(GMM) Corporate Cash Holdings - An Empirical Investigation of UK Companies

Corporate cash holdings:
An empirical investigation of UK companies

Aydin Ozkan
a,
*
, Neslihan Ozkan
b
a
Department of Economics and Related Studies, University of York, Heslington, York Y010 5DD, UK
b
Department of Economics, University of Bristol, Bristol BS8 1TN, UK
Received 4 May 2001; accepted 8 August 2003
Available online 18 December 2003
Abstract
This paper investigates the empirical determinants of corporate cash holdings for a sample
of UK rms. We focus on the importance of managerial ownership among other corporate
governance characteristics including board structure and ultimate controllers of companies.
We present evidence of a signicant non-monotonic relation between managerial ownership
and cash holdings. In addition, we observe that the way in which managerial ownership exerts
inuence on cash holdings does not change with board composition and, in general, the pres-
ence of ultimate controllers. The results reveal that rms growth opportunities, cash ows,
liquid assets, leverage and bank debt are important in determining cash holdings. Our analysis
also suggests that rm heterogeneity and endogeneity are crucial in analysing the cash struc-
ture of rms.
2003 Elsevier B.V. All rights reserved.
JEL classication: G3; G32
Keywords: Cash holdings; Ownership structure; Firm heterogeneity; Panel data
1. Introduction
Why do rms hold large amounts of cash and cash equivalents? Various explana-
tions have been oered for the incentives of rms to hold cash. A popular explana-
tion is that cash provides low cost nancing for rms. According to this view, raising
external nance costs more in the presence of asymmetric information between rms
*
Corresponding author. Tel.: +44-1904-434672; fax: +44-1904-433759.
E-mail address: ao5@york.ac.uk (A. Ozkan).
0378-4266/$ - see front matter 2003 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2003.08.003
www.elsevier.com/locate/econbase
Journal of Banking & Finance 28 (2004) 21032134
and external investors (Myers and Majluf, 1984); costly agency problems such as
underinvestment and asset substitution (Myers, 1977; Jensen and Meckling, 1976);
and transaction costs and other nancial restrictions. Therefore, managers trying
to minimize the costs associated with external nancing in imperfect capital markets
may nd it optimal to maintain sucient internal nancial exibility. However, there
are also potential adverse eects of cash holdings. Central to this view is the argu-
ment that agency conicts existing between shareholders and managers can be most
severe when rms have large free cash ows (Jensen, 1986). Managers can pursue
their own interests at the expense of shareholders and cash serves the interests of
managers more than those of shareholders in this respect.
The investigation of cash holdings of rms has recently gained a great deal of
attention in the empirical literature. An important strand of this literature focuses
on the determinants of corporate cash holdings.
1
For example, Kim et al. (1998)
analysed the determinants of cash holdings for a sample of US companies. They re-
port that rms facing higher costs of external nancing, having more volatile earn-
ings, and those rms with relatively lower returns on assets hold signicantly larger
liquid assets. For similar rms, Opler et al. (1999) provide evidence that small rms
and rms with strong growth opportunities and riskier cash ows hold larger
amounts of cash. More recently, Pinkowitz and Williamson (2001) examine the cash
holdings of rms from the United States, Germany, and Japan. In addition to the
ndings similar to those in Opler et al. (1999), they document that the monopoly
power of banks has a signicant impact on cash balance.
2
In this paper, we examine the empirical determinants of cash holdings for a sam-
ple of UK rms over the period 19841999. The UK is often described as being
similar to other Anglo-Saxon countries with respect to ownership structures of com-
panies and institutional and legal framework. There are, however, distinct corporate
governance features in the UK, which, we believe, may have important implications
with regard to the cash holding behaviour of rms. For example, as we discuss in
Section 3, the UK corporate sector is characterised by insucient external market
discipline and the lack of ecient monitoring by nancial institutions and company
boards. This, in turn, can provide managers with greater freedom to pursue their
own interests that may include holding higher cash balances.
Our paper contributes to the literature on cash holding decisions of rms on several
grounds. First, we investigate the role of ownership and control structure of rms in
determining their cash holdings. We mainly focus on the association between mana-
gerial ownership and cash holdings, and the nature of this relationship. Prior research
points to the conicts of interest between managers and shareholders arising from the
separation of ownership and control. For example, managers may have incentives to
hold large cash balances, which enable them to pursue their own objectives at the ex-
1
The other important strand of this literature examines the relationship between cash holdings and
corporate performance (see, for example, Blanchard et al., 1994; Harford, 1999; Mikkelson and Partch,
2003).
2
Other related studies, examining the determinants of corporate cash holdings for the US rms, include
Almeida et al. (2002) and Dittmar et al. (in press).
2104 A. Ozkan, N. Ozkan / Journal of Banking & Finance 28 (2004) 21032134
pense of those of shareholders, i.e. squandering funds by consuming perquisites or
making inecient investment decisions (Jensen, 1986). It is, however, suggested that
greater ownership by managers can align the interests of managers and shareholders.
Therefore, one would expect a negative relationship between managerial ownership
and cash holdings (i.e. the incentive alignment eect). However, it is argued that
the impact of managerial ownership is likely to be non-monotonic. As managerial
ownership continues to increase, the ability of the outside shareholders to monitor
and inuence managers declines, possibly leading to a greater degree of managerial
control and entrenchment of managers (see Morck et al., 1988; McConnell and Ser-
vaes, 1990). Consequently, managers may choose to hold more cash to pursue private
benets and hence the relationship between cash holdings and managerial ownership
can become positive at higher levels of managerial ownership (i.e. the entrenchment
eect). We test these hypotheses using a non-linear model of cash holdings.
In addition, we investigate whether board structure of companies, the presence
and the identity of controlling shareholders, and the divergence between largest
shareholders control rights and cash-ow rights have any impact on cash holdings
and the incentives of managers to hold cash. For example, we argue that the presence
of a controlling shareholder may aect cash holding decisions of rms. If large hold-
ings of cash serve controlling shareholders interests one would expect rms with
controlling shareholders to have higher cash holdings. Also, it is possible that the
incentive and the ability to monitor managers changes with the identity of control-
lers. This, in turn, implies that the relationship between managerial ownership and
cash holdings may depend on the identity of the rms controlling shareholder.
Second, distinct from previous empirical studies, we explicitly consider the endo-
geneity problem in the empirical analysis of cash holdings. We believe that the end-
ogeneity issue in this context is important for several reasons. First, it is highly likely
that observable as well as unobservable shocks aecting cash holdings of rms can
also aect some of the rm-specic characteristics such as leverage and market-
to-book ratios. Second, it is possible that observed relations between cash and its po-
tential determinants reect the eects of cash on the latter rather than vice versa. To
control for the endogeneity problem, we employ an average cross-sectional analysis
and a panel data analysis combined with the Generalised Method of Moments
estimation procedure.
Our last contribution lies in the dynamic analysis of the cash holding decision. We
incorporate the view that market imperfections such as adjustment and transaction
costs may prevent rms from rapidly adapting to new circumstances. We utilise a
partial target-adjustment model that allows for the possibility of delays in response
of rms in adjusting their cash holdings. We are not the rst to investigate this issue.
Opler et al. (1999), for example, estimate a target-adjustment model relating rms
actual cash holdings to their target cash holdings, providing evidence that rms have
target cash levels. However, distinct from their analysis, in estimating the target-
adjustment model, we also incorporate unobservable xed eects and time eects
as well as the rm-specic factors. This is because, to the extent that these eects
are signicant in the underlying target cash model and not controlled for, estimated
coecients of the target-adjustment model will be biased.
A. Ozkan, N. Ozkan / Journal of Banking & Finance 28 (2004) 21032134 2105
Our analysis reveals that managerial ownership plays an important role in deter-
mining corporate cash holdings in the UK. Moreover, we provide evidence that the
relationship between managerial ownership and cash holdings is non-monotonic.
The results also suggest that board composition and the presence of ultimate control-
lers do not have a signicant impact on cash holdings. However, the identity of con-
trollers and the divergence between control rights and cash ow rights seem to
matter. First, rms having families as ultimate controllers tend to hold more cash
than those rms having, for example, nancial institutions as controllers. Second,
the wedge between the largest shareholders control and cash ow rights has a neg-
ative impact on cash holdings. We also provide evidence of signicant dynamic ef-
fects in the determination of rms cash holdings and of a positive inuence of
cash ow and growth opportunities on cash holdings. In addition, there is signicant
evidence for the negative impact of liquid assets. Finally, the results suggest that
higher cash holdings are associated with lower levels of bank debt and leverage.
The rest of the paper is organised as follows. Section 2 reviews the relevant the-
ory and derives the empirical hypotheses. Section 3 presents the main features of
corporate governance in the UK. Section 4 explains the construction of the data
set. Section 5 presents the empirical results. Finally, Section 6 oers our main
conclusions.
2. Theory and empirical hypotheses
The current literature on corporate cash holdings emphasises two major motives
for cash holdings: the transaction costs motive and the precautionary motive. The
former points out that rms facing a shortage of internal resources can raise funds,
for example, by selling assets, issuing new debt and/or equity, or cutting dividends.
However, all these strategies involve costs that have both xed and variable compo-
nents. Consequently, one would expect rms that are likely to incur higher transac-
tion costs to hold greater amounts of liquid assets. On the other hand, the
