۱- Introduction

۲- Literature review and hypothesis development

۳- Research design

۴- Empirical results

۵- Additional analysis

۶- Conclusion

References

Abstract

This study examines whether the managerial ability of a chief executive officer (CEO) is associated with a marginal value of cash. We predict that more talented CEOs make better use of cash, creating the marginal value of cash. Using the managerial ability measures of Demerjian et al. (2012) and the cash value model developed by Faulkender and Wang (2006), we find that CEO managerial ability significantly increases the marginal value of cash. We also find that the effect of managerial ability on the marginal value of cash is generally greater for financially constrained firms. We further show that that the positive impact of managerial ability on the marginal value of cash is more evident for firms with higher levels of free cash flows and lower management entrenchment. Overall, our findings suggest that the market places a higher value on cash if the cash is managed by more able CEOs, which is consistent with the view that shareholders consider the ability of a CEO when they evaluate cash.

Introduction

In this study, we examine whether a firm’s marginal value of cash can be attributed to the firm’s CEO’s managerial ability. This study is motivated by the following. Cash is an important source of internal capital that is under the control of CEOs. That is, decisions about how to deploy cash are at the managers’ discretion (Liu & Mauer, 2011). A firm’s survival generally depends upon how effectively the firm manages its cash. Consistent with this view, a stream of research (e.g., Fazzari, Hubbard, & Petersen, 1988; Jensen, 1986; Pinkowitz & Williamson, 2004) shows that the value of cash depends on its availability and on how CEOs use it. In particular, Jensen (1986) argues that the individual characteristics of CEOs, such as personal interests and incentives, affect utilization of cash because available cash is under CEOs’ control. He also claims that managers may abuse their managerial discretion over the use of cash to pursue their own interests when the firm has a high level of cash. In particular, existing theoretical studies (e.g., Faulkender & Wang, 2006; Jensen, 1986; Myers & Majluf, 1984) suggest that a dollar of cash held by a firm may be valued at more than a dollar by its shareholders. For instance, Faulkender and Wang (2006) show that the marginal value of cash declines as cash reserves increase. Overall, prior evidence suggests that the marginal value of cash can be significantly influenced by CEOs’ ability. It is therefore critical for shareholders and investors to investigate how effectively managers utilize cash to maximize the marginal value of cash. Nonetheless, there is little research on the association between the marginal value of cash and managerial ability. Numerous studies (e.g., Baik, Farber, & Lee, 2011; Banker, Darrough, Huang, & Plehn-Dujowich, 2013; Carter, Franco, & Tuna, 2010; Chang, Dasgupta, & Hilary, 2010; Goodman, Neamtiu, Shroff, & White, 2013; Harris & Holmstrom, 1982; Jian & Lee, 2011; Rajgopal, Shevlin, & Zamora, 2006; Trueman, 1986) report that more able CEOs better manage a firm’s business operations, thereby enhancing the firm’s performance. In their theoretical work, Harris and Holmstrom (1982) argue that firms observe and assess a manager’s ability and the manager’s output over time and that a more experienced and high-ability manager’s productivity is perceived to be high. Recently, Demerjian, Lev, and McVay (2012) show that more able CEOs are expected to deliver a higher marginal outcome from the same level of resources, thereby enhancing the value of the firm. Accordingly, the marginal value of $1 of cash may not be valued at $1 by investors for various reasons, including managerial ability if high-quality CEOs generate a higher rate of output from given inputs than lower-quality CEOs (Demerjian et al., 2012). Thus, we argue that the marginal value of cash is impacted by management talents and should be higher than $1 if the cash is managed by more able managers.