[GMM] Corporate Cash Holdings- An Empirical Investigation of UK Companies

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Journal of Banking & Finance 28 (2004) 2103–2134

Corporate cash holdings:An empirical investigation of UK companies

Aydin Ozkan a,*, Neslihan Ozkan b

a Department of Economics and Related Studies, University of York, Heslington, York Y010 5DD, UKb Department of Economics, University of Bristol, Bristol BS8 1TN, UK

Received 4 May 2001; accepted 8 August 2003

Available online 18 December 2003

Abstract

This paper investigates the empirical determinants of corporate cash holdings for a sample

of UK firms. We focus on the importance of managerial ownership among other corporate

governance characteristics including board structure and ultimate controllers of companies.

We present evidence of a significant non-monotonic relation between managerial ownership

and cash holdings. In addition, we observe that the way in which managerial ownership exerts

influence on cash holdings does not change with board composition and, in general, the pres-

ence of ultimate controllers. The results reveal that firms’ growth opportunities, cash flows,

liquid assets, leverage and bank debt are important in determining cash holdings. Our analysis

also suggests that firm heterogeneity and endogeneity are crucial in analysing the cash struc-

ture of firms.

� 2003 Elsevier B.V. All rights reserved.

JEL classification: G3; G32

Keywords: Cash holdings; Ownership structure; Firm heterogeneity; Panel data

1. Introduction

Why do firms hold large amounts of cash and cash equivalents? Various explana-

tions have been offered for the incentives of firms to hold cash. A popular explana-

tion is that cash provides low cost financing for firms. According to this view, raising

external finance costs more in the presence of asymmetric information between firms

*Corresponding author. Tel.: +44-1904-434672; fax: +44-1904-433759.

E-mail address: [email protected] (A. Ozkan).

0378-4266/$ - see front matter � 2003 Elsevier B.V. All rights reserved.

doi:10.1016/j.jbankfin.2003.08.003

mail to: [email protected]

2104 A. Ozkan, N. Ozkan / Journal of Banking & Finance 28 (2004) 2103–2134

and external investors (Myers and Majluf, 1984); costly agency problems such as

underinvestment and asset substitution (Myers, 1977; Jensen and Meckling, 1976);

and transaction costs and other financial restrictions. Therefore, managers trying

to minimize the costs associated with external financing in imperfect capital markets

may find it optimal to maintain sufficient internal financial flexibility. However, thereare also potential adverse effects of cash holdings. Central to this view is the argu-

ment that agency conflicts existing between shareholders and managers can be most

severe when firms have large free cash flows (Jensen, 1986). Managers can pursue

their own interests at the expense of shareholders and cash serves the interests of

managers more than those of shareholders in this respect.

The investigation of cash holdings of firms has recently gained a great deal of

attention in the empirical literature. An important strand of this literature focuses

on the determinants of corporate cash holdings. 1 For example, Kim et al. (1998)analysed the determinants of cash holdings for a sample of US companies. They re-

port that firms facing higher costs of external financing, having more volatile earn-

ings, and those firms with relatively lower returns on assets hold significantly larger

liquid assets. For similar firms, Opler et al. (1999) provide evidence that small firms

and firms with strong growth opportunities and riskier cash flows hold larger

amounts of cash. More recently, Pinkowitz and Williamson (2001) examine the cash

holdings of firms from the United States, Germany, and Japan. In addition to the

findings similar to those in Opler et al. (1999), they document that the monopolypower of banks has a significant impact on cash balance. 2

In this paper, we examine the empirical determinants of cash holdings for a sam-

ple of UK firms over the period 1984–1999. The UK is often described as being

similar to other Anglo-Saxon countries with respect to ownership structures of com-

panies and institutional and legal framework. There are, however, distinct corporate

governance features in the UK, which, we believe, may have important implications

with regard to the cash holding behaviour of firms. For example, as we discuss in

Section 3, the UK corporate sector is characterised by insufficient external marketdiscipline and the lack of efficient monitoring by financial institutions and company

boards. This, in turn, can provide managers with greater freedom to pursue their

own interests that may include holding higher cash balances.

Our paper contributes to the literature on cash holding decisions of firms on several

grounds. First, we investigate the role of ownership and control structure of firms in

determining their cash holdings. We mainly focus on the association between mana-

gerial ownership and cash holdings, and the nature of this relationship. Prior research

points to the conflicts of interest between managers and shareholders arising from theseparation of ownership and control. For example, managers may have incentives to

hold large cash balances, which enable them to pursue their own objectives at the ex-

1 The other important strand of this literature examines the relationship between cash holdings and

corporate performance (see, for example, Blanchard et al., 1994; Harford, 1999; Mikkelson and Partch,

2003).2 Other related studies, examining the determinants of corporate cash holdings for the US firms, include

Almeida et al. (2002) and Dittmar et al. (in press).

A. Ozkan, N. Ozkan / Journal of Banking & Finance 28 (2004) 2103–2134 2105

pense of those of shareholders, i.e. squandering funds by consuming perquisites or

making inefficient investment decisions (Jensen, 1986). It is, however, suggested that

greater ownership by managers can align the interests of managers and shareholders.

Therefore, one would expect a negative relationship between managerial ownership

and cash holdings (i.e. the incentive alignment effect). However, it is argued thatthe impact of managerial ownership is likely to be non-monotonic. As managerial

ownership continues to increase, the ability of the outside shareholders to monitor

and influence managers declines, possibly leading to a greater degree of managerial

control and entrenchment of managers (see Morck et al., 1988; McConnell and Ser-

vaes, 1990). Consequently, managers may choose to hold more cash to pursue private

benefits and hence the relationship between cash holdings and managerial ownership

can become positive at higher levels of managerial ownership (i.e. the entrenchment

effect). We test these hypotheses using a non-linear model of cash holdings.In addition, we investigate whether board structure of companies, the presence

and the identity of controlling shareholders, and the divergence between largest

shareholders’ control rights and cash-flow rights have any impact on cash holdings

and the incentives of managers to hold cash. For example, we argue that the presence

of a controlling shareholder may affect cash holding decisions of firms. If large hold-

ings of cash serve controlling shareholders’ interests one would expect firms with

controlling shareholders to have higher cash holdings. Also, it is possible that the

incentive and the ability to monitor managers changes with the identity of control-lers. This, in turn, implies that the relationship between managerial ownership and

cash holdings may depend on the identity of the firm’s controlling shareholder.

Second, distinct from previous empirical studies, we explicitly consider the endo-

geneity problem in the empirical analysis of cash holdings. We believe that the end-

ogeneity issue in this context is important for several reasons. First, it is highly likely

that observable as well as unobservable shocks affecting cash holdings of firms can

also affect some of the firm-specific characteristics such as leverage and market-

to-book ratios. Second, it is possible that observed relations between cash and its po-tential determinants reflect the effects of cash on the latter rather than vice versa. To

control for the endogeneity problem, we employ an average cross-sectional analysis

and a panel data analysis combined with the Generalised Method of Moments

estimation procedure.

Our last contribution lies in the dynamic analysis of the cash holding decision. We

incorporate the view that market imperfections such as adjustment and transaction

costs may prevent firms from rapidly adapting to new circumstances. We utilise a

partial target-adjustment model that allows for the possibility of delays in responseof firms in adjusting their cash holdings. We are not the first to investigate this issue.

Opler et al. (1999), for example, estimate a target-adjustment model relating firms’

actual cash holdings to their target cash holdings, providing evidence that firms have

target cash levels. However, distinct from their analysis, in estimating the target-

adjustment model, we also incorporate unobservable fixed effects and time effects

as well as the firm-specific factors. This is because, to the extent that these effects

are significant in the underlying target cash model and not controlled for, estimated

coefficients of the target-adjustment model will be biased.


Our analysis reveals that managerial ownership plays an important role in deter-

mining corporate cash holdings in the UK. Moreover, we provide evidence that the

relationship between managerial ownership and cash holdings is non-monotonic.

The results also suggest that board composition and the presence of ultimate control-

lers do not have a significant impact on cash holdings. However, the identity of con-trollers and the divergence between control rights and cash flow rights seem to

matter. First, firms having families as ultimate controllers tend to hold more cash

than those firms having, for example, financial institutions as controllers. Second,

the wedge between the largest shareholder’s control and cash flow rights has a neg-

ative impact on cash holdings. We also provide evidence of significant dynamic ef-

fects in the determination of firms’ cash holdings and of a positive influence of

cash flow and growth opportunities on cash holdings. In addition, there is significant

evidence for the negative impact of liquid assets. Finally, the results suggest thathigher cash holdings are associated with lower levels of bank debt and leverage.

The rest of the paper is organised as follows. Section 2 reviews the relevant the-

ory and derives the empirical hypotheses. Section 3 presents the main features of

corporate governance in the UK. Section 4 explains the construction of the data

set. Section 5 presents the empirical results. Finally, Section 6 offers our main

conclusions.

2. Theory and empirical hypotheses

The current literature on corporate cash holdings emphasises two major motives

for cash holdings: the transaction costs motive and the precautionary motive. The

former points out that firms facing a shortage of internal resources can raise funds,

for example, by selling assets, issuing new debt and/or equity, or cutting dividends.