precautionary motive places more emphasis on the costs arising from the foregone
investment opportunities. According to this approach, rms accumulate cash to meet
their unanticipated contingencies that may arise and to nance their investments
if the costs of other sources of funding are prohibitively high.
Accordingly, one would expect small rms to maintain higher cash balances to
avoid, for example, signicant xed costs involved in obtaining external funds. In
addition, rms with better investment opportunities are expected to hold more cash
to minimise the opportunity costs of foregone investment. Similarly, rms with more
volatile cash ows, and hence a higher frequency of cash ow shortfalls, need to
accumulate more cash. Finally, rms that currently pay dividends can aord to hold
less cash as they are more capable of raising funds when needed by cutting dividends.
In the following section, we discuss these points in more detail. In addition, we pro-
vide a detailed discussion on the relationship between cash holdings and ownership
characteristics of companies.
2.1. Asymmetric information, agency costs of debt
The existence of asymmetric information between rms and investors makes exter-
nal nancing costly. Myers and Majluf (1984) argue that in the presence of asymmet-
ric information rms tend to follow a hierarchy in their nancing policies in the sense
that they prefer internal over informationally sensitive external nance. They argue
that the asymmetric information problem is more severe for rms whose values are
determined by growth options. If a rm has investment opportunities that would in-
crease its value when taken and nds itself being short of cash, it may have to pass up
some of these investments. Hence rms with such opportunities would hold greater
amounts of cash in an attempt to make it less likely that they will have to give up valu-
able investment opportunities in some states of nature. In addition, it is important to
note that rms with greater growth opportunities are expected to incur higher bank-
ruptcy costs (Williamson, 1988; Harris and Raviv, 1990; Shleifer and Vishny, 1992).
This is because growth opportunities are intangible in nature and their value falls
sharply in nancial distress and bankruptcy. This would in turn imply that rms with
greater growth opportunities have more incentives to avoid nancial distress and
bankruptcy and hence hold more cash and marketable securities.
Growth opportunities are also related to agency costs of debt arising from the
conicts of interest between shareholders and debt holders. It is argued that growth
rms face higher agency costs because rms with risky debt and greater growth
opportunities are likely to pass up valuable investment opportunities in more states
of nature (Myers, 1977). Higher expected agency costs in turn make external nanc-
ing expensive, implying higher cash holdings.
To proxy for growth opportunities of rms we use the market-to-book ratio de-
ned as the ratio of book value of total assets minus the book value of equity plus
the market value of equity to book value of assets.
It is also suggested that large rms have less information asymmetry than small
rms (Brennan and Hughes, 1991; Collins et al., 1981). Therefore, small rms face
more borrowing constraints and higher costs of external nancing than large rms
(Whited, 1992; Fazzari and Petersen, 1993; Kim et al., 1998). To the extent that size
is an inverse proxy for the degree of informational asymmetry and, in turn, the cost
of external nancing, a negative relation should be expected between size and cash
holdings. Finally, size of rms can also have an impact on the expected costs of
nancial distress. For example, it is argued that larger rms are more likely to be
diversied and thus less likely to experience nancial distress (Titman and Wessels,
1988) and smaller rms are more likely to be liquidated when they are in nancial
distress (Ozkan, 1996). If this is the case, small rms are expected to hold relatively
more cash to avoid nancial distress.
We use the natural logarithmof total assets in1984 prices as a proxy for the size of rms.
2.2. Liquidity constraints and cash substitutions
The greater the rms cash ow variability, the greater the number of states of
nature in which the rm will be short of liquid assets. As noted earlier, it may be
costly to be short of cash and marketable securities if the rm has to pass up valuable
investment opportunities. There is evidence that rms with cash shortfalls do indeed
fail to take up some of the valuable growth opportunities. For example, Minton and
Schrand (1999) show that rms with higher cash ow volatility permanently forgo
investment rather than reacting to cash ow shortfalls by changing the discretionary
timing of investment. They also argue that a higher frequency of cash ow shortfalls
in the presence of capital market imperfections increases a rms cost of accessing
external capital. This also adversely aects the level of investment. Thus, rms with
more volatile cash ows are expected to hold more cash in an attempt to mitigate the
expected costs of liquidity constraints. The measure we use for cash ow volatility
is the standard deviation of cash ows divided by average total assets.
To the extent that there are substitutes for holding high levels of cash, rms can
use them when they have cash shortfalls. For example, rms can use borrowing as a
substitute for holding cash because leverage can act as a proxy for the ability of rms
to issue debt (John, 1993). Moreover, Baskin (1987) argues that the cost of funds
used to invest in liquidity increases as the ratio of debt nancing increases, which
would imply a reduction in cash holdings with increased debt in capital structure.
We, therefore, predict that there should be a negative relation between the rms
cash holdings and its leverage. However, one should note that higher debt levels
can increase the likelihood of nancial distress. In that case one would expect a rm
with a high debt ratio to increase its cash holdings to decrease the likelihood of nan-
cial distress. This would induce a positive relation between leverage and cash hold-
ings. Leverage is measured by the ratio of total debt to total assets.
Another substitution eect is due to other liquid assets rms may have besides
cash. It is reasonable to assume that the cost of converting non-cash liquid assets
into cash is much lower as compared with other assets. Firms with sucient liquid
assets may not have to use the capital markets to raise funds when they have a short-
age of cash. The proxy we use for non-cash liquid assets is the ratio of net working
capital minus cash to total assets.
Finally, we include the dividend payout ratio in our regressions to control for the
potential impact of the rms dividend policy on its cash holdings. To the extent that
rms that pay dividends can raise funds relatively easily by cutting their dividends, a
negative relationship is expected between dividend and cash holdings (Opler et al.,
1999). However, it is possible that dividend-paying rms can also hold more cash
than non-dividend paying rms simply to avoid a situation in which they are short
of cash to support their dividend payments. If this is the case a positive relation can
be observed.
2.3. Bank relationship
It is often argued that bank nancing is more eective than public debt in reduc-
ing problems associated with agency conicts and informational asymmetry (see,
e.g., Diamond, 1984; Boyd and Prescott, 1986; Berlin and Loeys, 1988). This is
mainly because of the comparative advantage of banks in monitoring rms activities
and in collecting and processing information. Fama (1985) argues that banks have a
comparative advantage as lenders in minimizing information costs and can get access
to information not otherwise publicly available. Therefore, banks can be viewed as
performing a screening role employing private information that allows them to eval-
uate and monitor borrowers more eectively than other lenders. Thus, a banks will-
ingness to provide a loan or renew a loan to a rm can signal positive information
about that rm.
3
Moreover, by providing signals about the borrowing rms credit
worthiness, the existence of a bank relationship would enhance the ability of rms to
raise external nance. These arguments suggest that rms with more bank debt in
their capital structures are expected to have easier access to external nance. This
would, in turn, imply that such rms should hold less cash. Another reason for a po-
tential negative eect of bank debt nancing on cash holdings is that bank debt is
more easily renegotiated when rms need to (see, e.g., Chemmanur and Fulghieri,
1994). By providing exibility through renegotiation, bank debt can serve as a sub-
stitute for holding high levels of cash and marketable securities. We measure bank
debt as the ratio of total bank debt to total debt.
2.4. Ownership and cash holdings
In this section, we discuss how rms ownership structure may aect their choices
of cash holdings. We mainly focus on the role of managerial ownership and whether
the presence of controllers and their identity can inuence rms cash holding deci-
sions. In addition, we discuss how board composition can have an impact on cash
holdings.
2.4.1. Managerial ownership
The conicts of interest between managers and shareholders arising mainly from
the separation of ownership and control have been well-documented. One of these
conicts is related to the rms cash holdings. Jensen (1986) argues that managers
can have incentives to hold large amounts of cash reserves to pursue their own objec-
tives at the expense of those of shareholders. They can, for example, squander funds
by consuming perquisites and/or making inecient investment decisions (Jensen and
Meckling, 1976). Moreover, greater cash holdings serve managers interests by pos-
sibly providing protection against disciplining by external investors.
There is a large body of literature that supports the notion that managerial own-
ership can help align the interests of managers with those of shareholders. That is,
with increased managerial ownership, managers are less likely to divert resources
away from value maximisation as they bear part of the costs of their actions. To
the extent that this is the case and holding cash is costly, one would expect a negative
3
James (1987) and Mikkelson and Partch (1986) document that the announcement of a bank credit
agreement conveys positive news to the stock market about the borrowing rms credit worthiness. Billett
et al. (1995) reconrms that, unlike public debt issuance, bank loan announcements are associated with
positive borrower returns. Additionally, Slovin and Young (1990) demonstrate that the presence of a
banking relationship lessens the degree of expected underpricing associated with the initial public oerings
of client rms.
relationship between managerial ownership and cash holdings (i.e. the incentive-
alignment eect). Furthermore, lower expected agency costs due to the alignment
of interests are likely to increase the rms ability to raise external nance, which
would reduce rms incentives to accumulate cash.
However, the relationship between managerial ownership and the alignment of
shareholder and managerial interests can be non-monotonic, implying that the mar-
ginal eect of increased managerial ownership depends on the current level. At high-
