentage suggests that there has been a rise in cash rich firms as compared to low leverage firms, if we look at the absolute value, the figures tell us a different result. The number of firms following low leverage policy is significantly higher than the firms following only cash rich policy. We can see such a trend for maintaining low leverage as debt is costlier and the cost of debt outperforms the benefits of higher cash holding in certain cases. For example, if a firm does not have enough cash and foregoes a profitable investment opportunity the loss would be much lesser than the condition of non fulfilling of debt contracts as we do not exactly lost what we didn't get.
Also, another major finding of this research is that on comparing the panel data for years 1984-87 and 1999-2002 we have discovered that the variables (for example cash, leverage, size and market to book) which are not significant in the previous years gradually became significant in a span of about a decade. We have observed this result in all the three categories of firms and thus, we believe our results to be true. Also, the result suggests that size of the firm and growth opportunities that a firm has are very significant and important factors in determining the firm's conservatism as these two variables are consistently significant. Small firms tend to hold more cash than large firms as they find difficulty in raising external cash and they need not forego profitable investment opportunities due to lack of funds. One of the major finding is that the coefficient of leverage is negative to the cash variable which implies that the more a firm is cash conservative, lesser is the leverage level. In other words, it means that the firms holding high cash holdings tend to hold less amount of debt.
Also we can see for the leverage conservative firms that the coefficient of cash is positive to the leverage variable which implies that the firms which are tend to be leverage conservative also ten to hold cash. We can conclude that firms following cash conservatism are also leverage conservative and vice versa. Also, there exists a correlation between the two policies (i.e. cash conservatism and low leverage) and we cannot draw conclusions solely on the basis of their individual analysis and hence need to study them jointly as well.
Chapter 7
References
