When is cash good or bad for firm performance?

• Date: 01 February 2017
• Author: Palash Deb,Parthiban David,Jonathan O'Brien
• DOI: http://doi.org/10.1002/smj.2486
• Published date: 01 February 2017

Strategic Management Journal

Strat. Mgmt. J.,38: 436–454 (2017)

Published online EarlyView 4 February 2016 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2486

Received 4 May 2015;Final revision received29 September 2015

WHEN IS CASH GOOD OR BAD FOR FIRM

PERFORMANCE?

PALASH DEB,1PART HI B AN D AV ID , 2*and JONATHAN O’BRIEN3

1Department of Management, College of Business Administration, California State

University San Marcos, San Marcos, California, U.S.A.

2Department of Management, Kogod School of Business, American University,

Washington, District of Columbia, U.S.A.

3Department of Management, University of Nebraska-Lincoln, Lincoln, Nebraska,

U.S.A.

Research summary: Cash can create shareholder value when used for adaptation to unfolding

contingencies, but can also reduce value when appropriatedby other stakeholders. We synthesize

arguments from the behavioral theory of the rm, economic perspectives like agency theory, and

the value-creation versus value-appropriation literatures to argue that the implications of cash

for rm performance are context-specic. Cash is more benecial for rms operating in highly

competitive, research-intensive,or growth-focused industries that are typical of contexts requiring

adaptation in the face of uncertainties. Conversely, cash is more detrimental to performance in

rms that are poorly governed, diversied, or opaque,as are typical of contexts where stakeholder

conicts, information asymmetries, or power imbalances can encourage value appropriation by

other stakeholders.

Managerial summary: Cash can create shareholder value when used for adaptation to unfolding

contingencies, but can also reduce value when appropriated by other stakeholders. While

cash-rich rms have higher performance on average, with those in the 75th percentile having

a market-to-book value 15 percent higher than those in the 25th percentile, we nd that the

performance benets of cash depend on the context. Cash is more benecial for rms operating in

highly competitive, research-intensive, or growth-focused industries that are typical of contexts

requiring adaptation in the face of uncertainties. Conversely, cash is more detrimental to

performance in rms that are poorly governed, diversied, or opaque, as are typical of contexts

where stakeholder conicts, information asymmetries, or power imbalances can encourage value

appropriation by other stakeholders. Copyright © 2015 John Wiley & Sons, Ltd.

Conicts of interest between shareholders

and managers over payout policies are espe-

cially severe when the organization gener-

ates substantial free cash ow. The problem

Keywords: cash; behavioral theory of the rm; adaptation;

information asymmetry; value creation; value appropria-

tion

*Correspondence to: Parthiban David, Department of Man-

agement, Kogod School of Business, American University,

4400 Massachusetts Avenue, Washington, DC 20016, Phone:

+1-240-676-3236. E-mail: parthiban.david@american.edu

Copyright © 2015 John Wiley & Sons, Ltd.

is how to motivate managers to disgorge the

cash rather than investing it at below the

cost of capital or wasting it on organization

inefciencies.

(Jensen, 1986: 323)

I have pledged— to you, the rating agencies

and myself— to always run Berkshire with

more than ample cash. Wenever want to count

on the kindness of strangers in order to meet

tomorrow’s obligations.

(Warren Buffet, quoted in Bershidsky, 2014)

When Is Cash Good or Bad for Firm Performance? 437

INTRODUCTION

Is cash good or bad for rm performance? Media

reports on the large cash stockpiles of US rms have

voiced conicting opinions about the value of hold-

ing cash. While some commentators argue that cash

reserves can help rms avert another Lehman-like

crisis or match the intensity of their rivals’ research

and development (R&D) efforts, others lament how

CEOs choose to earn a negative real return on idle

cash that could be more productively invested else-

where. Concurrently, academic researchers are also

divided on the issue of the performance implica-

tions of cash.1While many studies show that cash

improves rm performance (Daniel et al., 2004;

Kim and Bettis, 2014), several nd that cash is

detrimental to performance (Dittmar, Mahrt-Smith,

and Servaes, 2003; Harford, Mansi, and Maxwell,

2008), while some nd an inverted“U” shaped asso-

ciation (Tan and Peng, 2003).