However, all these strategies involve costs that have both fixed and variable compo-

nents. Consequently, one would expect firms that are likely to incur higher transac-tion costs to hold greater amounts of liquid assets. On the other hand, the

precautionary motive places more emphasis on the costs arising from the foregone

investment opportunities. According to this approach, firms accumulate cash to meet

their unanticipated contingencies that may arise and to finance their investments

if the costs of other sources of funding are prohibitively high.

Accordingly, one would expect small firms to maintain higher cash balances to

avoid, for example, significant fixed costs involved in obtaining external funds. In

addition, firms with better investment opportunities are expected to hold more cashto minimise the opportunity costs of foregone investment. Similarly, firms with more

volatile cash flows, and hence a higher frequency of cash flow shortfalls, need to

accumulate more cash. Finally, firms that currently pay dividends can afford to hold

less cash as they are more capable of raising funds when needed by cutting dividends.

In the following section, we discuss these points in more detail. In addition, we pro-

vide a detailed discussion on the relationship between cash holdings and ownership

characteristics of companies.


2.1. Asymmetric information, agency costs of debt

The existence of asymmetric information between firms and investors makes exter-

nal financing costly. Myers and Majluf (1984) argue that in the presence of asymmet-

ric information firms tend to follow a hierarchy in their financing policies in the sensethat they prefer internal over informationally sensitive external finance. They argue

that the asymmetric information problem is more severe for firms whose values are

determined by growth options. If a firm has investment opportunities that would in-

crease its value when taken and finds itself being short of cash, it may have to pass up

some of these investments. Hence firms with such opportunities would hold greater

amounts of cash in an attempt to make it less likely that they will have to give up valu-

able investment opportunities in some states of nature. In addition, it is important to

note that firms with greater growth opportunities are expected to incur higher bank-ruptcy costs (Williamson, 1988; Harris and Raviv, 1990; Shleifer and Vishny, 1992).

This is because growth opportunities are intangible in nature and their value falls

sharply in financial distress and bankruptcy. This would in turn imply that firms with

greater growth opportunities have more incentives to avoid financial distress and

bankruptcy and hence hold more cash and marketable securities.

Growth opportunities are also related to agency costs of debt arising from the

conflicts of interest between shareholders and debt holders. It is argued that growth

firms face higher agency costs because firms with risky debt and greater growthopportunities are likely to pass up valuable investment opportunities in more states

of nature (Myers, 1977). Higher expected agency costs in turn make external financ-

ing expensive, implying higher cash holdings.

To proxy for growth opportunities of firms we use the market-to-book ratio de-

fined as the ratio of book value of total assets minus the book value of equity plus

the market value of equity to book value of assets.

It is also suggested that large firms have less information asymmetry than small

firms (Brennan and Hughes, 1991; Collins et al., 1981). Therefore, small firms facemore borrowing constraints and higher costs of external financing than large firms

(Whited, 1992; Fazzari and Petersen, 1993; Kim et al., 1998). To the extent that size

is an inverse proxy for the degree of informational asymmetry and, in turn, the cost

of external financing, a negative relation should be expected between size and cash

holdings. Finally, size of firms can also have an impact on the expected costs of

financial distress. For example, it is argued that larger firms are more likely to be

diversified and thus less likely to experience financial distress (Titman and Wessels,

1988) and smaller firms are more likely to be liquidated when they are in financialdistress (Ozkan, 1996). If this is the case, small firms are expected to hold relatively

more cash to avoid financial distress.

Weuse the natural logarithmof total assets in 1984 prices as a proxy for the size of firms.

2.2. Liquidity constraints and cash substitutions

The greater the firm’s cash flow variability, the greater the number of states of

nature in which the firm will be short of liquid assets. As noted earlier, it may be


costly to be short of cash and marketable securities if the firm has to pass up valuable

investment opportunities. There is evidence that firms with cash shortfalls do indeed

fail to take up some of the valuable growth opportunities. For example, Minton and

Schrand (1999) show that firms with higher cash flow volatility permanently forgo

investment rather than reacting to cash flow shortfalls by changing the discretionarytiming of investment. They also argue that a higher frequency of cash flow shortfalls

in the presence of capital market imperfections increases a firm’s cost of accessing

external capital. This also adversely affects the level of investment. Thus, firms with

more volatile cash flows are expected to hold more cash in an attempt to mitigate the

expected costs of liquidity constraints. The measure we use for cash flow volatility

is the standard deviation of cash flows divided by average total assets.

To the extent that there are substitutes for holding high levels of cash, firms can

use them when they have cash shortfalls. For example, firms can use borrowing as asubstitute for holding cash because leverage can act as a proxy for the ability of firms

to issue debt (John, 1993). Moreover, Baskin (1987) argues that the cost of funds

used to invest in liquidity increases as the ratio of debt financing increases, which

would imply a reduction in cash holdings with increased debt in capital structure.

We, therefore, predict that there should be a negative relation between the firm’s

cash holdings and its leverage. However, one should note that higher debt levels

can increase the likelihood of financial distress. In that case one would expect a firm

with a high debt ratio to increase its cash holdings to decrease the likelihood of finan-cial distress. This would induce a positive relation between leverage and cash hold-

ings. Leverage is measured by the ratio of total debt to total assets.

Another substitution effect is due to other liquid assets firms may have besides

cash. It is reasonable to assume that the cost of converting non-cash liquid assets

into cash is much lower as compared with other assets. Firms with sufficient liquid

assets may not have to use the capital markets to raise funds when they have a short-

age of cash. The proxy we use for non-cash liquid assets is the ratio of net working

capital minus cash to total assets.Finally, we include the dividend payout ratio in our regressions to control for the

potential impact of the firm’s dividend policy on its cash holdings. To the extent that

firms that pay dividends can raise funds relatively easily by cutting their dividends, a

negative relationship is expected between dividend and cash holdings (Opler et al.,

1999). However, it is possible that dividend-paying firms can also hold more cash

than non-dividend paying firms simply to avoid a situation in which they are short

of cash to support their dividend payments. If this is the case a positive relation can

be observed.

2.3. Bank relationship

It is often argued that bank financing is more effective than public debt in reduc-ing problems associated with agency conflicts and informational asymmetry (see,

e.g., Diamond, 1984; Boyd and Prescott, 1986; Berlin and Loeys, 1988). This is

mainly because of the comparative advantage of banks in monitoring firms’ activities

and in collecting and processing information. Fama (1985) argues that banks have a


comparative advantage as lenders in minimizing information costs and can get access

to information not otherwise publicly available. Therefore, banks can be viewed as

performing a screening role employing private information that allows them to eval-

uate and monitor borrowers more effectively than other lenders. Thus, a bank’s will-

ingness to provide a loan or renew a loan to a firm can signal positive informationabout that firm. 3 Moreover, by providing signals about the borrowing firms’ credit

worthiness, the existence of a bank relationship would enhance the ability of firms to

raise external finance. These arguments suggest that firms with more bank debt in

their capital structures are expected to have easier access to external finance. This

would, in turn, imply that such firms should hold less cash. Another reason for a po-

tential negative effect of bank debt financing on cash holdings is that bank debt is

more easily renegotiated when firms need to (see, e.g., Chemmanur and Fulghieri,

1994). By providing flexibility through renegotiation, bank debt can serve as a sub-stitute for holding high levels of cash and marketable securities. We measure bank

debt as the ratio of total bank debt to total debt.

2.4. Ownership and cash holdings

In this section, we discuss how firms’ ownership structure may affect their choices

of cash holdings. We mainly focus on the role of managerial ownership and whether

the presence of controllers and their identity can influence firms’ cash holding deci-

sions. In addition, we discuss how board composition can have an impact on cash

holdings.

2.4.1. Managerial ownership

The conflicts of interest between managers and shareholders arising mainly from

the separation of ownership and control have been well-documented. One of these

conflicts is related to the firm’s cash holdings. Jensen (1986) argues that managers

can have incentives to hold large amounts of cash reserves to pursue their own objec-

tives at the expense of those of shareholders. They can, for example, squander fundsby consuming perquisites and/or making inefficient investment decisions (Jensen and

Meckling, 1976). Moreover, greater cash holdings serve managers’ interests by pos-

sibly providing protection against disciplining by external investors.

There is a large body of literature that supports the notion that managerial own-

ership can help align the interests of managers with those of shareholders. That is,

with increased managerial ownership, managers are less likely to divert resources

away from value maximisation as they bear part of the costs of their actions. To

the extent that this is the case and holding cash is costly, one would expect a negative

3 James (1987) and Mikkelson and Partch (1986) document that the announcement of a bank credit

agreement conveys positive news to the stock market about the borrowing firms’ credit worthiness. Billett

et al. (1995) reconfirms that, unlike public debt issuance, bank loan announcements are associated with

positive borrower returns. Additionally, Slovin and Young (1990) demonstrate that the presence of a

banking relationship lessens the degree of expected underpricing associated with the initial public offerings

of client firms.


relationship between managerial ownership and cash holdings (i.e. the incentive-

alignment effect). Furthermore, lower expected agency costs due to the alignment

of interests are likely to increase the firm’s ability to raise external finance, which

would reduce firms’ incentives to accumulate cash.

