Financial Conservatism, Capital Structure and

their impact on the Value of Firm: A

Comparison between UK and Italian Firms

By Debjyoti Chakravorty (Student ID: 130500739)

MSc Banking & Finance (Full-time) 2013-14

Supervisor - Dario Maimone Ansaldo Patti

School of Economics and Finance

Queen Mary, University of London

Mile End Road, London E1 4NS

1

Financial Conservatism, Capital Structure and their impact on the Value

of Firm: A Comparison between UK and Italian Firms

August 22, 2014

Abstract

This paper differentiates financially conservative firms from non-conservative firms and

investigates how financially conservatism policies and capital structure policies affect their

firm values. A firm is said to be financially conservative if it has high cash holdings as a

protection against future financial constraints, on the basis of which I have classified firms as

either conservative or non-conservative. Using two samples of UK and Italian firms from

1995 to 2013, I have provided evidence that financially conservative firms do not have the

highest firm value, even if they are cash rich and/ or have low levels of debt, and a detailed

comparison has been made between active UK and Italian firms to illustrate this.

2

Contents

Section Title Page

1 Introduction 3

2 Literature Review 4

3 Empirical Framework 7

4 Data Description:

4.1 The Data 10

4.2 Correlations among Independent Variables 12

5 Empirical Analysis and Results:

5.1 Comparison between UK and Italian firms 14

5.2 Logistic Regression Results 15

5.3 Marginal effects of independent variables on the dependent

Variable

17

5.4 Impact of Financial Conservatism and Leverage on the Firm

Value

19

6 Summary and Conclusions 21

7 References 23

List of Tables

Table No. Table Name Page

1 (A) Correlation Matrix showing Correlations among variables for UK

firms

12

1 (B) Correlation Matrix showing Correlations among variables for

Italian firms

12

2 Mean values of the variables for UK and Italian firms 14

3 Logistic Model Results for Cash Conservatism for UK and Italy 15

4 Marginal Effects of independent variables on the dependent

variable for UK and Italian firms

18

5 Test for Differences in Means between Conservative and Non-

conservative UK and Italian firms

20

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1 Introduction

Traditionally, it was considered that the ultimate objective of any firm is to maximise its

profits. Profit maximisation is however, not the only aim of a firm. Another objective of a

firm is to maximise its market value. In other words, maximisation of the market value of a

firm implies maximising the wealth of its shareholders. It is nowadays argued that value or

wealth maximisation should be the overall objective of financial management and that of a

firm (i.e. the modern concept) as wealth maximisation, unlike profit maximisation, is for

long-term. The value of a firm, which is given by the market value of equity and debt,

depends upon two factors, namely the earnings per share (i.e. profitability) and the market

capitalisation rate (i.e. the rate of return required by the equity shareholders). An increase in

the earnings per share and a decrease in the capitalisation rate or the cost of equity lead to

maximisation of firm value.

Significant empirical work has been done previously on this area and researchers have

identified relationships between large cash holdings and firm values and many have found

out that the value of firm is maximised when a certain level of cash has been held by a firm.

Also, other papers have established relationships between leverage and firm values. Usually,

it is seen that the firm value rises with leverage up to a certain level and then declines as more

debt is used. This can be attributed to the fact that higher the debt, higher is the interest

payment on debt which is a tax deductible expense. As a result, a firm’s tax liability

decreases leading to higher profits and an increase in earnings per share and the firm’s value

(tax-shield benefit). The debt-equity mix, using which the firm value is maximised, is the

optimal capital structure and a further increase of debt beyond this level will only decrease

the firm value. This is because the expectations of equity shareholders (i.e. cost of equity)

will only increase due to the high risk element. Obviously, too much of debt is unbearable

due to financial distress costs which include accounting and lawyer costs in case of

bankruptcy and other associated indirect costs. The positive effects of tax shield will be more

than compensated by the higher distress costs and result in decrease in firm value. This is the

traditional theory as proposed by Modigliani and Miller.

This paper investigates as to how financial conservatism and capital structure policies

affect the value of a firm. This research paper mainly comprises two parts. In the first part,

using large samples of UK and Italian firms over the period from 1995 to 2013, each firm is

classified whether it is financially conservative or not, depending on its cash holdings. This

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has been achieved using a logistic (or logit) model and the relationships between the

likelihood that a firm adopts financial conservative policy and the degree of leverage the firm

uses and other such variables are established. In the second part, the firm values have been

computed separately for conservative and non-conservative firms of UK and Italy and a

detailed comparison has been made between them to illustrate how financial conservatism

policies and leverage affect the values of these firms – whether they lead to an increase or a

decrease in the firm value is my research question.

The rest of the paper has been organised as follows. In section 2, I have presented

previous working papers to review the literature on my research topic. Section 3 describes the

methodology used in my dissertation. This includes which econometric model(s) I have used

and the reason behind the use of such model(s). Details have also been provided as to which

formula I have used to compute the firm values of each UK and Italian firm in my samples

and an explanation of the formula has also been given. Section 4 is the data description

section and it contains information relating to the data used i.e. the type of data, its source,

the time period and for which countries. Moreover, this section also describes the dependent

and independent variables used in the econometric model(s) and how these variables have

been defined (i.e. the formulae used to calculate the variables). In section 5, I have presented

the results of the econometric model(s) and have also given a clear interpretation of these

results. Finally, section 6 is the conclusion and contains a detailed summary of the results.

