Firm Structure & Corporate Cash Holdings

Abstract

We analyze whether organizational structure of firms (i.e., whether a firm is diversified or focused) affects corporate cash holdings. Focusing on organizational structure allows us to throw light on the non-governance related factors that affect cash holdings, which complements the recent spate of research on the impact of governance mechanisms on cash policy. There are several reasons why firm structure could affect cash holdings. We examine three hypotheses, the complementary growth, asset sales, and influence cost hypotheses. First, in diversified firms, since the time-series of investment opportunities for different segments may not be perfectly correlated, the total cash need for a diversified firm may be less volatile over time. If firms hold cash for potential growth needs, diversified firms would need less to meet the investment need at any one point in time. Additionally, if there is an active internal capital market within diversified firms, the cash flow of one segment is available as capital for another segment. This reduces the need of external capital thereby reducing a benefit of holding cash. Second, diversified firms are more likely than single-segment firms to be able to raise funds by selling substantial assets, especially assets of non-core segments. This reduces the benefits of cash holdings. Hence, firms with more than one segment should have lower levels of cash holdings. Finally, a particular type of agency problem, the influence costs, that arise from segment-managers' value-dissipating competition for firm-wide resources is more severe among diversified firms than single segment firms. Thus the marginal cost of holding cash and liquid assets, which generate these influence costs, are higher for diversified firms than for focused firms. Hence, we would expect diversified firms to hold less cash. All three hypotheses predict that diversified firms will have less cash holdings than their stand-alone counterparts. Using Compustat financial and segment data in the 1988-2002 period, we find evidence that diversified firms hold significantly less cash than their focused counterparts. This result holds even after industry adjustment at the segment level, and after controlling for the different factors found to be important determinants of corporate cashing holdings in the extant literature. Using time-series, cross-sectional, and additional robustness tests, we are able to attribute the lowered optimal cash holdings among diversified firms to the presence of internal capital markets, and the potential for asset sales among these firms.