Information Asymmetry and Corporate Cash Holdings

• Author: Jang‐Chul Kim,Young Sang Kim,Kee H. Chung,Hao Zhang
• DOI: http://doi.org/10.1111/jbfa.12173
• Published date: 01 November 2015
• Date: 01 November 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1341–1377, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12173

Information Asymmetry and Corporate

Cash Holdings

KEE H. CHUNG,JANG-CHUL KIM,YOUNG SANG KIM AND HAO ZHANG∗

Abstract: This study analyzes the effect of information asymmetry on corporate cash holdings.

Using various measures of information asymmetry, this study shows that companies that operate

in environments with higher information asymmetry have smaller cash holdings. This study

continues to find a negative relationship between information asymmetry and corporate cash

holdings from a battery of sensitivity analyses, including the tests using different regression

methods and the difference-in-difference tests employing brokerage-firm merger and closure

events. On the whole, the results support the monitoring cost hypothesis of cash holdings over

the investment opportunities hypothesis.

Keywords: cash holdings, information asymmetry, monitoring cost

1. INTRODUCTION

This study analyzes the effect of information asymmetry on corporate cash holdings.

Although information asymmetry is an important element in many financial theories,

prior research provides only limited evidence regarding the role of information

asymmetry in corporate cash-holding decisions. This study contributes to the litera-

ture by testing two competing hypotheses on the relationship between information

asymmetry and corporate cash holdings using various stock-market-based measures of

information asymmetry and a battery of empirical methodologies.

US corporations hold large amounts of liquid assets. For instance, cash and

marketable securities account for 22.5% of total assets of US publicly traded companies

∗The first author is from School of Management, State University of New York (SUNY) at Buffalo and School

of Business, Sungkyunkwan University. The second and third authors are from Haile/US Bank College

of Business, Northern Kentucky University, and the fourth author is from Saunders College of Business,

Rochester Institute of Technology. The paper benefitted greatly from the comments of an anonymous

referee and the Associate Editor, Ronan Powell. The authors thank Soku Byoun, Claire Celerier, Clarke

Cogsdill, Jaehoon Hahn, Nikolay Halov, Jie He, Chun-Keung (Stan) Hoi, Alexander Ljungqvist, Kyojik

‘Roy’ Song, Qiang Wu and session participants at the Annual Conference of the Financial Management

Association International and the Annual Conference of the European Financial Management Association

for valuable comments and discussion. This work was supported by the National Research Foundation

of Korea Grant funded by the Korean Government (NRF-2014S1A3A2036037). The authors gratefully

acknowledge research support from their respective institutions. (Paper received April 2014, revised revision

accepted November 2015).

Address for correspondence: Kee H. Chung, Department of Finance, School of Management, State

University of New York (SUNY) at Buffalo, Buffalo, NY 14260.

e-mail: keechung@buffalo.edu

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1342 CHUNG, KIM, KIM AND ZHANG

during the 10-year period from 2000 through 2009.1Using data from 47 countries,

Charoenwong et al. (2014) show that firms in about half of these countries hold

cash and marketable securities that account for more than 15% of their total assets.

Corporate cash holdings allow firms to exploit profitable investment opportunities

and make obligatory debt payments in case of cash flow shortfalls without having

to access external capital markets. However, higher corporate cash holdings may

prove a disadvantage if managers use them for their own benefit at the expense of

shareholders.

Information asymmetry is likely to influence corporate cash holdings because it

affects both managerial behavior and the ability of outsiders to understand that

behavior. For example, higher information asymmetry might exacerbate the free cash

flow problem (Jensen, 1986) because it would make it harder for outsiders to monitor

and interpret managerial actions. Alternatively, higher information asymmetry might

make both managers and shareholders more concerned about firms’ future capital

needs if higher information asymmetry makes it more likely that future equity offerings

will be underpriced (Myers and Majluf, 1984).

Prior studies of cash holdings can be clustered into two broad groups. The first

strand of research analyzes the determinants of corporate cash holdings. These studies

suggest that firms hold cash for the transaction cost, precautionary, tax and agency

motives. Meltzer (1993) and Mulligan (1997) analyze the transaction cost motive for

holding cash. Song and Lee (2012) find that firms in East Asian countries maintain

large precautionary cash holdings even after the economy recovered from the

1997 financial crisis. Neamtiu et al. (2014) show that macro-economic ambiguity leads

to greater cash holdings. Foley et al. (2007) provide evidence for the tax motive for

cash holdings, while Bates et al. (2009) provide evidence against the tax motive. Using

international samples, Dittmar et al. (2003) and Kalcheva and Lins (2007) analyze the

agency motive for holding cash.2

The second strand of research examines the effect of cash holdings on firm

performance and firm value. Mikkelson and Partch (2003) show that holding large

cash reserves does not impair corporate performance. Faulkender and Wang (2006)

show that the marginal value of cash declines with larger cash holdings, higher

leverage and better access to capital markets. Using a sample that spans 35 countries

and 11 years, Pinkowitz et al. (2006) find that the market valuation of corporate cash is

smaller in countries with poorer investor protection. Pinkowitz and Williamson (2007)

find that cash is more valuable for firms with greater and more volatile investment

opportunities.3

1 Non-financial US companies hold US$ 1.73 trillion in cash in year 2015 (Source:MarketWatch.com,7May

2015).

