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Parent-subsidiary investment layers and the value of corporate cash holdings

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Abstract

Our study investigates whether agency costs arising from organizational structure in terms of the number of investment layers which connect the parent firm and its lowest-tiered subsidiaries within the corporate pyramid are associated with the value of cash holdings. Using a sample of Taiwanese publicly traded firms, we find that a change of a dollar in cash holdings is associated with less than a dollar change in market value. In line with our expectation, we find that the marginal value of cash decreases with the number of investment layers, supporting the agency theory of excess cash holdings. We also find that the negative association between the number of layers and the value of cash holdings is stronger for firms with high deviation between cash flow and voting rights and for family-controlled firms.

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Notes

  1. Figure 1 maps the organizational structure of Asus Corp., a famous multinational corporation in Taiwan, based on “Quanxi Business Operation Report,” Asus Corp.’s 2009 annual report, as follows: ASUS Corp. (TW), at layer zero, the top of the investment structure, indirectly controls the lowest-tier firm, Tubesonic Technology Ltd. (China), at layer six through Pegatron Co. (layer one), HuaWei Investing Corp. (layer two), Kinsus Interconnect Technology Corp. (layer three), Kinsus Holding (Samoa) (layer four), and Kinsus Holding Ltd. (Cayman) (layer five). Thus, the number of investment layers for Asus Corp is six.

  2. Kusnadi (2011) uses a sample of firms listed in Malaysia and Singapore and finds that pyramid firms with a single leadership structure (i.e. the CEO and the Chairman of the Board are the same person) hold more cash than those with more effective governance, consistent with the notion that entrenched managers of pyramid firms have more discretion to hoard cash reserves. However, Kusnadi (2011) uses only an indicator variable to capture the pyramidal structure of ultimate family controllers. They do not include detailed features such as the number of investment layers and the deviation between cash flow rights and voting rights.

  3. For firms with multiple chains in investment structures, we focus on the longest chain, i.e., the chain with the largest number of intermediate layers. All pyramidal firms can be handled in the same manner and processed using the TEJ database.

  4. However, we are not able to rule out the possibility that the value of cash holdings may increase along with the number of investment layers for the following reason. A firm with a large number of investment layers has higher agency costs, which can make it difficult for external funding providers to assess and monitor its operations. Consistent with this argument, Hsu et al. (2015) find that the number of investment layers for FDI (foreign direct investment) in China increases agency costs, which reduces creditors’ willingness to provide capital. Chan and Hsu (2013) directly document a positive association between the number of investment layers and the cost of debt. Myers and Majluf (1984) argue that external finance is costly and cash provides a safe buffer. Corporate cash holdings enable firms to make additional investments without raising external capital, helping companies avoid high financing costs. Thus, as external finance tends to be more expensive for pyramid firms due to their organizational complexity, each additional dollar of cash holdings by such firms may have a higher value.

  5. To calculate the benchmark portfolio’s value-weighted return, we use 25 Fama and French (1993) portfolios based on size and book-to-market. In particular, for each fiscal year, we assign each firm into one of 25 portfolios based on its size and book-to-market ratio.The benchmark portfolios are designed to offset the expected return component of stock i due to its size and book-to-market ratio at the beginning of the fiscal year. As noted in Dittmar and Mahrt-Smith (2007), specification of the returns in excess of the benchmark portfolio controls for risk and discount rate, which may affect both cash holdings and stock returns other than cash holdings and their interaction.

  6. Following some other studies, such as Pinkowitz et al. (2006), we also use Fama and French’s (1998) valuation regression as a robustness check, where the market value of the firm is regressed on cash holdings, the variables of interest, and a set of control variables. The inferences from the untabulated results do not change.

  7. Instead of using cash and cash equivalents to measure a firm’s cash holdings, we also include marketable securities as cash holdings, as do Faulkender and Wang (2006), because marketable securities can also be converted to cash easily; the results are qualitatively the same.

  8. For U.S. studies, the G-index of Gompers et al. (2003) is usually used to proxy for governance; it is constructed using the U.S. database, Investor Responsibility Research Center (IRRC). IRRC tracks 28 distinct corporate governance provisions, including four provisions that intend to delay hostile takeover bidders, six provisions that protect directors and officers from legal liability and job termination, six provisions that deal with shareholder voting rights, six provisions that address state takeover laws, and six provisions that are related to other takeover defenses. For every firm, Gompers et al. (2003) add one point for every provision that reduces shareholder rights and construct a "Governance Index" as a proxy for the balance of power between shareholders and managers. However, in Taiwan, merger and acquisition is not so common and shareholder activism does not rise as much as in the U.S. Following Gul et al. (2017), we construct an index that adds one point for each governance feature that protects shareholder rights as a proxy for the strength of corporate governance. We believe this index better fits the Taiwan business environment.

