The 46 reference contexts in paper Christopher F. Baum, Atreya Chakraborty, Liyan Han, Boyan Liu (2009) “The Effects of Uncertainty and Corporate Governance on Firms' Demand for Liquidity” / RePEc:boc:bocoec:726

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    3508
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    Research on the motives for cash holdings finds that the uncertainty facing a firm affects cash holdings. Managers hold cash reserves to better cope with adverse shocks: often referred to as the precautionary motive for holding cash.1
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    Bates et al. (2009)
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    find that the average cash-to-assets ratio for U.S. industrial firms has more than doubled between 1980 and 2006. Their research indicates that this affinity for cash is primarily driven by the precautionary motive—the need for liquidity as their business environment has become more risky—rather than agency considerations.
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    Their research indicates that this affinity for cash is primarily driven by the precautionary motive—the need for liquidity as their business environment has become more risky—rather than agency considerations. However, new evidence has emerged that agency considerations are also important to a firm’s cash holding decisions.
    Exact
    Harford et al. (2008)
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    find that firms with weaker corporate governance (i.e., larger values of the Gompers et al. (2003)Gindex) spend their cash quickly and hold smaller cash reserves. Faleye (2004) finds that that higher cash reserves increase 1See Opler et al. (1999), Baum et al. (2006), Baum et al. (2008). 2 the possibility of proxy fights and that incumbent managers are more likely to lose their jobs after such co
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  3. Start
    4063
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    However, new evidence has emerged that agency considerations are also important to a firm’s cash holding decisions. Harford et al. (2008) find that firms with weaker corporate governance (i.e., larger values of the
    Exact
    Gompers et al. (2003)
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    Gindex) spend their cash quickly and hold smaller cash reserves. Faleye (2004) finds that that higher cash reserves increase 1See Opler et al. (1999), Baum et al. (2006), Baum et al. (2008). 2 the possibility of proxy fights and that incumbent managers are more likely to lose their jobs after such contests.
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  4. Start
    4149
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    However, new evidence has emerged that agency considerations are also important to a firm’s cash holding decisions. Harford et al. (2008) find that firms with weaker corporate governance (i.e., larger values of the Gompers et al. (2003)Gindex) spend their cash quickly and hold smaller cash reserves.
    Exact
    Faleye (2004)
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    finds that that higher cash reserves increase 1See Opler et al. (1999), Baum et al. (2006), Baum et al. (2008). 2 the possibility of proxy fights and that incumbent managers are more likely to lose their jobs after such contests.
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    Harford et al. (2008) find that firms with weaker corporate governance (i.e., larger values of the Gompers et al. (2003)Gindex) spend their cash quickly and hold smaller cash reserves. Faleye (2004) finds that that higher cash reserves increase 1See
    Exact
    Opler et al. (1999), Baum et al. (2006), Baum et al. (2008).
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    2 the possibility of proxy fights and that incumbent managers are more likely to lose their jobs after such contests. In this paper we first investigate if U.S. corporations’ demand for liquidity is influenced by (i) the degree of uncertainty faced by a firm, and (ii) the quality of corporate governance.
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    Previous research on the role of uncertainty on cash holdings provides clues for our research questions. The agency cost literature, for example, points to asymmetry of information between investors and managers as the key to excess cash holdings
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    (Jensen (1986), Stulz (1990)).
    Suffix
    As uncertainty within which a firm operates increases, entrenched managers are better positioned to use the resources of the firm for their personal interests. In those times, it is more difficult for investors to monitor their actions or estimate the true value of their investment decisions.
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    Given the high cost of accessing the debt market, firms hold cash to reduce their liquidity risks, particularly in uncertain times. Recent findings indicate that bondholders view 2A recent work considering interactions of corporate governance with managerial ownership is
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    Agca and Mansi (2008).
    Suffix
    3 antitakeover provisions favorably. This is consistent with the view that even a valueincreasing takeover may result in wealth transfer from bondholders to stockholders (Shleifer and Summers (1988), Levene (1960), Warga and Welch (1993)).
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    Recent findings indicate that bondholders view 2A recent work considering interactions of corporate governance with managerial ownership is Agca and Mansi (2008). 3 antitakeover provisions favorably. This is consistent with the view that even a valueincreasing takeover may result in wealth transfer from bondholders to stockholders
    Exact
    (Shleifer and Summers (1988), Levene (1960), Warga and Welch (1993)).
