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We examine the impact of managerial incentive on firms' cash holdings policy. We find that firms with more equity-based compensation have more cash reserves. We also find that managers with equity-based compensation strongly prefer internal investment through R&D and capital expenditures. Furthermore, we find that firms with both high cash and high equity-based compensation subsequently experience higher operating performance. The results suggest that higher cash reserves in firms with higher equity- based compensation are the result of a decision by managers to provide flexibility to fund profitable projects, rather than wasting it, which improves firm value through increasing future profitability.
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INTRODUCTION
Due to the separation of ownership and control, managers have incentives to take self-serving activities (Jensen, 1986). The decision of how to deploy internal funds is central to the conflict between shareholders and managers. Firms hold substantial and increasing amounts of cash reserves and the value of these cash holdings represents a significant fraction of all corporate wealth. In 2003, the sum of all cash and marketable securities represented more than 13% of the sum of all assets for large publicly traded US firms, reflecting a substantial increase from 5% in 1990. Although it is optimal for firms to hold some cash to finance day-to-day operations and to provide a buffer against the cost of externally financing their investments, holding excessive cash resources may have negative value implications if managers use these liquid resources inefficiently. Cash reserves are easily accessible by management with little scrutiny and much of their use is discretionary. Since executive compensation plays an important role in shaping managerial incentives and decision-making on firm policy, including how much cash to hold and how to use. An important question to ask is: how do managerial incentives impact the amount and eventual use of cash reserves?
Prior work on cash reserves in the U.S. provides mixed evidence on whether shareholders should be concerned about large reserves. For example, Opler et al. (1999) find that the transitional probabilities out of the high cash group were slow, suggesting that managers hold cash as part of a precautionary motive. Similarly, Mikkelson and Partch (2003) find that persistent extreme cash holdings do not lead to poor performance and do not represent...