The Effect of Cash Reserves on Corporate Investment and Performance in Industry Downturns

1
The Effect of Cash Reserves on Corporate
Investment and Performance in Industry Downturns

• Jarrad Harford, Wayne Mikkelson and Megan Partch
• University of Washington and University of Oregon

2
Background and Motivation

• Tension between managers and shareholders over
  disposition of excess cash
• Shareholders worry about value-destroying
  decisions
• Managers claim the need for internal financing
  during a downturn

3
Background and Motivation

• Chrysler is bracing for a possible sharp
  recession by seeking to build up a 7.5 billion
  cash cushion.
• Chrysler nearly bled to death in each of the
  past three recessions. In the 1990-91 recession
  and succeeding weak years, it burned through 4.5
  billion, had its credit rating downgraded and was
  forced to resort to costly ways of raising cash.
  
• "The big issue for us -- the real leverage in our
  business -- is being able to maintain aggressive
  product spending in a downturn. That's where we
  do the most for our shareholders," WSJ, Oct
  1995

4
Background and Motivation

• Ford's Cash Position Speeds Toward Zero ---
  It's More Than a Crunch, It's a Crisis
• The share buybacks and the recapitalization plan
  were done in part to appease Wall Street, which
  until early this year was clamoring for Ford --
  and other cash-rich companies -- to return more
  money to shareholders.
• In the 20-20 view of hindsight, however, Ford
  management had good reason to hoard cash against
  hard times, because the hard times were under way
  even as the company was distributing its big
  bonus to shareholders in late 2000. WSJ, Nov
  2001

5
Background and Motivation

• Evidence concerning excess cash
• Blanchard, et al. (1994), Harford (1999),
  Mikkelson and Partch (2002)
• Evidence concerning financing frictions
• In general Fazzari, et al. (1988), Froot, et al.
  (1993), Opler, et al. (1999)
• Specific to industry conditions Shleifer and
  Vishny (1992), Pulvino (1998)

6
Hypotheses

• Financing Frictions
• Cash reserves enable firms with significant costs
  of external financing to finance profitable
  investment during and following a downturn
• Reduced Spending Discipline
• Profitable investment opportunities decline in an
  industry downturn. Cash reserves insulate
  managers from the spending discipline created by
  lower cash flow, potentially leading to
  overinvestment during the downturn.

7
Hypotheses

• Substitute Financing
• Sources of external financing closely substitute
  for internal funds. Firms with low cash reserves
  can finance profitable investment externally
  during and following an industry downturn.

8
Predictions

• Financing Frictions
• Firms with greater reserves will invest more
  during and following an industry downturn
• Investment by high cash firms is less sensitive
  to the revenue decline accompanying the downturn
• Firms with more cash undertake more profitable
  investments and subsequently experience better
  performance than their constrained rivals

9
Predictions

• Reduced Spending Discipline
• Assumptions Downturn is accompanied by reduced
  investment opportunities and managers incentives
  are not aligned with shareholders
• High cash firms will invest more and be less
  sensitive to the revenue decline
• Greater investment will be value-reducing and
  will damage future performance
• Managers with weakest incentives will invest the
  most

10
Predictions

• Substitute Financing
• Investment is insensitive to how much cash a firm
  has
• Therefore, post-downturn performance is also
  unrelated to cash holdings going into the
  downturn
• Cash-poor firms will rely more on external
  financing during and following the downturn

11
Sample

• Fama/French (1997) 48 Industry Groupings
  (1980-1998)
• An industry downturn occurs if
• 75 or more of the firms experienced a decrease
  in sales following 2 or more years of growth
• The median decline in sales growth was at least
  one standard deviation of the time-series of
  changes
• Median stock return is at least one std dev below
  average

12
Sample

• Result 8 Industries
• Apparel, Mining, Textiles (1985)
• Business supplies, Construction, Construction
  Materials, Machinery, Shipping Containers (1991)
• 642 total firms (ranging from 29 to 185 per
  industry)
• Control Sample 11 Randomly Selected
• No downturn.
• Event year is 1986 or 1996

13
Summary of Sample

• Clear overall contraction in sales, ROA and
  spending
• Firms in top two quintiles of cash spent down
  some of their reserves during and after the
  downturn.
• Firms with the most cash prior to the downturn
  were the only ones to see a full recovery in
  sales growth, ROA and spending
• No Evidence that external capital was readily
  available to substitute for cash reserves

14
Effect of Cash on Performance

• Firms with sufficient cash reserves spend more
• Greater spending and more cash lead to greater
  performance improvements
• For control firms, while firms with greater cash
  still spend more,
• greater cash leads to worse performance
• evidence on whether greater spending helps
  performance is mixed

15
Evidence from firms likely to be constrained

• Little evidence that spending is effected any
  differently than for other firms
• Some evidence that performance improvements are
  more significant for constrained firms with
  access to sufficient cash reserves

16
Conclusions

• Cash reserves enable firms to increase spending
  during and following a downturn
• Consistent with both Financing Frictions and
  Reduced Spending Discipline
• Spending in the presence of greater cash reserves
  during a downturn leads to greater improvements
  in operating performance
• Extra cash reserves are beneficial to firms
  during downturns

17
Future Work

• Some measure of market value implications of the
  cash reserves and subsequent spending
• Add corporate governance data to better examine
  the Reduced Spending Hypothesis
• Use SDC samples of MA and Divestiture activity
  to find out whos buying and whos selling during
  downturns