4. The Value of Cash Holdings

Another way to see whether cash should be held within the firm or paid out to shareholders is to look at how the market values corporate cash holdings: To what extent is a dollar of (excess) cash holdings reflected in the firm's market value?

In a frictionless market, one would expect that the market value of a dollar in cash is one dollar. As we show in more detail below, that need not necessarily be the case in reality. Depending on how the market values cash, the management implications are as follows:

 

  • If a dollar of cash is less valuable inside the firm than outside the firm (put differently, if corporate cash holdings are valued at a discount), paying out excess cash helps firms remove that discount and therefore increases firm value.
     
    Example: Suppose a company has 100 million in excess cash but this cash is only valued at 60 million by the market because market participants expect the firm's management to engage in wasteful "investments." Moreover, let us assume that, if paid out, shareholders would value the cash at 100 million (i.e., there are no taxes or other frictions). If the company decides to return that cash to its shareholders, the discount disappears and shareholder value increases by 40 million. 

  • In contrast, if cash is more valuable inside the firm than outside the firm, paying out excess cash harms firm value.
     
    Example: Suppose a young firm has many great investment opportunities but limited access to external financing. To that firm, cash is very valuable because it secures its ability to conduct investments. Paying out cash would hamper that ability and, therefore, harm firm value.

 

Empirical evidence

There are several scientific studies that look at the market valuation of cash. In particular, Dittmar and Mahrt-Smith (2007) show that there is a large group of firms in which cash is valued at a substantial discount: firms that are poorly governed. In these poorly governed firms, a dollar of cash is valued at only 42 to 88 cents whereas the valuation of cash approximately doubles in well governed firms. The authors also show that poorly governed firms dissipate cash in ways that harm operating performance. Clearly, for these firms, more aggressive cash payouts could be a value-enhancing proposition.