Product Market Threats and the Value of Corporate Cash Holdings

• Published date: 01 August 2016
• DOI: http://doi.org/10.1111/fima.12119
• Date: 01 August 2016

Product Market Threats and the Value

of Corporate Cash Holdings

Jianxin (Daniel) Chi and Xunhua Su∗

We construct a model to showthat predatory strategies by a financially strong rival can cause a

financially weak firm to underinvest. This threat intensifies when the two firms produce similar

products and share similar future investment opportunities. We show that cash holdings become

more valuable by providing liquidity to fund investment opportunities as they emerge, thereby

mitigating the underinvestment problem. Empirical evidence supports these model predictions.

The value of cash is significantly higher for firms facing higher predatory threats. The results

are robust to various controls for financial constraints, corporate governance, risk factors, and

industry-level measures of product market competition. An identification strategy that exploits

exogenous variation in financial constraints further corroborates the causal effect of predatory

threats on the value of cash.

In product markets, a financially constrained firm may face competitive threats from strong

rivals who adopt predatory strategies, such as exceptionally low prices or saturating advertising

campaigns (Telser, 1966; Bolton and Scharfstein, 1990). Subjected to these strategies, the con-

strained firm may suffer reduced cash flow and diminished ability to fully capture investment

opportunities. In the longer term, it can lose market share or even be driven out of the market al-

together. An example is the web-browser war between Microsoft and Netscape in the mid-1990s.

The Netscape web browser,Navigator, initially had more than 80% of the market share. Microsoft

then bundled its browser, Internet Explorer (IE), with Windows and effectively set the price of

IE at zero. Within a few years, IE dominated the web-browser market while Navigator suffered a

precipitous loss in market share and eventually exited the market.1

The “long-purse” theory implies that predatory threats force firms to enhance f inancial flex-

ibility. For example, the seminal study by Bolton and Scharfstein (1990) shows that a firm

with financial constraints, which emerge endogenously to reduce agency problems, is subject to

Wethank Raghu Rau (Editor) and an anonymous referee for valuablesuggestions. For helpful comments and discussions,

we also thank Fred Bereskin, Carsten Bienz, Jacopo Bizzotto, Fredrik Carlsen, Jay Coughenour, Bidisha Chakrabarty,

Saeyoung Chang, B. Espen Eckbo, LaurentFr´

esard, Mariassunta Giannetti, Stefan Hirth, Jerry Hoberg, JeyeshKhana-

pure, Naveen Khanna, Yelena Larkin, Paul Laux, Sangwon Lee, Mikko Leppamaki, Marc Lipson, Michelle Lowry,

Hsien-Hsing Liao, Xiaoxia Lou, Adrien Matray,Gordon Phillips, Nagpurnanand Prabhala, FranciscoSantos, Mike Sul-

livan, Qian Sun, PaulThistle, Karin Thorburn, Neng Wang, Han Xia, Kangzhen Xie, Lan Xu, Guoqing Zhang, and Guofu

Zhou; participants at FM Writer’sWorkshop (Venice 2015), WFA (Monterey 2014), Frontiersof Finance (Warwick2014),

Nordic FinanceResearch Workshop(Oslo 2014), FMA (Chicago 2013), AsianFA (Nanchang2013), and FRCFM (Dalian

2013); seminar participants at Delaware,Gothenburg, Nevada (Las Vegas),NHH (Bergen), NTNU (Trondheim), SHUFE

(Shanghai), and TBS (Trondheim); and especially Scott Lee. Chi gratefully acknowledges support from the National

Natural Science Foundationof China (grant number: 71172136). Su gratefully acknowledges financial support from the

NHH Corporate Finance Center. Part of the workwas done during Su’s visit at Wharton Financial Institutions Center,

kindly supported by FranklinAllen, and during Su’s stay at the NorwegianUniversity of Science and Technology (NTNU).

∗Jianxin (Daniel) Chi is an Assistant Professor of Financein the Lee Business School at the University of Nevada in Las

Vegas, NV. Xunhua Su is an Assistant Professor of Finance in the Department of Finance at the Norwegian School of

Economics (NHH) in Bergen, Norway.

1For a more detailed account of the browser war,see http://en.wikipedia.org/Browser_wars.

Financial Management •Fall 2016 •pages 705 – 735

706 Financial Management rFall 2016

predation. To reduce this predatory threat, the firm should lower the sensitivity of its investing

ability to current firm perfor mance. We argue that one way to lower this sensitivity is to accu-

mulate internal cash. Cash becomes more valuable because it provides unconditional liquidity

to readily capture investment opportunities as they emerge, thereby mitigating the competition-

induced underinvestment problem. Building upon this intuition, we study what conditions affect

the intensity of predatory threats and how predatory threats affect the value of corporate cash

holdings.

We build a model to illustrate the idea and to structure the hypotheses and empirical tests.

Consider a financially weak firm (the target or prey) competing with a financially strong rival

(the predator) over twoperiods. The target f irm’s current value consists of three parts: 1) free cash

flow that can be retained as cash at a cost or paid out as dividends, 2) noncash productive assets

that last in the first period, and 3) an investment opportunity that will emerge in the second period.

To finance the investment opportunity, the target can use cash holdings, cash flow generated in

the first period from productive assets, and external financing. If the target’s external financing

is constrained, the strong rival can adopt predatory strategies to reduce the target’s cash flow in

the first period and hence impede the target’s ability to undertake the investment opportunity. By

doing so, the predator gains market power in the second period. Facing this predatory threat, the

target’s cash holdings become more valuable because cash holdings can readily fund investment

opportunities as they emerge, thereby mitigating the underinvestment problem. Our empirical

tests provide strong evidence that predatory threats indeed raise the value of corporate cash

holdings.

The theoretical model shows two important elements that affect the level of predatory threats.

First, the costs of predation are lower when the predator’s products are similar to the target’s,

because more similar products allow the predator to more easily displace the target in the market

place. Second,the benef its from predation are larger whenthe predator shares more interdependent

investmentoppor tunities with the target,because more interdependent opportunities mean that the

predator will gain larger market share if the target underinvests.Therefore, we propose similarity

of current products and interdependence of future investment opportunities as two necessary

components of predation risk.

The model generates the following testablepredictions. First, both similarity of cur rent products

and interdependence of future investment opportunities raise the value of cash, and the effects

of these two components reinforce each other. Second, predation will occur only if the prey is

more financially constrained than the predator. Therefore, the effect of predation risk is more

pronounced for financially constrained firms.

We employ the empirical model of Faulkender and Wang (2006) to test these predictions. This

empirical model, through examining how change in cash holdings affects market valueof equity,

estimates the marginal value of cash holdings. To measure product similarity, we use product

market fluidity, constructed by Hoberg, Phillips, and Prabhala (2014). Based on textual analysis

of business descriptions in firms’ 10-K f ilings, fluidity captures the intensity that a firm’s rivals

are moving toward the firm’s product space. Higher fluidity indicates higher product similarity

and lower costs of predation. We follow Haushalter, Klasa, and Maxwell (2007) and measure

interdependence of investment opportunities by firm industry stock beta. The higher the industry

beta, the higher the interdependence of investment opportunities, and the larger the potential

benefits to the predator. In the data, fluidity and industry beta have a low correlation of 0.15,

suggesting that they capture different aspects of firms’ competitive threats.

Our empirical results confirm the model predictions. First, the value of cash is about $0.36

higher when either fluidity or industry beta is above the sample median. Second, fluidity and

industry beta reinforce each other’s effect on the value of cash—the positive effect of industry