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Authors and Affiliations

  1. National Taiwan University, Taipei, Taiwan

    Audrey Wenhsin Hsu & Sophia Hsintsai Liu

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  1. Audrey Wenhsin Hsu
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Correspondence to Audrey Wenhsin Hsu.

Appendix

Appendix

Variable definitions

(1) Variables of interests

LAYER

The number of investment layers of the longest investment chain in a firm’s investment structure

DLARGE

An indicator which equals 1 if the number of layers is equal to or greater than 3 and 0 otherwise

DEV

An indicator variable which equals one if the parent firm has any subsidiary within the investment structure with ownership of less than 50% and zero otherwise

FF

An indicator variable which equals one when the family members either hold the position of CEO or chairman of the board of directors, have more than 50% of the directorship, or hold more control rights than what it is necessary to maintain control over the company, and zero otherwise

LEGAL

The legal environment score given by La Porta et al. (2000) for the country where the subsidiary is located

(2) Variables used for propensity score matching procedure

SIZE

The natural logarithm of total net assets in year t, where net assets is total assets minus cash assets

MB

The ratio of the book value of debt plus the market value of equity scaled by total assets

BLEV

The ratio of total debts to total assets, where total debts consist of short-term debts and long-term debts

CAPEX

The ratio of the capital expenditure for firm i at time t (cash outflows or the funds used for additions to the company’s property, plant and equipment, excluding amounts arising from acquisitions, reported in the Statement of Cash Flows) to net assets

INVESTEE

The natural logarithm of the number of investees

TAXH

The natural logarithm of the number of investees in tax havens, based on the list of tax havens in Dyreng and Lindsey (2009)

DUALITY

An indicator variable that equals one if the CEO also serves as chairman of the board and zero otherwise

INSIDEB

Director ownership

INSIDEM

Management ownership

INST

The percentage of common stocks held by institutional investors

FOREIGN_INST

The percentage of common stocks held by foreign institutional investors

INDE

The proportion of independent directors

PLEDGE

The percentage of equity shares used by blockholders as a pledge for financing

BSIZE

The natural logarithm of the number of directors sitting on the board

(3) Variables used in the cash valuation model of Faulkender and Wang ( 2006 )

ABNORMAL_RET

Abnormal stock returns, measured as the stock returns for firm i over fiscal year t minus the annual returns of a benchmark portfolio based on Fama and French’s 25 size-book-to-market portfolio classifications for each year

M i, t− 1

The market value of firm i at time t − 1

CASH

Cash holdings of firm i at time t

EARN

Earnings before interest and taxes of firm i at time t

NetAssets

The net assets of firm i at time t, calculated by total assets minus cash

RD

Research and development expenditures of firm i at time t, set to zero if it is missing

INTEREST

Interest expense of firm i at time t

DIVIDEND

The total amount of dividends (other than stock dividends) declared on the common stocks of firm i at time t

NF

Net financing, the funds received from equity issuance minus repurchases plus funds received from debt issuance minus debt redemption, i.e., sale of common and preferred stock (on statement of cash flows) + sale of common stock to employees (on statement of cash flows) − stock repurchase (on statement of cash flows) + long-term debt issuance (on statement of cash flows) − long-term debt reduction (on the statement of cash flows)

CASH i, t− 1

Cash holdings of firm i at time t − 1

MLEV

Market leverage for firm i at time t, calculated as total debt divided by total debt plus market value of equity

(4) Other variables

DUALITYD

An indicator which equals 1 if the CEO and the chairman of the board are not the same individual and 0 otherwise

BSIZED

An indicator which equals 1 for firms with board size more than the sample median and 0 otherwise

INDED

An indicator which equals 1 for firms for which the proportion of independent directors on the board is greater than the sample median and 0 otherwise

INSTD

An indicator which equals 1 for firms for which the proportion of institutional ownership is greater than the sample median and 0 otherwise

FOREIGN_INSTD

An indicator which equals 1 for firms in which the proportion of foreign institutions is greater than the sample median and 0 otherwise

PLEDGED

An indicator which equals 1 for firms whose percentage of equity shares used by the directors as a pledge for financing is smaller than the sample median and 0 otherwise

GOV

The six dichotomized variables added, ranging from 0 to 6, that capture the strength of the firm’s overall governance environment

Portfolio_Adjusted_∆CASH

The realized change in cash holdings minus the average change in cash holdings in the corresponding benchmark portfolio over the same period to measure the unexpected change in cash holdings

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Hsu, A.W., Liu, S.H. Parent-subsidiary investment layers and the value of corporate cash holdings. Rev Quant Finan Acc 51, 651–681 (2018). https://doi.org/10.1007/s11156-017-0684-3

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