However, the relationship between managerial ownership and the alignment ofshareholder and managerial interests can be non-monotonic, implying that the mar-

ginal effect of increased managerial ownership depends on the current level. At high-

er levels of managerial ownership outside shareholders may find it difficult to

monitor the actions of managers because greater ownership gives managers more di-

rect control over the firm, increasing their ability to resist outside pressures. Conse-

quently, entrenched managers who are relatively free of external discipline would

choose to hold more cash to pursue their own interests without risking replacement

(i.e. the entrenchment effect). 4

The net impact of these two effects would determine the sign of the relation-

ship between managerial ownership and cash holdings. To test the hypothesised

non-linear nature of the relationship between cash holdings and managerial owner-

ship we estimate a cubic model that implies two turning points. That is, as manage-

rial ownership increases, we expect to observe first a negative (incentive-alignment),

then a positive (entrenchment) effect exerted by managerial ownership on cash hold-

ings. In addition, our cubic specification allows the possibility that the relationship

becomes negative again at high levels of managerial ownership. This can happen be-cause managerial interests are more likely to converge to those of shareholders as

managers’ stake in the firm increases to substantially high levels.

Theory does not shed much light on the exact nature of the relationship between

cash holdings and managerial ownership and hence which of the two effects will

dominate at various levels of managerial ownership is difficult to predict ex ante.

We, therefore, carry out a preliminary investigation about the pattern of the relation-

ship between cash holdings and managerial ownership by plotting the association

between the two.As can be seen in Fig. 1, cash holdings first decrease with the equity ownership of

managers, consistent with the incentive-alignment argument. Companies with man-

agerial ownership between 20% and 30% have the lowest cash holdings. Neverthe-

less, after reaching a minimum, the association between cash and managerial

ownership becomes positive, providing some support for the entrenchment effect

of managerial ownership. This increase is not monotonic either. It seems that com-

panies with managers having substantial shareholdings tend to have lower cash hold-

ings than those with moderate managerial ownership levels. Consequently, ourpreliminary investigation points to a cubic functional form to depict the relationship

between cash holdings and managerial ownership. We measure managerial owner-

ship as the percentage of equity ownership by directors.

4 This argument is in line with the findings of prior research that investigates the relationship between

managerial ownership and corporate value and provides evidence for a significant non-linear relationship

(see Morck et al., 1988; McConnell and Servaes, 1990; Hermalin and Weisbach, 1991; among others).

Fig. 1. Cash holdings and managerial ownership.


We note that the extent to which managerial ownership impacts cash holdings of a

firm may depend on the firm’s growth opportunities. For example, it can be argued

that the entrenchment effect becomes less significant as the firm’s growth opportuni-

ties increase because the interests of managers and shareholders are better aligned

with greater growth opportunities. To control for this potential impact we interact

the managerial ownership terms with the proxy for growth opportunities.

2.4.2. Board structure of companies

One increasingly important issue relating to agency conflicts between managers

and shareholders concerns the role of board composition in influencing managerial

incentives (see, Hermalin and Weisbach, 2003, for an extensive survey). A generally

accepted view in the literature is that the degree of alignment between the interests of

managers and shareholders varies with the composition of the board. More specifi-

cally, it is argued that outside (non-executive) directors are appointed to act in the

shareholders’ interests (Rosenstein and Wyatt, 1997; Mayers et al., 1997) and outsidedirectors have incentives to signal that they indeed act in that way (Fama and Jensen,

1983). Accordingly, boards with greater outside director representation will make

better decisions than boards dominated by inside (executive) directors. There is some

empirical evidence supporting these predictions that the market reacts more posi-

tively to decisions taken by outsider-dominated firms than those taken by insider-

dominated firms (see Borokhovich et al., 1996, for an extensive discussion).

To the extent that non-executive directors perform a significant monitoring and

disciplining function over executive directors, one would expect that the board struc-ture of companies exerts some influence on their cash holdings. More specifically,

assuming that firms with outside-dominated boards are likely to experience a reduc-

tion in the agency costs of external finance, one would expect these firms to hold

lower amounts of cash.


To test this hypothesis for UK companies in our sample we adopt two measures

of the degree of board independence: the fraction of non-executive directors on the

board and a dummy variable which takes a value of one if the chief executive officer

(CEO) and the chairman of the board (COB) are the same person and 0 otherwise.

These variables are prompted by the two main recommendations of the CadburyCommittee Report on Corporate Governance, issued in 1992 in the U.K. In an attempt

to mainly reduce the CEO’s influence over the board, the Cadbury Report recom-

mended, among other things, that boards of public companies include at least three

non-executive directors and the roles of chairman (COB) and chief executive officer

(CEO) are separated.

2.4.3. Controlling shareholders

We now turn to the question of whether corporate cash holdings are affected when

there is a controller among the firm’s shareholders. It is argued that one of the ways

of alleviating the agency problem between managers and shareholders is to effec-

tively monitor managers to ensure that they act in the interests of shareholders.

However, shareholders bear all the costs related to their monitoring activities whilebenefiting from monitoring only in proportion to their shareholding (Grossman and

Hart, 1988). Therefore, for an average shareholder there may be little or no incentive

to monitor managers as the cost of monitoring is likely to outweigh the benefit. In

contrast, large shareholders, having claims on a large fraction of the firm’s cash

flows, can have more incentives to monitor managers. Moreover, they can monitor

more effectively. Consequently, in the presence of a large shareholder, managerial

discretion is curbed to some extent and agency costs between managers and share-

holders are reduced (Stiglitz, 1985; Shleifer and Vishny, 1986). To the extent that thisargument holds, the cost of external financing would be lower for firms with large

shareholders, implying less need to hold higher levels of cash. 5

While enhanced monitoring by large shareholders can help reduce some of the

agency problems associated with management, there are also private benefits of con-

trol accruing to large shareholders, not necessarily shared by minority sharehold-

ers. 6 Recent studies emphasise the potential conflicts of interest between the

controlling shareholder and other shareholders. For example, Shleifer and Vishny

(1997) argue that when large owners gain nearly full control of the corporation, theyprefer to generate private benefits of control that are not shared by minority share-

holders (see also Faccio et al., 2001; Holderness, 2002). Consequently, large share-

holders might have incentives to increase the amounts of funds under their control

to consume private benefits at the expense of minority shareholders. This, in turn,

5 The empirical evidence on the effectiveness of the monitoring by large shareholders is mixed. Mehran

(1995) finds that the use of executive compensation declines with outside blockholders’ ownership, which is

interpreted as evidence of a significant role for blockholders in monitoring executives. Franks et al. (2001),

on the other hand, report that large shareholders in the UK do not seem to discipline the management of

poorly performing companies (see Holderness, 2002, for a survey on the effectiveness blockholders in

monitoring management).6 We use large shareholders and controllers interchangeably throughout the paper.


suggests that firms with large shareholders are more likely to accumulate more cash

than widely-held firms.

We investigate these hypotheses by incorporating two proxies in our empirical

analysis. First, we identify those firms with controllers with a dummy variable, tak-

ing a value of one if there is a controlling shareholder in the firm. A firm is said tohave a controlling shareholder if the direct and indirect voting rights of this share-

holder in the firm exceed 10%. Second, we include a variable defined as the ratio

of the largest shareholder’s control rights to cash-flow rights; i.e. the divergence be-

tween control rights and cash-flow rights. We believe that the latter proxy can pro-

vide more insights as to whether the private benefits accruing to controllers dominate

the shared benefits of control.

2.4.4. Identity of ultimate controllers

To the extent that the incentives to monitor managers depend on the category of

controlling shareholders, the identity of a controlling shareholder can have a signif-icant impact on the firm’s incentives for cash holdings. For example, it can be argued

that the direct involvement of controlling family owners in the management of the

firm is more likely than that of financial institutions (see Faccio and Lang, 2002).

This, in turn, would lead to higher agency costs regarding the relationship between

managers and outside shareholders. In particular, family owners may want to keep

their control over the firm inefficiently long from the outside shareholders’ perspec-

tive. In the context of our analysis this implies that family controlled firms would

hold more cash than those controlled by other owners. For example, financial insti-tutions as controlling shareholders might provide more effective monitoring of the

management as long as they have superior monitoring abilities. If they exert suffi-

cient monitoring, their presence as a controller may lead to a reduction in the fric-

tions between managers and shareholders, lowering the agency costs associated

with higher levels of managerial ownership. This would, in turn, imply that firms

controlled by financial institutions have lower cash balances.

3. Features of corporate governance in the UK

Several features of the UK corporate governance system make the cash holding

analysis of UK firms interesting. In this section, we review these features and observe

that they may contribute to a high degree of managerial discretion, which may even-

tually influence the relationship between managerial ownership and cash holdings.

In particular, we focus on the influence of institutional shareholders and board

composition, and the role of regulation.

3.1. Institutional shareholders

In the UK, the ownership of listed UK equities by financial institutions (including

insurance companies, pension funds, and unit and investment trusts) is signifi-

cantly high. A report on ownership of shares, published by the Office for National


Statistics (2001), shows that the proportion of shares held by domestic financial insti-

tutions grew steadily from 29% in 1963 to 56.2% in 2000. It is argued that there are

two primary causes of the increase in the ownership of financial institutions, namely

the substantial increase in funds available to the institutions for investment as a re-

sult of the growth in long-term savings; and the disposition of insurance companiesand pension funds towards equities (Stapledon, 2000). It is also argued that the UK

has far fewer regulatory restrictions on the shareholdings of banks, pension funds,

mutual funds, and insurance companies in corporations than the US does (see,

e.g., Allen and Gale, 2000). 7 Moreover, tax considerations might also have played

a role in the institutionalisation of the UK equity market. For instance, pension fund

investments and unit trust portfolios are exempt from capital gains tax and life insur-

ance companies have tax privileges.