er levels of managerial ownership outside shareholders may nd it dicult to
monitor the actions of managers because greater ownership gives managers more di-
rect control over the rm, increasing their ability to resist outside pressures. Conse-
quently, entrenched managers who are relatively free of external discipline would
choose to hold more cash to pursue their own interests without risking replacement
(i.e. the entrenchment eect).
4
The net impact of these two eects would determine the sign of the relation-
ship between managerial ownership and cash holdings. To test the hypothesised
non-linear nature of the relationship between cash holdings and managerial owner-
ship we estimate a cubic model that implies two turning points. That is, as manage-
rial ownership increases, we expect to observe rst a negative (incentive-alignment),
then a positive (entrenchment) eect exerted by managerial ownership on cash hold-
ings. In addition, our cubic specication allows the possibility that the relationship
becomes negative again at high levels of managerial ownership. This can happen be-
cause managerial interests are more likely to converge to those of shareholders as
managers stake in the rm increases to substantially high levels.
Theory does not shed much light on the exact nature of the relationship between
cash holdings and managerial ownership and hence which of the two eects will
dominate at various levels of managerial ownership is dicult to predict ex ante.
We, therefore, carry out a preliminary investigation about the pattern of the relation-
ship between cash holdings and managerial ownership by plotting the association
between the two.
As can be seen in Fig. 1, cash holdings rst decrease with the equity ownership of
managers, consistent with the incentive-alignment argument. Companies with man-
agerial ownership between 20% and 30% have the lowest cash holdings. Neverthe-
less, after reaching a minimum, the association between cash and managerial
ownership becomes positive, providing some support for the entrenchment eect
of managerial ownership. This increase is not monotonic either. It seems that com-
panies with managers having substantial shareholdings tend to have lower cash hold-
ings than those with moderate managerial ownership levels. Consequently, our
preliminary investigation points to a cubic functional form to depict the relationship
between cash holdings and managerial ownership. We measure managerial owner-
ship as the percentage of equity ownership by directors.
4
This argument is in line with the ndings of prior research that investigates the relationship between
managerial ownership and corporate value and provides evidence for a signicant non-linear relationship
(see Morck et al., 1988; McConnell and Servaes, 1990; Hermalin and Weisbach, 1991; among others).
We note that the extent to which managerial ownership impacts cash holdings of a
rm may depend on the rms growth opportunities. For example, it can be argued
that the entrenchment eect becomes less signicant as the rms growth opportuni-
ties increase because the interests of managers and shareholders are better aligned
with greater growth opportunities. To control for this potential impact we interact
the managerial ownership terms with the proxy for growth opportunities.
2.4.2. Board structure of companies
One increasingly important issue relating to agency conicts between managers
and shareholders concerns the role of board composition in inuencing managerial
incentives (see, Hermalin and Weisbach, 2003, for an extensive survey). A generally
accepted view in the literature is that the degree of alignment between the interests of
managers and shareholders varies with the composition of the board. More speci-
cally, it is argued that outside (non-executive) directors are appointed to act in the
shareholders interests (Rosenstein and Wyatt, 1997; Mayers et al., 1997) and outside
directors have incentives to signal that they indeed act in that way (Fama and Jensen,
1983). Accordingly, boards with greater outside director representation will make
better decisions than boards dominated by inside (executive) directors. There is some
empirical evidence supporting these predictions that the market reacts more posi-
tively to decisions taken by outsider-dominated rms than those taken by insider-
dominated rms (see Borokhovich et al., 1996, for an extensive discussion).
To the extent that non-executive directors perform a signicant monitoring and
disciplining function over executive directors, one would expect that the board struc-
ture of companies exerts some inuence on their cash holdings. More specically,
assuming that rms with outside-dominated boards are likely to experience a reduc-
tion in the agency costs of external nance, one would expect these rms to hold
lower amounts of cash.
Fig. 1. Cash holdings and managerial ownership.
To test this hypothesis for UK companies in our sample we adopt two measures
of the degree of board independence: the fraction of non-executive directors on the
board and a dummy variable which takes a value of one if the chief executive ocer
(CEO) and the chairman of the board (COB) are the same person and 0 otherwise.
These variables are prompted by the two main recommendations of the Cadbury
Committee Report on Corporate Governance, issued in 1992 in the U.K. In an attempt
to mainly reduce the CEOs inuence over the board, the Cadbury Report recom-
mended, among other things, that boards of public companies include at least three
non-executive directors and the roles of chairman (COB) and chief executive ocer
(CEO) are separated.
2.4.3. Controlling shareholders
We now turn to the question of whether corporate cash holdings are aected when
there is a controller among the rms shareholders. It is argued that one of the ways
of alleviating the agency problem between managers and shareholders is to eec-
tively monitor managers to ensure that they act in the interests of shareholders.
However, shareholders bear all the costs related to their monitoring activities while
beneting from monitoring only in proportion to their shareholding (Grossman and
Hart, 1988). Therefore, for an average shareholder there may be little or no incentive
to monitor managers as the cost of monitoring is likely to outweigh the benet. In
contrast, large shareholders, having claims on a large fraction of the rms cash
ows, can have more incentives to monitor managers. Moreover, they can monitor
more eectively. Consequently, in the presence of a large shareholder, managerial
discretion is curbed to some extent and agency costs between managers and share-
holders are reduced (Stiglitz, 1985; Shleifer and Vishny, 1986). To the extent that this
argument holds, the cost of external nancing would be lower for rms with large
shareholders, implying less need to hold higher levels of cash.
5
While enhanced monitoring by large shareholders can help reduce some of the
agency problems associated with management, there are also private benets of con-
trol accruing to large shareholders, not necessarily shared by minority sharehold-
ers.
6
Recent studies emphasise the potential conicts of interest between the
controlling shareholder and other shareholders. For example, Shleifer and Vishny
(1997) argue that when large owners gain nearly full control of the corporation, they
prefer to generate private benets of control that are not shared by minority share-
holders (see also Faccio et al., 2001; Holderness, 2002). Consequently, large share-
holders might have incentives to increase the amounts of funds under their control
to consume private benets at the expense of minority shareholders. This, in turn,
5
The empirical evidence on the eectiveness of the monitoring by large shareholders is mixed. Mehran
(1995) nds that the use of executive compensation declines with outside blockholders ownership, which is
interpreted as evidence of a signicant role for blockholders in monitoring executives. Franks et al. (2001),
on the other hand, report that large shareholders in the UK do not seem to discipline the management of
poorly performing companies (see Holderness, 2002, for a survey on the eectiveness blockholders in
monitoring management).
6
We use large shareholders and controllers interchangeably throughout the paper.
suggests that rms with large shareholders are more likely to accumulate more cash
than widely-held rms.
We investigate these hypotheses by incorporating two proxies in our empirical
analysis. First, we identify those rms with controllers with a dummy variable, tak-
ing a value of one if there is a controlling shareholder in the rm. A rm is said to
have a controlling shareholder if the direct and indirect voting rights of this share-
holder in the rm exceed 10%. Second, we include a variable dened as the ratio
of the largest shareholders control rights to cash-ow rights; i.e. the divergence be-
tween control rights and cash-ow rights. We believe that the latter proxy can pro-
vide more insights as to whether the private benets accruing to controllers dominate
the shared benets of control.
2.4.4. Identity of ultimate controllers
To the extent that the incentives to monitor managers depend on the category of
controlling shareholders, the identity of a controlling shareholder can have a signif-
icant impact on the rms incentives for cash holdings. For example, it can be argued
that the direct involvement of controlling family owners in the management of the
rm is more likely than that of nancial institutions (see Faccio and Lang, 2002).
This, in turn, would lead to higher agency costs regarding the relationship between
managers and outside shareholders. In particular, family owners may want to keep
their control over the rm ineciently long from the outside shareholders perspec-
tive. In the context of our analysis this implies that family controlled rms would
hold more cash than those controlled by other owners. For example, nancial insti-
tutions as controlling shareholders might provide more eective monitoring of the
management as long as they have superior monitoring abilities. If they exert su-
cient monitoring, their presence as a controller may lead to a reduction in the fric-
tions between managers and shareholders, lowering the agency costs associated
with higher levels of managerial ownership. This would, in turn, imply that rms
controlled by nancial institutions have lower cash balances.
3. Features of corporate governance in the UK
Several features of the UK corporate governance system make the cash holding
analysis of UK rms interesting. In this section, we review these features and observe
that they may contribute to a high degree of managerial discretion, which may even-
tually inuence the relationship between managerial ownership and cash holdings.
In particular, we focus on the inuence of institutional shareholders and board
composition, and the role of regulation.
3.1. Institutional shareholders
In the UK, the ownership of listed UK equities by nancial institutions (including
insurance companies, pension funds, and unit and investment trusts) is signi-
cantly high. A report on ownership of shares, published by the Oce for National
Statistics (2001), shows that the proportion of shares held by domestic nancial insti-
tutions grew steadily from 29% in 1963 to 56.2% in 2000. It is argued that there are