2 Literature Review

It is suggested that a firm can achieve financial flexibility by adopting financially

conservative policies. Financial flexibility generally refers to a firm’s ability to deal with

unforeseen or unpredicted events or occurrences depending on the firm’s financial structure

and policies. A firm is considered to be financially flexible if the firm is solvent and has the

ability to convert its assets into cash quickly so that it can meet its debt obligations as and

when they fall due. These firms have flexibility in funding capital expenditure and

acquisitions in which internally generated funds in the form of internal cash flows and

retained earnings are preferred over external financing. If however, internal funds are

insufficient to fund investments, the firms raise funds externally and they prefer debt to

equity issuance (Myers and Majluf, 1984). In Myers (1984), the static trade-off framework is

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contrasted with the old-fashioned pecking order theory and the results conclude that the latter

performs at least as well as the former. The static trade-off framework is one in which the

firm sets a target debt-to-value ratio (which is the optimal debt ratio) and gradually moves

towards achieving it. Shyam-Sunder and Myers (1999) also tested static trade-off against the

pecking order model and the results suggested greater confidence in the pecking order model

when these two were tested jointly.

Financially conservative policies are of two types mainly – cash conservative and leverage

conservative. In other words, a firm is said to be financially conservative if it either holds

large cash reserves or uses low leverage. Previously, there has been a lot of research

conducted on firms which have substantial balances of cash and cash equivalents. Studies by

Kim, Mauer and Sherman (1998); and Opler, Pinkowitz, Stulz and Williamson (1999)

investigated the determinants of firms’ liquidity ratios. This was achieved by conducting

cross-sectional and time series tests of firms’ cash ratios and regressing firms’ cash holdings

on several variables. The results obtained were consistent with the trade-off theory. Ozkan

and Ozkan (2004) found out which factors or set of variables affect cash holdings of UK

firms and proved that there exists a significant non-monotonic relation between cash holdings

and managerial ownership. According to Mikkelson and Partch (2003), for firms which

persistently hold large reserves of cash, financially conservative policies support investments

without hindering corporate performance and also facilitate growth of the firms. In their

paper, it is stated that a firm is cash conservative if it annually holds cash and cash

equivalents in excess of 25% of its total assets for five consecutive years. They estimated a

logit model of whether firms retained high cash holdings. Similarly, in my research, I have

classified a firm as cash or financially conservative if it held more than 25% of its assets in

cash and cash equivalents each year, rather than five consecutive years and have also

estimated a logit model, the details of which are given in the following section.

For firms that adopt policies of low debt (i.e. leverage conservatism policies), however,

much less empirical work has been done in prior years. It is because of this reason that in my

research, I have classified only those firms which hold large reserves of cash as financially

conservative i.e. those firms which adopt cash conservatism policies. Minton and Wruck

(2001) classifies a firm as leverage or financially conservative if it persistently holds low

levels of debt i.e. its annual ratio of long-term debt to total assets is less than 20% for five

consecutive years. Similar to Mikkelson and Partch (2003), they also used a logit regression

to identify the firms which are leverage conservative. From the results, they conclude that

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financially conservative firms follow the pecking order theory and that they stockpile the debt

capacity, which are then utilised later to finance acquisitions and capital expenditure. Minton

and Wruck (2001) is the most notable or prominent out of the very few research works

carried out on leverage conservative firms.

However Iona, Leonida and Ozkan (2004) have combined the literature on leverage

conservatism and capital structure with the literature on cash conservatism and cash holdings.

According to them, a firm is said to be financially conservative if it adopts both cash

conservatism and leverage conservatism policies jointly. In other words, a firm must have

high levels of cash holdings and low leverage simultaneously to be considered as financially

conservative. The findings of this working paper are in line with other papers such as

Hovakimian and Titman (2003); Fazzari, Hubbard and Petersen (1996) and Kim, Mauer and

Sherman (1998), which argue that financially constrained firms have more incentives to hold

substantial cash reserves. Moreover, this paper also studies whether corporate governance

characteristics like managerial ownership, board composition, etc. affect the probability of

firms adopting conservative policies.

Going into how capital structure policies affect firm values, Modigliani and Miller, 1958

argued that the degree of leverage used by a firm has no impact on its overall cost of capital

and as a result, the firm value remain unchanged. This paper assumed no taxes, no transaction

costs and no bankruptcy costs. This means that no matter how much a firm borrows, there

will be no tax benefits from interest payments and therefore, no change in firm value. In

Modigliani and Miller, 1963 (i.e. the traditional theory as discussed above), corrections were

made and they took into account corporate taxes and bankruptcy costs and concluded that

changes in capital structure do have an impact on firm values due to the positive effects of tax

shield associated with interest payments and as a result firm value increases with debt until

the optimal debt ratio is reached. However, Miller, 1977 pointed out that the traditional

approach ignored personal taxes and although interest payments helped firms decrease their

tax liabilities, interest income was taxed at the personal level. Graham, 2000 also argued that

firms can increase tax benefits by issuing debt until the marginal tax benefits begin to decline.

The results proved that the tax benefit of debt equals 9.7% of firms’ market value or as low as

4.3%, net of personal taxes. His results also showed surprisingly that large, profitable, liquid

firms having low costs of distress and growth opportunities use debt conservatively and this

policy of leverage conservatism is persistent.

7

The following papers have revealed how holding large cash reserves impacts firm values.

Martinez-Sola, Garcia-Teruel and Martinez-Solano, 2013 investigated the effect of cash

holding on the firm value for US firms. Their results confirm that there is a concave

relationship between cash holding and firm value and that there exists an optimal level of

cash holding which maximises the firm value which they estimated to be 14% of total assets.