Despite the large ownership position of financial institutions, there is a great dealof evidence that institutions do not take an active role in corporate governance in the

UK. For example, Faccio and Lasfer (2000) analyse the monitoring role of occupa-

tional pension funds in the UK and provide evidence that supports the view that

occupational pension funds are not effective monitors. Similarly, Franks et al.

(2001) observe, for a sample of UK firms, that there is no significant relationship

between high levels of institutional ownership and managerial disciplining. Further-

more, Goergen and Renneboog (2001) provide evidence of a passive role of institu-

tional shareholders in the UK and point to the factors that might contribute to theirpassive stance, including low-cost passive index strategies and insider-trading regu-

lations. 8 More evidence of the passive stance by financial institutions in the UK

is provided by Cosh and Hughes (1997). They report that the presence of institutions

as major shareholders has no significant impact on either the level of pay or the like-

lihood of dismissal of top managers. Finally, Plender (1997) reports that financial

institutions in the UK do not frequently vote at shareholders’ meetings as they are

not obligated to do so as they are in the US. He observes that only about 28% of

pension funds vote on a regular basis whereas 21% never vote and 32% cast theirvote only on extraordinary items.

To summarize, the evidence suggests that the institutional shareholders in the UK

seem to adopt a passive stance towards monitoring and disciplining firms’ manage-

ment. Accordingly, one would expect financial institutions to have little influence on

managers in the UK and hence an insignificant impact on cash holding decisions

of companies.

7 For instance, in the UK life insurance companies have voluntary self-limitation of holding of stock in

any single company for the purpose of diversification, while in the US life insurance companies’ investment

in stocks must be less than 20% of assets and holdings of shares of any single company are limited to 2% of

total assets.8 Black and Coffee (1994) provide evidence that the intervention by large institutional shareholders is

triggered by financial crisis and poor company performance. Mayer (2000) also reports that financial

institutions are reluctant to intervene in the face of poor performance unless there is clear evidence of

failure.


3.2. Board structure of UK companies

The UK has a one-tier board structure in which both executive and non-executive

directors sit on the same board and the chairman of the board can at the same time

be an executive officer. The main criticism of this structure relates to the indepen-dence of outside directors and their ability to monitor and control executive directors

(see, e.g, Blair, 1995; Ezzamel and Watson, 1997). It is also important to note that

there are no formal requirements for companies in the UK to appoint outside direc-

tors and company boards can function without outsider representation. 9 The con-

sequences of these features are reflected in the board composition of companies.

For our sample, we find that 298 firms (35.5% of the sample) have fewer than three

non-executive directors on their boards in 1997. We also observe that the average

percentage of non-executive directors is 43 and non-executive directors have a major-ity of the board in only 208 companies (24.8% of the sample). 10 Finally, it is impor-

tant to note that non-executive directors in the UK have a more advisory role rather

than performing a disciplinary function, possibly due to the less clearly defined fidu-

ciary responsibilities of non-executive directors in the UK (Franks et al., 2001).

As discussed earlier, outside-dominated boards are more likely than inside-

dominated boards to effectively monitor and control managers. To the extent that

this is the case, UK company boards dominated by inside directors are not expected

to play an important role in limiting the exercise of managerial discretion. 11

3.3. Role of regulation

It is suggested that the regulatory features in the UK can have a significant influ-

ence on the pattern of corporate governance. Franks et al. (2001) argue that, despite

the characterisation of the UK as having a common law regulatory system (La Porta

et al., 1998), there are several distinctive regulatory characteristics in the UK, whichmight have implications for disciplining management. First, the UK Takeover Code

makes accumulation of controlling blocks expensive. 12 Second, the UK has stronger

9 As previously stated, the UK Code of Best Practice based on the report of the Cadbury Committee

recommends that boards of UK companies include at least three outside directors and that the positions of

chairperson and CEO be held by different individuals. While the Code is voluntary, the London stock

Exchange requires that all listed companies explicitly indicate whether they comply with the Code or not.10 This finding is consistent with that of Vafeas and Theodorou (1998) who report that the average

percentage of non-executive directors on UK boards is 39. In contrast, the average percentage of outside

directors on US boards is over 70 (Borokhovich et al., 1996; Klein, 1998).11 Goergen and Renneboog (2001) argue that proxy votes can further increase the power of directors in

the UK as they are frequently exercised by directors who can also ask for proxy votes from institutional

investors.12 Franks and Mayer (1996), in contrast to the findings of Martin and McConnell (1991) for US

companies, provide evidence that takeovers do not work as a corporate governance mechanism for

disciplining poor managers in the UK. However, there is evidence of high management turnover, disposal

of assets, sales of subsidiaries and break-up of firms subsequent to a bid going through, which, Mayer

(2000) argues, suggests that the market for corporate control is more closely associated with changes

in strategies of firms than with corporate governance and the disciplining of bad management.


minority protection laws ‘‘discouraging partial accumulation of share blocks in fa-

vour of full acquisitions in takeovers’’, making share blocks a weak disciplining de-

vice. Third, as mentioned above, there are few fiduciary obligations on directors in

the UK, which, Franks et al. (2001)argue, result in non-executive directors playing

more of an advisory role than a disciplinary role.In summary, insufficient external market discipline and the lack of efficient mon-

itoring by financial institutions and company boards in the UK is more likely to pro-

vide managers with greater freedom to pursue their own interests which include

holding higher cash balances.

4. Data description

For our empirical analysis of corporate cash holdings we use a sample of publicly

traded UK firms from 1984 to 1999 (though the sample period for the cross-sectional

analysis is 1995–1999 due to the reasons to be discussed in the next section). Our ini-

tial sample is the set of all firms for which data are available on the Datastream data-

base which provides both accounting data for firms and market value of equity. The

panel data set for this study has been constructed as follows. First, financial firms

were excluded from the sample. Second, missing firm-year observations for any var-

iable in the model during the sample period were dropped. Finally, from these firms,only those with at least five continuous time series observations during the sample

period have been chosen. These criteria have provided us with a total of 1029 firms,

which represents 12,960 firm-year observations. We obtain information regarding

the equity ownership structure from two different sources. Data for the sharehold-

ings of directors were collected from the 1997 September edition of the Price Water-

house Corporate Register, consisting of beneficial as well as non-beneficial directors’

holdings, in which the latter refers to holdings by directors on behalf of their families

and charitable trusts. Although managers do not obtain benefit from these holdingsdirectly, they usually have control rights. Data on the board characteristics of com-

panies were also collected from the same source. Data for the ultimate controllers of

firms in 1997 were obtained from Faccio and Lang (2002) and merged with the man-

agerial ownership. Consequently, we were left with 839 firms for our cross-sectional

analysis.

Table 1 presents descriptive statistics for the main variables used in our analysis.

It reveals that the mean cash ratio is 9.9% and the median value is 5.9%. These values

are in general in line with those reported for US firms. For example, Kim et al.(1998) report that the mean and median values of the cash ratio are 8.1% and

4.7% respectively. However, in Opler et al. (1999), the mean ratio is reported as

17% whereas the median cash ratio is 6.5%. The higher mean value in their analysis

is most probably due to normalizing cash and marketable securities by total assets

minus cash and marketable securities rather than total assets.

As reported in Table 1, the average managerial ownership for our sample of firms

is 14.2% (the median is 5.1%). In an average firm, the numbers of executive and non-

executive directors are 4.12 and 3.24, respectively. That is, on average boards of

Table 1

Descriptive statistics

Mean Min 25% Median 75% Max

CASH 0.099 0 0.018 0.059 0.127 0.988

CFLOW 0.088 )0.627 0.062 0.094 0.131 0.301

LIQ 0.048 )0.562 )0.067 0.034 0.152 0.788

LEV 0.162 0 0.076 0.155 0.224 0.842

BANKDEBT 0.570 0 0.258 0.634 0.886 1

MKTBOOK 1.769 0.351 1.049 1.406 1.990 8.077

SIZE 10.873 6.225 9.640 10.570 11.875 16.497

VARIABILITY 0.067 0.004 0.036 0.055 0.082 0.335

DIVIDEND 0.419 )5.622 0.237 0.389 0.513 2.127

MAN 0.142 0 0.005 0.051 0.207 0.844

EX 4.121 1 3 4 5 18

NON EX 3.241 0 2 3 4 15

NON EX=DIR 0.435 0 0.333 0.429 0.5 0.833

CEO COB 0.086 0 0 0 0 1

This table shows the sample characteristics for 839 firms over the period 1995 to 1999. The means of the

variables are measured over the period 1995–1998 (except MAN and NON EX=DIR, measured in 1997)

CASH is the ratio of total cash and equivalent items to total assets. CFLOW is the ratio of pre-tax profit

plus depreciation to total assets. LIQ is the ratio of current assets minus current liabilities and total cash to

total assets. LEV is the ratio of total debt to total assets. BANKDEBT is the ratio of total bank bor-

rowings to total debt. MKTBOOK is the ratio of book value of total assets minus the book value of equity

plus the market value of equity to book value of assets. SIZE is the natural log of total assets in 1984

prices. VARIABILITY is the standard deviation of cash flow divided by average total assets. DIVIDEND

is the ratio of dividend payments to total assets. MAN is the total percentage of equity ownership by

company directors. EX is the number of executive directors. NON EX is the number of non-executive

directors. NON EX=DIR is the ratio of the number of non-executive directors to the total number

of directors. CEO COB is a dummy variable which takes a value of 1 if the positions of CEO and the

COB are held by the same individual and 0 otherwise.


companies comprise 7.36 directors. The table also reveals that the mean percentage

of non-executive directors is 43.5%. Finally, we were able to identify only 72 firms

(8.6%) in which the positions of CEO and COB were held by the same person.Table 2 provides a detailed analysis of the ultimate ownership structure of the UK

companies used in our analysis. Companies are mainly classified into two groups:

those that are widely held in the sense that they have no owners with significant con-

trol rights and those companies that have controlling owners. We report results for

two different cut-off levels, namely 10% and 20% thresholds. The reported results rely

on voting rights that may differ from cash flow rights for a variety of reasons such as

pyramiding or issuing different classes of shares (for a detailed discussion see Faccio

and Lang, 2002). In Table 2 controlling owners are further classified into six catego-ries: widely held corporations, financial institutions, family, unlisted companies,

state, and miscellaneous.

