Conclusion
Existing empirical studies on cash holdings focus mainly on the effects of corporate cash reserves on firm value and firm performance (e.g., Mikkelson and Partch, 2003; Pinkowitz and Williamson, 2007; Brown and Peterson, 2011). In this paper, we assess the costs and the benefits of excess cash by investigating the link between excess cash and the liquidity risk faced by investors and their required liquidity premium. To this end, we propose and test two competing hypotheses. The investment opportunities hypothesis asserts that excess cash reduces the volatility in the value of assets-in-place and attracts more uninformed trading, which, in turn, reduces trading costs, increases trading continuity, and reduces liquidity risk. In contrast, the management entrenchment hypothesis suggests that managers hoard cash to pursue their own objectives at shareholder expense. The growing fear of expropriation renders firms with excess cash unattractive to uninformed traders. The reduced participation of these traders, in turn, increases the cost at which market makers provide liquidity services, reduces investors’ propensity to trade and increases liquidity risk. We examine a large sample of US stocks and find evidence consistent with the investment opportunities hypothesis. Specifically, we show that excess cash reduces incidents of no trading and reduces stock price vulnerability to shocks to market liquidity. As investors face reduced liquidity risk, they require a lower liquidity premium. In terms of economic significance, our analysis suggests that a one unit increase in excess cash is associated with a 0.06 decline in liquidity beta, which translates into an average reduction of 0.489 percentage points (or 5.366% relative the sample mean) per annum in the cost of equity capital. We also investigate the impact of excess cash holdings on firm value. We show that while the direct effect of excess cash on firm value is negative, its indirect effect through liquidity is positive. Specifically, we find that the value to the marginal dollar of excess cash held by illiquid firms is significantly higher than that held by more liquid firms.