Any deviations from this optimal level of cash holdings decrease the firm value. Other paper

such as Pinkowitz, Stulz and Williamson, 2006 also establish the relationship between cash

balance and firm value and concluded that the marginal effect of cash on firm value is much

less in countries with poor investor protection than other countries.

It is to be noted that two countries, UK and Italy have been selected in my dissertation as

Italian firms use an estimated average debt-equity ratio of 50% in comparison to that of UK’s

20% (Fan, Titman and Twite, 2012). This shows that UK and Italian firms have capital

structure policies different from each other with Italian firms having an average debt of

approximately 2.5 times as that of UK firms. The Italian firms thus, tend to be non-

conservative, whereas UK firms tend to be more financially conservative. Due to this, the

differences in the logit model results between UK and Italy can be illustrated better.

Similarly, the differences between the firm values of UK and Italian firms can be explained

and hence, the comparison between UK and Italian firms.

3 Empirical Framework

In this section, I have summarised the methodology I have used in my dissertation to carry

out the econometric test(s). In my model, the dependent variable can only accept either of

two values, 1 and 0. It will be equal to 1 if the firm is financially conservative and 0 if non-

conservative. In other words, the dependent variable has a dichotomous structure. To deal

with such cases, a binary model in the form of either probit or logit has to be used rather than

the Ordinary Least Squares (OLS) estimator. Both probit and logit will give similar results

because their densities are very similar and the difference between the two is qualitatively

small. However, I have used the logit model in my analysis (Mikkelson and Partch, 2003;

and Minton and Wruck, 2001).

Two separate datasets of UK and Italian firms have been used and the objective is to

differentiate the cash or financially conservative firms from the non-conservative ones. Each

8

UK and Italian firm is represented by a unique global company key. For every year (1995 to

2013), each of these firms’ year ending figures of current assets, total assets, current

liabilities, capital expenditure, common or ordinary equity, cash, cash flows (i.e. increase and

decrease in cash and cash equivalents), long term debt, preference dividend, earnings before

interest and tax, interest paid, inventories, sales and total income tax have been obtained (all

figures in millions). This constitutes a panel of microeconomic data, which has been used in

my model. However, the panel of data is unbalanced as the data for a number of firms in the

samples is not available for few years. It is to be noted that the data obtained is for both active

and inactive UK and Italian firms. Thus, the data for inactive firms has been deleted before

estimating the equation as only active UK and Italian firms have been taken in my research.

The following equation has been estimated with the two samples of the resultant active

UK and Italian firms:

CASH_CONi = C + γ1(CASHFLOW)i + γ2(LIQUIDITY)i + γ3(LEVERAGE)i + γ4(MTB)i

+ γ5(CAPEX)i + γ6(SIZE)i +εi (1)

where CASH_CONi is the dependent or dummy variable, CASHFLOW is the firm’s flow of

cash, LIQUIDITY denotes the liquidity position of the firm, LEVERAGE is total long term

debt to equity, MTB is the firm’s market to book value, CAPEX is the ratio of capital

expenditure to total assets and SIZE defines the size of the firm given by log of total assets.

The firm-year observations for which total assets, current liabilities and common or

ordinary equity are equal to 0 have been deleted before estimating the model. The reason for

this has been explained in the next section. Also, how each of these independent variables is

defined has been explained in the next section (i.e. the formulae to compute these variables or

the ratios used). For each firm, the cash to asset ratio given by Cash/ Total Assets has been

computed. The dependant variable, CASH_CON takes 1 for those observations if the annual

cash to asset ratio is higher than 0.25 and 0 otherwise, after which the model is run and the

results estimated (Mikkelson and Partch, 2003). As discussed earlier, I have classified a firm

as being cash conservative if its cash to asset ratio exceeds 0.25 for a year, rather than for five

consecutive years (Fama and French, 1999; Graham, 2000 and Titman and Wessels, 1988).

This means that a particular firm maybe cash conservative in one year and non-conservative

the following years (i.e. the one-year definition has been used). In order to classify whether

the firms are financially conservative or not, the fitted values are compared with the in-

sample probability. The fitted values, in a logit model, are always restricted within the (0,1)

9

interval. The in-sample probability is given by the number of observations with dependent

variable equal to 1 divided by the total number of observations taken in the model. If the

fitted value is higher than the in-sample probability, the firm is financially conservative and

otherwise non-conservative.

Since, the logistic regression is non-linear, it is also necessary to find out the marginal

impacts of each of the independent variables on the dependent variable. Therefore, the

marginal impacts of unitary changes in CASHFLOW, LIQUIDITY, LEVERAGE, MTB,

CAPEX and SIZE on CASH_CON have been computed. The marginal impact of each

independent variable can either by positive or negative. If positive, it implies that a unitary

increase in the independent variable generates a certain level of increase in the possibility of

the firm adopting cash conservative policy, while a negative marginal impact generates a

certain level of decrease in the likeliness that the firm adopts cash conservative policy.

To see how financial conservatism affects the value of a firm, the conservative UK firms

are separated from the non-conservative ones and the same is done with the Italian firms and

then, the value of each firm is calculated using a simple formula (2) given below. For this

calculation EBIT, interest paid, total taxes, preference dividends, total long-term debt (all

figures in millions) and cost of equity of UK and Italian firms are used. The average of the

firm values are calculated separately for the conservative and non-conservative UK and

Italian firms and a comparison is made between them. Clearly, a conservative firm will be

less levered than a non-conservative firm and as discussed before, the degree of leverage for

Italian firms are much more than that of UK firms. Thus, this will show how financial

conservatism and capital structure policies impact firm values.

