Impact of firm's financial policy, investment opportunities, and the cost of external capital on the value of cash

Abstract

PURPOSE OF THE STUDY The purpose of this thesis is to examine the cross-sectional variation of the value of firm’s cash holdings, and how the value of cash changes over time. The study contributes to the existing literature on the value of cash in two important ways. First, the study examines how the financing constraints and investment opportunities together affect the value the shareholders place on cash. Second, the thesis establishes a link between the value of cash and the time-variation of the cost of external capital.

The thesis also aims to find support for the findings related to the cross-sectional variation in the earlier literature. While earlier studies have mainly focused on the US firms, this study uses data from the U.K.

DATA The data in this study comprise of 8,243 firm-year observations from a total of 1,193 U.K. publicly listed firms. The dependent variable in the analysis is firm-specific excess return during a fiscal year, and the independent variables consist of firm-specific variables controlling for profitability, financing policy, and investment policy. The data cover all years from 1997 to 2008.

RESULTS The main findings of this study are, first, that neither financing constraints nor investment opportunities alone affect the value the shareholders place on firm’s cash holdings. However, firms that are financially constrained and have good investment opportunities have the highest value placed on cash. Second, the value of cash does change over time, and is dependent on the cost of raising external capital.

The thesis also confirms most of the cross-sectional variation found in the earlier studies. However, statistically significant evidence for the value of cash decreasing as the cash levels increase is not found.