In Panel A of Table 2 we present percentage and number of firms controlled by

different categories of owners at two different cut-off levels. At the 10% level, only

23.24% of firms are widely-held. Family-controlled firms comprise 26.58% of firms

in our sample, which makes it the largest category. 19.43% of firms are controlled

Table 2

Ownership structure of UK companies

Widely

held

Widely held

corporation

Financial

institution

Family Unlisted

company

State Misc.

Panel A: Percentage of controlled firms and controllersa

10% Cutoff 23.24 1.19 19.43 26.58 20.26 0.48 8.82

No. of firms 195 10 163 223 170 4 74

20% Cutoff 66.39 0.95 6.20 14.78 8.46 0.24 2.98

No. of firms 557 8 52 124 71 2 25

Panel B: Descriptive statistics of ultimate ownership by different categoriesb

Mean 0 39.35 20.25 29.77 23.53 23.33 20.62

Min 0 11.07 10.04 10.05 10.09 12.00 10.30

25% 0 20.60 11.76 16.17 15.74 12.93 13.92

Median 0 27.02 15.91 24.69 15.74 18.98 14.90

75% 0 65.01 22.79 40.91 25.00 33.74 26.20

Max 0 83.22 89.90 84.50 86.88 43.37 64.93

Panel C: Ratio of cash flow to control rightsc

Mean 0.968 0.682 0.794 0.952 0.902 0.868 0.662

Min 0.391 0.24 0.048 0.106 0.107 0.471 0.202

25% 1 0.747 0.660 1 0.787 0.736 0.332

Median 1 0.832 1 1 1 1 0.725

75% 1 0.832 1 1 1 1 1

Max 1 1 1 1 1 1 1

This table presents summary statistics on ultimate controllers for a sample of 839 UK firms used in our

analysis.a Based on the ownership of the largest control holder.bAt the 10% ultimate control threshold.c The largest controlling holder has at least 5% of the voting rights. Source: Our own calculations based

on the ultimate ownership and control data in Faccio and Lang (2002).


by financial institutions. Another important category is the unlisted companies that

control 20.26% of firms at the 10% threshold. Control by widely-held corporations

and the state is trivial (1.19% and 0.48%, respectively). As expected, the control

structure of firms at the 20% threshold is significantly different than that at the10% level. At this more conservative cut-off, 66.39% of companies have no control-

ling owner. The characteristics of controllers are, however, similar. More specifically,

family is still the most important category at 14.78%. As can be seen from the table,

only 6.2% of non-financial firms in the UK are controlled by financial institutions at

the 20% ultimate control threshold. However, the decrease in the percentage of firms

with financial institutions as a controller at the higher cut-off level is more significant

than that with family control. The percentage of companies controlled by unlisted

companies also drops dramatically from 20.26% to 8.46%.In Panel B of Table 2 we report summary statistics on the control rights of the

largest controlling owner in each category of controller, where the ultimate control

threshold is 10%. The findings reveal that the average percentage values of control

rights of the largest controlling shareholder are 39.35 and 29.77 for firms that are

controlled by widely-held corporations and family, respectively. The average per-


centage of control rights for firms where the largest controlling shareholder is a

financial institution is 20.25%.

Finally, Panel C reports descriptive statistics for the ratio of cash-flow to control

rights of the largest controlling shareholder. This ratio is a measure for the discrep-

ancy between the largest controlling shareholder’s ownership and control rights. Thereported statistics are based on firms where the largest ultimate controller owns at

least 5% of control rights. The largest ultimate shareholder’s average ratio of

cash-flow to voting rights is 86.12% for our sample of 839 firms (not reported in

Table 2). This is in line with Faccio and Lang (2002) who report the ratio as

86.80% for 1628 UK firms. Panel C shows that the average ratio of cash-flow to con-

trol rights is 68.28% for firms where the largest controller is a widely held corpora-

tion. Comparing this value with that of other categories we can observe that the

separation of ownership and control is highest for firms where the largest controlleris a widely held corporation (ignoring miscellaneous category that has a ratio of

66.17%). The average ratio of cash flow to control rights for firms controlled by fam-

ilies is 95.18%. Thus, the evidence suggests that firms that are controlled by families,

with the exception of only one state-controlled firm, are less likely than those with

other controllers to have divergence between ownership and control.

5. Regression results

In what follows we first present the results for our cross-sectional regressions by

focusing on the question of whether ownership characteristics influence cash levels of

firms after controlling for the firm-specific determinants. Section 5.2 provides results

on the dynamic panel data model. In this section, we also describe the empirical

methods used in the analysis.

5.1. Ownership, board structure and cash holdings

We begin our examination of the determinants of cash holdings by focusing on

the question of whether managerial ownership and the characteristics of board struc-

ture and ultimate controllers of firms affect cash levels. To do so, we estimate a cross-sectional cash model using the average values of each of the firm characteristics

(except variability and ownership variables) over four years in an attempt to mitigate

problems that might arise due to short-term fluctuations or extreme values in one

year. We measure cash holdings (the dependent variable) in 1999 and the explana-

tory variables over the period 1995–1998. Using past values also reduces the likeli-

hood of observed relations reflecting the effects of cash holdings on firm-specific

factors (see also Rajan and Zingales, 1995, for a similar methodology). Ownership

variables are measured in 1997. Given that equity ownership structure of firms ina country is relatively stable over a certain period of time, we do not expect that mea-

suring ownership characteristics in a single year would yield a significant bias in our

results (see also La Porta et al., 2002, among others).


Table 3 presents the first set of estimation results for the cross-sectional cash

model. The inclusion of the higher ordered managerial ownership terms, namely

MAN, MAN2 and MAN3, allows for the effect of managerial ownership on cash

holdings to vary with the value of managerial ownership. This differs from the linear

regression framework that examines a constant effect. That is, the relationship is aconditional relationship in the former case whereas the traditional linear regression

represents a general relationship.

In column (1), we report the regression results for the basic model that includes

the control variables described in Section 2 and the managerial ownership variables.

In column (2), we additionally test whether board composition impacts the cash

holding decisions of firms. To do so, we incorporate two additional variables into

the model, namely (NON EX=DIR) which gives the fraction of non-executive direc-

tors on the board of directors, and a dummy variable (CEO COB) that takes a valueof one if the firm’s chief executive officer and chairman of the board are the same

individual. In column (3), we interact managerial ownership terms with the proxy

for growth opportunities, MKTBOOK, to control for the potential impact of the

firm’s growth opportunities on managerial discretion.

In general, the estimated coefficients are in line with the hypothesized signs. The

notable exception is the coefficient of cash flows (CFLOW), which is negative and

significant. There is a strong support that liquidity (LIQ) exerts a negative impact

on cash holdings of firms. The estimated coefficient is significant at the 1% level. Sim-ilarly, consistent with the prediction of the theory, the relationship between cash

holdings and leverage (LEV) is negative and significant at the 1% level. We also find

strong evidence that firms with more growth opportunities hold more cash, given by

the positive and significant coefficient of MKTBOOK. One of the results that is not

in line with the predicted effect is due to the estimated coefficient of VARIABILITY.

We cannot find any evidence to support the view that firms with more volatile cash

flows hold more cash. The estimated coefficient is positive but insignificant under all

specifications. Also, the results do not provide support for the negative relation be-tween cash holdings and size. Finally, there is no evidence that dividend policy of

firms exerts a significant influence on firms’ cash holdings.

The results for model (1) suggest that levels of managerial ownership exert a sig-

nificant influence on cash holding decisions of UK firms. Moreover, the results pro-

vide support for the non-linear relationship between managerial ownership and cash

holdings. More specifically, the estimated coefficients of MAN, MAN2 and MAN3

suggest that management move from alignment to entrenchment, and to alignment

again as their shareholdings in the firm increase. Cash holdings of firms fall as man-agerial ownership increases up to 24%, and then rise as managerial ownership in-

creases to 64%. Finally, cash holdings fall again for managerial ownership levels

above 64%. The estimated coefficient of MAN is negative and statistically significant.

