۱- Introduction

۲- Related literature and hypothesis development

۳- Measurement of variables and model specification

۴- Data and summary statistics

۵- Empirical findings

۶- Conclusion

References

Abstract

This study investigates the impact of excess cash on the liquidity risk faced by investors and their required liquidity premium. It shows that excess cash improves trading continuity and reduces both liquidity risk and the cost of equity capital. These findings are consistent with the view that firms with excess cash attract more traders even when market liquidity dries up. The increase in investors’ trading propensity reduces stock price exposure to shocks to market liquidity and the liquidity premium required by investors. We also examine the impact of excess cash on firm value. We show that while the direct effect of excess cash on firm value is negative, its indirect effect through liquidity is significantly positive, indicating that investors are less likely to sanction (or even reward) illiquid firms for holding excess cash. Further analysis suggests that the liquidity benefits of excess cash are greater for financially constrained firms and firms with high growth opportunities. Our results are robust over time, after addressing endogeneity concerns, and to alternative estimation methods and alternative measures of liquidity.

Introduction

Cash reserves held by US firms have increased considerably in the last few decades. According to Huang et al. (2013), non-financial firms increased their holdings of cash and other liquid assets to a record $2 trillion in 2011. Early studies, such as Jensen and Meckling (1976), Jensen (1986), and Myers and Majluf (1984), have debated the potential costs and benefits of corporate cash holdings. Related studies by Opler et al. (1999) and Harford et al. (2008) have investigated the effect of various financial variables on the level of corporate cash reserves and identified size, book-to-market ratio, and past cash flows as the key determinants of corporate cash holdings. More recently, a number of papers have focused on whether investors sanction firms for hoarding cash in excess of the level predicted by firm characteristics (“excess cash”). However, the results of these studies have been relatively mixed. For example, Simutin (2010) documents a positive association between excess cash and stock returns, implying that investors view excess cash as a proxy for risky growth opportunities. Nevertheless, Asem and Alam (2014) show that the relationship between excess cash and stock returns depends on investors’ outlook for firm prospects and conclude that investors’ support for cash hoards is not ubiquitous. In this study, we assess investors’ perceptions of excess cash from a different perspective. Specifically, we investigate whether excess cash affects stock trading continuity and the liquidity risk faced by investors. Excess cash may affect stock trading continuity and liquidity risk in two ways. On the one hand, it is commonly argued that managers hoard cash to cushion shortfalls in future cash flows (e.g., Bates et al., 2009; Palazzo, 2012) or to finance growth (Simutin, 2010). Consistent with this prediction, Faulkender and Wang (2006) and Denis and Sibilkov (2009) show that cash holdings are more valuable for financially constrained firms with valuable growth opportunities.