Corporate and business cash‐holding policies can be described by economic and behavioral theory. The previous includes trade‐off theory and financial hierarchy theory, and the latter is essentially agency theory. The trade‐off theory of cash holdings posits that companies have two motives for holding cash: transaction cost and the precautionary motive. The deal‐cost motive shows that firms hold cash because raising money in capital markets is more expensive than retaining existing cash (because exterior financing involves setting costs and variable costs related to the amount of capital raised). The financial hierarchy theory of cash holdings, however, shows that there is no optimal degree of cash holdings.
Because of information asymmetry, the cost of external financing for investment tasks is greater than the cost of internal financing. Thus, firms tend to use internally produced cash before they seek external financing. This shows that keeping as much cash as is possible on a hand is preferable for companies numerous investment opportunities, especially for those facing greater challenges in obtaining external financing.
According to the company literature, an increased level of cash holdings provides managers with greater discretion. Papaioannou et al. (1992) claim that managers tend to retain more cash as a privilege, and Myers and Rajan (1998) argue that managers can buy more private benefits from liquid property. Opler et al. (1999) also document that managers choose the control that is included with holding cash rather than paying dividends to stockholders.
A key difference between two economic ideas (trade‐off and financial hierarchy) is the partnership between investment and cash holdings (Dittmar et al., 2003). Similarly, how the company theory pertains to these two financial theories depends on the level of investment opportunities. On the contrary, when companies (particularly detailed new economy companies) have many investment opportunities available, cash is essential.
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The success of the firms depends highly on the uniqueness of their business enhancements, and they have a tendency to devote cash to R&D activities thus. With special patents, they can commercialize their innovations and keep maintaining competitive positions in dynamic environments (Bahrami and Evans, 1987; Wasserman, 1988). Boyle and Guthrie (2003) claim that holding a higher level of cash is necessary for potential assets. Without sufficient internal funds, companies with higher exterior‐financing costs might forgo investment opportunities, reducing firm value and shareholder prosperity. To avoid such losses, companies that require more capital because of their investment opportunities must retain more cash, especially those facing challenges obtaining external financing.
Thus, there might not be an optimum level of cash holdings; cash needs may instead depend on capital needs for investment opportunities. Proposition 1: Effective corporate governance mechanisms to decrease the degree of cash holdings for old economy companies but boost the level of cash holdings for new economy firms. Managerial possession indicates the known degree of the eye position between managers and outside shareholders, and thus its effect is the investigated in the agency and governance literature mainly. The board of directors is a key internal mechanism of governance, and its independence affects the functions of the board of director in protecting shareholder interests. Furthermore, exterior takeover dangers play the role of an external mechanism disciplining self‐interested managers.
Thus, this study investigates the effect of corporate and business governance on corporate and business cash holdings, with respect to managerial ownership especially, board independence, and takeover. The conflicts of interest between managers and shareholders are because of the separation of possession and control mainly. Increasing managerial ownership can better align the interests of managers and shareholders (Jensen and Meckling, 1976). A high level of cash reserves provides managers with the discretion to pursue their own interests at the trouble of shareholders.
Jensen (1986) argues a higher level of managerial ownership reduces the agency problem of cash moves. Therefore, the impact of managerial possession on cash holdings should be negative. The evidence from UK companies examined by Ozkan and Ozkan (2004) supports this hypothesis. In addition, Opler et al. US companies. They find that companies with insider ownership lower than 5 per cent tend to keep more cash, and companies with insider possession greater than 5 per cent have a tendency to keep less cash. They conclude that the positive relationship between insider ownership and cash holdings for companies with less than 5 per cent of managerial ownership is because of managerial risk aversion.