How They Spend It - A Study of Corporate Cash Holdings and Spending Behaviour

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M&A Research Centre MARC

How They Spend It:A study of corporate cash levels and spending behaviou r

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MARC is the Mergers and Acquisitions Research Centre at Cass Business School, City University London the first research centre at a major business school to pursue focussed leading-edge research into the global mergers and acquisitions industry.

MARC blends the expertise of M&A accountants, bankers, lawyers, consultants and other key market participants with the academic excellence of Cass to provide fresh insights into the world of deal-making.

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Cass Business School February 2012

Overviewash is king. Now more than ever is this saying true. Companies which were listed on the London Stock

Exchange at any point in time during the last 15 years are currently holding record levels of cash reserves, on average 40% of net assets in 2010, translating to an aggregate amount of $643bn. Given the recent turmoil in the European financial markets, the retention and, therefore, the immediate availability of cash reserves are functioning as a safety net. But is the cash at companies disposal in excess of the so-called sufficient cash level? How do companies tend to spend this excess cash, and which spending strategy has the potential to generate the highest returns for shareholders?

The M&A Research Centre (MARC) at Cass Business School has, in collaboration with its senior sponsors, Credit Suisse and Ernst & Young, performed an in-depth analysis of a) the factors which determine the cash levels which companies need to keep at hand, b) the spending habits of corporates and c) the cash disposal strategies which are most successful.

Highlights of this report:

The cash reserves at companies disposal are at an all-time high. The average cash to net asset ratio for the study sample was equal to 40% in 2010, compared to a long-term average of 26%. The average ratio of excess cash to net assets (as defined by our model) reached 30%, compared to a long-term average of 10%. These figures translate into actual and excess cash levels of $643bn and $450bn respectively for 2010.

The most cash-rich industries, in terms of their cash to net assets ratio, are Technology (49%), Healthcare (47%), Consumer Services (44%) and Industrials (34%), but the factors which influence the sufficiency of the cash reserves at firms disposal can differ substantially across industries. Nevertheless,

there are four factors which appear to determine cash levels for most companies, irrespective of their industry. These are the current net cash flow, managements expectation of the degree to which cash flow in subsequent periods will meet the need for planned investments, as well as the size and liquidity of a companys business.

The analysis of the timing of firms cash disposal activities reveals that the spending type which adjusts most rapidly to changes in excess cash is increase in dividends. In addition, companies tend to prioritise spending for the purpose of investments in the form of acquisitions or organic growth (which occur in the first or second year following a period with excess cash) as compared to other forms of spending, such as buybacks (which tend to occur at a later stage, i.e. in the second or third year following a period with positive excess cash).

Corporates which choose to keep the excess cash reserves at hand for a period longer than one year are penalised by the market. The analysis shows that this strategy is the worst way of managing the additional liquid funds at firms disposal, resulting in an average risk-and index-adjusted underperformance of -15% in the long term.

Two of the spending strategies clearly outperform the others, namely acquisitions and share buybacks. Buybacks reap benefits earlier (generating average returns amounting to 7% after 24 months). However, the strategy of spending on M&A generates even higher returns - equal to 11% - realised in the third year after the implementation of the strategy. When adjusted for risk, however, the two strategies are almost at par, generating 15% and 14% respectively in the third year following implementation.

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Corporate Cash Holdingsorporates are holding record levels of cash reserves. Since the mid 90s, companies which were listed on the

London Stock Exchange at any point in time during the last 15 years have maintained cash levels of around 26% of net assets. This level increased substantially during 2009 and 2010, with the average cash reserves to net asset ratio equal to the all-time record levels of 34% and 40% respectively. The aggregate cash holdings of the sample companies amounted to $574bn in 2009 and $643bn in 2010 as compared to a long-term annual aggregate average of $423bn. However, it is important to note that not all of these cash reserves represent extra liquidity. Financial theory states that each firm needs to maintain a specific level of cash in order to perform its ordinary business activities and to avoid financial difficulties or bankruptcy.1 This level will henceforth be referred to as the sufficient level of cash. The difference between the actual and sufficient cash reserves constitutes the so-called excess cash, i.e. the proportion of cash which the company can freely choose how and when to utilise. But is it possible to measure the size of the sufficient cash reserves which companies should hold and thereby determine the proportion which is in excess?