    Suffix
    Consistent with this view, Klock et al. (2005) find that “firms with strongest management rights are associated with a lower cost of debt financing (about fifteen basis points), while firms with strongest shareholders rights are associated with a higher cost of debt financing (about eighteen basis points) after controlling for firm and security specific characteristics.” (p. 696).
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    This is consistent with the view that even a valueincreasing takeover may result in wealth transfer from bondholders to stockholders (Shleifer and Summers (1988), Levene (1960), Warga and Welch (1993)). Consistent with this view,
    Exact
    Klock et al. (2005)
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    find that “firms with strongest management rights are associated with a lower cost of debt financing (about fifteen basis points), while firms with strongest shareholders rights are associated with a higher cost of debt financing (about eighteen basis points) after controlling for firm and security specific characteristics.” (p. 696).
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    In the empirical implementation, we augment this model of cash holdings under uncertainty with a measures of corporate governance, and allow for interactions between uncertainty and governance indicators. Our empirical findings are presented in Section 4 and Section 5 offers concluding remarks. 2 Cash holdings, uncertainty, and corporate governance Recent research (for instance,
    Exact
    Ozkan and Ozkan (2004) and
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    the references therein) has emphasized the importance of firm-specific characteristics as a determinant of firms’ cashholding behavior. However, the macroeconomic environment within which firms operate could be an equally important determinant of their demand for liquidity.
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    11191
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    Firm-level studies of many aspects of corporate behavior have found that various governance indicators play an important role in managers’ decision-making. The effect of governance indicators on firms’ cash holdings has recently been carefully examined by
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    Harford et al. (2008),
    Suffix
    who arrive at some novel findings about this relationship. 5 In this section of the paper, we discuss relevant aspects of these two strands of literature and motivate our study in which they are intertwined. 2.1 The effects of uncertainty on cash holding behavior It is well known that some nonfinancial corporations hold significant amounts of cash equaling a considerable fraction of
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    on cash holding behavior It is well known that some nonfinancial corporations hold significant amounts of cash equaling a considerable fraction of their annual turnover: in many cases, exceeding their indebtedness.3,4Why do firms hold such a significant fraction of their assets in the form of cash? There has been extensive literature on corporate cash holding, going back to
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    Keynes (1936).
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    He suggests three major motives for cash holdings: (i) the transactions motive, (ii) the precautionary motive and (iii) the speculative motive. In general, a firm will hold cash to meet its transaction needs that would arise in the course of carrying out its daily business activities.
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    The precautionary motive requires that a firm will accumulate cash to meet its unanticipated contingencies that may arise, while the speculative motive argues that a firm will accumulate cash to take advantage of profit-making opportunities that may develop.5 Focusing on macroeconomic shocks,
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    Cummins and Nyman (2004)
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    demonstrate that firms facing a fixed cost of acquiring external finance in an uncertain environment will hold cash as a buffer against the need to borrow in later periods. Graham and Harvey (2001b) emphasize the importance of financial flexibility (having enough internal financing sources) when managers make financing decisions to avoid curtailing their business
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    the speculative motive argues that a firm will accumulate cash to take advantage of profit-making opportunities that may develop.5 Focusing on macroeconomic shocks, Cummins and Nyman (2004) demonstrate that firms facing a fixed cost of acquiring external finance in an uncertain environment will hold cash as a buffer against the need to borrow in later periods.
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    Graham and Harvey (2001b)
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    emphasize the importance of financial flexibility (having enough internal financing sources) when managers make financing decisions to avoid curtailing their business activities in response to macroeconomic shocks.
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    However, if the firm’s cash flow is subject to macroeconomic shocks, the optimal amount of cash holdings will crucially depend on the manager’s perception of firm-specific information through the veil of macroeconomic disturbances. Given that all managers are faced with a similar problem to a greater or 3This section borrows heavily from
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    Baum et al. (2008).
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    4See Bates et al. (2009). 5One would expect stronger motives for corporate cash holdings to appear in imperfect financial markets where external finance involves a high premium. Adverse selection and moral hazard problems stemming from information asymmetry between lenders and borrowers would lead to costly external financing.
