External financing, corporate governance and the value of cash holdings

This study investigates the role of corporate governance in the deployment of internal resources when access to credit is hampered and external financing is costly. The extant literature has focused on the rise in cash holdings amongst firms, but little is still known about when and under what conditions firms deploy and use accumulated internal resources. Using a panel data of 1,599 U.S firms for the period 2004 to 2016, the 2008 financial crisis as a quasi-natural experiment and a difference-in-difference estimation strategy, we examine how managers deploy and allocate cash reserves and excess cash. We find that the propensity to invest out of pre-crisis cash reserves is highest for weakly-governed firms and that these firms finance additional investment using short-term debt and allocate a higher fraction of post-crisis excess cash towards building up cash balances. Contrastingly, well-governed firms have a higher propensity to allocate excess cash towards increasing the value of pledgeable assets and deploy any accumulated cash balances to reduce short-term debt financing. Our findings are important as they reconcile the flexibility and the spending hypothesis of cash holdings, showing that well-governed firms trade-off the cost of cash holdings against the benefit of minimizing future demand for costly external financing; effectively hedging against foregoing profitable future investment opportunities.