To address these questions, we first need to identify the factors which affect the level of cash reserves that companies need to keep in order to perform their ordinary business activities and to avoid financial difficulties or bankruptcy, i.e. the sufficient cash reserves. These factors can be broadly classified as macro-economic and company-specific. The macro-economic factors are related to the level of economic activity, the availability of financial capital, i.e. financial liquidity, as well

1 See e.g., Opler et al. (1999) The determinants and implications of corporate cash holdings in the Journal of Financial Economics.

as the overall market sentiment. The company-specific factors relate to the effect of current cash flows on company cash reserves, managements expectation of the likelihood that the companys future inflow of cash will be either sufficient or insufficient to meet future planned investment, the growth opportunities faced by the company, the riskiness of its business, the ease with which it can access external finance, its working capital requirements, cost of capital and level of leverage. In order to identify the most important determinants of companies sufficient cash levels, we modelled firms current cash reserves to variables which proxy for the aforementioned macro-economic and company-specific factors over the period 1996 to 2010. Given that cash levels can vary substantially across industries, we performed the analysis separately for the eight industries included in our study.2 We used the industry-specific cash models to estimate the sufficient cash level for each firm. The difference between the actual and sufficient cash represents the excess cash at a companys disposal.3

Exhibit 1 presents the historical evolution of the sample companies average actual, sufficient and excess cash (as determined by our model) reserves between 1996 and 2010. Companies were sitting on approximately $450bn of excess cash in 2010. The ratio of excess cash to net assets reached an all-time high of 30% in 2010 as compared to a long-term annual average of 10%.

2 This follows the methodology adopted by Harford (1999) in Corporate Cash Reserves and Acquisitions in The Journal of Finance. 3 Excess cash can be either negative or positive depending on whether a given company needs to increase its cash reserves in order to do business as usual or whether it is in possession of more than what is necessary.

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Exhibit 1: The evolution of average actual, sufficient and excess cash between 2006 and 2010

Exhibit 2: Industry breakdown of sufficient and excess cash for 2009 and 2010

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FTSE All-Share Sufficient Actual Excess

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Sufficient Cash Excess Cash Actual Cash

TechnologyTelecom

Basic Materials

HealthcareIndustrials

Consumer Goods

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Exhibit 1 shows the evolution of annual average sufficient, excess and actual cash (all deflated by net assets) over the sample period. Excess cash is measured on the right axis, whereas actual and sufficient cash reserves as well as the percentage yearly change in FTSE All-Share Index are measured on the left axis. The level of sufficient and excess cash must add up to the actual cash reserves at a given companys disposal according to our methodology. Exhibit 2 shows the breakdown of average actual cash levels into sufficient and excess cash per industry for 2009 and 2010. Please refer to the Data and Methodology section of this report for further details on the sufficient and excess cash estimation procedure.

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Exhibit 1 also reveals that the level of the sample companies excess cash and the FTSE All-Share index are inversely related, i.e. companies tend to accumulate excess cash reserves in periods of economic downturn. Actual and excess cash reserves steadily increased over the sample period. Conversely, sufficient cash decreased over the same period, particularly after 2004. There are two explanations for the long-term trends which sufficient and excess cash display over our sample period. First, companies appear to have become increasingly more efficient users of the external capital market, which has enabled them to maintain their ordinary business activities without the need to accumulate large cash reserves. This argument is supported by a decrease in the average cost of capital of the sample companies by 29% between 2002 and 2007. We report growth figures before the financial crisis as it is expected that with the substantial increase in market risk during the period 2008 to 2010, the cost of capital also increased during the latter period. According to our sample data, the average cost of capital increased by 15% during the crisis period. Secondly, companies have improved their ability to manage their cash conversion cycle, meaning that they are more confident that future cash inflows will suffice to meet the planned outflows of cash which are necessary in order to maintain ordinary business activities. We support this argument with the observation that the average net working capital of the sample companies decreased by 32% between 2002 and 2007. It should be noted that the average net working capital holdings increased by 6% during the financial crisis period between 2008 and 2010.

