Too much liquidity? Seemingly excess cash for innovative firms

• Published date: 01 February 2020
• Date: 01 February 2020
• DOI: http://doi.org/10.1111/fire.12210
• Author: Stephen Ciccone,Zhaozhao He

DOI: 10.1111/fire.12210

ORIGINAL ARTICLE

Too much liquidity? Seemingly excess cash

for innovative firms

Zhaozhao He Stephen Ciccone

PeterT. Paul College of Business and Economics,

University of New Hampshire, Durham, New

Hampshire

Correspondence

ZhaozhaoHe, Peter T. PaulCollege of Business

andEconomics, University of New Hampshire,

10Garrison Avenue, Durham, NH 03824.

Email:zhaozhao.he@unh.edu

Abstract

We show that more cash allows innovative firms facing financing

constraints to undertake more research and development projects

and that this phenomenon has been more pronounced since 1980. In

contrast to the secular increase in the levelof cash holdings, average

excess cash has not increased appreciably. Weanalyze excess cash

disposition and document a strong relation between excesscash and

research and developmentspending. Finally, our results suggest that

increased difficulty in valuing research and development might be

a source of financing frictions. These findings imply that “seemingly

excess cash” has played an increasingly important role in mitigating

underinvestment in innovation.

KEYWORDS

cash holdings, excess cash disposition, financing constraints,

research and development investments, value of research and

development

JEL CLASSIFICATIONS

G30, G32, O30

1INTRODUCTION

Financing of corporate research and developmentis an important channel through which finance promotes innovation

and economic growth (Brown, Fazzari, & Petersen, 2009; Kamien & Schwartz, 1978; Klette & Kortum,2004). Figure 1

presents evidence for a rising predominance of research and development investments in aggregate U.S. economic

activities. Research and development, however,is difficult to finance with external sources due to its high degree of

information asymmetry, lack of collateral value, and highly uncertain outcomes (Akerlof, 1970; Hall, 2002). Recently,

research has found that innovative firms have accumulated increasing amounts of cash and liquid assets relative to

total assets since 1980—up from 8% to roughly 30% (He & Wintoki, 2016). Nevertheless, little is known about the

economic consequences of such cash hoarding behavior.

The goal of this paper is to improve our understanding of the implications of this increased liquidity.1In princi-

ple, cash can be valuable because greater cash holdings enable firms to avoid underinvestment when facing external

1Thisexcessive liquidity has attracted considerable attention from the financial press (see, e.g., McDonald, 2006a, 2006b).

Financial Review.2020;55:121–144. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 121

122 HE ANDCICCONE

Panel A: R&D and capital expenditures as a share of GDP

Panel B: Aggregate R&D investment to aggregate total (R&D plus Capex) investments

0.006

0.008

0.010

0.012

0.014

0.016

0.018

0.020

0.030

0.040

0.050

0.060

0.070

0.080

0.090

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

R&D/GDP

Capex/GDP

CAPEX/GDP R&D/GDP

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Aggregate R&D/Aggregate Investment

FIGURE 1 The rising research and development investmentover 1970–2012

Notes. Panel A reports aggregate research and developmentor capital expenditures relative to U.S. GDP over the

sample period of 1970–2012. Panel B plots the ratiosof aggregate research and development to aggregate total

investment measured bythe sum of research and development and capital expenditures since 1970. The sample

includes all nonfinancial and nonutility U.S. industrial firms with COMPUSTATcoverage during the period of

1970–2012. Firms must have nonnegativevalues for cash, sales, and common equity before entering the sample.

Firm-years with lagged book assets smaller than $1 million are excludedto mitigate outliers.

financing frictions. The increased cash balances over time imply that this role of cash may have become increasingly

important.2Toexplore this possibility, we examine whether firms with more cash are associated with more research

and development investmentsand how this association has changed over time. We then analyze how innovative firms

dispose of excess cash to illuminate whether they hold more cash than necessary.Finally, we explore changes to the

attributes of research and development projects that maybe related to the changing role of cash holdings in determin-

ing the level of research and developmentinvestments.

2Analternative explanation is that increased cash holdings may reflect worsening agency problems in U.S. firms. Evidence on this view is still mixed (e.g., Bates,

Kahle,& Stulz, 2009). Moreover, studies consistently find that the value of cash is higher in firms investing in research and development, which is inconsistent

withthis agency theory view.