Magazine

Cash on hand

Associate Professor of Finance Thomas Bates researches the rationale behind the rise in the value of corporate financial holdings.

By Jenn Woolson

2018-09-21

Associate Professor of Finance Thomas Bates researches the rationale behind the rise in the value of corporate financial holdings

In sunny Arizona, no one thinks much about rainy days.

But it turns out preparing for rainy days is one of the key factors behind the economic puzzle of why companies’ cash holdings have increased to record levels over the past 30 years and why that cash is worth more than it used to be.

In their research paper, “Why Has the Value of Cash Increased Over Time?” published in the April 2018 issue of the Journal of Financial and Quantitative Analysis, ASU Associate Professor of Finance Thomas Bates, along with collaborators Ching-Hung Chang and Jianxin Daniel Chi, looked to find the why behind this phenomenon.

“A lot of pundits in the media were saying firms were making a mistake by hoarding cash just before the great recession,” Bates says. In his 2009 research, “Why Do Firms Hold So Much More Cash Than They Used To?” Bates and his collaborators wanted to find out if this cash “hoarding” behavior, which looks unusual, could be explained by economically rational corporate decision-making. This follow-up research looks at how investors value hoarding behavior.

Cash and competition

Researchers found two fundamental forces at work over the past 30 years affecting corporate liquidity. As the U.S economy underwent dramatic changes, U.S. manufacturing companies responded with changes in their liquidity policies.

1. Traditional vs. tech — The nature of the average company has changed dramatically. “In the 1970s, companies made things: cars, turbines, washing machines,” Bates says. “The bank made a loan to a simple firm: one that generated a cash flow and repaid the interest.”

Companies today are more heavily weighted toward technology, so they rely more on research and development (R&D) to continuously innovate. “You really can’t stop making R&D expenditures without losing the benefits of innovation,” he says. If they take out bank debt, making the interest payment might make them forgo essential R&D.

2. Emergency funds — “A lot of people underestimate the extent to which the U.S. economy has become much more competitive over the past 30 years, even for traditional manufacturing firms,” Bates says. These companies need to be financially prepared when what they thought was going to happen doesn’t materialize because of competition. Companies prepare for potential rainy days by storing cash on the balance sheet so they can make critical investments in case of a shortfall.

Building a rainy-day fund

These two factors affect how easy it is for firms to access affordable external financing when they need it — and that changes the average value of each dollar on their balance sheet.

Think of it this way: Your average 1970s company was like a factory worker with a pension. He didn’t need tons of savings. His income was steady and getting a mortgage loan was pretty easy. The companies that started to grow in the 1990s and today are more entrepreneurial. Their outlay for innovation is higher; their income isn’t guaranteed, and, as a result, getting financing can be difficult.

The savvy entrepreneur overcomes that funding challenge by building up a rainy-day fund. R&D-reliant firms that don’t have easy, cheap access to external financing, hold onto cash because they need to.

“The sophistication and breadth of U.S. financial markets would seem to suggest that, on average, firms would have an easier time accessing cheaper capital,” Bates says. “What we documented is the opposite.”

From an investor perspective, he says, it changes the way we think about the value of companies that have real liquidity shortfalls. “The temptation for a lot of investors is to push companies to divest. But we don’t want to punish companies or pay less for stock because they’re holding cash. It’s the right economic choice for the company that’s trying to save for the rainy day.”

That savings trend has affected the value of cash. In the 1980s, the marginal value of a dollar was around $0.70. “Companies saving money then were probably wasting it,” Bates says, on bad acquisitions and empire building — getting bigger but not better. Since the dramatic shifts in the 1990s, the marginal value of that dollar has gone from $0.70 to more than $1.20 due to the riskier competitive landscape. “The average firm couldn’t go out and borrow, so marginal value of those savings was more valuable.”

Access to capital

For the average investor, Bates’ research explains a phenomenon that looked puzzling. “Our evidence suggests these companies are building up a large surplus of what looks like excess cash,” Bates says. “But they’re doing it for completely economically rational reasons.”

He says there’s still a lot of work to do to make it easier for companies to access sources of capital. “If there is a systematic decline in liquidity for the average company, it means they are underinvesting in capital projects,” he says. “Ultimately, that’s a negative drain on our economy.”

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Autumn 2018 Faculty Research Finance