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Motives for corporate cash holdings: the CEO optimism effect

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Abstract

We examine the chief executive officer (CEO) optimism effect on managerial motives for cash holdings and find that optimistic and non-optimistic managers have significantly dissimilar purposes for holding more cash. This is consistent with both theory and evidence that optimistic managers are reluctant to use external funds. Optimistic managers hoard cash for growth opportunities, use relatively more cash for capital expenditure and acquisitions, and save more cash in adverse conditions. By contrast, they hold fewer inventories and receivables and their precautionary demand for cash holdings is less than that of non-optimistic managers. In addition, we consider debt conservatism in our model and find no evidence that optimistic managers’ cash hoarding is related to their preference to use debt conservatively. We also document that optimistic managers hold more cash in bad times than non-optimistic managers do. Our work highlights the crucial role that CEO characteristics play in shaping corporate cash holding policy.

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Notes

  1. Other studies relate cash policy to different issues. For example, Almeida et al. (2004) examine the propensity to save cash out of cash flow for financially constrained firms. Faulkender and Wang (2006) examine the marginal value of an extra dollar to shareholders to show that the value of cash differs across firms. Pinkowitz et al. (2006) examine the value of cash across countries and find that the value of cash matters less than in countries with better investor protection. Acharya et al. (2007) document that the demand for liquidity (higher cash) by financially constrained firms is highly dependent on the level of hedging needs. Dittmar and Mahrt-Smith (2007) study that the shareholders of poorly and well-governed firms have dramatically different values of cash. Riddick and Whited (2009) study that firms save more out of cash flows when external financing is costly or when they have lumpy investment projects. Hill et al. (2014) show that firms with stronger political connections hold lower cash balances. Other studies investigate corporate cash holdings for specific targets, including those of Ozkan and Ozkan (2004) for the UK, Pinkowitz and Williamson (2001) for Japan, Ferreira and Vilela (2004) for European countries, and Drobetz and Grüninger (2007) for Switzerland.

  2. For instance, Campbell et al. (2011) use ExecuComp’s exercisable options data as the proxy for CEO optimism, which in their setting is closely related to the CEO overconfidence measure of Malmendier and Tate (2005a), who use a dataset combining stock ownership and a set of option packages provided by Brian Hall and David Yermack from Hall and Liebman (1998) and Yermack (1995).

  3. In general, external financing is more expensive than internal financing for firms, particularly for financially constrained firms. Biased managers are much more reluctant to use outside financing than rational managers, since they believe firm value is underestimated in the financial markets and the cost of external financing is thus overpriced. Malmendier and Tate (2005a) find that corporate investment decisions made by overconfident chief executive officers (CEOs) are substantially related to internal funds. Heaton (2002) builds a model to show that optimistic managers will decline positive NPV projects if they have to fund externally for these projects. Hackbarth (2008) shows theoretically that biased managers have higher debt levels than unbiased managers.

  4. The managers may become risk averse and hoard cash if they have a high ownership share. In that case, this measure may be less related to their level of optimism. However, our later findings show that the interaction term of managerial ownership percentage and CEO optimism is negative and significant, which means, ceteris paribus, that optimistic managers hold less cash than non-optimistic managers as their share ownership increases. This would seem to suggest that holding deep-in-the-money options is not reflecting the same managerial characteristics as holding many shares. Another possible weakness of the measure is that new CEOs might have different incentives to pursue higher cash balances if their options are way out of the money. However, the option-based optimism measure that we apply in our study considers the exercising status beyond the vesting period. This means that new CEOs are likely to be excluded. We also consider an alternative measure of optimism, based on firm investment levels, which we describe below. Our findings from either measure are consistent.

  5. In the study of the tradeoff between undiversified executives and their exercisable options by Hall and Murphy (2002), the authors find that risk-averse and undiversified executives (defined as those that hold more than 67 % of their wealth in company stock) hold in-the-money options less longer than relatively less risk-averse and less undiversified executives. That is, greater risk aversion and under-diversification lead the manager to exercise options early or immediately after the vesting period. From this we could reasonably infer that a manager who is risk-averse and undiversified can be considered to be optimistic if they persist in holding deep in-the-money options, since this would not be expected if they are risk averse and hold too many shares.

  6. All models include year and industry fixed effects and the results are robust to clustering standard errors by firm for heteroskedasticity and arbitrary serial correlation.

  7. Managerial ownership has been found to influence cash holdings in many countries, see, for example, Luo and Hachiya (2005) for Japan and Yu et al. (2015) for Taiwan.

  8. Han and Qiu (2007) and Riddick and Whited (2009) show that cash flow shocks do matter for corporate propensity for savings. There is a positive relation between a firm's income uncertainty and cash savings.

  9. The net working capital ratio in this paper is net of cash. Thus, a negative relation between the cash ratio and the net working capital ratio is expected in the regression analysis.

  10. Utility companies’ cash holdings may relate to regulatory supervision across many states. Financial companies have a number of main businesses involving inventories of marketable securities that are part of cash.