A firm has to pay dividend to its preference shareholders first and then to equity

shareholders and hence, preference dividend is subtracted from the firm’s profits before

dividends are paid to equity shareholders. Therefore, only the residual profit is used for

paying dividend to equity holders. The value of equity is calculated by dividing profit

available for equity shareholders by the cost of equity (i.e. the market capitalisation rate) and

then added with the value of debt to obtain the firm value.

Thus, the firm value is given by:

10

(Cost Accounting and Financial Management Part-2: Financial Management Volume 1,

Board of Studies, The Institute of Chartered Accountants of India. (2013). 1st ed. New Delhi

110 002, India: The Publication Department of ICAI, pp.4.36 - 4.42)

It is to be noted that the firm-year observations for which the cost of equity is equal to 0

have been deleted before calculating the firm values to obtain accurate results. As seen from

the above formula (2), if this is not done, the values of equity of few observations cannot be

found (since division by 0 gives error) and hence, the firm values cannot be computed.

4 Data Description

4.1 The Data

As discussed above, the two separate samples of dataset for UK and Italian firms from

January 1995 to December 2013 have been obtained from Wharton Research Data Services

(WRDS) under COMPUSTAT. This constitutes an unbalanced panel of microeconomic/

firm-specific data, which has been used in my model.

Iona, Leonida and Ozkan 2004; and Ozkan and Ozkan, 2004 argue that the likelihood of a

firm being cash conservative depends on factors (or set of variables) such as the firms’

CASHFLOW, LIQUIDITY, LEVERAGE, MTB, CAPEX and SIZE. These variables have

been used as independent or explanatory variables in my model which affect the dependent

variable CASH_CON. For my model, cash flows (i.e. cash inflows and outflows) is the

increase or (decrease) in cash and cash equivalents and represents the net change in cash

position. Cash inflows are presented as positive numbers whereas cash outflows as negative

numbers. The independent variable CASHFLOW is given by the ratio of cash flows over

total assets. For LIQUIDITY, the Acid-test ratio or the Quick ratio has been used which is

given by (current assets - inventories)/ current liabilities. This ratio is preferred over current

ratio because in the quick ratio, inventories (the most illiquid of all assets) is deducted from

the current assets figure and is therefore a more accurate measure. It is to be noted that

current liabilities includes the current portion of the long-term debt. The current assets figure

already includes inventories and inventories figure is the total of raw materials, work-in-

progress and finished goods. There are various methods to measure the extent of leverage a

firm uses. These include long-term debt ratio, total debt ratio, debt-equity ratio, etc. For

11

LEVERAGE, debt-equity ratio has been taken which is given by long-term debt/ equity.

Equity is the total of common or ordinary stock, capital surplus and retained earnings. MTB,

which represents a firm’s growth opportunities, has been taken as proxy of total sales divided

by total assets. Total assets here, includes fixed assets, investments and current assets.

CAPEX is given by capital expenditure divided by total assets. Capital expenditure refers to

money spent in additions to property, plant and machinery, equipment, etc. but excludes

amounts arising from acquisitions. SIZE is equal to the logarithm of total assets of the firm,

which is a measure of a firm’s size or scale of operations. Looking at the above formulae

used for each of the independent variables, it is therefore necessary to delete all the firm-year

observations with total assets, current liabilities and common or ordinary equity equal to 0

before estimating the regression (1) so as to avoid the errors due to division by 0.

In order to calculate the firm values of the conservative and non-conservative UK and

Italian firms, each firm’s EBIT, interest paid, income taxes and preference dividend are used,

which also have been obtained under COMPUSTAT from WRDS. EBIT is the firm’s earning

or profit or before interest and taxes have been deducted from it. It is given by total sales or

turnover less cost of goods sold less selling, general and administrative expenses less

depreciation and/ or amortisation. Interest is the amount of interest on long term debt, while

tax is given by the total of all income taxes imposed by federal, state and foreign

governments. Preference dividend is the total of the dividends paid to preference shareholders

during the year. For cost of equity or the market capitalisation rate, the return on equity

(ROE) which is given by profit available for equity shareholders divided by common or

ordinary equity has been used. The cost of equity and return on equity are very closely related

concepts. Cost of equity refers to the return required by the equity shareholders given the

level of risk taken, whereas return on equity is useful for shareholders who invest in the

firm’s equity as it allows them to see how much return they can earn on their investment. In

other words, cost of equity is a cost while return on equity is an income from the firm’s

perspective.

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4.2 Correlations among Independent Variables

Tables 1(A) and 1(B) report the correlations among the variables for the UK and Italian firms

respectively.

CORRELATION

PROBABILITY CASHFLOW LIQUIDITY LEVERAGE MTB CAPEX SIZE CASH TO ASSET

CASHFLOW 1.0000

-

LIQUIDITY 0.066482 1.0000

0.0000*** -

LEVERAGE -0.000302 -0.004609 1.0000

0.9708 0.5765 -

MTB -0.033299 -0.084684 -0.008526 1.0000

0.0001*** 0.0000*** 0.3014 -

CAPEX -0.042511 -0.043833 0.005745 -0.008823 1.0000

0.0000*** 0.0000*** 0.4862 0.2849 -

SIZE 0.052698 -0.074489 0.02423 -0.018864 0.039658 1.0000

0.0000*** 0.0000*** 0.0033*** 0.0222** 0.0000*** -

CASH TO ASSET 0.096806 0.245622 -0.021026 -0.076047 -0.068654 -0.361676 1.0000

0.0000*** 0.0000*** 0.0108** 0.0000*** 0.0000*** 0.0000*** -

TABLE 1 (A)