two primary causes of the increase in the ownership of nancial institutions, namely
the substantial increase in funds available to the institutions for investment as a re-
sult of the growth in long-term savings; and the disposition of insurance companies
and pension funds towards equities (Stapledon, 2000). It is also argued that the UK
has far fewer regulatory restrictions on the shareholdings of banks, pension funds,
mutual funds, and insurance companies in corporations than the US does (see,
e.g., Allen and Gale, 2000).
7
Moreover, tax considerations might also have played
a role in the institutionalisation of the UK equity market. For instance, pension fund
investments and unit trust portfolios are exempt from capital gains tax and life insur-
ance companies have tax privileges.
Despite the large ownership position of nancial institutions, there is a great deal
of evidence that institutions do not take an active role in corporate governance in the
UK. For example, Faccio and Lasfer (2000) analyse the monitoring role of occupa-
tional pension funds in the UK and provide evidence that supports the view that
occupational pension funds are not eective monitors. Similarly, Franks et al.
(2001) observe, for a sample of UK rms, that there is no signicant relationship
between high levels of institutional ownership and managerial disciplining. Further-
more, Goergen and Renneboog (2001) provide evidence of a passive role of institu-
tional shareholders in the UK and point to the factors that might contribute to their
passive stance, including low-cost passive index strategies and insider-trading regu-
lations.
8
More evidence of the passive stance by nancial institutions in the UK
is provided by Cosh and Hughes (1997). They report that the presence of institutions
as major shareholders has no signicant impact on either the level of pay or the like-
lihood of dismissal of top managers. Finally, Plender (1997) reports that nancial
institutions in the UK do not frequently vote at shareholders meetings as they are
not obligated to do so as they are in the US. He observes that only about 28% of
pension funds vote on a regular basis whereas 21% never vote and 32% cast their
vote only on extraordinary items.
To summarize, the evidence suggests that the institutional shareholders in the UK
seem to adopt a passive stance towards monitoring and disciplining rms manage-
ment. Accordingly, one would expect nancial institutions to have little inuence on
managers in the UK and hence an insignicant impact on cash holding decisions
of companies.
7
For instance, in the UK life insurance companies have voluntary self-limitation of holding of stock in
any single company for the purpose of diversication, while in the US life insurance companies investment
in stocks must be less than 20% of assets and holdings of shares of any single company are limited to 2% of
total assets.
8
Black and Coee (1994) provide evidence that the intervention by large institutional shareholders is
triggered by nancial crisis and poor company performance. Mayer (2000) also reports that nancial
institutions are reluctant to intervene in the face of poor performance unless there is clear evidence of
failure.
3.2. Board structure of UK companies
The UK has a one-tier board structure in which both executive and non-executive
directors sit on the same board and the chairman of the board can at the same time
be an executive ocer. The main criticism of this structure relates to the indepen-
dence of outside directors and their ability to monitor and control executive directors
(see, e.g, Blair, 1995; Ezzamel and Watson, 1997). It is also important to note that
there are no formal requirements for companies in the UK to appoint outside direc-
tors and company boards can function without outsider representation.
9
The con-
sequences of these features are reected in the board composition of companies.
For our sample, we nd that 298 rms (35.5% of the sample) have fewer than three
non-executive directors on their boards in 1997. We also observe that the average
percentage of non-executive directors is 43 and non-executive directors have a major-
ity of the board in only 208 companies (24.8% of the sample).
10
Finally, it is impor-
tant to note that non-executive directors in the UK have a more advisory role rather
than performing a disciplinary function, possibly due to the less clearly dened du-
ciary responsibilities of non-executive directors in the UK (Franks et al., 2001).
As discussed earlier, outside-dominated boards are more likely than inside-
dominated boards to eectively monitor and control managers. To the extent that
this is the case, UK company boards dominated by inside directors are not expected
to play an important role in limiting the exercise of managerial discretion.
11
3.3. Role of regulation
It is suggested that the regulatory features in the UK can have a signicant inu-
ence on the pattern of corporate governance. Franks et al. (2001) argue that, despite
the characterisation of the UK as having a common law regulatory system (La Porta
et al., 1998), there are several distinctive regulatory characteristics in the UK, which
might have implications for disciplining management. First, the UK Takeover Code
makes accumulation of controlling blocks expensive.
12
Second, the UK has stronger
9
As previously stated, the UK Code of Best Practice based on the report of the Cadbury Committee
recommends that boards of UK companies include at least three outside directors and that the positions of
chairperson and CEO be held by dierent individuals. While the Code is voluntary, the London stock
Exchange requires that all listed companies explicitly indicate whether they comply with the Code or not.
10
This nding is consistent with that of Vafeas and Theodorou (1998) who report that the average
percentage of non-executive directors on UK boards is 39. In contrast, the average percentage of outside
directors on US boards is over 70 (Borokhovich et al., 1996; Klein, 1998).
11
Goergen and Renneboog (2001) argue that proxy votes can further increase the power of directors in
the UK as they are frequently exercised by directors who can also ask for proxy votes from institutional
investors.
12
Franks and Mayer (1996), in contrast to the ndings of Martin and McConnell (1991) for US
companies, provide evidence that takeovers do not work as a corporate governance mechanism for
disciplining poor managers in the UK. However, there is evidence of high management turnover, disposal
of assets, sales of subsidiaries and break-up of rms subsequent to a bid going through, which, Mayer
(2000) argues, suggests that the market for corporate control is more closely associated with changes
in strategies of rms than with corporate governance and the disciplining of bad management.
minority protection laws discouraging partial accumulation of share blocks in fa-
vour of full acquisitions in takeovers, making share blocks a weak disciplining de-
vice. Third, as mentioned above, there are few duciary obligations on directors in
the UK, which, Franks et al. (2001)argue, result in non-executive directors playing
more of an advisory role than a disciplinary role.
In summary, insucient external market discipline and the lack of ecient mon-
itoring by nancial institutions and company boards in the UK is more likely to pro-
vide managers with greater freedom to pursue their own interests which include
holding higher cash balances.
4. Data description
For our empirical analysis of corporate cash holdings we use a sample of publicly
traded UK rms from 1984 to 1999 (though the sample period for the cross-sectional
analysis is 19951999 due to the reasons to be discussed in the next section). Our ini-
tial sample is the set of all rms for which data are available on the Datastream data-
base which provides both accounting data for rms and market value of equity. The
panel data set for this study has been constructed as follows. First, nancial rms
were excluded from the sample. Second, missing rm-year observations for any var-
iable in the model during the sample period were dropped. Finally, from these rms,
only those with at least ve continuous time series observations during the sample
period have been chosen. These criteria have provided us with a total of 1029 rms,
which represents 12,960 rm-year observations. We obtain information regarding
the equity ownership structure from two dierent sources. Data for the sharehold-
ings of directors were collected from the 1997 September edition of the Price Water-
house Corporate Register, consisting of benecial as well as non-benecial directors
holdings, in which the latter refers to holdings by directors on behalf of their families
and charitable trusts. Although managers do not obtain benet from these holdings
directly, they usually have control rights. Data on the board characteristics of com-
panies were also collected from the same source. Data for the ultimate controllers of
rms in 1997 were obtained from Faccio and Lang (2002) and merged with the man-
agerial ownership. Consequently, we were left with 839 rms for our cross-sectional
analysis.
Table 1 presents descriptive statistics for the main variables used in our analysis.
It reveals that the mean cash ratio is 9.9% and the median value is 5.9%. These values
are in general in line with those reported for US rms. For example, Kim et al.
(1998) report that the mean and median values of the cash ratio are 8.1% and
4.7% respectively. However, in Opler et al. (1999), the mean ratio is reported as
17% whereas the median cash ratio is 6.5%. The higher mean value in their analysis
is most probably due to normalizing cash and marketable securities by total assets
minus cash and marketable securities rather than total assets.
As reported in Table 1, the average managerial ownership for our sample of rms
is 14.2% (the median is 5.1%). In an average rm, the numbers of executive and non-
executive directors are 4.12 and 3.24, respectively. That is, on average boards of
companies comprise 7.36 directors. The table also reveals that the mean percentage
of non-executive directors is 43.5%. Finally, we were able to identify only 72 rms
(8.6%) in which the positions of CEO and COB were held by the same person.
Table 2 provides a detailed analysis of the ultimate ownership structure of the UK
companies used in our analysis. Companies are mainly classied into two groups:
those that are widely held in the sense that they have no owners with signicant con-
trol rights and those companies that have controlling owners. We report results for
two dierent cut-o levels, namely 10% and 20% thresholds. The reported results rely
on voting rights that may dier from cash ow rights for a variety of reasons such as
pyramiding or issuing dierent classes of shares (for a detailed discussion see Faccio
and Lang, 2002). In Table 2 controlling owners are further classied into six catego-
ries: widely held corporations, nancial institutions, family, unlisted companies,
state, and miscellaneous.
In Panel A of Table 2 we present percentage and number of rms controlled by
dierent categories of owners at two dierent cut-o levels. At the 10% level, only
23.24% of rms are widely-held. Family-controlled rms comprise 26.58% of rms
