Effectiveness of monitoring, managerial entrenchment, and corporate cash holdings

Abstract

We develop a dynamic model of a firm in which cash management is partially delegated to a self-interested manager. Shareholders trade off the cost of dismissing the manager with the cost of managerial discretion over the use of liquid funds. An improvement in corporate governance quality may have a positive or a negative effect on levels and values of cash balances, depending on the source of the improvement. While a reduction of managerial entrenchment results in lower cash balances and mostly higher marginal cash values, we demonstrate that the opposite is true when the monitoring of managerial actions becomes more effective. A managerial asset substitution problem produces a novel hump-shaped relation between the firm's liquidity levels and the collective propensity of shareholders and managers to reduce cash flow risk. We also discuss the firm's risk management strategies as well as derive implications of the presence of an investment opportunity, debt financing, and shareholder activism.