This can be viewed as evidence to support the notion that at lower levels of mana-

gerial ownership the interests of managers and shareholders are aligned. Moreover,

the positive coefficient of MAN2 possibly suggests that managers are entrenched at

higher levels of ownership and can hold more cash to pursue their own interests at

the expense of other shareholders. As discussed previously, holding large cash

Table 3

Cross-sectional regressions of cash holdings on managerial ownership, controlling shareholder and other firm

characteristics

Independent variables Predicted Sign (1) (2) (3)

Dependent variable : CASH

CFLOW + )0.205�� )0.207�� )0.210��

(0.082) (0.083) (0.079)

LIQ – )0.072�� )0.072�� )0.074��

(0.025) (0.025) (0.025)

LEV – )0.327�� )0.321�� )0.324��

(0.042) (0.041) 0.042

BANKDEBT – )0.037�� )0.036�� )0.037��

(0.013) (0.013) (0.013)

MKTBOOK + 0.018�� 0.018�� 0.027��

(0.006) (0.006) (0.010)

SIZE – 0.001 0.001 0.001

(0.003) (0.003) (0.003)

VARIABILITY + 0.089 0.098 0.084

(0.125) (0.126) (0.125)

DIVIDEND ± )0.007 )0.004 )0.007(0.021) (0.021) (0.021)

NON EX=DIR – – )0.037 –

(0.033)

CEO COB + – )0.005 –

(0.014)

MAN – )0.390�� )0.426�� )0.362(0.139) (0.141) 0.264

MAN2 ± 1.130�� 1.229�� 1.808�

(0.501) (0.508) (0.963)

MAN3 ± )0.861� )0.948� )1.889��

(0.483) (0.489) (0.938)

MAN MKTBOOK )0.007(0.155)

MAN2 MKTBOOK )0.458(0.588)

MAN3 MKTBOOK 0.676

(0.596)

R2 0.24 0.24 0.25

Number of firms 839 839 839 839

This table presents cross-sectional regressions predicting cash holdings. The dependent variable is CASH,

measured in 1999, as the ratio of total cash and equivalent items to total assets. The means of the independent

variables are measured over the period 1995–1998 (except MAN, NON EX=DIR, and CEO COB, measured in

1997). All regressions include industry dummies. CFLOW is the ratio of pre-tax profit plus depreciation to total

assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is the ratio of

total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt. MKTBOOK is the

ratio of book value of total assets minus the book value of equity plus the market value of equity to book value of

assets. SIZE is the natural log of total assets in 1984 prices. VARIABILITY is the standard deviation of cash

flows divided by average total assets. DIVIDEND is the ratio of dividend payments to total assets.

NON EX=DIR is the ratio of the number of non-executive directors to the total number of directors. CEO COB

is a dummy variable which takes a value of 1 if the positions of CEO and the COB are held by the same individual

and 0 otherwise. MAN is the percentage of equity ownership by directors. MAN2 and MAN3 are the square and

cube of the percentage of equity ownership by directors. Standard errors robust to heteroscedasticity are reported

in parentheses. ***, ** and * indicate coefficient is significant at the 1%, 5% and 10% level, respectively.



reserves can protect them from outside pressures. Alternatively, the positive effect

can be an indication of managerial risk aversion at higher levels of ownership. As

stated earlier, managerial ownership can make management more risk averse, who

can then accumulate cash as a protection for their human capital. Finally, the neg-

ative and significant coefficient of MAN3 possibly suggests that the incentive align-ment effect of increased managerial ownership dominates the entrenchment effect at

sufficiently high levels of managerial ownership. We have no theoretical explanation

of why managers would switch to alignment again at high levels of ownership. How-

ever, both the empirical analysis and the graphical investigation provided in Section

2 (Fig. 1) suggests that this may be the case.

Our results differ from those Opler et al. (1999) found for US firms regarding the

impact of shareholdings of managers on firms’ cash levels. They report a positive

(significant at 10%) relation between cash holdings and managerial ownership atlow levels of ownership. There is, however, no significant influence of managerial

ownership on cash holdings at higher ownership levels, i.e. there exists neither align-

ment nor entrenchment. The difference between our findings and those of Opler et al.

(1999) can possibly be interpreted as evidence of the view that managerial discretion

is relatively higher in the UK than in the US. As discussed in Section 3, UK firms’

managers can be entrenched at higher levels of managerial ownership possibly due to

the lack of efficient monitoring and external disciplining. This, in turn, can provide

some explanation for the positive impact of managerial ownership on cash holdingsat somewhat higher levels.

The results reported in column (2) suggest that the fraction of non-executive direc-

tors (NON EX=DIR) and the dummy variable (CEO COB) have no significant im-

pact on cash holdings. We also interact these measures with managerial ownership

variables MAN, MAN2 and MAN3) to investigate whether the relationship between

managerial ownership and cash holdings depends on board composition but we

could not find any significant impact. We, therefore, conclude that board composi-

tion does not act as an effective constraint on managers’ attitude towards cash hold-ings.

There is also a possibility that the nature of the relationship between managerial

ownership and cash holdings may vary with firms’ growth opportunities. One may

observe that the alignment of the interests of managers and shareholders can occur

even at high levels of managerial ownership when firms have greater growth oppor-

tunities. In model (3), we explore these possibilities by interacting managerial own-

ership variables (MAN, MAN2 and MAN3) with growth opportunities proxied by

(MKTBOOK). In order to avoid the possibility that main effects and interaction ef-fects get confounded, we also include the main effects of the variables (i.e. MAN,

MAN2, MAN3 and MKTBOOK) in the model. We find no evidence that the impact

of managerial ownership on cash holdings changes with the presence of growth

opportunities. The estimated coefficients of the interaction variables are not signifi-

cant. However, they are jointly significant and hence are retained in the following

estimations.

Under this new specification, the estimated coefficient of MAN becomes insigni-

ficant. It is inconclusive whether the interests of managers and shareholders


are aligned at low levels of managerial ownership. The results, however, continue to

support the view that managers become entrenched at higher ownership levels. The

estimated coefficient of MAN2 is still positive and significant. There is also some evi-

dence that alignment still occurs to some extent at high managerial ownership levels.

In order to provide more insight into the impact of ownership on cash holdings wepresent in Table 4 the results for three additional estimations. First, in column (1) we

include a dummy variable (CONTROLLER) which identifies those firms with con-

trollers. Second, in column (2) we replace the controller dummy (CONTROLLER)

with two other dummies which represent the identity of controllers. FAMILY is a

dummy variable to identify those firms in which the controller is a family. Similarly,

INSTITUTION is a dummy variable which takes the value of one if the ultimate

controller is a financial institution and zero otherwise. In column (2), we also incor-

porate a proxy to measure the control in excess of the controller’s cash-flow owner-ship, CONT CASH, defined as the ratio of the largest shareholder’s control rights

to cash-flow rights.

The results provide some evidence that family owners as controllers exert a posi-

tive and significant impact on firms’ choices of cash holdings. As noted earlier, this is

consistent with the view that controlling shareholders may want to increase funds

under their control to better defend their privileged position. However, we do not

observe any significant impact exerted by financial institutions on cash holdings, pos-

sibly supporting the view that financial institutions in the UK are relatively passive indisciplining management. This is in line with the view that monitoring by institu-

tional investors may be ineffective because fund managers themselves have no direct

holdings in the companies they invest in and hence have little incentives for monitor-

ing. The estimated coefficient of CONT CASH is negative and statistically signifi-

cant, possibly lending support to the view that the shared benefits dominate the

private benefits of controllers as with the accumulation of control rights in excess

of cash-flow rights.

We also examine the impact of the controlling shareholder’s identity on manage-ment incentives by interacting the managerial ownership variables with the identity

of controllers, namely financial institutions and family. We cannot find any significant

effect of the controller identity on managerial choice of cash holdings and hence the

results are not reported. Although shareholdings by families is individually significant

in determining cash holdings of UK companies, their impact on the relationship be-

tween managerial ownership and cash holdings is insignificant. These findings are

not supportive of the notion that the impact of families and financial institutions as

controllers on managers’ incentives would differ because financial institutions areregarded more passive than families in monitoring and disciplining management.

Finally, in column (3) in Table 4 we report the results after we dropped the variables

whose impact have been found insignificant. The earlier results are generally con-

firmed.

In summary, the cross-sectional results indicate that levels of managerial owner-

ship matter in determining the amount of cash and marketable securities firms hold.

