The Three Theoretial Models Of Corporate Cash Holdings Decisions

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Corporate finance researchers suggest three theoretical models that can help identify which firm characteristics determine corporate cash holdings decisions. Thus, the corporate cash holding determinants have since been a subject of explanation in the framework of: the trade-off theory, financial hierarchy theory and free cash flow theory.
2.1.1 Trade-Off Theory
The literature on trade-off model about cash explicitly applied to companies is usually traced back to Tobin (1956), and Miller and Orr (1966). According to the trade-off theory, firms set their optimal cash levels by comparing marginal benefits against marginal costs of holding cash (Opler et al., 1999; Ferreira & Vilela, 2004; Afza and Adnan, 2007). As such, the cash holdings are
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This model presents a different way of looking at investment decisions by considering how the investment is financed. The financial hierarchy theory asserts that to minimize asymmetric information costs and other financing costs, firms should finance investments first with retained earnings, then with safe debt and risky debt, and finally with equity (Myers & Majluf, 1984). This theory suggests that firms do not have target cash levels, but cash is used as a buffer between retained earnings and investment needs. Thus, the motive for holding cash is to avoid external financing. Consequently, when retained earnings are inadequate to finance new investments, firms use their cash holdings and then issue new debt and finally when they get out of their debt servicing capacity they will issue securities. As such, the cash level would just be the result of the financing and investment decisions, and therefore debt and cash are viewed as opposite sides of the same coin (Dittmar et al., 2003; Saddour, 2006). Thus, when resources are adequate and surpass the amount required for investments, the firm will pay dividends, pay debt when it becomes due, and will otherwise accumulate cash (Opler et al., 1999; Dittmar et al., 2003). Accordingly, cash holdings follow an inverse pattern over time, that is cash decreases when investments exceed retained earnings, …show more content…
This theory deals with the relationship of the investors (who delegate authority) and the managers (agents) who have to perform the duties delegated to them. Jensen (1986) contends that managers have an incentive to build up cash to increase the amount of assets under their control and to gain discretionary power over the firm investment decision. The availability of cash therefore, permits management to make investments that the financial markets would not be willing to finance. Furthermore, Fama and Jensen (1983) proclaim that managers are risk averse and are not fully diversified and therefore more entrenched managers hold surplus cash to avoid market discipline. Ferreira and Vilela (2004) are of the opinion that cash reduces the pressure to perform well and allows managers to invest in projects that best suit their own interests, but may not be in the shareholders’ best interest. Accordingly, corporate cash holdings are viewed as free cash flows since they can be used by managers to serve their own interests at the expense of shareholders’, thus escalating the conflicts of interest between the two parties (Jensen, 1986; Harford, 1999). Nevertheless, a firm’s cash-holding policy is a subject of managerial discretion, and therefore the level of cash holdings raises concerns when managers do not act in the best interests of shareholders. Therefore, cash holdings are considered as risk-free investments and hence a

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