Correlation Matrix showing Correlations among variables for UK firms

***, ** and * stand for statistical significance at 1%, 5% and 10% levels respectively.

CORRELATION

PROBABILITY CASHFLOW LIQUIDITY LEVERAGE MTB CAPEX SIZE CASH TO ASSET

CASHFLOW 1.0000

-

LIQUIDITY 0.125389 1.0000

0.0000*** -

LEVERAGE -0.020791 -0.053002 1.0000

0.2689 0.0048*** -

MTB -0.01138 -0.186055 -0.044992 1.0000

0.5451 0.0000*** 0.0167** -

CAPEX -0.070354 -0.086612 -0.032547 -0.097499 1.0000

0.0002*** 0.0000*** 0.0835* 0.0000*** -

SIZE 0.021342 -0.065979 0.071735 -0.056958 0.051226 1.0000

0.2565 0.0004*** 0.0001*** 0.0024*** 0.0064*** -

CASH TO ASSET 0.22223 0.376463 -0.045385 -0.06257 -0.08789 -0.264043 1.0000

0.0000*** 0.0000*** 0.0158** 0.0009*** 0.0000*** 0.0000*** -

***, ** and * stand for statistical significance at 1%, 5% and 10% levels respectively.

TABLE 1 (B)

Correlation Matrix showing Correlations among variables for Italian firms

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As far as the results show, for both UK and Italian firms, there exist a positive correlation

between LIQUIDITY and CASH TO ASSET (or cash holdings). This is expected, as a liquid

firm must have high cash holding so that it can meet its debts and obligations as and when

they fall due. Similarly, LIQUIDITY is also positively correlated to the firm’s CASHFLOW.

LEVERAGE has a negative correlation with CASH TO ASSET and CASHFLOW indicating

that higher the leverage, higher will be the interest paid which will decrease the cash holdings

as well as the net profits of the firm. This will also affect the liquidity position of the firm and

therefore, the correlation between LEVERAGE and LIQUIDITY is also negative. This

indicates that a firm can adopt both cash and leverage conservatism policies simultaneously

i.e. financially constrained firms can hold large cash reserves (Iona, Leonida and Ozkan,

2004). This is also consistent with Hovakimian and Titman, 2003; Fazzari, Hubbard and

Petersen, 1996; and Kim, Mauer and Sherman, 1998 working papers in which it is argued

that managers of firms stockpile cash so as to avoid the use of leverage. Contrary to this,

others claimed that cash and leverage conservatism policies only act as substitutes and that

these cannot exist simultaneously (Kaplan and Zingales, 1997; and Kashyap, Lamont and

Stein, 1994). According to them, firms holding high cash and cash equivalents do not adopt

leverage conservatism policies since their investments are not limited by lack of finance. The

results also suggest that LEVERAGE is negatively correlated to MTB and it supports the

view that a firm with greater growth opportunity have an incentive to use debt sparingly as a

precaution (Barclay, Morellec and Smith, 2003; Rajan and Zingales, 1995; and Smith and

Watts, 1992). This is consistent with the Pecking order theory as well, according to which,

firms with high growth opportunities and holding large cash reserves first exhaust internally

generated funds in the form of cash flows and retained earnings and then, opt to go for

external financing in the form of debt and equity issuance (Myers, 1984; and Myers and

Majluf, 1984). The correlation between MTB and CASH TO ASSET is however, negative for

my samples of UK and Italian firms not supporting the view that a firm with a greater growth

opportunity holds more cash. Thus, the correlation between MTB and LIQUIDITY is also

negative. This is not consistent with the findings of prior researchers. Also, the amount spent

on capital expenditure by a firm (i.e. CAPEX) and its SIZE are negatively correlated to its

CASH TO ASSET and LIQUIDITY meaning that the higher a firm spends on capital

equipment and its expansion, the lower is its cash holdings, which is obvious. Moreover, the

correlation between SIZE and LEVERAGE is positive which reveals that larger firms are

more financed by debt as compared to smaller firms. This is because the cost of raising debt

is cheaper for large firms as compared to smaller firms and that small firms also exhibit

14

precautionary behaviour and therefore, use internal funds the most. It is important to note that

for my sample of UK firms, there exists a positive correlation between CAPEX and

LEVERAGE, whereas for my sample of Italian firms, the same is negative. This indicates

that levered UK firms often make additions to their capital equipment for growth and

expansion, while that is not the case with levered Italian firms, which in comparison, do not

spend much on capital expenditure.

5 Empirical Analysis and Results

In this section, I have illustrated and explained my analysis and findings in details.

5.1 Comparison between UK and Italian firms

First, it is necessary to make a general comparison between UK and Italian firms in terms of

their cash flows, liquidity, proportion of debt (i.e. leverage), market to book values, capital

expenditure, size and cash holdings. This has been done using the averages of the firms’

CASHFLOW, LIQUIDITY, LEVERAGE, MTB, CAPEX, SIZE and CASH TO ASSET as

reported in Table 2 below.