Moreover, the presence of controllers does not have an impact on cash holdings. We

observe that the identity of controllers seems to matter in that firms controlled by

Table 4

Cross-sectional cash holding regressions on interaction terms of managerial ownership and controlling shareholder,

and other firm characteristics

Independent variables Predicted sign (1) (2) (3)


CFLOW + )0.210�� )0.211�� )0.216��

(0.079) (0.079) (0.076)

LIQ – )0.073�� )0.072�� )0.075��

(0.025) (0.025) (0.025)

LEV – )0.325�� )0.329�� )0.325��

(0.041) (0.042) (0.041)

BANKDEBT – )0.037�� )0.036�� )0.036��

(0.013) (0.013) (0.013)

MKTBOOK + 0.027�� 0.027�� 0.029��

(0.010) (0.011) (0.010)

SIZE – 0.001 0.001

(0.003) (0.003)

VARIABILITY + 0.091 0.093

(0.125) (0.125)

DIVIDEND ± )0.007 )0.003(0.021) (0.020)

CONTROLLER ± 0.013

(0.010)

FAMILY ± 0.021�� 0.017�

(0.010) (0.009)

INSTITUTION ± 0.011

(0.011)

CONT CASH ± )0.0001�� )0.0001��

(0.00006) (0.00005)

MAN – )0.349 )0.363 )0.355(0.263) (0.264) (0.255)

MAN2 ± 1.745� 1.716� 1.682�

(0.960) (0.955) (0.934)

MAN3 ± )1.821� )1.774� )1.747�

(0.936) (0.931) (0.917)

MAN(MKTBOOK) )0.009 )0.011 )0.021(0.155) (0.155) (0.153)

MAN2 (MKTBOOK) )0.455 )0.449 )0.415(0.588) (0.588) (0.584)

MAN3(MKTBOOK) 0.673 0.669 0.639

(0.595) (0.595) (0.595)

R2 0.25 0.25 0.25

Number of firms 839 839 839

This table presents cross-sectional regressions predicting cash holdings. The dependent variable is CASH, measured in

1999, as the ratio of total cash and equivalent items to total assets. The means of the independent variables are measured

over the period 1995–1998 (except MAN and CONT CASH, measured in 1997). All regressions include industry

dummies. CFLOW is the ratio of pre-tax profit plus depreciation to total assets. LIQ is the ratio of current assets minus

current liabilities and total cash to total assets. LEV is the ratio of total debt to total assets. BANKDEBT is the ratio of

total bank borrowings to total debt. MKTBOOK is the ratio of book value of total assets minus the book value of equity

plus the market value of equity to book value of assets. SIZE is the natural log of total assets in 1984 prices. VARI-

ABILITY is the standard deviation of cash flow divided by average total assets. DIVIDEND is the ratio of dividend

payments to total assets. CONTROLLER is a dummy variable which takes a value of 1 if there is a controlling

shareholder in the firm. FAMILY is a dummy variable which takes a value of 1 if the controller of the firm is a family and

0 otherwise. INSTITUTION is a dummy variable which takes a value of 1 if the controller of the firm is a financial

institution and 0 otherwise. CONT CASH is the ratio of the largest shareholder’s control rights to cash flow rights. MAN

is the percentage of equity ownership by directors. MAN2 and MAN3 are the square and cube of the percentage of equity

ownership by directors. Standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate

coefficient is significant at the 1%, 5% and 10% level, respectively.



families tend to have greater cash holdings. However, the identity of controllers

does not seem to have a significant impact on the relationship between managerial

ownership and cash holdings.

5.2. Dynamic panel data estimations

We now proceed to motivate the dynamic model. The static cash holding model

frequently used in previous research implicitly assumes that firms can instantaneously

adjust towards the target cash level following changes in firm-specific characteristicsand/or random shocks. In this paper, we adopt an approach recognising that an

adjustment process may take place, involving a lag in adjusting to changes in the tar-

get cash structure. The possibility of delays in the adjustment process can be justified

by the existence of transaction and other adjustment costs, causing the current cash

structure not to be immediately adjusted to a new desired cash structure (for a discus-

sion in a capital structure context see, e.g., Myers (1984) and Fischer et al. (1989)). We

investigate these issues by modelling the firm’s behaviour as a partial adjustment to a

target cash ratio, which is explained in the Appendix A. Accordingly, we report esti-mates of the following dynamic panel data specification:

13 T

in the

depend

that th

not be

CASHit ¼ c1CASHit�1 þ c2CFLOWit þ c3LIQit þ c4LEVit þ c5BANKDEBTit

þ c6MKTBOOKit þ c7SIZEit þ c8DIVIDENDit þ ai þ at þ uitð1Þ

where ai and at represent firm-specific effects and time-effects, respectively.It is as-

sumed that firm-specific effects are unobservable but have a significant impact on

cash holdings. They differ across firms but are fixed for a given firm through time. Incontrast, time-effects vary through time but are the same for all firms in a given year,

capturing mainly economy-wide factors that are outside the firms’ control. We

estimate the dynamic cash model by controlling for fixed-effects by a first-difference

transformation.

Despite its appeal, the dynamic specification in (1) involves several estimation

problems. Even when unobservable firm-specific effects are not correlated with the

regressors, it is still necessary to control for them in the dynamic framework. This

is because CASHi;t�1 will be correlated with ai that does not vary through timeand the first-difference transformation to eliminate fixed effects introduces corre-

lation between the lagged dependent variable and differenced errors. That is,

DCASHi;t�1 and Duit will be correlated through terms CASHi;t�1 and ui;t�1, and hence

OLS will not consistently estimate the coefficient parameters. 13

he alternative to first-difference transformation is the within transformation that is commonly used

literature. Although it controls for the fixed effects, it introduces correlation between the lagged

ent variable and time-averaged idiosyncratic error term, leading to biased estimates. It is shown

e bias falls with the number of years T (see Nickell, 1981; Chamberlain, 1982). This would, however,

the case in our analysis as T is fairly small ranging from 5 to 16.


Another estimation problem, that is not necessarily specific to the dynamic spec-

ification, arises because the firm-specific variables are unlikely to be strictly exoge-

nous. That is, shocks affecting cash holdings of firms are also likely to affect some

of the regressors such as market value of equity, liquidity, and leverage. Moreover,

it is likely that some of the regressors may be correlated with the past and currentvalues of the idiosyncratic component of disturbances.

The problems outlined above advocates the use of an instrumental variables (IV)

estimation method, where the lagged dependent variable and endogenous regressors

are instrumented. This paper, therefore, employs the GMM method of estimation

which provides consistent parameter estimates by utilizing instruments that can be

obtained from the orthogonality conditions that exist between the lagged values of

the variables and disturbances (see Arellano and Bond, 1991). The consistency of esti-

mates is obviously subject to an optimal choice of instruments where the validity ofinstruments depends on the absence of higher-order serial correlation in the idiosyn-

cratic component of the error term. Therefore, a test for the second-order serial cor-

relation is reported. We also report the statistic for the Sargan test of over-identifying

restrictions, indicating whether the instruments and residuals are independent.

Table 5 reports GMM estimates of the dynamic cash model. In the first specifica-

tion, all variables except lagged cash are treated as exogenous whereas all variables

are treated as endogenous in the second one. Also, time dummies are included

among the independent variables under both specifications.We note that the results for both GMM regressions show similarities in terms of

the estimated coefficients and test-statistics. However, there is evidence of misspeci-

fication under the first GMM specification where only the lagged dependent variable

is treated as endogenous. The null hypothesis of valid instruments is rejected at the

1% level of significance. We accordingly conclude that it is inappropriate to assume

that the regressors are strictly exogenous in estimating the dynamic cash-holding

model. Consequently, we restrict our attention to GMM estimates where the depen-

dent and explanatory variables are assumed to be endogenous and lagged valuesof regressors are used to instrument them. 14

Turning to the preferred GMM specification, as expected there is evidence for

negative first-order serial correlation, whereas Correlation 2 test suggests that sec-

ond-order serial correlation is absent. Moreover, the Sargan test indicates that the

instruments used in the GMM estimation are not correlated with the error term.

The results reveal that the coefficient of the lagged cash is positive and significantly

different from zero. The adjustment coefficient, k given by 1� c0, is greater than 0.6,

possibly providing evidence that the dynamic nature of our model is not rejected and

14 We investigate whether the explanatory variables are predetermined or strictly exogenous with

respect to the error term. To do this, we start using instruments dated t � 2 for each regressor. Later, we

add the instrument dated t � 1 to analyse the potential bias arising from the correlation between xi;t�1 and

the first-differenced error term, Duit. To investigate the possibility of strict exogeneity we also include the

current value, xi;t, in the instrument set. This investigation leads us to conclude that the explanatory

variables are neither predetermined nor strictly exogenous. We, therefore, use instruments dated t � 2 in

our estimation (see also Blundell et al., 1992).

Table 5

Cash holdings regressions: dynamic panel data estimation results

Independent variables Predicted sign GMM-exogenous

(1)

GMM-endogenous

(2)


CASHit�1 + 0.526�� 0.395��

(0.021) (0.027)

CFLOWit + )0.011 0.035�

(0.009) (0.019)

LIQit – )0.099�� )0.043�

(0.019) (0.023)

LEVit – 0.006 )0.123��

(0.008) (0.030)

BANKDEBTit – 0.002 )0.089��

(0.003) (0.011)

MKTBOOKit + 0.0001 0.012��

(0.002) (0.003)

SIZEit – )0.016�� 0.007

(0.005) (0.006)

DIVIDENDit ± 0.011�� 0.001

(0.004) (0.012)

Number of firms 1029 1029

Correlation 1 )12.970 )13.30Correlation 2 1.120 1.65

Sargan test (df) 144.44 (104) 118.68 (104)

This table presents panel data regressions predicting cash holdings. The sample period in all regressions is

1984–1999 though the available number of observations for each firm changes across firms. Time dummies

are included in all regressions. Column (1) gives the GMM estimates for the dynamic model where only the

lagged dependent variable is treated as endogenous and CASHi;t�2, is used as instrument. Column (2)

shows the GMM estimates or the dynamic model, where CASHi;t�2, CFLOWi;t�2, LIQi;t�2, LEVi;t�2,

BANKDEBTI ;t�2, MKTBOOKi;t�2, SIZEi;t�2, DIVIDENDi;t�2 are used as instruments. CASH is the ratio

of total cash and equivalent items to total assets. CFLOW is the ratio of pre-tax profit plus depreciation to

total assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is

the ratio of total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt.

