Creditor Control Rights and Firm Cash Holdings

Abstract

We examine firm’s cash holdings from the perspective of the agency cost of debt and find that firms with outstanding loans hold significantly less cash than firms without outstanding loans. This relationship is particularly stronger in financially constrained firms with higher hedging needs, suggesting that it the creditor control but not the voluntary reduction that leads to lower level of cash holdings because cash is more valuable to those firms. We show that creditors influence firms’ cash holdings by setting up stricter covenants in those with more excess cash especially when there is higher information opacity, financial constraints with higher hedging needs and higher agency cost of debt. Results also show that covenants are effective in reducing cash holdings. Lastly, we study how cash changes around covenant violation where creditors could exert direct influence on firms’ cash holding policies. We find that while cash increases in the firms that fail to meet financial performance covenants, those with managerial violations actually experience significant cash reductions.