Firm Level Cash Flow Sensitivity Of Cash And Corporate Governance
We construct a new measure of firm-level “cash flow sensitivity of cash” using a correlated random effects estimation model. This measure is able to incorporate unobservable, time-invariant firm characteristics in the analysis of firm’s cash flows, in addition to the traditional observable, firm specific characteristics (e.g. governance, growth opportunities, and the degree of financial constraints). Thus, the use of this measure can significantly improve the assessments of the impact of firm individual characteristics and cash stock piling activities on firm value and firm’s investment policies. We empirically implement this measure and methodology using proxies for the level of firm’s financial constraints, agency conflicts, and governance, and the tangibility of assets. We find that stronger governance reduce the propensity of firms to stockpile cash. Furthermore, and consistent with this result, stronger governance in financially constrained firms induce lower level of investments and higher payouts to stock holders. This situation is not observed in unconstrained firms and may have important effects on firm values. Our new proposed methodology to compute cash flow sensitivity may play a central role in future empirical research expanding upon this new dimension of governance, as reflected in the power struggle between management and shareholders, particularly in relation to financing constraints and cash accumulation policies.
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