Investment opportunities and cash holdings of firms: an empirical study on Korean firms

ABSTRACT

We find that the cash flow sensitivity of cash holdings of firms whose investment opportunities are lower is significantly higher by examining a panel data of 898 Korean firms for 1999–2014. The cash flow sensitivity of investment is also found to be lower in case of low investment opportunity. Both findings suggest that firms decide to hold cash in response to an increase in cash flow when they do not have a good investment opportunity. Precautionary motive because of financial constraints and uncertainty, and agency problems, however, are not associated with the cash flow sensitivity of cash holdings. These findings imply that it is necessary to develop new investment opportunities to encourage firms to spend more cash in Korea.

KEYWORDS:

• Cash flow sensitivity of cash
• investment opportunity
• financial constraints
• Korea

JEL CLASSIFICATION:

• G31
• G32
• D23
• D92

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Adjusting for the measurement error in Tobin’s Q, Riddick and White (2009), however, find negative cash flow sensitivity of cash in case of positively serially correlated shocks, inconsistently with Almeida, Campello, and Weisbach (2004). Bao, Chan, and Zhang (2012) compromise that the cash flow sensitivity of cash is negative in face of a positive cash flow while that is positive in face of negative cash flows.

² Because dividend ratio is not statistically significant in estimation, we exclude it from Equation (1).

³ The effect of short-term debt on cash holdings is ambiguous. If firms regard short-term debts as cash equivalents, an increase in short-term debts may result in a decrease in cash holdings.

⁴ The partial derivative of (ΔCASH/TA) with respect to (CF/TA) is (${\beta }_1+{\beta }_2{X}_i$), which increases with X.

⁵ This specification of investment is widely used after Fazzari, Hubbard, and Petersen (1988).

⁶ We collect firms that report financial statements on December only. Among 1,148 firms, we exclude 30 firms that do not report on December, 172 firms that have data shorter than 5 years, 27 firms which have zero values in any accounting item, and 21 firms that have outliers.

⁷ Chaebol is a unique business group in Korea like Samsung, LG, and Hyundai Motors.

⁸ Negative effect of an increase in short-term debt on cash holding is unexpected. If short-term debt is liquidable and regarded as an alternative to cash, an increase in short-term debt may cause a decrease in cash holding.

⁹ This result is not inconsistent with the positive sign in Tobin’s Q in cash equations. While an increase in Q results in an increase in cash holdings, the sensitivity of cash holdings to cash flows of firms with high average Q is lower.

Additional information

Funding

Jaewoon Koo is grateful for the financial support provided by the Research Foundation of the College of Business Administration, Chonnam National University, the Republic of Korea.