in our sample, which makes it the largest category. 19.43% of rms are controlled
Table 1
Descriptive statistics
Mean Min 25% Median 75% Max
CASH 0.099 0 0.018 0.059 0.127 0.988
CFLOW 0.088 )0.627 0.062 0.094 0.131 0.301
LIQ 0.048 )0.562 )0.067 0.034 0.152 0.788
LEV 0.162 0 0.076 0.155 0.224 0.842
BANKDEBT 0.570 0 0.258 0.634 0.886 1
MKTBOOK 1.769 0.351 1.049 1.406 1.990 8.077
SIZE 10.873 6.225 9.640 10.570 11.875 16.497
VARIABILITY 0.067 0.004 0.036 0.055 0.082 0.335
DIVIDEND 0.419 )5.622 0.237 0.389 0.513 2.127
MAN 0.142 0 0.005 0.051 0.207 0.844
EX 4.121 1 3 4 5 18
NON EX 3.241 0 2 3 4 15
NON EX=DIR 0.435 0 0.333 0.429 0.5 0.833
CEO COB 0.086 0 0 0 0 1
This table shows the sample characteristics for 839 rms over the period 1995 to 1999. The means of the
variables are measured over the period 19951998 (except MAN and NON EX=DIR, measured in 1997)
CASH is the ratio of total cash and equivalent items to total assets. CFLOW is the ratio of pre-tax prot
plus depreciation to total assets. LIQ is the ratio of current assets minus current liabilities and total cash to
total assets. LEV is the ratio of total debt to total assets. BANKDEBT is the ratio of total bank bor-
rowings to total debt. MKTBOOK is the ratio of book value of total assets minus the book value of equity
plus the market value of equity to book value of assets. SIZE is the natural log of total assets in 1984
prices. VARIABILITY is the standard deviation of cash ow divided by average total assets. DIVIDEND
is the ratio of dividend payments to total assets. MAN is the total percentage of equity ownership by
company directors. EX is the number of executive directors. NON EX is the number of non-executive
directors. NON EX=DIR is the ratio of the number of non-executive directors to the total number
of directors. CEO COB is a dummy variable which takes a value of 1 if the positions of CEO and the
COB are held by the same individual and 0 otherwise.
by nancial institutions. Another important category is the unlisted companies that
control 20.26% of rms at the 10% threshold. Control by widely-held corporations
and the state is trivial (1.19% and 0.48%, respectively). As expected, the control
structure of rms at the 20% threshold is signicantly dierent than that at the
10% level. At this more conservative cut-o, 66.39% of companies have no control-
ling owner. The characteristics of controllers are, however, similar. More specically,
family is still the most important category at 14.78%. As can be seen from the table,
only 6.2% of non-nancial rms in the UK are controlled by nancial institutions at
the 20% ultimate control threshold. However, the decrease in the percentage of rms
with nancial institutions as a controller at the higher cut-o level is more signicant
than that with family control. The percentage of companies controlled by unlisted
companies also drops dramatically from 20.26% to 8.46%.
In Panel B of Table 2 we report summary statistics on the control rights of the
largest controlling owner in each category of controller, where the ultimate control
threshold is 10%. The ndings reveal that the average percentage values of control
rights of the largest controlling shareholder are 39.35 and 29.77 for rms that are
controlled by widely-held corporations and family, respectively. The average per-
Table 2
Ownership structure of UK companies
Widely
held
Widely held
corporation
Financial
institution
Family Unlisted
company
State Misc.
Panel A: Percentage of controlled rms and controllers
a
10% Cuto 23.24 1.19 19.43 26.58 20.26 0.48 8.82
No. of rms 195 10 163 223 170 4 74
20% Cuto 66.39 0.95 6.20 14.78 8.46 0.24 2.98
No. of rms 557 8 52 124 71 2 25
Panel B: Descriptive statistics of ultimate ownership by dierent categories
b
Mean 0 39.35 20.25 29.77 23.53 23.33 20.62
Min 0 11.07 10.04 10.05 10.09 12.00 10.30
25% 0 20.60 11.76 16.17 15.74 12.93 13.92
Median 0 27.02 15.91 24.69 15.74 18.98 14.90
75% 0 65.01 22.79 40.91 25.00 33.74 26.20
Max 0 83.22 89.90 84.50 86.88 43.37 64.93
Panel C: Ratio of cash ow to control rights
c
Mean 0.968 0.682 0.794 0.952 0.902 0.868 0.662
Min 0.391 0.24 0.048 0.106 0.107 0.471 0.202
25% 1 0.747 0.660 1 0.787 0.736 0.332
Median 1 0.832 1 1 1 1 0.725
75% 1 0.832 1 1 1 1 1
Max 1 1 1 1 1 1 1
This table presents summary statistics on ultimate controllers for a sample of 839 UK rms used in our
analysis.
a
Based on the ownership of the largest control holder.
b
At the 10% ultimate control threshold.
c
The largest controlling holder has at least 5% of the voting rights. Source: Our own calculations based
on the ultimate ownership and control data in Faccio and Lang (2002).
centage of control rights for rms where the largest controlling shareholder is a
nancial institution is 20.25%.
Finally, Panel C reports descriptive statistics for the ratio of cash-ow to control
rights of the largest controlling shareholder. This ratio is a measure for the discrep-
ancy between the largest controlling shareholders ownership and control rights. The
reported statistics are based on rms where the largest ultimate controller owns at
least 5% of control rights. The largest ultimate shareholders average ratio of
cash-ow to voting rights is 86.12% for our sample of 839 rms (not reported in
Table 2). This is in line with Faccio and Lang (2002) who report the ratio as
86.80% for 1628 UK rms. Panel C shows that the average ratio of cash-ow to con-
trol rights is 68.28% for rms where the largest controller is a widely held corpora-
tion. Comparing this value with that of other categories we can observe that the
separation of ownership and control is highest for rms where the largest controller
is a widely held corporation (ignoring miscellaneous category that has a ratio of
66.17%). The average ratio of cash ow to control rights for rms controlled by fam-
ilies is 95.18%. Thus, the evidence suggests that rms that are controlled by families,
with the exception of only one state-controlled rm, are less likely than those with
other controllers to have divergence between ownership and control.
5. Regression results
In what follows we rst present the results for our cross-sectional regressions by
focusing on the question of whether ownership characteristics inuence cash levels of
rms after controlling for the rm-specic determinants. Section 5.2 provides results
on the dynamic panel data model. In this section, we also describe the empirical
methods used in the analysis.
5.1. Ownership, board structure and cash holdings
We begin our examination of the determinants of cash holdings by focusing on
the question of whether managerial ownership and the characteristics of board struc-
ture and ultimate controllers of rms aect cash levels. To do so, we estimate a cross-
sectional cash model using the average values of each of the rm characteristics
(except variability and ownership variables) over four years in an attempt to mitigate
problems that might arise due to short-term uctuations or extreme values in one
year. We measure cash holdings (the dependent variable) in 1999 and the explana-
tory variables over the period 19951998. Using past values also reduces the likeli-
hood of observed relations reecting the eects of cash holdings on rm-specic
factors (see also Rajan and Zingales, 1995, for a similar methodology). Ownership
variables are measured in 1997. Given that equity ownership structure of rms in
a country is relatively stable over a certain period of time, we do not expect that mea-
suring ownership characteristics in a single year would yield a signicant bias in our
results (see also La Porta et al., 2002, among others).
Table 3 presents the rst set of estimation results for the cross-sectional cash
model. The inclusion of the higher ordered managerial ownership terms, namely
MAN, MAN
2
and MAN
3
, allows for the eect of managerial ownership on cash
holdings to vary with the value of managerial ownership. This diers from the linear
regression framework that examines a constant eect. That is, the relationship is a
conditional relationship in the former case whereas the traditional linear regression
represents a general relationship.
In column (1), we report the regression results for the basic model that includes
the control variables described in Section 2 and the managerial ownership variables.
In column (2), we additionally test whether board composition impacts the cash
holding decisions of rms. To do so, we incorporate two additional variables into
the model, namely (NON EX=DIR) which gives the fraction of non-executive direc-
tors on the board of directors, and a dummy variable (CEO COB) that takes a value
of one if the rms chief executive ocer and chairman of the board are the same
individual. In column (3), we interact managerial ownership terms with the proxy
for growth opportunities, MKTBOOK, to control for the potential impact of the
rms growth opportunities on managerial discretion.
In general, the estimated coecients are in line with the hypothesized signs. The
notable exception is the coecient of cash ows (CFLOW), which is negative and
signicant. There is a strong support that liquidity (LIQ) exerts a negative impact
on cash holdings of rms. The estimated coecient is signicant at the 1% level. Sim-
ilarly, consistent with the prediction of the theory, the relationship between cash
holdings and leverage (LEV) is negative and signicant at the 1% level. We also nd
strong evidence that rms with more growth opportunities hold more cash, given by
the positive and signicant coecient of MKTBOOK. One of the results that is not
in line with the predicted eect is due to the estimated coecient of VARIABILITY.
We cannot nd any evidence to support the view that rms with more volatile cash
ows hold more cash. The estimated coecient is positive but insignicant under all
specications. Also, the results do not provide support for the negative relation be-
tween cash holdings and size. Finally, there is no evidence that dividend policy of
rms exerts a signicant inuence on rms cash holdings.
The results for model (1) suggest that levels of managerial ownership exert a sig-
nicant inuence on cash holding decisions of UK rms. Moreover, the results pro-
vide support for the non-linear relationship between managerial ownership and cash
holdings. More specically, the estimated coecients of MAN, MAN
2
and MAN
3
suggest that management move from alignment to entrenchment, and to alignment
again as their shareholdings in the rm increase. Cash holdings of rms fall as man-
agerial ownership increases up to 24%, and then rise as managerial ownership in-
creases to 64%. Finally, cash holdings fall again for managerial ownership levels
above 64%. The estimated coecient of MAN is negative and statistically signicant.
This can be viewed as evidence to support the notion that at lower levels of mana-
gerial ownership the interests of managers and shareholders are aligned. Moreover,
the positive coecient of MAN
2
possibly suggests that managers are entrenched at
higher levels of ownership and can hold more cash to pursue their own interests at
the expense of other shareholders. As discussed previously, holding large cash
Table 3
Cross-sectional regressions of cash holdings on managerial ownership, controlling shareholder and other rm
characteristics
Independent variables Predicted Sign (1) (2) (3)
Dependent variable : CASH
CFLOW + )0.205
)0.207
)0.210
(0.082) (0.083) (0.079)