The mixed evidence suggests that rms may

differ in the extent to which cash can enhance

or reduce rm performance, implying that context

may shape the performance consequences of cash.

We therefore ask the question: when does cash

create value and improve performance, and when

does it lead to value appropriation and impaired

performance? Our ndings indicate that cash is

benecial in contexts where it is used for adaptation,

but its benets are eroded in contexts where it can

be easily appropriated by other stakeholders.

Our research is grounded in three distinct

but complementary perspectives. The rst is the

value creation and appropriation (VCA) frame-

work (Coff, 1999). This perspective claries how

valuable resources can create value, but may

fail to enhance rm performance to the extent

this value is appropriated by stakeholders other

than shareholders. The second perspective is

Cyert and March’s (1963) behavioral theory of

the rm (BTF). According to the BTF, cash has

the potential to enhance performance by facili-

tating the adaptation and innovation that confer

competitive advantage and by buffering the rm

1A large literature in management has studied organizational

slack and distinguishes between three different types: available

slack, absorbed slack, and potential slack (Bourgeois, 1981;

George, 2005; Tan and Peng, 2003). Consistent with Kim and

Bettis (2014), we focus on cash, the most liquid and common form

of available slack, which provides high discretion to managers to

deploy quickly for adaptation, but can also be easily appropriated

by stakeholders.

from environmental turbulence. Conversely, the

BTF also recognizes the possibility that cash can

be a source of slack that is “up for grabs,” and

that powerful stakeholders (including managers)

may bargain hard to appropriate the value created

by cash, thereby undermining the performance

benets. Finally, some economic perspectives

also support the idea of value creation from cash,

arguing that because of inefciencies in capital

markets, cash-rich rms may have an advantage in

more quickly adapting to environmental changes

(Faulkender and Wang, 2006), thereby enhancing

performance. Other economics-based approaches,

such as agency theory, argue that free cash can be

dissipated by managers for private benet, resulting

in value appropriation from cash and undermining

performance (Jensen, 1986). In this paper, we

combine these three approaches (VCA, BTF, and

economic) to provide a framework for understand-

ing the contexts that shape the performance effects

of cash.

Our paper makes two important contributions to

the literature. First, using a framework based in

current theory, it highlights the primacy of context

in determining the cash– performance relationship.

Our research builds on prior work that studied con-

textual moderators of the cash– performance asso-

ciation (Bradley, Wiklund, and Shepherd, 2011;

George, 2005) by proposing a dichotomous typol-

ogy of contexts (i.e., value creation and valueappro-

priation). We show that cash creates more value

in contexts where there is greater need for adapta-

tion to unfolding contingencies, while value tends

to be appropriated in contexts where conict over

resources, information asymmetry, and stakehold-

ers’ bargaining power make it easier to appropriate.

Second, we also contribute to the literature by

dovetailing the VCA perspective offered by strat-

egy scholars with the BTF and agency approaches

adopted by extant studies on cash (Tan and Peng,

2003), and then suggesting new contextual mod-

erators of the cash– performance relationship.

These include three value creation moderators (or

contexts)— industry competition, industry R&D

intensity, and industry growth—and three value

appropriation moderators (or contexts)— corporate

governance, diversication, and corporate opac-

ity. While the corporate governance context for

cash has been employed in some prior studies

(Dittmar and Mahrt-Smith, 2007; O’Brien and

Folta, 2009), we put it into perspective by situating

it within a broader framework of contextual factors

Copyright © 2015 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 436–454 (2017)

DOI: 10.1002/smj