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    However, if the firm’s cash flow is subject to macroeconomic shocks, the optimal amount of cash holdings will crucially depend on the manager’s perception of firm-specific information through the veil of macroeconomic disturbances. Given that all managers are faced with a similar problem to a greater or 3This section borrows heavily from Baum et al. (2008). 4See
    Exact
    Bates et al. (2009).
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    5One would expect stronger motives for corporate cash holdings to appear in imperfect financial markets where external finance involves a high premium. Adverse selection and moral hazard problems stemming from information asymmetry between lenders and borrowers would lead to costly external financing.
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    This approach leads to a model linking variations in uncertainty to thedistributionof firms’ cash-to-asset ratios, but does not make predictions about individual firms’ choices. Firms may react not only to variations in macroeconomic uncertainty but also to uncertainty affecting their industry or merely their firm (firm-level uncertainty). In the approach taken by
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    Baum et al. (2008),
    Suffix
    both sources of uncertainty are considered in a dynamic model of individual firms’ behavior. Their model is motivated by a simple two-period cash bufferstock model in which managers choose the level of liquidity to maximize the expected value of the firm.
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    ’ cash-to-asset ratios. 2.2 The effects of corporate governance on cash holding behavior Cash clearly provides value-increasing flexibility but can easily be used to serve managerial interests. In countries with stronger shareholder rights, firms appear to have lower cash holdings.6However, it is not possible to predicta priorihow governance at the firm level should affect cash holdings.
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    Harford et al. (2008)
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    provide some recent empirical evidence on this issue. They find that firms with weaker corporate governance keep smaller cash reserves. Our results support their findings. Excess cash holding by self-interested managers can insulate them from the disciplines of the capital market (Jensen (1986)).
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    They find that firms with weaker corporate governance keep smaller cash reserves. Our results support their findings. Excess cash holding by self-interested managers can insulate them from the disciplines of the capital market
    Exact
    (Jensen (1986)).
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    An entrenched manager may then find various ways to increase consumption of perquisites. Relying on internally generated funds enables greater autonomy, and lack of oversight from the capital market allow these managers to engage in value-destroying investments.7 6See Dittmar and Servaes (2003), Pinkowitz et al. (2003)). 7See Lang et al. (1991), Blanchard et al. (1994) and Harford (1999)).
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    Relying on internally generated funds enables greater autonomy, and lack of oversight from the capital market allow these managers to engage in value-destroying investments.7 6See Dittmar and Servaes (2003),
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    Pinkowitz et al. (2003)).
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    7See Lang et al. (1991), Blanchard et al. (1994) and Harford (1999)). 7 A manager’s desire to hoard cash from an agency perspective looks attractive. Cash also serve as a good takeover deterrent. Cash allows easy access to some well-proven defenses such as repurchasing stocks, paying greenmail, acquiring a potential bidder or purchasing a related firm that causes a takeover to fail on antitrust g
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    Relying on internally generated funds enables greater autonomy, and lack of oversight from the capital market allow these managers to engage in value-destroying investments.7 6See Dittmar and Servaes (2003), Pinkowitz et al. (2003)). 7See
    Exact
    Lang et al. (1991), Blanchard et al. (1994) and Harford (1999)).
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    7 A manager’s desire to hoard cash from an agency perspective looks attractive. Cash also serve as a good takeover deterrent. Cash allows easy access to some well-proven defenses such as repurchasing stocks, paying greenmail, acquiring a potential bidder or purchasing a related firm that causes a takeover to fail on antitrust grounds.
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    Cash allows easy access to some well-proven defenses such as repurchasing stocks, paying greenmail, acquiring a potential bidder or purchasing a related firm that causes a takeover to fail on antitrust grounds. Empirical evidence on the success of such strategies is well documented
    Exact
    (Bagwell (1991), Stulz (1988), Dann and DeAngelo (1988)).
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    However even for the self-serving manager, there are costs to holding significant cash reserves. Excess cash attracts proxy contests that usually result in the incumbent management getting replaced.
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    However even for the self-serving manager, there are costs to holding significant cash reserves. Excess cash attracts proxy contests that usually result in the incumbent management getting replaced.
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    Faleye (2004),
    Suffix
    for example, points out that moving from the first to the third quartile of excess cash increases the probability of a proxy fight by 39%. Both Harford et al. (2008) and Faleye (2004) find that there are significant disciplinary costs for management if they accumulate excess cash reserves.