As seen in this table, Italian firms, on an average, have a higher flow of cash (i.e. increase

in cash and cash equivalents) than UK firms. In terms of liquidity, UK firms are

approximately 2.5 times more liquid as compared to the Italian firms. This shows that UK

firms are more solvent and have a greater ability to meet their debts and obligations as these

fall due. This is a particularly important consideration as a large proportion of firms that fail

VARIABLES UK FIRMS ITALIAN FIRMS

CASHFLOW 0.001 0.003

LIQUIDITY 3.311 1.311

LEVERAGE 0.367 0.633

MTB 1.083 0.761

CAPEX 0.053 0.042

SIZE 4.091 7.259

CASH TO ASSET 0.159 0.061

Mean values of the variables for UK and Italian firms

TABLE 2

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are profitable when they do so. It is because of a shortage of cash which forces them into

liquidation. This implies that the cash holdings of the UK firms are higher than those of the

Italian firms, as evident from the mean cash to asset ratios. The average leverage (debt-equity

ratio) that Italian firms use is 63%, which is approximately 1.7 times that of the UK firms,

which use 37%. This is consistent with Fan, Titman and Twite, 2012 which states that Italian

firms use 50% of debt on an average as compared to that of UK firms which use 20% (i.e. 2.5

times that of UK firms). The high leverage of the Italian firms implies high financial risks for

their ordinary shareholders of not receiving dividends due to high interest payments. UK

firms also have superior opportunities for growth than Italian firms, as evident from the

superior market to book values of the UK firms. In spite of being larger in size (1.8 times)

than UK firms, the Italian firms spend less on capital expenditure.

5.2 Logistic Regression Results

In Table 3, the estimation results of the logistic regressions for the active UK and Italian

firms respectively have been presented and comparison has been made between the results.

VARIABLES UK ITALY

C -0.399693 -0.752483

(-4.017206)*** (-1.581703)

CASHFLOW 0.727431 3.627061

(2.66348)*** (3.333269)***

LIQUIDITY 0.091346 0.264027

(4.247012)*** (3.587741)***

LEVERAGE -0.00676 -0.038531

(-2.811852)*** (-1.715844)*

MTB -0.01758 -1.301645

(-0.662967) (-3.294726)***

CAPEX -0.473764 -3.999199

(-1.463651) (-1.050711)

SIZE -0.368816 -0.338313

(-31.77059)*** (-6.45472)***

McFadden R-squared 0.182738 0.251675

LR statistic 2679.642 237.2896

Prob (LR statistic) 0.0000 0.0000

TABLE 3

Logistic Model Results for Cash Conservatism for UK and Italy

The z-statistics are reported in the brackets. ***, ** and * indicate that the

coefficients are statistically significant at 1%, 5% and 10% level respectively.

16

For the sample of active UK firms (after deleting the inactive firms), there is a total of

14,692 firm-year observations, out of which 2,924 have CASH_CON (i.e. dependent

variable) equal to 1, while the remaining 11,768 observations have CASH_CON equal to 0.

This means that only 2,924 observations have CASH TO ASSET equal to 0.25 or more. In

other words, these have 25% or higher cash holdings as a percentage of total assets. Thus, the

in-sample probability that a firm is cash conservative is equal to 0.199 i.e. 19.9%

(2,924/14,692*100). All the coefficients are statistically significant other than MTB and

CAPEX, having probabilities equal to 0.5074 and 0.1433 respectively, both of which are

higher than 10% significance level. As per this table, larger CASHFLOW and LIQUIDITY

are associated with larger possibility that the firm is cash conservative. This is because their

coefficients are positive, 0.727431 and 0.091346 respectively. On the other hand, larger

LEVERAGE and SIZE are associated with lesser likelihood that the firm is cash conservative

due to their negative coefficients of -0.00676 and -0.368816 respectively. The McFadden R-

squared shows that this model explains approximately 18.27% of the variability in the sample

data. Also, Prob (LR statistic) proves that overall this model is statistically significant as it is

equal to 0. After comparing the fitted values with the in-sample probability, it is classified

whether a firm is financially conservative or not. If the fitted value is higher than the in-

sample probability, the firm is said to be financially conservative and otherwise, financially

non-conservative. From the results, it is found out that 5,355 firm-year observations out of

14,692 are financially conservative, while the remaining 9,337 are non-conservative. This

implies that 36.45% of the observations are financially conservative.

For the sample of Italian firms, which is relatively smaller, the total number of firm-year

observations is equal to 2,829 of which 112 have CASH_CON equal to 1, while the

remaining 2,717 observations have CASH_CON equal to 0. This means that only 112

observations hold 25% or higher cash as a percentage of total assets. Here, the in-sample

probability that a firm is cash conservative is equal to 0.03958 i.e. 3.96% (112/ 2,829*100).

In this case, all the coefficients are statistically significant except CAPEX, which has a

probability of 0.2934. Similar to the UK firms, the results show that larger CASHFLOW and

LIQUIDITY are associated with higher chance that a firm is cash conservative. This is

because their coefficients are positive, 3.627061 and 0.264027 respectively, which implies

that these independent variables have a positive effect on CASH_CON. However, increases

in LEVERAGE, MTB and SIZE, on the other hand, are associated with a decrease in the

likeliness of the firm being cash conservative as their coefficients are negative, -0.038531, -

17

1.301645 and -0.338313 respectively. The McFadden R-squared indicates that this model

explains approximately 25.17% of the variability in the data, as compared to 18.27% in the

previous model for UK firms. Moreover, Prob (LR statistic) equal to 0 indicates that this

model is statistically significant. Thus, this model performed better than the previous one on

the sample of UK firms. In this sample of active Italian firms, only 671 observations are

financially conservative, while the remaining 2,158 are non-conservative i.e. only 23.72% are

financially conservative.

It is thus concluded from the above results that 36.45% of UK firms are financially

conservative, whereas only 23.72% Italian firms are conservative. This can be attributed to

the difference between UK and Italian firms in terms oftheir cash flows, liquidity, proportions

of debt to equity (i.e. leverage), market to book values, capital expenditure, size and cash

holdings as already explained above and shown in Table 2.

