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«Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications Aswath Damodaran Stern School of Business September ...»

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Dealing with Cash, Cross Holdings and Other Non-Operating

Assets: Approaches and Implications

Aswath Damodaran

Stern School of Business

September 2005

The Value of Cash and Cross Holdings

Most businesses hold cash, often in the form of low-risk or riskless investments

that can be converted into cash at short notice. The motivations for holding cash vary

across firms. Some hold cash to meet operating needs whereas others keep cash on hand

to weather financial crises or take advantage of investment opportunities. In the first part of this paper, we will begin by looking at the extent of cash holdings at publicly traded firms and some of the motives for the cash accumulation. We will also look at how best to value these cash holdings in both discounted cash flow and relative valuation models.

In the second part of the paper, we will turn to a trickier component – cross holdings in other companies. We will begin by looking at the way accountants record these holdings and the implications for valuation. We will then consider how to incorporate the value of these cross holdings in a full information environment, followed by approximations that work when information about cross holdings is partial or missing.

Most firms, private and public, have assets on their books that can be considered to be non-operating assets. The first and most obvious example of such assets is cash and near-cash investments – investments in riskless or very low-risk investments that most companies with large cash balances make. The second is investments in equities and bonds of other firms, sometimes for investment reasons and sometimes for strategic ones.

The third is holdings in other firms, private and public, which are categorized in a variety of ways by accountants. Finally, there are assets that do not generate cash flows but nevertheless could have value –undeveloped land in New York or Tokyo or an overfunded pension plan. When valuing firms, little or no serious attention is paid to these assets and the consequences can be serious. In this paper, we examine some of the challenges associated with valuing non-operating assets and common errors that can enter valuations of these assets.

Cash and Near Cash Investments On every firm’s balance sheet, there is a line item for cash and marketable securities, referring to its holding of cash and near cash investments. Investments in short-term government securities or commercial paper, which can be converted into cash quickly and with very low cost, are considered near-cash investments. We will begin by considering the motives for holding cash and the extent of such holdings at companies.

We will then discuss various approaches used to categorize cash holdings and how best to deal with cash holdings in both discounted cashflow and relative valuations.

Why do companies hold cash?

Every business has some cash on its books and many have very large cash balances, as a percent of their values. Keynes provided three motives for individuals to hold money. He suggested that they hold cash for transactions, as a precaution against unanticipated expenses and for speculative purposes. 1 It can be argued that firms accumulate cash for the same reasons, but there is anadded incentive. The separation of 1Keynes, J.M., The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and World, 1936) management and stockholders at large publicly traded companies can create an additional incentive for firms (or at least the managers in these firms) to accumulate cash. 2

1. Operating (Transactions) Motive Firms need cash for operations and the needs are likely to be different for different businesses. For instance, retail firms have to have cash available in the cash registers of the stores to run their businesses. Furthermore, these firms need access to cash to replace depleted inventory and to meet their weekly payrolls.3 In contrast, a computer software company may be able to get away with a much smaller operating cash balance. We would expect cash needs for operations to be a function of the following


Cash oriented versus Credit oriented businesses: Firms that are in cash oriented • businesses (fast food restaurants, discount retailers) will require more cash for operations than firms that operate in credit oriented businesses.

Small versus Large transactions: Firms that generate their revenues in multitudes • of small transactions are more likely to require cash for their businesses than firms that generate revenues in a few large transactions. It is unlikely that a firm like Boeing, which receives its revenues on a few large transactions, will receive or pay cash on most of its transactions. As a related point, there should be some economies of scale that allow larger firms to maintain lower (proportional) operating cash balances than smaller firms.4 Banking system: As banking systems evolve, fewer and fewer transactions will be • cash based. As a consequence, we would expect cash requirements to decrease as banking systems get more sophisticated, allowing customers to pay with credit cards or checks.

2 Opler, Tim, Lee Pinkowitz, René Stulz and Rohan Williamson, 1999, The determinants and implications of corporate cash holdings, Journal of Financial Economics, v52, 3-46. This paper examines the determinants of cash holdings and notes that many of the variables that lead companies to have low debt ratios (significant growth opportunities, high risk) also lead to large cash balances.

3 Miller, M. H., and Orr D., 1966. A Model of the Demand for Money by Firms. Quarterly Journal of Economics, 413-435. They develop a simple model for computing the optimal operating cash balance, as a function of the opportunity cost of holding cash and cash requirements for operations.

4 Faulkender, M., 2002, Cash Holdings among Small Businesses, Working Paper, SSRN. This paper finds that there are economies of scale and that cash balances decrease as firms get bigger.

While we can debate how much operating cash is needed in a firm, there can be little argument that banking technology and investment opportunities have improved for most firms in most economies, leading to lower operating cash requirements across the board.

2. Precautionary Motives The second reason for holding cash is to cover unanticipated expenses or to meet unspecified contingencies. For example, cyclical firms will accumulate cash during economic booms and draw on that cash in the event of a recession to cover operating deficits. In general, therefore, we would expect this component of the cash balance to be

a function of the following variables:

Volatility in the economy: Firms should accumulate more cash, other things • remaining equal, in unstable and volatile economies than they do in mature economies. There is a far greater likelihood of shocks in the former and thus a much higher need for cash.5 Volatility in operations: In any given economy, we would expect firms with more • volatile operating cashflows to hold higher cash balances to meet contingencies than firms with stable cashflows. Technology companies often have large cash balances precisely because they are so uncertain about their future earnings.

