Corporate Governance and Cash Holdings: Listed New Economy versus Old Economy Firms

• DOI: http://doi.org/10.1111/j.1467-8683.2008.00701.x
• Published date: 01 September 2008
• Author: Yenn‐Ru Chen
• Date: 01 September 2008

Corporate Governance and Cash Holdings:

Listed New Economy versus

Old Economy Firms

Yenn-Ru Chen*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the impact of corporate governance on the cash-holding policies of f‌irms

with different investment opportunities. It is diff‌icult to determine the optimal level of cash holdings for “listed new

economy” f‌irms (f‌irms in the computer, software, Internet, telecommunications, or networking industries), which require

large amounts of capital for investment opportunities with high return potential. Unlike in “old economy” f‌irms, for which

investment opportunities are relatively limited, corporate governance in listed new economy f‌irms may create shareholder

protections that make investors willing to accept higher levels of corporate cash holdings.

Research Findings/Results: By examining American Standard and Poor 1,500 companies, the evidence shows that CEO

ownership and board independence affect the cash holdings in listed new economy and old economy f‌irms differently.

Specif‌ically, higher managerial cash holdings tend to reduce cash holdings in old economy f‌irms and higher board

independence tend to increase cash holdings in listed new economy f‌irms.

Theoretical Implications: This study provides empirical support for the association between agency theory and cash

theories. Given different f‌irm characteristics, the impact of corporate governance on cash holdings verif‌ies the implication

of agency theory in explaining corporate cash policy.

Practical Implications: While f‌irms in new economy industries may be eager for more f‌lexible governance codes in order

to maintain the freedom of decision making, the evidence from this study suggests that establishing effective governance

mechanisms may, in turn, effectively enlarge the degree of freedom for these f‌irms to make timely business decisions.

Keywords: Agency Theory, Takeover Defenses, Corporate Control Market, Board of Directors Issues, Ownership Issues

INTRODUCTION

Two economic theories explain why corporations retain

excess cash: trade-off and f‌inancial hierarchy theories.

These two theories differ mainly in the relationship between

investment and cash holdings and in the existence of an

optimal level of cash holdings (Kim, Mauer and Sherman,

1998; Opler, Pinkowitz, Stulz and Williamson, 1999;

Dittmar, Mahrt-Smith and Servaes, 2003; Ozkan and Ozkan,

2004). In addition, corporate cash holdings can also be

explained by agency theory, in relation to these two

economic theories.

Because a company’s cash-holding policy is a matter of

managerial discretion, the level of cash holdings raises con-

cerns about the agency cost of cash f‌low when managers do

not act in the best interests of shareholders, especially in

companies that have broad shareholder bases and low man-

agerial ownership (Papaioannou, Strock and Travlos, 1992;

Myers and Rajan, 1998). When companies hold excess cash,

managers are able to pursue their own interests by spending

on unnecessary expenses and unprof‌itable investments,

without market discipline (Jensen, 1986). This, in turn,

implies that the agency literature effectively assumes that

trade-off theory dominates f‌inancial hierarchy theory in

explaining corporate cash policy. Corporate governance

therefore mitigates this agency problem of free cash f‌lows

by lowering the level of cash holdings.

It is reasonable to wonder whether trade-off theory is

always dominant in explaining corporate cash policy, or

*Address for correspondence: Department of Accountancy and Graduate Institute of

Finance and Banking, National Cheng Kung University, 1 University Road, Tainan,

701, Taiwan. Tel: +886-6-2757575 ext 53425; Fax: +886-6-2744101; E-mail: yrchen@

mail.ncku.edu.tw

430 CORPORATE GOVERNANCE

Volume 16 Number 5 September 2008 © 2008 TheAuthor

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00701.x