Despite the short-term reversal of these trends in the change in cost of capital and net working capital between 2008 and 2010, the level of sufficient cash that companies needed in order to perform ordinary business activities continued to decrease over the same period. We note that the level of sufficient cash reserves that companies hold moves in line with economic growth, as companies need more

cash in order to expand. As UK economic activity slowed down substantially between 2008 and 2010, it is expected that companies needed less cash in order to maintain their businesses over the same period. The UK GDP annual growth rate was approximately 52% lower than that reported for 2007.4

Exhibit 2 presents a breakdown of actual reserves into sufficient and excess cash at the industry level for 2009 and 2010. The exhibit shows that the most cash-rich industries, in terms of their cash to net assets ratio, are Technology (49%), Healthcare (47%), Consumer Services (44%) and Industrials (34%). These results confirm the findings of previous studies which analyse company cash reserves.5 Exhibit 2 also reveals that, in many cases, the average sufficient cash reserves are lower than the excess cash reserves at companies disposal, which is in accordance with our findings for the overall sample. The discrepancy between excess and sufficient cash reserves, i.e. the amount by which excess cash reserves exceed sufficient cash, is most pronounced in the Healthcare (where this gap amounts to +26pp), Technology (+25pp), Consumer Goods (+17pp) and Oil & Gas (+12pp) sectors. Despite the differences in the determinants of cash reserves between the sample industries, the results from the industry-specific cash models indicate that there are four factors which affect most companies, irrespective of their industry, namely current net cash flow; managements expectation of the degree to which cash flows in subsequent periods will meet the need for planned investments; the liquidity of the business, as identified by the ratio of net working capital to net assets; and the size of the firms business.

4 This figure is based on data provided by Eurostat. 5 See e.g., Harford (1999) in Corporate Cash Reserves and Acquisitions in The Journal of Finance.

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Corporates Spending Patternsompanies are faced with various options when it comes to how and when to utilise the excess cash at their

disposal. The different methods of spending excess cash can be divided into five so-called spending strategies, namely: 1) invest the funds internally in the form of capital expenditure; 2) invest the funds externally in the form of acquisitions; 3) increase cash dividends or introduce special dividends; 4) repurchase shares; and 5) decrease the level of long-term debt. In addition, companies can choose the timing of excess cash disposition, i.e. they can opt for immediate cash utilisation or delay spending until a feasible opportunity occurs. Is there a given pecking order that companies attach to the different spending options with which they are faced?

In order to answer this question, we adopted a regression analysis to determine whether excess cash can explain a companys spending strategy. Thus, in our models, the amount spent on each strategy (i.e. an increase in capital expenditure, acquisitions, an increase in dividend, share repurchase or a reduction in long-term debt) is explained by the level of excess cash together with a number of control factors (i.e. other variables which affect this particular type of spending).6 The analysis reveals that increasing dividends is the spending type which adjusts most rapidly to changes in excess cash, i.e. the change in dividend payment responds immediately (next year) to the level of excess cash in a given year. In contrast, 6 This type of analysis of company cash reserves follows the methodology used by Harford in the Journal of Finance (2005). It should also be noted that each spending model includes the excess as well as the sufficient cash levels at companies disposal. This makes it possible to disentangle the effects of the two types of cash reserve. In order to capture how quickly the spending behaviour adjusts to increases in excess cash, each spending model accounts for the size of the two types of cash reserve over a period of three years before the time of spending.

there is a slight delay in the adjustment of spending on M&A and capital expenditure to the changes in excess cash which happen over the two-year period following the year when the company reported excess cash. The results also demonstrate that the change in spending on share repurchases takes effect over a three-year period, i.e. the delay in the adjustment of buyback spending is higher relative to the delay observed for the spending strategies of acquisition and capital expenditure. There is no discernible speed of adjustment of the amount used in order to reduce long-term debt, i.e. companies which have excess cash will use some of it in order to deleverage, however the timing of this spending strategy is not a priority.

Overall, the analysis reveals that the spending method which appears to take place sooner than the others is increasing cash dividends. This is followed by acquisitions and increases in capital expenditure, with the spending type with the slowest speed of adjustment to variations in excess liquid funds being share buybacks. The planning which is necessary in order to make the decision to acquire another company or expand organically is much more complex than that required when it comes to changing the level of dividends. At the same time, in a highly competitive environment, when an investment opportunity arises, the company which succeeds is the one that moves first. Therefore, investment-type cash spending, such as acquisitions and increases in capital expenditure, happen faster than other types of spending, such as share buybacks. The finding that share repurchases are characterised by the slowest speed of adjustment to changes in excess cash is consistent with firms tendency to embark on so-called buyback programmes which are typically implemented over long periods of time.

