CASH HOLDINGS, DIVIDEND POLICY AND CORPORATE GOVERNANCE: A CROSS-COUNTRY ANALYSIS A quick review of the article by Lee Pinkowitz, Rohan Williamson, René M. Stulz, Journal Of Applied Corporate Finance, Winter 2007

Liquid Assets are a Double-edged Sword High levels of cash are often an indication of past success in generating profits. There is little uncertainty about the value of such assets. For smaller, riskier companies, cash acts as a buffer against adverse outcomes. For companies with abundant investment opportunities, cash is a low-cost means of funding.

Liquid Assets are a Double-edged Sword (ctd…) But excess cash can pose challenges for investors. For controlling shareholders, it is far easier to expropriate/divert/misuse cash than fixed assets. Moreover, there is a tendency on the part of corporate managers in mature companies to retain excess cash instead of paying it out to shareholders. This cash is then wasted on value reducing projects, such as diversification into unrelated areas.

Hypothesis 1: Cash is Valued at a Discount in Countries with Weak Investor Protection Companies with controlling shareholders in weak governance regimes will hold more than the value-maximizing level of cash. And such cash holdings are more vulnerable to future expropriation. So we would expect investors to anticipate this possibility by discounting the value of the cash.

Hypothesis 2: Dividends Are Valued More Highly In Countries With Weaker Investor Protection  In countries with limited investor protection, investors prefer dividends because of concerns about misuse of corporate cash. Companies that pay out a higher proportion of their earnings and cash flows should be worth more to minority shareholders. A dollar of dividends can be worth much more than a dollar to the shareholders because they expect the firm to keep paying that amount of dividends in the future.

Hypothesis 2: Dividends Are Valued More Highly In Countries With Weaker Investor Protection (ctd…) This result is at variance with the world of Miller and Modigliani. In the MM model, shareholders are not better off if the firm chooses to pay more dividends. For MM, a dollar held by the firm is the same as a dollar in the shareholders’ pockets.

The Market Value of Cash Holdings In countries with better investor protection, cash contributes significantly more to firm value. In countries with high levels of corruption, each additional dollar of cash holdings was associated with an increase in firm value of just $0.33. In contrast, in countries deemed to have the least corruption, the next dollar of cash appeared to be worth $0.91. A dollar of cash built up over the most recent year was associated with a change in firm value of $0.29 in countries with a low minority shareholder rights index and $0.95 in countries with a high value of the index.  

Conclusion Minority shareholders do assign a lower effective value to the cash holdings of companies in countries with weaker investor protection and greater probability of misuse by the controlling shareholders. Minority shareholders do put a premium value on dividends in countries with less investor protection. Companies that choose to borrow good governance practices from countries with better investor protection (say, by listing in those countries), have higher values than otherwise comparable firms.

Conclusion (ctd…) This “good governance” premium is inversely correlated with the protection enjoyed by minority investors. Tunneling, the practice of diverting valuable assets from the firm, is a widespread practice in countries with poor investor protection. There is a natural tendency on the part of corporate managers in mature companies to retain and then waste excess cash on low-return projects.

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