Valuation Effects of Corporate Cash Holdings: Evidence from Germany

Abstract

Cash holdings obviously play an important role in financial management of corporations: the largest firms in the world held 1.5 trillion USD in cash and marketable securities in 1998. Finance theory however has not dealt with this subject in detail until the mid 90's. Especially concerning the valuation effects of corporate cash holding empirical studies are very rare. Harford (1999) finds that cash-rich firm engage in value destroying acquisitions. Opler et al. (1999) report that firms use excess cash in order to finance operating losses. Mikkelson/Partch (2002) analyze firms with persitent large cash reserves but do not report significant effects on performance. We contribute to this literature in two ways: first, we adapt and refine the methodology of Mikkelson/Partch (2002) and do find a significant operating underperformance of German firms that previously held excess cash over a three-year period. This can be interpreted as evidence for agency based hypotheses stating that large excessive cash holdings represent stocks of free cash flow which may be invested inefficiently by managers. Second, we study direct valuation effects of corporate cash holdings by constructing excess enterprise values of firms using an adaptation of the Berger/Ofek (1995) valuation algorithm. Our results suggest that both positive and negative deviations from the industry median cash to sales ratio have a significant impact upon excess value. While lower than median cash to sales ratios yield lower excess values - thus at least in part supporting our joint version of the trade off hypothesis of corporate cash holdings - positive deviations have a positive impact upon excess values. So in an overall perspective our results fail to support our joint version of the trade off hypothesis.