MKTBOOK is the ratio of book value of total assets minus the book value of equity plus the market value

of equity to book value of assets. SIZE is the natural log of total assets in 1984 prices. DIVIDEND is the

ratio of dividend payments to total assets.

Correlation 1 and 2 are test statistics for first and second order autocorrelations in residuals, respec-

tively, distributed as standard normal N(0,1) under the null of no serial correlation. Sargan test is a test of

overidentifying restrictions, distributed as chi-square under the null of instrument validity. Asymptotic

standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate coefficient

is significant at the 1%, 5% and 10% level, respectively.


firms adjust their cash holdings relatively quickly in an attempt to reach the target

cash ratio. One possible explanation for the relatively high value of the adjustment

coefficient might be that the costs of deviating from the target are significant and

firms’ cash holdings are persistent over time. However, the value of the adjustment

coefficient may also lend support to the view that the adjustment process is costly.

We investigate the target-adjustment process further by also estimating a target-

adjustment model similar to that in Opler et al. (1999). This model implies a simple


target adjustment behaviour where changes in cash holdings can be explained by

deviations of current cash holdings from target levels. Unobservable targets are

proxied using historical average values of cash holdings. We find that the estimated

target-adjustment coefficient has a positive value of 0.54 and is significant at 1%, sup-

porting the view that firms adjust toward a target cash ratio. This value is slightlylower than what the above GMM results suggest. However, one should be cautious

in comparing these two results. As noted earlier in the paper, the estimated coeffi-

cient of the simple target-adjustment model is likely to be biased as the model does

not incorporate those firm-specific characteristics described as relevant in determin-

ing cash holdings. Furthermore, it is also important to control for unobservable fixed

effects as well as firm-constant time effects, which are assumed to be significant in the

underlying target cash model. 15

The effect of cash flows on cash holdings is positive and significant at 10%. Thepositive coefficient of cash flows (CFLOW) is consistent with the view that firms that

have higher cash flows are expected to hold larger amounts of cash as a result of their

preference for internal over external finance. To the extent that cash flows are also a

proxy for firms’ growth opportunities the positive impact may indicate that firms

with higher cash flows also hold higher cash reserves to avoid situations in which

they give up valuable investment opportunities in some states of nature.

Liquidity (LIQ), as expected, exerts a negative impact on firms’ cash-holding deci-

sions, though the estimated coefficient is significant at the 10% level. This result mayindicate that firms can use their non-cash liquid assets, defined as net working capital

minus cash and marketable securities, as substitute for cash holdings.

There is strong support for the negative relation between leverage (LEV) and

cash holdings. The coefficient of leverage is negative and significant at 1%. Consis-

tent with John (1993), Baskin (1987), and Fazzari et al. (1996), our results provide

evidence that firms with higher debt ratios have lower cash holdings. Moreover, as

we discussed earlier, to the extent that high leverage is a proxy for the ability

of firms to issue debt, firms may use borrowing as a substitute for holdinglarger amounts of cash and marketable securities. Also, the negative coefficient of

leverage may indicate that the cost of holding high levels of cash is higher with debt

financing.

Our regression results show a significant positive relation between growth oppor-

tunities (proxied by the market-to-book ratio, MKTBOOK) and cash holdings. This

is consistent with the view that firms with higher levels of growth opportunities pre-

fer to hold more cash to avoid situations in which they give up profitable investment

opportunities because they are short of cash. This finding also lends support to theprediction that firms with higher market-to-book ratios would wish to hold more

cash and marketable securities to avoid financial distress because costs are substan-

tially higher for such firms. Finally, the positive coefficient is in line with the hypoth-

15 Overall, our dynamic findings are in line with the previous findings of the target-adjustment models

in the capital structure literature, providing evidence for the target capital structure of firms (see, e.g.,

Taggart, 1977; Marsh, 1982; Jalilvand and Harris, 1984; Shyam-Sunder and Myers, 1999).


esis that firms with greater growth opportunities are likely to have higher agency

costs and hence to resort to internal financing when possible.

Our findings also provide strong evidence that bank-debt financing exerts a neg-

ative and significant influence on cash and marketable holdings of firms. The esti-

mated coefficient is significant at 1%. This is in line with the above arguments thatpredict a negative relation between cash holdings and bank debt financing. More

specifically, the negative coefficient for total bank debt (BANKDEBT) provides sup-

port for the view that bank financing can be effective in reducing costs associated

with agency relations and asymmetric information, thereby lowering the cost of

external financing. It also provides support for the view that bank debt conveys po-

sitive news to the market about the borrowing firms’ credit worthiness. According to

this view, firms with higher bank debt would be expected to have easier access

to external finance (see, e.g., James, 1987; Mikkelson and Partch, 1986). It is possi-ble that the observed negative relation between cash holdings and bank debt

reflects the effect of cash on bank debt rather than vice versa. In fact, Cantillo and

Wright (2000) provide evidence that firms with high cash flows prefer to issue traded

obligations rather than bank debt. However, our analysis control for this potential

problem by instrumenting bank debt variable using its lagged values.

One interesting result stems from the estimated coefficient of size variable (SIZE),

which is positive but insignificant. This finding does not lend support to the view that

larger firms hold lower levels of cash because they are less likely to experience finan-cial distress, more diversified and have better excess to external financing. However,

the positive coefficient suggests that there may be other factors affecting the way in

which size of firms exerts influence on their cash-holding decisions. For example, it

may be that larger firms are more successful in generating cash flows (and profit) so

that they can accumulate more cash and marketable securities. Also, to the extent

that large firms have greater growth opportunities and smaller liquid assets besides

cash and marketable securities, they may choose to hold higher levels of cash.

However, none of these effects seem to prevail.

6. Conclusions

This paper has investigated the empirical determinants of corporate cash holdings

for a sample of UK firms. There are several important features of our analysis,

which, we believe, extend the literature on the empirical determinants of cash hold-

ings of firms. First, we incorporate the ownership and board structure of firms intothe analysis of cash holding decisions. Second, distinct from previous empirical stud-

ies, we effectively control for the endogeneity problem that is likely to arise in the

empirical investigation of cash holdings. Last but not least, our analysis incorporates

the dynamic nature of the response of firms to changes in their target cash levels,

where the target adjustment coefficient is estimated by controlling for firm heteroge-

neity as well as endogeneity and measurement errors.

Our results suggest that ownership structure of firms plays an important role in

determining cash holdings of UK companies. Our findings reveal a non-monotonic


relationship between managerial ownership and cash holdings. We find that cash

holdings first fall as managerial ownership increases up to 24%, possibly suggesting

that the alignment effects of managerial ownership dominate the entrenchment ef-

fects. Then, cash holdings rise as managerial ownership increases to 64%, then falls

at higher levels of managerial ownership. This nature of the relationship does notseem to change significantly with either the firm’s board composition or the presence

of ultimate controllers. In addition, we provide evidence that firms controlled by

families hold higher levels of cash and marketable securities.

Our analysis also reveals that there are significant dynamic effects in the determi-

nation of firms’ cash holdings. Moreover, it provides evidence that cash flows and

growth opportunities of firms exert positive impacts on their cash holdings. There

is also significant evidence for the negative impact of liquid assets, leverage and bank

debt. Finally, our findings suggest that unobserved firm heterogeneity, as reflected inthe time-constant fixed effects, is significant in affecting cash-holding decisions.

Acknowledgements

We gratefully acknowledge helpful comments and suggestions from ChristopherF. Baum, Mustafa Caglayan, Mara Faccio, Gulcin Ozkan, two anonymous referees

and participants at the 2002 European Finance Association Meetings; the 2002

European Financial Management Association Conference; and the 2001 METU

International Economics Symposium. Research assistance was provided by Maria-

Teresa Marchica and Roberto Mura. The standard disclaimer applies.

Appendix A. Panel data specification

Suppose that the unobservable target cash ratio of firms, CASH�it, is taken to be a

function of several firm-specific characteristics, K, suggested by theory, and a distur-

bance term eit.

CASH�it ¼

X

k

bkxkit þ eit ðA:1Þ

where firms are represented by subscript i ¼ 1; . . . ;N , and time by t ¼ 1; . . . ; T .Firms adjust their cash holdings in order for their current cash ratio to be close to the

target ratio. This leads to a partial adjustment mechanism given by

CASHit � CASHi;t�1 ¼ kðCASH�it � CASHi;t�1Þ ðA:2Þ

where CASHit is the actual cash ratio. (CASH�it � CASHi;t�1Þ can be interpreted as

the target change where only a fraction k of it is achieved. The value of the

adjustment coefficient k lies between 0 and 1, capturing the ability of firms to adjust

to their target cash levels. If k ¼ 1, it follows that firms are able to adjust immedi-


ately, i.e. CASHit ¼ CASH�it, implying zero adjustment costs. On the other hand,

if k ¼ 0, the model implies that adjustment costs are so large that firms cannot

change their existing cash structures, i.e. CASHit ¼ CASHi;t�1.

Combining (A.1) and (A.2) and including ai and at yield

CASHit ¼ c0CASHi;t�1 þX

k¼1

ckxkit þ ai þ at þ uit ðA:3Þ

where c0 ¼ 1� k, ck ¼ kbk, and uit ¼ keit and uit has the same properties as eit.

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Documents

[GMM] Corporate Cash Holdings- An Empirical Investigation of UK Companies