Poor Corporate Governance Reduces the Value of Excess Cash
The market value of excess cash reserves can shrink by up to one-half when companies are poorly governed, Ross School study shows.
ANN ARBOR, Mich.—Poor corporate governance usually leads to shoddy stock performance, but it also can hurt firm value by hindering how companies use extra cash, according to a University of Michigan business professor.
The market value of excess cash reserves is reduced by up to one-half when firms are poorly governed, says Amy Dittmar, assistant professor of finance at U-M's Stephen M. Ross School of Business.
In their study on the impact of corporate governance on firm value, Dittmar and colleague Jan Mahrt-Smith of the University of Toronto examined how managerial entrenchment and lack of shareholder oversight influence both the value and use of cash resources. Their sample consisted of nearly 2,000 publicly traded U.S. firms from 1990 to 2003.
The researchers found that companies with poor corporate governance dissipate excess cash more quickly than those with good governance and that poorly governed firms invest excess cash reserves in assets with low accounting returns.
"This negative impact of excess cash investment on operating performance is cancelled out if the firm is well governed," Dittmar said. "While much research examines the effect of corporate governance on overall firm value, our results clearly demonstrate a direct mechanism by which governance works. Through its impact on the use of liquid firm assets, good governance dramatically affects both firm value and behavior in magnitudes that are economically important."
Dittmar and Mahrt-Smith say they examined cash reserves because they are easily accessible with little scrutiny and much of their use is discretionary, firms hold sizeable and increasing amounts of cash reserves and their value represents a significant portion of all corporate wealth, and there is substantial variation in firm-level cash holdings over time.
According to the researchers, cash and marketable securities comprised more than 12 percent of total assets for the median publicly traded U.S. firm in 2003. The aggregate cash held by U.S. firms that year represented about 10 percent of annual U.S. Gross Domestic Product.
On average, firms hold 23 percent of sales in cash, although the median firm holds 5 percent of sales in cash. Moreover, since 1990, median cash holdings have increased from 4 percent to 11 percent.
Using block ownership to measure governance, the researchers found that the value of a dollar of cash is $0.87 in a poorly governed firm, but $1.23 in a well-governed firm. Using management entrenchment due to anti-takeover provisions as a governance proxy, the value of a dollar is $0.38 in a poorly governed firm, but $1.54 in a well-governed firm.
"Our findings indicate that even though there are value-enhancing benefits to holding cash, these benefits are eroded if a firm is not well-governed," Dittmar said. "In other words, if left unchecked, a dollar of cash is worth much less than a dollar."
Overall, the researchers say their evidence shows that when poorly governed firms dissipate cash, they experience a decline in operating performance, but the same is not true for well-governed firms.
"These results provide insight into how good governance improves the value of cash resources and show that well-governed firms have their excess resources better fenced in and thus do not waste excess cash on poor-return, value-reducing investments."
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