Business Cycle, Investor Protection And The Value Of Cash

The financial market is imperfect because of information asymmetry, and liquid assets have strategic roles. Managers can take cash as buffer stocks to maximize the value of their firms. According to transaction cost theory, both investment options and financial constraints are positively relative to the value of cash holdings. Considering agency cost theory, in countries with better investor protection the value of cash holdings is higher. Interestingly, we don’t know whether the value of cash holdings varies over the business cycle, given the fact that both financial constraints and investment opportunities change with macroeconomic conditions.We try to address the issue that how the value of cash holdings differs between the prosperous phase and the recession phase of the business cycle. Cash holdings could be more valuable either during recessions due to financial constraint effect or during booms due to investment option effect. Then, we test whether the positive correlation between investor protection and the value of cash holdings exists and whether this relationship is sensitive to the business cycle.Using a sample of firms from42countries over the period from1991to2009, this paper examines the relationship between business cycle, investor protection and the value of cash holdings. We document that investors place more value on a dollar of firm’s cash holdings during the prosperous phase of the business cycle relative to the recession phase of the business cycle. In addition to confirming previous findings that investors value firm’s cash holding higher in countries with strong legal protection of investors than in countries with weak legal protection of investors, we provide evidence that suggests investor protection influences a firm’s value of cash more during the recession phase of the business cycle than the prosperous phase of the business cycle. In general, our findings identify that not only the value of cash holding itself, but also the extent that investor protection impacts the value of cash, varies over the business cycle.Contributions of this paper include three points. Firstly, we introduce business cycle into the study of cash holdings. Secondly, using a cross-country sample, we find investors’valuation of cash holdings depend on the investment sets rather than financing sets of firms, supporting conclusions of Pinkowitz et al.(2006). Thirdly, we find that both the value of cash holdings and the effect of investor protection on the value of cash holdings are sensitive to the business cycle.