LIQ )0.072
)0.072
)0.074
(0.025) (0.025) (0.025)

LEV )0.327
)0.321
)0.324
(0.042) (0.041) 0.042

BANKDEBT )0.037
)0.036
)0.037
(0.013) (0.013) (0.013)

MKTBOOK + 0.018
0.018
0.027
(0.006) (0.006) (0.010)

SIZE 0.001 0.001 0.001
(0.003) (0.003) (0.003)
VARIABILITY + 0.089 0.098 0.084
(0.125) (0.126) (0.125)
DIVIDEND )0.007 )0.004 )0.007
(0.021) (0.021) (0.021)
NON EX=DIR )0.037
(0.033)
CEO COB + )0.005
(0.014)
MAN )0.390
)0.426
)0.362
(0.139) (0.141) 0.264
MAN
2
1.130
1.229
1.808
(0.501) (0.508) (0.963)

MAN
3
)0.861
)0.948
)1.889
(0.483) (0.489) (0.938)

MAN MKTBOOK )0.007
(0.155)
MAN
2
MKTBOOK )0.458
(0.588)
MAN
3
MKTBOOK 0.676
(0.596)
R
2
0.24 0.24 0.25
Number of rms 839 839 839 839
This table presents cross-sectional regressions predicting cash holdings. The dependent variable is CASH,
measured in 1999, as the ratio of total cash and equivalent items to total assets. The means of the independent
variables are measured over the period 19951998 (except MAN, NON EX=DIR, and CEO COB, measured in
1997). All regressions include industry dummies. CFLOW is the ratio of pre-tax prot plus depreciation to total
assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is the ratio of
total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt. MKTBOOK is the
ratio of book value of total assets minus the book value of equity plus the market value of equity to book value of
assets. SIZE is the natural log of total assets in 1984 prices. VARIABILITY is the standard deviation of cash
ows divided by average total assets. DIVIDEND is the ratio of dividend payments to total assets.
NON EX=DIR is the ratio of the number of non-executive directors to the total number of directors. CEO COB
is a dummy variable which takes a value of 1 if the positions of CEO and the COB are held by the same individual
and 0 otherwise. MAN is the percentage of equity ownership by directors. MAN
2
and MAN
3
are the square and
cube of the percentage of equity ownership by directors. Standard errors robust to heteroscedasticity are reported
in parentheses. ***, ** and * indicate coecient is signicant at the 1%, 5% and 10% level, respectively.
reserves can protect them from outside pressures. Alternatively, the positive eect
can be an indication of managerial risk aversion at higher levels of ownership. As
stated earlier, managerial ownership can make management more risk averse, who
can then accumulate cash as a protection for their human capital. Finally, the neg-
ative and signicant coecient of MAN
3
possibly suggests that the incentive align-
ment eect of increased managerial ownership dominates the entrenchment eect at
suciently high levels of managerial ownership. We have no theoretical explanation
of why managers would switch to alignment again at high levels of ownership. How-
ever, both the empirical analysis and the graphical investigation provided in Section
2 (Fig. 1) suggests that this may be the case.
Our results dier from those Opler et al. (1999) found for US rms regarding the
impact of shareholdings of managers on rms cash levels. They report a positive
(signicant at 10%) relation between cash holdings and managerial ownership at
low levels of ownership. There is, however, no signicant inuence of managerial
ownership on cash holdings at higher ownership levels, i.e. there exists neither align-
ment nor entrenchment. The dierence between our ndings and those of Opler et al.
(1999) can possibly be interpreted as evidence of the view that managerial discretion
is relatively higher in the UK than in the US. As discussed in Section 3, UK rms
managers can be entrenched at higher levels of managerial ownership possibly due to
the lack of ecient monitoring and external disciplining. This, in turn, can provide
some explanation for the positive impact of managerial ownership on cash holdings
at somewhat higher levels.
The results reported in column (2) suggest that the fraction of non-executive direc-
tors (NON EX=DIR) and the dummy variable (CEO COB) have no signicant im-
pact on cash holdings. We also interact these measures with managerial ownership
variables MAN, MAN
2
and MAN
3
) to investigate whether the relationship between
managerial ownership and cash holdings depends on board composition but we
could not nd any signicant impact. We, therefore, conclude that board composi-
tion does not act as an eective constraint on managers attitude towards cash hold-
ings.
There is also a possibility that the nature of the relationship between managerial
ownership and cash holdings may vary with rms growth opportunities. One may
observe that the alignment of the interests of managers and shareholders can occur
even at high levels of managerial ownership when rms have greater growth oppor-
tunities. In model (3), we explore these possibilities by interacting managerial own-
ership variables (MAN, MAN
2
and MAN
3
) with growth opportunities proxied by
(MKTBOOK). In order to avoid the possibility that main eects and interaction ef-
fects get confounded, we also include the main eects of the variables (i.e. MAN,
MAN
2
, MAN
3
and MKTBOOK) in the model. We nd no evidence that the impact
of managerial ownership on cash holdings changes with the presence of growth
opportunities. The estimated coecients of the interaction variables are not signi-
cant. However, they are jointly signicant and hence are retained in the following
estimations.
Under this new specication, the estimated coecient of MAN becomes insigni-
cant. It is inconclusive whether the interests of managers and shareholders
are aligned at low levels of managerial ownership. The results, however, continue to
support the view that managers become entrenched at higher ownership levels. The
estimated coecient of MAN
2
is still positive and signicant. There is also some evi-
dence that alignment still occurs to some extent at high managerial ownership levels.
In order to provide more insight into the impact of ownership on cash holdings we
present in Table 4 the results for three additional estimations. First, in column (1) we
include a dummy variable (CONTROLLER) which identies those rms with con-
trollers. Second, in column (2) we replace the controller dummy (CONTROLLER)
with two other dummies which represent the identity of controllers. FAMILY is a
dummy variable to identify those rms in which the controller is a family. Similarly,
INSTITUTION is a dummy variable which takes the value of one if the ultimate
controller is a nancial institution and zero otherwise. In column (2), we also incor-
porate a proxy to measure the control in excess of the controllers cash-ow owner-
ship, CONT CASH, dened as the ratio of the largest shareholders control rights
to cash-ow rights.
The results provide some evidence that family owners as controllers exert a posi-
tive and signicant impact on rms choices of cash holdings. As noted earlier, this is
consistent with the view that controlling shareholders may want to increase funds
under their control to better defend their privileged position. However, we do not
observe any signicant impact exerted by nancial institutions on cash holdings, pos-
sibly supporting the view that nancial institutions in the UK are relatively passive in
disciplining management. This is in line with the view that monitoring by institu-
tional investors may be ineective because fund managers themselves have no direct
holdings in the companies they invest in and hence have little incentives for monitor-
ing. The estimated coecient of CONT CASH is negative and statistically signi-
cant, possibly lending support to the view that the shared benets dominate the
private benets of controllers as with the accumulation of control rights in excess
of cash-ow rights.
We also examine the impact of the controlling shareholders identity on manage-
ment incentives by interacting the managerial ownership variables with the identity
of controllers, namely nancial institutions and family. We cannot nd any signicant
eect of the controller identity on managerial choice of cash holdings and hence the
results are not reported. Although shareholdings by families is individually signicant
in determining cash holdings of UK companies, their impact on the relationship be-
tween managerial ownership and cash holdings is insignicant. These ndings are
not supportive of the notion that the impact of families and nancial institutions as
controllers on managers incentives would dier because nancial institutions are
regarded more passive than families in monitoring and disciplining management.
Finally, in column (3) in Table 4 we report the results after we dropped the variables
whose impact have been found insignicant. The earlier results are generally con-
rmed.
In summary, the cross-sectional results indicate that levels of managerial owner-
ship matter in determining the amount of cash and marketable securities rms hold.
Moreover, the presence of controllers does not have an impact on cash holdings. We
observe that the identity of controllers seems to matter in that rms controlled by
Table 4
Cross-sectional cash holding regressions on interaction terms of managerial ownership and controlling shareholder,
and other rm characteristics
Independent variables Predicted sign (1) (2) (3)
CFLOW + )0.210
)0.211
)0.216
(0.079) (0.079) (0.076)

LIQ )0.073
)0.072
)0.075
(0.025) (0.025) (0.025)

LEV )0.325
)0.329
)0.325
(0.041) (0.042) (0.041)

BANKDEBT )0.037
)0.036
)0.036
(0.013) (0.013) (0.013)

MKTBOOK + 0.027
0.027
0.029
(0.010) (0.011) (0.010)

SIZE 0.001 0.001
(0.003) (0.003)
VARIABILITY + 0.091 0.093
(0.125) (0.125)
DIVIDEND )0.007 )0.003
(0.021) (0.020)
CONTROLLER 0.013
(0.010)
FAMILY 0.021
0.017
(0.010) (0.009)
INSTITUTION 0.011
(0.011)
CONT CASH )0.0001
)0.0001
(0.00006) (0.00005)
MAN )0.349 )0.363 )0.355
(0.263) (0.264) (0.255)
MAN
2
1.745
1.716
1.682
(0.960) (0.955) (0.934)

MAN
3
)1.821
)1.774
)1.747
(0.936) (0.931) (0.917)