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The Optimal Spending Strategiesccording to the Bank of England, the UK economy is set to start expanding in the first quarter of 2013. The Gross

Domestic Product (GDP) growth rate is expected to increase to 2.0% by Q1 2013 as compared to the GDP growth rate forecast for Q4 2011, which was equal to 1.3% at the time of writing. 7 Once the economy starts recovering, companies will come under even more pressure to use their cash in one form or another. Keeping the cash at hand would only earn a maximum return equal to the risk-free rate. However, simply disposing of these cash reserves when an opportunity arises may not prove to be the most profitable strategy to adopt either. Are certain spending strategies superior in terms of the financial performance in which they result?

In order to answer these questions, we examined the share price performance of the spending strategies adopted by the companies which, according to our cash model, possess excess cash. 8 In order to assess the share 7 The forecasts were obtained from the Bank of Englands website. 8 This report focuses on the five primary ways in which companies can dispose of cash, i.e. M&A (on which the sample companies spent an aggregate amount of $3.6 trillion over our sample period), share buybacks (on which the sample companies spent an aggregate amount of $2.7 trillion over our sample period), increases in dividends (the sample companies increased dividends by an aggregate amount of $254 billion over our sample period), increases in capital expenditure (the sample companies increased dividends by an aggregate amount of $415 billion over our sample period) and reduction in long-term debt (the sample companies reduced their leverage by an aggregate amount of $583 billion over our sample period). Since most of the spending strategies are not mutually exclusive, i.e. companies can simultaneously spend excess cash on more than one spending strategy, we devised a methodology whereby it is possible to choose the strategy with the highest importance in terms of the amount of excess cash devoted to it during the years when companies used cash for a combination of cash utilisation methods. In

price performance of companies which chose a given spending strategy, we estimated the so-called Buy and Hold Abnormal Returns (BHAR). 9 In the context of this study, the BHAR share price returns represent the gains which would result from a strategy of investing in a portfolio of all of the firms which opted for a given spending strategy during the last month of the year in which the cash spending took place and then selling this investment after 36 months. The average share price performance of companies which followed a given spending strategy in the first year after a period with excess cash is presented in Exhibit 3. Exhibit 4 presents the corresponding risk-adjusted performance, i.e. the average abnormal returns associated with each strategy deflated by the standard deviation of the returns of all of the companies which selected the same spending strategy. The analysis of risk-adjusted returns makes it possible to measure the abnormal returns per unit of risk that a given spending strategy can generate on average. Both Exhibits 3 and 4 clearly indicate that those companies which kept hold of their excess cash reserves instead of utilising them in one way or another generated the lowest abnormal returns per unit of risk, equal to -15%.

particular, for each of the years during which more than one spending method took place, we selected the spending strategy for which a company devoted the highest portion of cash. Also, it should be noted that in order to avoid double-counting, To evaluate the performance of companies which chose a given spending strategy, we only followed the spending behaviour of those companies from our sample which possessed excess cash in the first year of a three-year period. Please refer to the Data and Methodology section of this report for further details on the performance evaluation methodology. According to this methodology, we have a sample of 107 companies which performed M&A, 145 which performed share repurchases, 435 which increased dividends and 692 which decreased long-term debt. 9 Please refer to the data and methodology section for further details on the calculation of BHAR.

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The performance results also show that, among the five spending strategies investigated in this report, the best performing cash spending methods are M&A and buybacks. The maximum average abnormal return from buybacks (7%) is realised as early as two years after the strategy is implemented, whereas the maximum return from acquisitions, which is comparatively higher (11%), takes longer to materialise. The returns which these strategies generate on a risk-adjusted basis are almost identical, namely 15% and 14%, respectively. It should be noted, however, that the use of excess funds for the purpose of returning cash to investors is not directly comparable to spending on M&A. The latter spending option constitutes a way of investing excess funds in order to improve or expand business operations. In contrast, the former option represents a way of rewarding current shareholders by paying out the extra funds generated by a companys business operations. It follows that the two types of spending strategy should not be regarded as competing methods of cash utilisation, but rather as complementing each other. Financial theory suggests that companies should only invest in projects which are profitable, i.e. those which have positive net present value. However, when a company is not faced with any viable opportunities to improve or expand, it is better to return the extra funds to shareholders as investing in zero or negative net present value projects will result in poor financial performance.

