SMEs’ capital structure behavior on cash holdings to Korean financial crisis: The evidence from emerging market

Abstract

This paper explores the leverage impact on corporate cash holdings using SME data listed in the emerging Korean KOSPI market between 1980 and 2008. It is well known that SMEs are characterized by relatively high asymmetric information and agency cost. We focus on the relationship between cash holdings and leverage. We hypothesize that the impact of leverage on cash holdings is likely to be non-monotonic for listed Korean SMEs, as asserted by Guney et al. (2007). As firms’ leverage acts as a proxy for their ability to issue debt, we would expect to see a negative relation as a substitution effect between leverage and cash holdings. However, we might also expect firms to save larger cash levels as their leverage increases in order to minimize their risk of experiencing financial distress, costly bankruptcies, and the threat of default. Thus, we would expect to see a positive relation as a precautionary effect between leverage and cash holdings. We did not find this relationship during an analysis of a full period; we found only a substitution effect during the Korean financial crisis, whereas we found both the substitution and precautionary effects after the Korean financial crisis. Our findings provide robust support for the view that a significant non-monotonic relationship between leverage and cash holdings emerged only after the Korean financial crisis. It is clear, therefore, that SMEs tend to have a significant precautionary motivation for saving cash after suffering a financial shock. We make several discoveries by applying the Partial Adjustment Model (PAD) to market frictions such as adjustment and transaction costs. This application produces similar conclusions regarding the relationship between leverage and cash holdings. However, we can distinguish the results of the dynamic cash model from those of the static model as we analyze the relationship between cash holdings and size variable. This finding about SMEs suggests that, while large firms hold lower levels of cash, there may be other factors affecting the way in which the size of a firm exerted influence on the financial policy of its cash holding after the Korean financial crisis. Key words: Cash holdings, leverage, asymmetric information, agency cost, substitution effect, precautionary effect.