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    Excess cash attracts proxy contests that usually result in the incumbent management getting replaced. Faleye (2004), for example, points out that moving from the first to the third quartile of excess cash increases the probability of a proxy fight by 39%. Both
    Exact
    Harford et al. (2008) and Faleye (2004)
    Suffix
    find that there are significant disciplinary costs for management if they accumulate excess cash reserves. This insight is important to our research. Entrenched management will perhaps be personally better off if they err towards accumulating lower cash reserves.
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    We find that firms with poorer governance (i.e., with a more entrenched management) hold lower cash reserves. In situations where holding higher cash reserves may be in shareholders’ interests, managers in weakly-governed firms are likely to choose lower than optimal reserves.
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    Yun (2009)
    Suffix
    analyses the choice between cash holdings and lines of credit in the context of changes in anti-takeover laws. He finds that firms “increase cash relative to lines of credit when the threat of takeover weakens” (p. 1447), illustrating managers’ preferences for greater flexibility in their actions, whether or not they are in shareholders’ interests.
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    Agency costs are not observable, but it may be possible to evaluate the quality of corporate governance in a hedonic sense by considering a number of firm characteristics. This is the approach taken by
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    Gompers et al. (2003)
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    in forming theirGindexmeasure of the quality of governance. The Gindex is a broad index of antitakeover provisions that influence the likelihood that managers will be able to insulate themselves from the risk of takeover.
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    The 24 provisions, categorized in five groups (delay, protection, voting, state and other provisions) are noted by their presence or absence. TheGindexis then measured on 8 a scale of 0 to 24, with higher values indicating greater power in the hands of managers and higher agency costs.
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    Harford et al. (2008)
    Suffix
    find that theGindexis “. . . related to the economic fundamentals of the firm and its decision making. Gompers et al. (2003) and Core et al. (2006) document that firms with a large number of antitakeover provisions have lower operating performance compared to those with a small number of provisions.
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    TheGindexis then measured on 8 a scale of 0 to 24, with higher values indicating greater power in the hands of managers and higher agency costs. Harford et al. (2008) find that theGindexis “. . . related to the economic fundamentals of the firm and its decision making.
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    Gompers et al. (2003) and Core et al. (2006)
    Suffix
    document that firms with a large number of antitakeover provisions have lower operating performance compared to those with a small number of provisions. . . . Masulis et al. (2007) find that the GIndex is related to stockholder reaction of merger announcements, with high GIndex firms suffering larger losses on the announcement of a takeover attempt.
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    Gompers et al. (2003) and Core et al. (2006) document that firms with a large number of antitakeover provisions have lower operating performance compared to those with a small number of provisions. . . .
    Exact
    Masulis et al. (2007)
    Suffix
    find that the GIndex is related to stockholder reaction of merger announcements, with high GIndex firms suffering larger losses on the announcement of a takeover attempt. John and Litov (2008) find that firms with large antitakeover provisions have higher debt ratios than those with low provisions, while John and Knyazeva (2006) find that the GIndex is related to firm payout policy.” (
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    Masulis et al. (2007) find that the GIndex is related to stockholder reaction of merger announcements, with high GIndex firms suffering larger losses on the announcement of a takeover attempt.
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    John and Litov (2008)
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    find that firms with large antitakeover provisions have higher debt ratios than those with low provisions, while John and Knyazeva (2006) find that the GIndex is related to firm payout policy.” (p. 7) Thus, we consider that theGindexis a reasonable measure of the quality of corporate governance, with low values signifying strong shareholders’ rights, and high values indicative of agency costs. 3
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    Masulis et al. (2007) find that the GIndex is related to stockholder reaction of merger announcements, with high GIndex firms suffering larger losses on the announcement of a takeover attempt. John and Litov (2008) find that firms with large antitakeover provisions have higher debt ratios than those with low provisions, while
    Exact
    John and Knyazeva (2006)
    Suffix
    find that the GIndex is related to firm payout policy.” (p. 7) Thus, we consider that theGindexis a reasonable measure of the quality of corporate governance, with low values signifying strong shareholders’ rights, and high values indicative of agency costs. 3 Modeling firms’ cash holding behavior We test the hypotheses that both uncertainty and corporate governance have important effects on no
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    , we consider that theGindexis a reasonable measure of the quality of corporate governance, with low values signifying strong shareholders’ rights, and high values indicative of agency costs. 3 Modeling firms’ cash holding behavior We test the hypotheses that both uncertainty and corporate governance have important effects on nonfinancial firms’ cash holding behavior by extending the model of
    Exact
    Baum et al. (2008).