5.3 The Marginal Effects of the independent variables on the dependent

variable

It is necessary to compute the marginal effect of each independent variable on the dependent

variable. To do this, the non-linear logistic function has to be differentiated and as a result,

the following formula (3) is used. For example,

The marginal impact of CASHFLOW on CASH_CONi i.e.

where C1 = Coefficient of constant C, C2 = Coefficient of CASHFLOW, C3 = Coefficient of

LIQUIDITY, C4 = Coefficient of LEVERAGE, C5 = Coefficient of MTB, C6 = Coefficient

of CAPEX, C7 = Coefficient of SIZE, CF = Mean of CASHFLOW, LIQ = Mean of

LIQUIDITY, LEV = Mean of LEVERAGE, MtB = Mean of MTB, CPX = Mean of CAPEX

and SIZ = Mean of SIZE.

The impacts of the explanatory variables on the dependent variable are evaluated at their

mean values and hence mean values of the variables have been used in the above formula. In

18

this way, the marginal effects of all the explanatory variables on the dependent variable have

been computed and given in Table 4 below.

It can be seen from the table that 1 unit increase in cash flows generates around 0.117 and

0.063 increase in the likelihood of being cash conservative for UK and Italian firms

respectively. This shows that cash flows has a greater impact on UK firms being conservative

than Italian firms. Similarly, liquidity affects UK firms more than those of Italy. For every 1

unit increase in liquidity, there is a 0.015 increase in the possibility that a UK firm is

conservative, whereas there is only a 0.005 increase in the possibility that an Italian firm is

conservative. On the other hand, increases in leverage, capital expenditure and the size of

firms decrease the chance that the firm is conservative for both UK and Italy. Leverage, as it

can be seen, has a very small effect on cash conservatism. A unitary increase in leverage

decreases the possibility that a UK firm is conservative by 0.001 and decreases the

probability that an Italian firm is conservative by 0.0007. Capital expenditure and size of the

firm however, have a much higher impact on cash conservatism for both UK and Italian firms

as compared to leverage. Moreover, for my sample of UK and Italian firms, an increase in

market to book ratio decreases the possibility that the firms are cash conservative. As

discussed earlier, this is not in line with prior research and findings. Previous researchers

have found out that with increase in market to book ratio, the likeliness that a firm is cash

conservative increases. However, in the above table, the marginal effects of all the

explanatory variables on the dependent variable have been calculated. It is to be noted that as

seen in the logit model results, market-to-book ratio and capital expenditure doesn’t affect

VARIABLES UK FIRMS ITALIAN FIRMS

CASHFLOW 0.117 0.063

LIQUIDITY 0.015 0.005

LEVERAGE -0.001 -0.001

MTB -0.003 -0.023

CAPEX -0.076 -0.070

SIZE -0.059 -0.006

Marginal Effects of independent variables on CASH_CON for UK and Italian firms

TABLE 4

19

UK firms as their coefficients were found out to be statistically insignificant. For Italian

firms, however, only capital expenditure has no effect.

5.4 Impact of Financial Conservatism and Leverage on the Firm Value

In order to evaluate how financial conservatism and leverage impact the value of a firm, the

conservative UK firms have been separated from the non-conservative ones and their firm

values have been computed using formula (2). The same has been done with the conservative

and non-conservative Italian firms. As per my sample of active UK and Italian firms, there

are 5,355 UK firms which are conservative while 9,337 are non-conservative. Similarly, there

are 671 conservative Italian firms and 2,158 non-conservative Italian firms. However, the

firm-year observations which have cost of equity equal to 0 have been deleted as for those

observations, the value of equity cannot be computed. After deleting these observations, we

have 5,321 observations of conservative UK firms and 9,334 observations of non-

conservative UK firms. Similarly, we have 671 observations of conservative Italian firms and

2,156 observations of non-conservative Italian firms. A comparison is now made among

conservative UK firms, non-conservative UK firms, conservative Italian firms and non-

conservative Italian firms using their mean values of EBIT, interest, taxes, value of equity,

value of debt and value of firm.

Table 5 reports the test for differences in mean values (using the test of equality) of these

variables between conservative and non-conservative UK firms, and between conservative

and non-conservative Italian firms. For each of these groups of firms, the mean values of

leverage will differ. Obviously, as discussed above, Italian firms use higher leverage (1.7

times for my samples) as compared to UK firms.

20

From this table, it can be seen that the mean leverage for conservative UK firms is

negative. The degree of leverage can never be negative. Therefore, the average leverage equal

to -0.13 only indicates that these firms use extremely low leverage (almost equal to 0). Non-

conservative UK firms, which use much higher debt, have an average leverage of 65%.

Conservative Italian firms, on the other hand, use approximately 28% leverage, while for

non-conservative Italian firms, the leverage is as high as 74%. It is also to be noted that the

mean leverage values of conservative UK and Italian firms are significantly different from

those of non-conservative UK and Italian firms, the t-statistics being statistically significant

at 1% significance level. As discussed before, the higher the leverage, the higher is the

interest paid on debt which results in tax saving on the payment of interest as this interest on

debt is a tax deductible expense. This results in higher earnings of the firm due to the reduced

tax liability. The EBIT for conservative UK firms is therefore negative, which means that

most conservative UK firms incur losses due to use of excessively low leverage, even though

they are financially conservative. The EBIT is very high at 65% of leverage and in fact, it is

even higher than the EBIT level of conservative Italian firms which use approximately 28%

debt. The mean EBIT of non-conservative Italian firms is however, very high due to the

benefits of tax shield associated with high leverage of 74%. This table shows that the mean

EBIT levels are significantly different between conservative UK and Italian firms and the

non-conservative firms of UK and Italy. The interest paid, as seen from the table is 0.1mn for