Competitive Environment: One factor that adds to instability is the presence of • strong competition in the business in which a firm operates. We would expect firms that operate in more intensely competitive sectors to hold more cash than otherwise similar firms that protected from competition.6 Financial Leverage: A firm that has a higher debt ratio, for any given operating • cash flow, has committed itself to making higher interest payments in the future.

5 Custodio, C. and C. Raposo, 2004, Cash Holdings and Business Conditions, Working Paper, SSRN. This paper finds strong evidence that financially constrained firms adjust their cash balance to reflect overall business conditions, holding more cash during recessions. Firms that are not financially constrained also exhibit the same pattern, but the linkage is much weaker. Their findings are similar to those in another paper by Baum, C.F., M. Caglayan, N. Ozkan and O. Talvera, 2004, The Impact of Macroeconomic Uncertainty on Cash Holdings for Non-financial Service Firms, Working Paper, SSRN.

6 Haushalter, D., S. Klasa and W.F. Maxwell, 2005, The Influence of Product Market Dynamics on the Firm’s Cash Holdings and Hedging Behavior, Working Paper, SSRN. In this paper, the authors find evidence that firms that share growth opportunities with strong rivals are more likely to accumulate higher cash balances, and that these cash holdings provide strategic benefits to the firms.

Concerns about being able to make these payments should lead to higher cash balances.

3. Future Capital Investments If capital markets were efficient and always accessible with no transactions costs, firms could raise fresh capital when needed to invest in new projects or investments. In the real world, firms often face constraints and costs in accessing capital markets. Some of the constraints are internally imposed (by management) but many are external, and they restrict a firm’s capacity to raise fresh capital to fund even good investments. In the face of these constraints, firms will set aside cash to cover future investment needs; if they fail to do so, they run the risk of turning away worthwhile investments. We would

expect this part of the cash balance to be a function of the following variables:

Magnitude of and Uncertainty about future investments: The need to hold cash • will be greatest in firms that have both substantial expected investment needs and high uncertainty about the magnitude of these needs. After all, firms that have large but predictable investment needs can line up external funding well in advance of their need, and firms with small investment needs can get away without setting aside substantial cash balances.7 Access to capital markets: Firms that have easier and cheaper access to capital • markets should retain less cash for future investment needs than firms without this access. Thus, we would expect cash balances to be higher (in proportional terms) in smaller companies than in larger ones, in private businesses than in publicly traded firms and in emerging market companies as opposed to developed market companies. Cash balances should also decrease with an increase in the financial choices that firms have to raise capital. Thus, the capacity to access corporate bond markets in addition to conventional banks for debt should allow nonfinancial corporations to reduce their cash balances.8 7 Acharya, V., H. Almeida and M. Campello, 2005, Is Cash Negative Debt? A Hedging Perspective on Corporate Financial Policies, Working Paper, SSRN. They present a twist on this argument by noting that firms that have to make significant investments when their operating cash flows are low, which they categorize as a hedging need, will maintain much larger cash balances to cover these investments.

8 Pinkowitz, Lee and Rohan Williamson, 2001, Bank power and cash holdings: Evidence from Japan, Review of Financial Studies 14, 1059-1082. They compare cash holdings of firms in Japan, Germany and Information asymmetry about investments: Firms will generally face far more • difficulty raising capital at a fair price for investments where external investors have less information about the potential payoffs than the firm does.9 Thus, we would expect firms to acquire larger cash balances in businesses where projects are difficult to assess and monitor. This may explain why cash holdings tend to be higher in firms that have substantial R&D investments; both lenders and equity investors face difficulties in evaluating the possibility of success with these investments.

4. Strategic Cash Holdings In some cases, companies hold cash not because they have specific investments in mind that they want to finance with the cash but just in case. “Just in case of what?” you might ask. These companies view cash as a strategic weapon that they can use to take advantage of opportunities that may manifest in the future. Of course, these opportunities may never show up but it would still be rational for firms to accumulate cash. In fact, the advantage of having cash is greatest when cash is a scarce resource and capital markets are difficult to access or closed. In many emerging markets, for instance, companies hold huge cash balances and use the cash during economic crises to buy assets from distressed firms at bargain prices. The advantage to holding cash becomes much smaller in developed markets but it will still exist.

5. Management Interests As we noted at the start of the section, the one variable that sets aside publicly traded companies from individuals is the separation of management and ownership. The cash may belong to the stockholders but the managers maintain the discretion on whether it should be returned to stockholders (in the form of dividends and stock buybacks) or held by the firm. In many firms, it can be argued that managers have their own agendas to the United States and conclude that the median Japanese firm holds two and half times more cash than the median German or US firm. They hypothesize (and provide evidence) that these higher cash balances reflect banks extracting rents from Japanese firms by forcing them to hold more cash than they need. In particular, they note that cash balances in Japan were higher during periods of high bank power.

9 Myers, S. and N. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics. v13, 187-221.

pursue and that cash provides them with the ammunition to fund the pursuit.10 Thus, a CEO who is intent on empire building will accumulate cash, not because it is good for stockholders, but because it can be used to fund expansion.11 If this rationale holds, we

would expect cash balances to vary across companies for the following reasons:

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