    Suffix
    Our specification is largely similar to that model, with the addition of terms representing corporate governance indices as well as the interaction of an uncertainty measure and corporate governance index to allow for their effects to vary over the range of the other variable.
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    The next subsections describe our econometric model specification, the strategy in generating proxies for macroeconomic and firm-level uncertainty. 3.1 Identifying macroeconomic uncertainty In our investigation, as in
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    Driver et al. (2005) and Byrne and Davis (2002),
    Suffix
    we use a GARCHmodel to proxy for macroeconomic uncertainty. We believe that this approach is 9 more appropriate compared to alternatives such as proxies obtained from moving standard deviations of the macroeconomic series (e.g.
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    and firm-level uncertainty. 3.1 Identifying macroeconomic uncertainty In our investigation, as in Driver et al. (2005) and Byrne and Davis (2002), we use a GARCHmodel to proxy for macroeconomic uncertainty. We believe that this approach is 9 more appropriate compared to alternatives such as proxies obtained from moving standard deviations of the macroeconomic series (e.g.,
    Exact
    Ghosal and Loungani (2000))
    Suffix
    or survey-based measures based on the dispersion of forecasts (e.g., Graham and Harvey (2001a), Schmukler et al. (1999)). We consider a volatility measure derived from changes in the consumer price index (CPI) as a proxy for the macro-level uncertainty that firms face in their financial and production decisions.
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    We believe that this approach is 9 more appropriate compared to alternatives such as proxies obtained from moving standard deviations of the macroeconomic series (e.g., Ghosal and Loungani (2000)) or survey-based measures based on the dispersion of forecasts (e.g.,
    Exact
    Graham and Harvey (2001a), Schmukler et al. (1999)).
    Suffix
    We consider a volatility measure derived from changes in the consumer price index (CPI) as a proxy for the macro-level uncertainty that firms face in their financial and production decisions.
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    The conditional variance derived from this GARCHmodel is averaged to the annual frequency and then employed in the analysis as our measure of macroeconomic uncertainty. 3.2 Identifying firm-level uncertainty One can employ different proxies to capture firm-specific risk. For instance,
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    Bo and Lensink (2005)
    Suffix
    use three measures: stock price volatility, estimated as the difference between the highest and the lowest stock price normalized by the lowest price; volatility of sales measured by the coefficient of variation of sales over a seven–year window; and the volatility of number of employees estimated similarly to volatility of sales.
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    For instance, Bo and Lensink (2005) use three measures: stock price volatility, estimated as the difference between the highest and the lowest stock price normalized by the lowest price; volatility of sales measured by the coefficient of variation of sales over a seven–year window; and the volatility of number of employees estimated similarly to volatility of sales.
    Exact
    Bo (2002)
    Suffix
    employs a slightly different approach, setting up the forecasting AR(1) equation for the underlying uncertainty variable driven by sales and interest rates. The unpredictable part of the fluctuations, the estimated residuals, are obtained from that equation and their three-year moving average standard deviation is computed.
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    Bo (2002) employs a slightly different approach, setting up the forecasting AR(1) equation for the underlying uncertainty variable driven by sales and interest rates. The unpredictable part of the fluctuations, the estimated residuals, are obtained from that equation and their three-year moving average standard deviation is computed.