MAN(MKTBOOK)
)0.009 )0.011 )0.021
(0.155) (0.155) (0.153)
MAN
2
(MKTBOOK)
)0.455 )0.449 )0.415
(0.588) (0.588) (0.584)
MAN
3
(MKTBOOK) 0.673 0.669 0.639
(0.595) (0.595) (0.595)
R
2
0.25 0.25 0.25
Number of rms 839 839 839
This table presents cross-sectional regressions predicting cash holdings. The dependent variable is CASH, measured in
1999, as the ratio of total cash and equivalent items to total assets. The means of the independent variables are measured
over the period 19951998 (except MAN and CONT CASH, measured in 1997). All regressions include industry
dummies. CFLOW is the ratio of pre-tax prot plus depreciation to total assets. LIQ is the ratio of current assets minus
current liabilities and total cash to total assets. LEV is the ratio of total debt to total assets. BANKDEBT is the ratio of
total bank borrowings to total debt. MKTBOOK is the ratio of book value of total assets minus the book value of equity
plus the market value of equity to book value of assets. SIZE is the natural log of total assets in 1984 prices. VARI-
ABILITY is the standard deviation of cash ow divided by average total assets. DIVIDEND is the ratio of dividend
payments to total assets. CONTROLLER is a dummy variable which takes a value of 1 if there is a controlling
shareholder in the rm. FAMILY is a dummy variable which takes a value of 1 if the controller of the rm is a family and
0 otherwise. INSTITUTION is a dummy variable which takes a value of 1 if the controller of the rm is a nancial
institution and 0 otherwise. CONT CASH is the ratio of the largest shareholders control rights to cash ow rights. MAN
is the percentage of equity ownership by directors. MAN
2
and MAN
3
are the square and cube of the percentage of equity
ownership by directors. Standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate
coecient is signicant at the 1%, 5% and 10% level, respectively.
families tend to have greater cash holdings. However, the identity of controllers
does not seem to have a signicant impact on the relationship between managerial
ownership and cash holdings.
5.2. Dynamic panel data estimations
We now proceed to motivate the dynamic model. The static cash holding model
frequently used in previous research implicitly assumes that rms can instantaneously
adjust towards the target cash level following changes in rm-specic characteristics
and/or random shocks. In this paper, we adopt an approach recognising that an
adjustment process may take place, involving a lag in adjusting to changes in the tar-
get cash structure. The possibility of delays in the adjustment process can be justied
by the existence of transaction and other adjustment costs, causing the current cash
structure not to be immediately adjusted to a new desired cash structure (for a discus-
sion in a capital structure context see, e.g., Myers (1984) and Fischer et al. (1989)). We
investigate these issues by modelling the rms behaviour as a partial adjustment to a
target cash ratio, which is explained in the Appendix A. Accordingly, we report esti-
mates of the following dynamic panel data specication:
CASH
it
c
1
CASH
it1
c
2
CFLOW
it
c
3
LIQ
it
c
4
LEV
it
c
5
BANKDEBT
it
c
6
MKTBOOK
it
c
7
SIZE
it
c
8
DIVIDEND
it
a
i
a
t
u
it
1
where a
i
and a
t
represent rm-specic eects and time-eects, respectively.It is as-
sumed that rm-specic eects are unobservable but have a signicant impact on
cash holdings. They dier across rms but are xed for a given rm through time. In
contrast, time-eects vary through time but are the same for all rms in a given year,
capturing mainly economy-wide factors that are outside the rms control. We
estimate the dynamic cash model by controlling for xed-eects by a rst-dierence
transformation.
Despite its appeal, the dynamic specication in (1) involves several estimation
problems. Even when unobservable rm-specic eects are not correlated with the
regressors, it is still necessary to control for them in the dynamic framework. This
is because CASH
i;t1
will be correlated with a
i
that does not vary through time
and the rst-dierence transformation to eliminate xed eects introduces corre-
lation between the lagged dependent variable and dierenced errors. That is,
DCASH
i;t1
and Du
it
will be correlated through terms CASH
i;t1
and u
i;t1
, and hence
OLS will not consistently estimate the coecient parameters.
13
13
The alternative to rst-dierence transformation is the within transformation that is commonly used
in the literature. Although it controls for the xed eects, it introduces correlation between the lagged
dependent variable and time-averaged idiosyncratic error term, leading to biased estimates. It is shown
that the bias falls with the number of years T (see Nickell, 1981; Chamberlain, 1982). This would, however,
not be the case in our analysis as T is fairly small ranging from 5 to 16.
Another estimation problem, that is not necessarily specic to the dynamic spec-
ication, arises because the rm-specic variables are unlikely to be strictly exoge-
nous. That is, shocks aecting cash holdings of rms are also likely to aect some
of the regressors such as market value of equity, liquidity, and leverage. Moreover,
it is likely that some of the regressors may be correlated with the past and current
values of the idiosyncratic component of disturbances.
The problems outlined above advocates the use of an instrumental variables (IV)
estimation method, where the lagged dependent variable and endogenous regressors
are instrumented. This paper, therefore, employs the GMM method of estimation
which provides consistent parameter estimates by utilizing instruments that can be
obtained from the orthogonality conditions that exist between the lagged values of
the variables and disturbances (see Arellano and Bond, 1991). The consistency of esti-
mates is obviously subject to an optimal choice of instruments where the validity of
instruments depends on the absence of higher-order serial correlation in the idiosyn-
cratic component of the error term. Therefore, a test for the second-order serial cor-
relation is reported. We also report the statistic for the Sargan test of over-identifying
restrictions, indicating whether the instruments and residuals are independent.
Table 5 reports GMM estimates of the dynamic cash model. In the rst specica-
tion, all variables except lagged cash are treated as exogenous whereas all variables
are treated as endogenous in the second one. Also, time dummies are included
among the independent variables under both specications.
We note that the results for both GMM regressions show similarities in terms of
the estimated coecients and test-statistics. However, there is evidence of misspeci-
cation under the rst GMM specication where only the lagged dependent variable
is treated as endogenous. The null hypothesis of valid instruments is rejected at the
1% level of signicance. We accordingly conclude that it is inappropriate to assume
that the regressors are strictly exogenous in estimating the dynamic cash-holding
model. Consequently, we restrict our attention to GMM estimates where the depen-
dent and explanatory variables are assumed to be endogenous and lagged values
of regressors are used to instrument them.
14
Turning to the preferred GMM specication, as expected there is evidence for
negative rst-order serial correlation, whereas Correlation 2 test suggests that sec-
ond-order serial correlation is absent. Moreover, the Sargan test indicates that the
instruments used in the GMM estimation are not correlated with the error term.
The results reveal that the coecient of the lagged cash is positive and signicantly
dierent from zero. The adjustment coecient, k given by 1 c
0
, is greater than 0.6,
possibly providing evidence that the dynamic nature of our model is not rejected and
14
We investigate whether the explanatory variables are predetermined or strictly exogenous with
respect to the error term. To do this, we start using instruments dated t 2 for each regressor. Later, we
add the instrument dated t 1 to analyse the potential bias arising from the correlation between x
i;t1
and
the rst-dierenced error term, Du
it
. To investigate the possibility of strict exogeneity we also include the
current value, x
i;t
, in the instrument set. This investigation leads us to conclude that the explanatory
variables are neither predetermined nor strictly exogenous. We, therefore, use instruments dated t 2 in
our estimation (see also Blundell et al., 1992).
rms adjust their cash holdings relatively quickly in an attempt to reach the target
cash ratio. One possible explanation for the relatively high value of the adjustment
coecient might be that the costs of deviating from the target are signicant and
rms cash holdings are persistent over time. However, the value of the adjustment
coecient may also lend support to the view that the adjustment process is costly.
We investigate the target-adjustment process further by also estimating a target-
adjustment model similar to that in Opler et al. (1999). This model implies a simple
Table 5
Cash holdings regressions: dynamic panel data estimation results
Independent variables Predicted sign GMM-exogenous
(1)
GMM-endogenous
(2)
CASH
it1
+ 0.526
0.395
(0.021) (0.027)
CFLOW
it
+ )0.011 0.035
(0.009) (0.019)
LIQ
it
)0.099
)0.043
(0.019) (0.023)
LEV
it
0.006 )0.123
(0.008) (0.030)
BANKDEBT
it
0.002 )0.089
(0.003) (0.011)
MKTBOOK
it
+ 0.0001 0.012
(0.002) (0.003)
SIZE
it
)0.016
0.007
(0.005) (0.006)
DIVIDEND
it
0.011
0.001
(0.004) (0.012)
Number of rms 1029 1029
Correlation 1 )12.970 )13.30
Correlation 2 1.120 1.65
Sargan test (df) 144.44 (104) 118.68 (104)
This table presents panel data regressions predicting cash holdings. The sample period in all regressions is
19841999 though the available number of observations for each rm changes across rms. Time dummies
are included in all regressions. Column (1) gives the GMM estimates for the dynamic model where only the
lagged dependent variable is treated as endogenous and CASH
i;t2
, is used as instrument. Column (2)
shows the GMM estimates or the dynamic model, where CASH
i;t2
, CFLOW
i;t2
, LIQ
i;t2
, LEV
i;t2
,
BANKDEBT
I;t2
, MKTBOOK
i;t2
, SIZE
i;t2
, DIVIDEND
i;t2
are used as instruments. CASH is the ratio
of total cash and equivalent items to total assets. CFLOW is the ratio of pre-tax prot plus depreciation to
total assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is
the ratio of total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt.
MKTBOOK is the ratio of book value of total assets minus the book value of equity plus the market value
of equity to book value of assets. SIZE is the natural log of total assets in 1984 prices. DIVIDEND is the
ratio of dividend payments to total assets.
Correlation 1 and 2 are test statistics for rst and second order autocorrelations in residuals, respec-
tively, distributed as standard normal N(0,1) under the null of no serial correlation. Sargan test is a test of
overidentifying restrictions, distributed as chi-square under the null of instrument validity. Asymptotic
standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate coecient
is signicant at the 1%, 5% and 10% level, respectively.
target adjustment behaviour where changes in cash holdings can be explained by
deviations of current cash holdings from target levels. Unobservable targets are
proxied using historical average values of cash holdings. We nd that the estimated
target-adjustment coecient has a positive value of 0.54 and is signicant at 1%, sup-
porting the view that rms adjust toward a target cash ratio. This value is slightly
lower than what the above GMM results suggest. However, one should be cautious
in comparing these two results. As noted earlier in the paper, the estimated coe-
cient of the simple target-adjustment model is likely to be biased as the model does
not incorporate those rm-specic characteristics described as relevant in determin-
ing cash holdings. Furthermore, it is also important to control for unobservable xed
eects as well as rm-constant time eects, which are assumed to be signicant in the
underlying target cash model.
15
The eect of cash ows on cash holdings is positive and signicant at 10%. The
positive coecient of cash ows (CFLOW) is consistent with the view that rms that
have higher cash ows are expected to hold larger amounts of cash as a result of their
preference for internal over external nance. To the extent that cash ows are also a
proxy for rms growth opportunities the positive impact may indicate that rms
with higher cash ows also hold higher cash reserves to avoid situations in which
they give up valuable investment opportunities in some states of nature.
Liquidity (LIQ), as expected, exerts a negative impact on rms cash-holding deci-
sions, though the estimated coecient is signicant at the 10% level. This result may
indicate that rms can use their non-cash liquid assets, dened as net working capital
minus cash and marketable securities, as substitute for cash holdings.
There is strong support for the negative relation between leverage (LEV) and
cash holdings. The coecient of leverage is negative and signicant at 1%. Consis-
tent with John (1993), Baskin (1987), and Fazzari et al. (1996), our results provide
evidence that rms with higher debt ratios have lower cash holdings. Moreover, as
we discussed earlier, to the extent that high leverage is a proxy for the ability
of rms to issue debt, rms may use borrowing as a substitute for holding
larger amounts of cash and marketable securities. Also, the negative coecient of
leverage may indicate that the cost of holding high levels of cash is higher with debt
nancing.
Our regression results show a signicant positive relation between growth oppor-
tunities (proxied by the market-to-book ratio, MKTBOOK) and cash holdings. This
is consistent with the view that rms with higher levels of growth opportunities pre-
fer to hold more cash to avoid situations in which they give up protable investment
opportunities because they are short of cash. This nding also lends support to the
prediction that rms with higher market-to-book ratios would wish to hold more
cash and marketable securities to avoid nancial distress because costs are substan-
tially higher for such rms. Finally, the positive coecient is in line with the hypoth-
15
Overall, our dynamic ndings are in line with the previous ndings of the target-adjustment models
in the capital structure literature, providing evidence for the target capital structure of rms (see, e.g.,
Taggart, 1977; Marsh, 1982; Jalilvand and Harris, 1984; Shyam-Sunder and Myers, 1999).
esis that rms with greater growth opportunities are likely to have higher agency
costs and hence to resort to internal nancing when possible.
Our ndings also provide strong evidence that bank-debt nancing exerts a neg-
ative and signicant inuence on cash and marketable holdings of rms. The esti-
mated coecient is signicant at 1%. This is in line with the above arguments that
predict a negative relation between cash holdings and bank debt nancing. More
specically, the negative coecient for total bank debt (BANKDEBT) provides sup-
port for the view that bank nancing can be eective in reducing costs associated
with agency relations and asymmetric information, thereby lowering the cost of
external nancing. It also provides support for the view that bank debt conveys po-
sitive news to the market about the borrowing rms credit worthiness. According to
this view, rms with higher bank debt would be expected to have easier access
to external nance (see, e.g., James, 1987; Mikkelson and Partch, 1986). It is possi-
ble that the observed negative relation between cash holdings and bank debt
reects the eect of cash on bank debt rather than vice versa. In fact, Cantillo and
Wright (2000) provide evidence that rms with high cash ows prefer to issue traded
obligations rather than bank debt. However, our analysis control for this potential
problem by instrumenting bank debt variable using its lagged values.
One interesting result stems from the estimated coecient of size variable (SIZE),
which is positive but insignicant. This nding does not lend support to the view that
larger rms hold lower levels of cash because they are less likely to experience nan-
cial distress, more diversied and have better excess to external nancing. However,
the positive coecient suggests that there may be other factors aecting the way in
which size of rms exerts inuence on their cash-holding decisions. For example, it
may be that larger rms are more successful in generating cash ows (and prot) so
that they can accumulate more cash and marketable securities. Also, to the extent
that large rms have greater growth opportunities and smaller liquid assets besides
cash and marketable securities, they may choose to hold higher levels of cash.
However, none of these eects seem to prevail.
6. Conclusions
This paper has investigated the empirical determinants of corporate cash holdings
for a sample of UK rms. There are several important features of our analysis,
which, we believe, extend the literature on the empirical determinants of cash hold-
ings of rms. First, we incorporate the ownership and board structure of rms into
the analysis of cash holding decisions. Second, distinct from previous empirical stud-
ies, we eectively control for the endogeneity problem that is likely to arise in the
empirical investigation of cash holdings. Last but not least, our analysis incorporates
the dynamic nature of the response of rms to changes in their target cash levels,
where the target adjustment coecient is estimated by controlling for rm heteroge-
neity as well as endogeneity and measurement errors.
Our results suggest that ownership structure of rms plays an important role in
determining cash holdings of UK companies. Our ndings reveal a non-monotonic
relationship between managerial ownership and cash holdings. We nd that cash
holdings rst fall as managerial ownership increases up to 24%, possibly suggesting
that the alignment eects of managerial ownership dominate the entrenchment ef-
fects. Then, cash holdings rise as managerial ownership increases to 64%, then falls
at higher levels of managerial ownership. This nature of the relationship does not
seem to change signicantly with either the rms board composition or the presence
of ultimate controllers. In addition, we provide evidence that rms controlled by
families hold higher levels of cash and marketable securities.
Our analysis also reveals that there are signicant dynamic eects in the determi-
nation of rms cash holdings. Moreover, it provides evidence that cash ows and
growth opportunities of rms exert positive impacts on their cash holdings. There
is also signicant evidence for the negative impact of liquid assets, leverage and bank
debt. Finally, our ndings suggest that unobserved rm heterogeneity, as reected in
the time-constant xed eects, is signicant in aecting cash-holding decisions.
Acknowledgements
We gratefully acknowledge helpful comments and suggestions from Christopher
F. Baum, Mustafa Caglayan, Mara Faccio, Gulcin Ozkan, two anonymous referees
and participants at the 2002 European Finance Association Meetings; the 2002
European Financial Management Association Conference; and the 2001 METU
International Economics Symposium. Research assistance was provided by Maria-
Teresa Marchica and Roberto Mura. The standard disclaimer applies.
Appendix A. Panel data specication
Suppose that the unobservable target cash ratio of rms, CASH
it
, is taken to be a
function of several rm-specic characteristics, K, suggested by theory, and a distur-
bance term e
it
.
CASH
it