The two strategies which could be considered as substitutes for buybacks and M&A - increasing dividends or expanding a business organically by increases in capital expenditure - can result in abnormal risk-adjusted returns amounting to 4% and -2%, respectively. We note that the average index-adjusted returns generated by these two strategies are very close to 0, i.e. at par with the index return. We conclude that neither of these spending strategies appears to generate superior returns for shareholders, but nor do they destroy value on average. We note that capital expenditure consists of both spending in order to maintain ordinary business activities, such

as replacing defunct equipment and machinery, as well as to expand business operations. In order to be directly comparable to the other spending strategies, we need to disentangle the capital expenditure which is used to maintain company operations from that which is used to grow the business organically. We distinguish between these two types of spending by taking the capital expenditure less depreciation as a proxy for spending for the purpose of expansion.

In summary, the analysis suggests that companies which keep excess cash at hand rather than spending it perform worst and are accordingly penalised by the market (-15%). In contrast, companies which are able to seize profitable investment opportunities through engaging in acquisitions or returning funds to shareholders, when they do not face any viable opportunities to expand, outperform the firms which follow other spending strategies. The reason why companies which use excess cash for organic growth neither out- nor underperform their respective benchmark could be that this form of business improvement or expansion is not a strategy that is aggressive enough to generate returns in excess of the market over a three-year period. It is also plausible that companies lack efficient communication techniques with regard to their internal growth strategies. Whereas takeovers and share repurchases tend to be highly publicised events and are therefore less likely to remain unnoticed by investors, increases in expenditure for organic growth are much more difficult for investors to identify. The performance results associated with spending on organic growth could suggest that companies are not able to convey their spending plans adequately to the investor community.

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Exhibit 3: Buy-and-hold returns for each spending strategy performed in the first year following a period with positive excess cash

Exhibit 4: Buy-and-hold returns adjusted for risk

All with excess cash M&A Capex Dividends Buyback

Reduction in long-term debt No spending

Month 1 -4% 1% -3% -2% -4% -2% -55% Month12 -10% -4% -11% -11% 2% -10% -27% Month 24 -5% 2% -7% 0% 16% -7% -19% Month 36 -1% 14% -2% 4% 15% -1% -15%

Exhibit 3 presents the performance in terms of the average returns of the five different portfolios consisting of all of the companies which opted for a given spending strategy in order to utilise the excess cash at their disposal as well as that of those companies which decided to keep the excess funds to hand. In addition, Exhibit 4 presents the risk-adjusted performance (i.e. the average return divided by the standard deviation of returns) of the aforementioned portfolios The M&A portfolio includes all of the sample companies which used their excess cash for the purpose of M&A and in which the method of payment was all cash; the Capex portfolio includes all of the sample companies which used their excess cash for the purpose of organic growth through capital expenditure; the Dividends portfolio includes all of the sample companies which used their excess cash for the purpose of distributing it in the form of cash dividends; the Buyback portfolio includes all of the sample companies which used their excess cash for the purpose of repurchasing a portion of their shares; and the Reduction in long-term debt portfolio includes all of the sample companies which used their excess cash for the purpose of reducing their indebtedness. It should be noted that, in order to be included in this graph, each spending strategy must have been adopted in the first year following a period of positive excess cash. The returns have been calculated on the basis of the Buy-and-Hold Abnormal Returns (BHAR) methodology. Please refer to the Data and Methodology section of this report for a detailed description of the method used for distinguishing between the different spending options as well as that used in order to evaluate the share price performance of each portfolio.

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Data and MethodologyThe initial study sample consisted of all non-financial and non-utility companies which were listed on the London Stock Exchange at any point in time between 1996 and 2010.10 This list of companies and the necessary financials were collected from Datastream. In order to estimate the so-called sufficient cash reserves at a firms disposal, we adopted a methodology similar to that used by Harford in his study from 1999, Corporate Cash Reserves and Acquisitions, published in the Journal of Finance. A separate cash model was estimated for each of the eight industry groups included in the sample. We excluded the Financial and Utilities sectors due to the fact that the cash policies of companies operating in these industries could be affected by different regulatory frameworks.