2 Pinkowitz and Williamson (2001) examine the effect of bank power on cash holdings and show that strong

Japanese banks influence firms to hold large cash balances. Bates et al. (2009) find a significant increase in

the average cash-to-assets ratio for US industrial firms during 1980–2006 and attribute it to an increase in

the overall riskiness of cash flows. Duchin (2010) and Subramaniam et al. (2011) show that diversified firms

hold less cash than single-division firms.

3 Dittmar and Mahrt-Smith (2007) show that cash holdings are more valuable for companies with better

governance structures, and Harford et al. (2008) find that firms with poor shareholder rights and excess

cash have lower profitability and smaller market valuations. More recently, Fresard and Salva (2010) find

that the value of excess cash is greater for firms cross-listed on the US market than their domestic peers.

Fresard (2010) finds that larger cash reserves lead to future market share gains and interprets the result as

evidence that corporate cash holdings strategically influence product market outcomes. Denis and Sibilkov

(2010) show that cash holdings are more valuable for financially constrained firms because higher cash

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INFORMATION ASYMMETRY AND CORPORATE CASH HOLDINGS 1343

Although prior research sheds light on the causes and consequences of cash hold-

ings, there is only limited evidence regarding the relationship between information

asymmetry and cash holdings. Opler et al. (1999) use a firm’s R&D as a proxy

for information asymmetry and show that firms with larger R&D expenditures hold

more liquid assets. Although firms with larger R&D expenditures may have greater

information asymmetry, larger R&D expenditures may also reflect greater growth

opportunities. If so, one may interpret their finding as evidence that firms with greater

growth opportunities hold more liquid assets. It is also possible that causality runs the

other way around: firms with larger cash reserves may spend more on R&D activities.

Similarly, Dittmar et al. (2003) use the market-to-book ratio as a proxy for information

asymmetry in their analysis of corporate cash holdings, and this measure is subject to

the same criticism as R&D expenditures because prior studies (e.g., Pinkowitz et al.,

2006) find that cash holdings positively influence firm value and market-to-book ratio.

In the present study, we re-examine the relationship between information asymmetry

and corporate cash holdings using measures and empirical methods that are less

subject to the endogeneity problem.

This study tests two competing hypotheses for the effect of information asymmetry

on corporate cash holdings. The monitoring cost hypothesis of cash holdings predicts

that the amount of cash that a firm holds is inversely related to the level of information

asymmetry between the firm’s managers and its outside shareholders. In contrast,

the investment opportunities hypothesis predicts a positive relationship between cash

holdings and information asymmetry. (Section 2 provides a detailed description of

these hypotheses). Our study differs from Drobetz et al. (2010) in that our study

analyzes the effect of information asymmetry on the level of corporate cash holdings,

whereas their study focuses on the effect of information asymmetry on the value of

cash holdings.4

Our empirical results show that corporate cash holdings are negatively and signif-

icantly related to various measures of information asymmetry, after controlling for

the effects of various firm characteristics. The results are robust to different estima-

tion methods, including the quantile regressions, firm fixed-effect regressions, and

Fama–MacBeth regressions. To address the endogeneity concern, we conduct a

difference-in-difference test employing brokerage-firm merger and closure events and

also estimate regressions using changes in the variables. We find a negative relationship

between information asymmetry and cash holdings in these tests. On the whole, our

results support the monitoring cost hypothesis of cash holdings. Additionally, we

conduct an ancillary test to examine whether the relationship between information

asymmetry and cash holdings is non-linear and find that the negative relationship

becomes weaker when information asymmetry is high, providing partial evidence for

the investment opportunities hypothesis.

Cash is a corporate asset that is highly vulnerable to managerial waste. Management

has easy access to corporate cash, and much of its use is discretionary. While the

holdings allow them to undertake value-increasing projects that might otherwise be bypassed. Liu and Mauer

(2011) find a positive relationship between the sensitivity of CEO compensation to stock price volatility

and cash holdings and a negative relationship between CEO risk-taking incentive and the value of cash to

shareholders. Tong (2011) shows that the value of cash is lower in diversified firms than in single-division

firms, and that firm diversification reduces the value of cash among firms with poor corporate governance.

4 Drobetz et al. (2010) show that cash adds more value in firms with lower information asymmetries

(i.e., smaller dispersion in analysts’ forecasts). In contrast, we use both stock-market-based measures of

information asymmetry and dispersion in analysts’ forecasts.

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