X
k
b
k
x
kit
e
it
A:1
where rms are represented by subscript i 1; . . . ; N, and time by t 1; . . . ; T.
Firms adjust their cash holdings in order for their current cash ratio to be close to the
target ratio. This leads to a partial adjustment mechanism given by
CASH
it
CASH
i;t1
kCASH
it
CASH
i;t1
A:2
where CASH
it
is the actual cash ratio. (CASH
it
CASH
i;t1
can be interpreted as
the target change where only a fraction k of it is achieved. The value of the
adjustment coecient k lies between 0 and 1, capturing the ability of rms to adjust
to their target cash levels. If k 1, it follows that rms are able to adjust immedi-
ately, i.e. CASH
it
CASH
it
, implying zero adjustment costs. On the other hand,
if k 0, the model implies that adjustment costs are so large that rms cannot
change their existing cash structures, i.e. CASH
it
CASH
i;t1
.
Combining (A.1) and (A.2) and including a
i
and a
t
yield
CASH
it
c
0
CASH
i;t1

X
k1
c
k
x
kit
a
i
a
t
u
it
A:3
where c
0
1 k, c
k
kb
k
, and u
it
ke
it
and u
it
has the same properties as e
it
.
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(GMM) Corporate Cash Holdings - An Empirical Investigation of UK Companies

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Corporate cash holdings:

An empirical investigation of UK companies

(0.082) (0.083) (0.079)

(0.025) (0.025) (0.025)

(0.042) (0.041) 0.042

(0.013) (0.013) (0.013)

(0.006) (0.006) (0.010)

(0.501) (0.508) (0.963)

(0.483) (0.489) (0.938)

(0.079) (0.079) (0.076)

(0.025) (0.025) (0.025)

(0.041) (0.042) (0.041)

(0.013) (0.013) (0.013)

(0.010) (0.011) (0.010)

(0.960) (0.955) (0.934)

(0.936) (0.931) (0.917)

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