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    Kalckreuth (2000)
    Suffix
    uses cost and sales uncertainty measures, regressing operating costs on sales. The three-month aggregated orthogonal residuals from that regression are used as uncertainty measures. In contrast to the studies cited above, In contrast to the studies cited above, we proxy firm-level uncertainty at the annual frequency by computing the standard deviation of the firm’s excess returns over
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    -level measures uncertainty are only weakly correlated. 3.3 Data For the empirical investigation we work primarily with Standard & Poor’s Annual Industrial COMPUSTATdatabase, 1990–2007, of U.S. firms and the Investor Responsibility Research Center (IRRC) database. Our estimation sample runs through 2006, as one year of future data is required to implement the model. Following
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    Harford et al. (2008),
    Suffix
    we exclude corporations with two-digit Standard Industrial Classification (SIC) codes of 49 (regulated industries), 60–69 (financial industries) and 88–99 (government enterprises). In order to construct firm-specific variables we utilizeCOMPUSTATdata items Cash and Short-term Investment (data1), Depreciation (data5), Total Assets (data6), Income before Extraordinary Items (data18), Capit
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    In order to measure the quality of corporate governance, we use theIRRCdatabase which provides annual data on anti-takeover provisions for the years 1990, 1993, 1995, 1998, 2000, 2002, 2004 and 2006 on anti-takeover provisions.8Following
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    Gompers et al. (2003),
    Suffix
    we use data fromIRRC, filling in the missing years, to construct an annual governance index (Gindex) as a measure of the quality of corporate governance. Although one might be concerned that this measure has little within-firm variation, we find that only 32% of firms in our estimation sample experience no change inGindexover the period.
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    Although one might be concerned that this measure has little within-firm variation, we find that only 32% of firms in our estimation sample experience no change inGindexover the period. In contrast, 8This expands on the sample used in
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    Harford et al. (2008),
    Suffix
    who did not consider the 2006 IRRC data. 11 34% of firms have one change and 21% of firms have two changes, with the remaining firms having multiple changes inGindexover the period. AlthoughGindexcannot change every year given its construction, but there is considerable variation in its behavior over time at the firm level.
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    From the means of the sample we see that firms hold almost 12 percent of their total assets in cash, which is in line with earlier research on firms’ cash holdings. 3.4 Model specification Our empirical investigation is based on the model specification of
    Exact
    Baum et al. (2008).
    Suffix
    This model develops a two-period cash buffer-stock model in which a firm’s manager varies the optimal level of liquid assets in response to macroeconomic and/or firm-level uncertainty. The basic setup of the model is particularly suitable for our exercise to highlight the role of governance.
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    , we modify this specification to estimate the impact of corporate governance and, more importantly, how a measure of governance interacts with uncertainty to influence firms’ cash holding behavior. 4 Econometric implementation and findings Estimates of optimal corporate behavior often suffer from endogeneity problems, and the use of instrumental variables is a possible solution. As
    Exact
    Yun (2009)
    Suffix
    notes, “. . . a firm’s state of corporate governance may covary with unobserved heterogeneity such as a firm’s unobservable investment opportunities.” (p. 1448) The use of instrumental variables techniques and the introduction of a forward-looking variable such as future sales (proxying the expected return on investment) should mitigate these endogeneity problems.
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    ’s unobservable investment opportunities.” (p. 1448) The use of instrumental variables techniques and the introduction of a forward-looking variable such as future sales (proxying the expected return on investment) should mitigate these endogeneity problems. We estimate our econometric models using a particular form of instrumental variables: the system dynamic panel data (DPD) estimator of
    Exact
    Blundell and Bond (1998).
    Suffix
    System DPD combines equations in differences of the variables with equations in levels of the variables. In this “system GMM” approach, lagged levels are used as instruments for differenced equations and lagged differences are used as instruments for level equations.
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    The errors of a properly specified model will exhibitAR(1), but will not exhibitAR(2). 4.1 Findings forGindex Table 3 presents our estimates of three forms of the model of firms’ cash-to-asset ratios. In the first column, for comparability with
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    Harford et al. (2008)
    Suffix
    we present a version of Equation 1 in which uncertainty terms are suppressed, but theGindexis included. We find, as did they, that theGindexhas a significant negative effect on cash holdings.
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    As stated above, there is evidence that these firms enjoy lower borrowing rates, as creditors prefer them to firms that are more susceptible to takeovers. Takeovers are usually viewed as adding to stockholders’ wealth at the expense of existing bondholders. Interestingly, this finding is also consistent to one of the rationales put forth by
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    John and Litov (2008) to
    Suffix
    explain their controversial finding that managers of poorly governed firms prefer more financial leverage. They suggest “...managers whose control is being challenged may use debt to inflate their relative voting rights...” (p. 17), increasing the riskiness of the firm in order to protect their investment in firm-specific human capital.
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