  11. The CEO optimism measure of Campbell et al. (2011) is also used by Malmendier et al. (2011) and Hirshleifer et al. (2012). Malmendier et al. (2011) use this measure alongside their own options-based measure and find consistent results after controlling for debt conservatism and market conditions. Hirshleifer et al. (2012) use this measure to study the relation between CEO optimism and investment in innovation.

  12. These definitions are inspired by the work of Campbell et al. (2011), who create measures of CEO optimism based on stock option holding. They classify high-optimistic managers as those who hold exercisable options that are more than 100 % in the money, in a given year. To be classified as high-optimistic in a given year, managers must have held options that are more than 100 % in the money for at least two of the years in the sample. In this paper, we focus on optimistic managers; thus we use the high-optimistic measure to define an optimistic manager. Their paper defines rational–optimistic managers who hold and/or exercise options with moneyness between 30 and 100 %. In addition, they define low-optimistic managers as those who exercise options that are <30 % in the money and do not hold options >30 % in the money. We group these latter two cases and define moneyness less than 100 % non-optimistic.

  13. The ExecuComp item identifiers are provided in parentheses.

  14. It is common for corporate finance studies to set missing R&D values to zero (e.g., Opler et al. 1999; Faulkender and Wang 2006; Dittmar and Mahrt-Smith 2007; Bates et al. 2009).

  15. One might be tempted to argue that high-Q optimistic firms should have lower cash holdings than low-Q optimistic firms as they can use more cash flows to finance future growth options. To examine this issue, we separate high-Q firms from low-Q firms within each group (optimistic and rational). The classification of Q ratios into high and low is based on its mean value. Appendix 2 shows the result that the mean cash holdings of the optimistic group with high Q ratios is higher than for the optimistic group with low Q ratios (p < 0.01). A similar result is found when we partition the sample by R&D, instead of Q.

  16. After matching the sample with ownership data and estimating the one-year lagged leverage, the effective period for our analysis is between 1993 and 2009.

  17. The starting and ending points of the bull and bear markets are based on the data of Cunado et al. (2008).

  18. We thank an anonymous referee for suggesting the use of the beta distribution. Examples of the development and application of the beta distribution in regression models include Kieschnick and McCullough (2003), Wagner (2001), and Berggren et al. (2014).

  19. Opler et al. (1999) find that cash holdings are positively related to low levels of managerial ownership (the low level of ownership is defined as a benchmark of 5 %). At high levels of ownership, cash holdings are negatively related to ownership.

  20. We also examined the model with year and industry fixed effects (with clustered by firm standard errors) with the addition of R&D fixed effects to control for the possibility that the relation between R&D, optimism and cash holdings is being driven by R&D intensive firms. The fixed effects partition the firms into five groups, zero R&D activity and four quartiles of positive R&D activity. We find that optimistic managers, even in low R&D intensive firms, have higher cash holdings for R&D than do non-optimistic managers.

  21. The absolute cash ratio change is defined as the absolute value of the current cash ratio minus the lagged cash ratio. Our data period for calculating the absolute cash change is between 1992 and 2010 and so the final sample period for this absolute-cash-change model is from 1993 to 2010.

  22. The variable Kink was developed by John Graham and is available until 2009. Our sample period for examining this specification therefore ends in 2009. We would like to thank John Graham for providing us with the Kink data.

  23. The Pearson-Spearman correlations table is available upon request.

  24. The industry-adjusted capital (acquisition; R&D) investment rate is defined as the capital (acquisition; R&D) investment rate minus the median of capital (acquisition; R&D) investment rates in the same industry. Capital expenditures are scaled by property, plant, and equipment; acquisition and R&D expenses are scaled by book assets.

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Acknowledgments

The authors thank Panayiotis Andreou, Jiyoon Lee, Christodoulos Louca, Lukas Roth, Lenos Trigeorgis, as well as the seminar participants at the 2013 Annual Meeting of the Academy of Behavioral Finance and Economics in Chicago, the 2013 European Finance Association Meeting in Cambridge, the 2012 British Accounting and Finance Association Annual Conference in Brighton, and the 2012 Multinational Financial Society Annual Conference in Krakow for discussions and helpful comments. We are also grateful to John Graham for providing the data on his kink measure of debt conservatism. This research reported herein was supported by a Leverhulme Trust Research Project Grant during 2010–2012.

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Authors and Affiliations

  1. Finance Group, Aston Business School, Aston University, Birmingham, B4 7ET, UK

    Winifred Huang-Meier & James M. Steeley

  2. Department of Commerce, Finance and Shipping, Cyprus University of Technology, 3603, Lemesos, Cyprus

    Neophytos Lambertides

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  1. Winifred Huang-Meier
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Correspondence to Winifred Huang-Meier.

Appendices

Appendix 1

See Table 9.

Table 9 Each variable utilized in the cash holdings model
Full size table

Appendix 2

See Table 10.

Table 10 Cash holdings by high/low Q and high/low R&D
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Appendix 3

See Table 11.

Table 11 Regressions of cash holdings on CEO optimism: debt conservatism effect test
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Huang-Meier, W., Lambertides, N. & Steeley, J.M. Motives for corporate cash holdings: the CEO optimism effect. Rev Quant Finan Acc 47, 699–732 (2016). https://doi.org/10.1007/s11156-015-0517-1

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