The industry-specific cash models are presented in Exhibit 5. 11 We control for the following variables in each of our eight cash models: the ratio of net working capital (measured as the working capital minus cash reserves) to net assets; the ratio of total debt to net assets; the Bank of Englands liquidity index; 12 the spread between AAA and BBB 10 Note that the majority of companies in the sample are registered in the UK. In 2010, 94% of the sample was made up of UK companies, accounting for 80% of the total cash reserves.11 Cash Reserves are defined as the cash plus marketable securities reported on a companys balance sheet and Net Assets as the total assets reported on a companys balance sheet minus the cash reserves. 12 This liquidity index is a simple, unweighted mean of nine liquidity measures normalised for the period 1999-2004. According to the Bloomberg database, the indicator is more reliable after 1997 as it is based on a greater number of underlying measures. Liquidity measures incorporate bid-ask spreads, return to volume ratio, and the Liquidity premia. This single index summarises all these measures. The index combines three key market measures -- the gaps between bid and offer prices on bonds, currencies and stocks, the ratio of market returns to trading volumes, and spreads in the credit market.

rated UK corporate bonds, obtained from Bloomberg; the six and 12 month UK Certificate of Deposit rate, which is measured on a yearly basis and obtained from Bloomberg; and the after tax cost of debt per company, which was also obtained from Bloomberg.13 The cash models were used in order to measure the level of sufficient cash which companies need to perform their ordinary business activities. The difference between the actual and sufficient cash reserves is defined as the excess cash level which companies are free either to keep at hand (i.e. not spend) or use for the purposes of performing acquisitions and/or buying back shares, increasing capital expenditure, reducing long-term debt and/or increasing cash dividends.

In order to evaluate whether the accumulation of excess cash can exert any influence on firms spending patterns, we performed a regression analysis. We constructed five spending models in order to investigate the type of relationship which exists between excess cash reserves and each of the five spending options.14 The dependent variable in each model is the annual amount spent on a given spending strategy divided by the average amount that the company spends on the same strategy. 15 The additional factors which were tested in the model are as follows:

13 Company financials are measured as of one year before the current period. 14 These spending models are based on the methodology presented by Opler et al. (1999) in the study The determinants and implications of corporate cash holdings. published in the Journal of Financial Economics. 15 The cash spending models include both the current and previous (relative to the year of spending) levels of excess and sufficient cash. In addition, it should be noted that both the sufficient and excess levels of cash were tested for statistical significance in each of the spending models in order to disentangle the effects of the two types of cash reserve on company spending patterns.

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1) In the models for acquisitions and capital expenditure: the Purchasing Managers Index (PMI); 16 the year-on-year sales growth was included in order to capture the need for spending funds for the expansion of operating capacity; the market-to-book ratio was used in order to capture the future growth opportunities encountered by the company. 2) In the model for share buybacks: the market-to-book ratio; the level of cash dividends to net assets was included in order to control for the fact that some managers may perceive share repurchases and dividend distributions as substitute methods of rewarding shareholders; the degree of firm leverage was included because the decision to repurchase shares could be viewed not only as a way to reward investors, but also as a way to change the mix of debt and equity used to finance the operations of the business. 3) In the model for dividend distributions: the market-to-book ratio; and the level of cash dividends to net assets as of one year before the current period.17 4) In the model for reductions in long-term debt: the market-to-book ratio; the ratio of long-term debt to net assets was included in order to control for the fact that companies with highly leveraged business operations are faced with a higher likelihood of experiencing financial distress or bankruptcy and thus more inclined to reduce their leverage. In order to evaluate company share price performance, we calculated the Buy-and-Hold Abnormal 16 The PMI is produced by Markit Group Limited and the Institute for Supply Management. It is an indicator of financial activity which measures the acquisitions of goods and services by companies and is constructed on the basis of monthly surveys of businesses. This index was obtained from Bloomberg. 17 The latter variable is identified as an important determinant of dividend distributions by previous studies (see e.g., Lintners 1956 study, according to which the change in dividends is presented as a function of a companys current income, the last periods dividend payments, the companys target payout ratio and its so-called speed of adjustment, i.e. the rate at which the company changes the level of dividends between the current and the ultimate target level that managers would like to pay out).

Returns (BHAR). BHAR can be defined as the average multi-year return from a strategy of investing in all firms that complete an event and selling at the end of a pre-specified holding period versus a comparable strategy using otherwise similar non-event firms (see e.g., Mitchell and Stafford, 2000). An advantage of using BHAR is that this approach to measuring company share price performance is closer to investors actual investment experience compared to the periodic rebalancing which other approaches to share price performance analysis involve.18 Six different portfolios of companies were constructed on the basis of the particular spending option which they chose: Portfolio 1 includes companies which opted for M&A; 19 Portfolio 2 includes companies which opted for organic growth; Portfolio 3 includes companies which opted for a decrease in leverage; Portfolio 4 includes companies which opted for share buybacks; Portfolio 5 includes companies which opted for an increase in cash dividends; Portfolio 6 includes companies which kept the excess cash at hand. 20 The calculation of BHAR is performed as follows:

, 1 , 1 ,

where , represents the return on bidder i over period T and , represents the return on the benchmark index over the same period.

