Environmental uncertainty and corporate cash holdings: The moderating role of CEO ability

• Published date: 01 September 2022
• Author: Efstathios Magerakis,Ahsan Habib
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/irfi.12355

ORIGINAL ARTICLE

Environmental uncertainty and corporate cash

holdings: The moderating role of CEO ability

Efstathios Magerakis

1

| Ahsan Habib

2

1

Department of Economics, University of

Patras, Patras, Greece

2

School of Accountancy, Massey University,

Auckland, New Zealand

Correspondence

Efstathios Magerakis, Department of

Economics, University of Patras,

Patras, Greece.

Email: smagerakis@upatras.gr

Abstract

This article empirically tests the association between envi-

ronmental uncertainty and corporate cash holdings and

whether CEO ability moderates this association. Based on

the precautionary motive for holding cash, we predict that

firms will hold more cash when operating in an environment

of high uncertainty. To test this prediction, we utilize a

panel of non-financial U.S. firms throughout 1980–2016.

Using the coefficient of variation in sales as a proxy for

environmental uncertainty, we find that environmental

uncertainty increases firm cash holding. We then explore

the moderating role of CEO ability and find that more-able

CEOs weaken the positive association between environ-

mental uncertainty and cash holding. Further, the results

demonstrate that small-sized, financially sound, and low lev-

eraged firms are likely to hoard more cash during periods of

heightened uncertainty. Our study provides new insights

for investors, shareholders, and policymakers into compa-

nies' decision-making concerning liquid assets.

KEYWORDS

business risk, cash holdings, environmental uncertainty,

managerial ability, sales volatility

JEL CLASSIFICATION

G30; G32; M41; M19

Received: 22 January 2021 Revised: 19 May 2021 Accepted: 4 June 2021

DOI: 10.1111/irfi.12355

© 2021 International Review of Finance Ltd. 2021

402 International Review of Finance. 2022;22:402–432.

wileyonlinelibrary.com/journal/irfi

1|INTRODUCTION

In this article we examine the association between environmental uncertainty and corporate cash holdings and fur-

ther explore the moderating roe of CEO ability on the relationship. Environmental uncertainty is defined as “the

unpredictability of the actions of customers, suppliers, competitors, and regulatory groups”(Govindarajan, 1984).

Organization theory literature highlights the strategic importance of external factors in formulating business policies

(L

opez-Gamero et al., 2011; Milliken, 1987). As unpredictable environment and new regulations are likely to increase

environmental volatility, proactive managers are expected to facilitate structural changes, including seeking new

investment projects to maximize firm competitiveness (Arag

on-Correa & Sharma, 2003). Further, Lewis and Har-

vey (2001) argue that heightened environmental uncertainty imposes financial constraints for firms. Such heightened

uncertainty requires managers to evade adverse shock proactively (e.g., Chandler, 1962; Galbraith, 1995; Snyder &

Glueck, 1982). We posit that holding more cash is one such hedging mechanism, and expect a positive association

between environmental uncertainty and corporate cash holdings.

Our focus on the level of cash stems from the importance of liquid assets for firms. U.S. firms hold trillions of

dollars in accumulated cash (e.g., Microsoft Corporation held about 58.46% of its total assets as cash and cash equiv-

alents at the end of 2016). Extant literature has offered several motives for explaining corporate cash holdings. First,

the transaction motive for cash holdings suggests that managers hold cash to make payments without liquidating

assets or seeking external financing (e.g., Miller & Orr, 1966; Mulligan, 1997). Miller and Orr (1966) identify the opti-

mal demand for cash when a firm incurs transaction costs associated with converting a noncash financial assetinto

cash, and uses cash for payments.

Further, Myers and Majluf (1984) note the cash holdings are important because they provide flexibility for firms

to meet their operating needs, and/or to pursue investment opportunities, when external financing is limited. The

precautionary motive for holding cash considers capital market frictions, and proposes that firms hold cash to cope

better with adverse shocks in the presence of costly external financing (e.g., Almeida et al., 2004; Han & Qiu, 2007).

The agency motive for cash holdings posits that entrenched managers squander away cash, for example, through

overinvestment, despite poor investment opportunities (e.g., J. C. Jensen, 1986). Harford (1999) shows that firms

with larger cash holdings engage in more acquisitions and these acquisitions are value decreasing. Evidence docu-

mented in previous studies also suggests that heightened uncertainty induces firms to hold more cash (Bates

et al., 2009; Phan et al., 2019). Therefore, we rely on the precautionary motive hypothesis to examine whether envi-

ronmental uncertainty has a significant effect on firm-level cash holding.

We then explore whether CEO characteristics, CEO ability in our case, moderates the relation between environ-

mental uncertainty and corporate cash holdings. Although firms weigh costs versus benefits in holding cash (Opler

et al., 1999), the benefits of cash holdings can be mitigated by agency problems, where managers may use a cash

buffer to serve private interests (M. C. Jensen & Meckling, 1976). The “dark side”of managerial ability links CEOs to

a higher possibility of stock price crash risk attributable to investment inefficiency (Habib & Hasan, 2017), unethical

behavior resulting from bad news hoarding (S. Lee et al., 2021), higher agency costs (Mishra, 2014), and opportunistic

financial reporting (Gul et al., 2017).

On the other hand, research has found that more-able CEOs should lead to better firm-level outcomes, including

high earnings quality (Demerjian et al., 2012,2013), higher value of cash (Gan & Park, 2017), and higher profitability

stemming from efficient investments (C. C. Lee et al., 2018) relative to their less-able peers. In our case, while firms

are expected to increase cash levels to protect against future downturns (Almeida et al., 2004), more-able CEOs may

absorb environmental uncertainty shocks, thereby, attenuating the positive effect of environmental uncertainty on

cash holdings. However, strengthening of the positive relationship would support the “dark side”of the managerial

ability story.

Finally, we investigate the effect of firm size, leverage, financial distress, and product market competition, as

four cross-sectional settings likely to affect the relationship among cash holdings, environmental uncertainty, and

managerial ability. Finance literature confirms that firm size matters in determining corporate outcomes and policies

MAGERAKIS AND HABIB 403