Conservativ

e UK

Non-

conservativ

e UK

t-statisticConservativ

e Italy

Non-

conservativ

e Italy

t-statistic

Leverage -0.13 0.65 (-4.75)*** 0.28 0.74 (-5.51)***

EBIT (millions) -1.16 285.21 (-11.44)*** 26.44 77423.61 (-2.97)***

Interest paid (millions) 0.10 31.81 (-8.46)*** 0.00 0.00 -

Income Taxes (millions) 0.05 91.87 (-8.48)*** 24.57 29704.19 (-3.04)***

Preference Dividend (millions) 0.11 3.36 (-3.84)*** 1.69 2133.26 -0.67

Profit Available for Equity

shareholders (millions) -1.22 181.11 (-12.01)*** 1.69 47543.00 (-2.90)***

Cost of Equity -0.23 0.04 (-1.68)* -0.02 0.04 -0.72

Value of Equity (millions) 10.89 1188.52 (-11.00)*** 1039.10 315801.04 (-3.48)***

Value of Debt (millions) 0.54 494.89 (-16.63)*** 32.11 222121.69 (-3.44)***

Value of Firm (millions) 11.43 1683.41 (-12.77)*** 1071.21 537922.72 (-3.59)***

***, ** and * mean that the test for differences in means rejects the null hypothesis of equality of means at 1%, 5%

and 10% significance levels respectively.

TABLE 5

Test for Differences in Means between Conservative and Non-conservative UK and Italian firms

21

conservative UK firms and it is 31.8mn for non-conservative UK firms, because of the

difference in the level of debt used. The interest figures for Italian firms are however not

available from WRDS, because of which it cannot be tested whether the mean figure of

interest for conservative Italian firms is significantly different from that of non-conservative

firms of Italy. The total taxes for non-conservative UK firms is approximately 1,837 times

that of conservative UK firms, whereas the taxes for non-conservative Italian firms is around

1,208 times that of conservative Italian firms. This shows that UK firms, because of their

lower debt levels as compared to Italian firms, pay 1.5 times (i.e. 1,837/ 1,208) higher tax.

The profit available for equity shareholders, as a result of EBIT, interest and taxes, also

increases with increase in leverage. The firm value increases with leverage due to the tax

shield effect as discussed before. It can be seen that the firm value is least for conservative

UK firms being equal to 11.43mn because of excessively low leverage. The average firm

value of non-conservative UK firms (=1,683mn) is approximately 1.6 times higher than that

of conservative Italian firms (=1,071mn), whereas the average firm value is obviously the

highest for non-conservative Italian firms (=537,923mn), which use 74% leverage, being

approximately 320 times higher than non-conservative UK firms having 65% debt. This is

however, very high and this can also be due to Italian firms being larger in size than UK

firms and it is cheaper for large firms to raise debt. The results also confirm that the mean

values of profit available for equity shareholders and value of firm for conservative UK and

Italian firms are significantly different from those of non-conservative UK and Italian firms,

the t-statistics being significant at 1% level. Furthermore, there is no evidence that the mean

preference dividend and cost of equity differ between conservative and non-conservative

Italian firms as the t-statistics are statistically insignificant.

6 Summary and Conclusion

In this section, I have summarised the findings or results of my thesis and explained what

these results demonstrate. First, a general comparison has been made between UK and Italian

firms with respect to their cash flows, liquidity positions, levels of debt used, growth

opportunities, sizes and amounts spent on capital expenditure. It is seen that Italian firms, on

an average, use about 1.7 times debt as compared to UK firms. Moreover, UK firms have

average cash to asset ratios, which is almost 2.6 times of those of the Italian firms and are

22

therefore more liquid. This shows that the probability that a UK firm is financially

conservative is higher than an Italian firm being financially conservative.

This is evident from the logistic regression results, according to which approximately 36%

UK firms from the sample are conservative whereas only 24% Italian firms are conservative.

It is to be noted that only active UK and Italian firms have been taken into consideration in

my research. For the sample of UK firms, it has been seen that market to book value and the

amounts spent on capital expenditure appear to be statistically insignificant and do not affect

the probability that the firm is financially conservative, whereas for the sample of Italian

firms, only capital expenditure appear to be insignificant. Apart from these, for both samples

of UK and Italian firms, cash flows and liquidity have positive effects on the probability that

a firm is conservative, while leverage and size have negative effects on the same. However,

for my sample of UK and Italian firms, it has been found that market to book values have a

negative correlation with cash holdings. This is inconsistent with prior research findings. To

support the above results, the marginal effects of each of the independent variables on the

probability that a firm is conservative have also been computed which shows the increase or

decrease in the probability that a firm is conservative for unitary increase in each independent

variable.

In the second part of my dissertation, I have demonstrated how financial conservative

policies and capital structure policies impact firm values. It is seen from the results that non-

conservative Italian firms maximise their firm values more than conservative UK firms, even

if the former hold less cash reserves and are very risky due to their high extent of leverage.

This is due to the effect of leverage and tax shield benefits. I have illustrated this concept (i.e.

the traditional theory of Modigliani Miller) in my research by comparing the firm values of

conservative and non-conservative UK and Italian firms and as per this concept, my results

show that the average firm value of non-conservative Italian firms is 320 times the average

firm value of non-conservative UK firms, although size of the Italian firms have an effect on

this.

After the financial crisis of 2008, many firms adopted financially conservative policies by

starting to hold higher cash reserves and low leverage, but these firms are not actually

maximising their wealth or creating value for their shareholders. In other words, these firms

are not maximising their firm values while many of them incur huge losses due to the use of

low leverage.

23

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