18 We removed the extreme values which result from the BHAR calculation.19 Only acquisitions with 100% cash are considered as a cash utilisation strategy. 20 We adjusted the BHAR by subtracting the returns to the FTSE Share index which were closest in terms of average market capitalisation to the specific company being benchmarked. In order to avoid double-counting, when evaluating the performance of companies which chose a given spending strategy, we only followed the spending behaviour of those companies from our sample which possessed excess cash in the first year of a three-year period. BHAR were measured over a period of 36 months. The BHAR corresponding to each portfolio are equally-weighted.

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Exhibit 5: Industry-specific factors determining corporates sufficient cash reserves

Factors Healthcare Basic Materials IndustrialsConsumer

Goods Consumer Services

Oil & Gas Technology Telecommunications

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Current cash flow Managements expectation of the degree to which future cash flow will meet the need for planned investments

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s

Economic productivity Economic growth Market liquidity

Factors Healthcare Basic Materials IndustrialsConsumer

Goods Consumer Services

Oil & Gas Technology Telecommunications

C

o

m

p

a

n

y

-

s

p

e

c

i

f

i

c

f

a

c

t

o

r

s

Current cash flow Managements expectation of the degree to which future cash flow will meet the need for planned investments

Size Growth opportunities Indebtedness Cost of debt Liquidity

M

a

c

r

o

-

e

c

o

n

o

m

i

c

f

a

c

t

o

r

s

Economic productivity Economic growth Market liquidity

Exhibit 5 shows the different factors which affect the size of sufficient cash reserves for each of the sample industries. These factors are determined on the basis of eight industry-specific models of sufficient cash. Current cash flow is measured as each companys net cash flow deflated by net assets; Managements expectation of the degree to which future cash flow will meet the need for planned investments is measured as the consensus analyst forecast of future net cash flow one and two years ahead of the current period; Size is measured as the natural logarithm of total assets; Growth opportunities are measured as each companys current market-to-book ratio; company Indebtedness is measured as each companys long-term debt deflated by net assets as of one year before the current period; the Cost of debt for each company was obtained from Bloomberg; Liquidity is measured as the net working capital deflated by net assets; Economic productivity is measured as the UK productivity index, provided by the Bloomberg database; Economic growth is measured as the annual change in the MSCI World Index; and Market liquidity is the Bank of Englands liquidity index. For further details on how each variable is constructed please refer to the Data and Methodology section of this report.


Notes on Authors

Anna Faelten, Senior Researcher at the M&A Research Centre. She was previously the editor of Deal Monitor and has recently completed an Executive MBA programme at Cass Business School. Dr Naaguesh Appadu provided additional research assistance. He is a Cass MARC researcher who recently completed a PhD on The Determinants of the Fixed and Floating Rate Debt: a case for UK non-financial firms at Middlesex University.

Valeriya Vitkova, Cass MARC researcher, currently pursuing a PhD programme with a focus on Corporate Finance at Cass Business School.

Scott Moeller, Director of MARC and Professor in the Practice of Finance. His research and teaching focuses on the full range of mergers and acquisitions activities. Contact: [email protected]

Cass Business School 106 Bunhill Row London EC1Y 8TZ Tel +44 (0)20 7040 8600 www.cass.city.ac.uk/marc

Cass Business School In 2002, City Universitys Business School was renamed Sir John Cass Business School following a generous donation towards the development of its new building in Bunhill Row. The Schools name is usually abbreviated to Cass Business School.

Sir John Casss Foundation Sir John Casss Foundation has supported education in London since the 18th century and takes its name from its founder, Sir John Cass, who established a school in Aldgate in 1710. Born in the City of London in 1661, Sir John served as an MP for the City and was knighted in 1713.

Front CoverResearch Report Inside Front CoverHow They Spend It_30 04 2012.pdfResearch Report Back Cover

Documents

How They Spend It - A Study of Corporate Cash Holdings and Spending Behaviour