The Static Tradeoff Theory

The most important approach in corporate financial management is cash holding, which is related to corporate governance, corporate development, and the institutional environment.

According to the trade-off approach, the organization's leadership should set the level of cash holding by balancing the marginal cost of holdings with the marginal benefit of cash holding. Furthermore, according to the notion, corporations can employ liquid capital to fund both their investment and operational activities (Hillier, Grinblatt and Titman, 2012, p. 44). In summary, the trade-off theory claims that there should be an optimal sum of cash a firm can hold and it should be the equitation of marginal benefits of holding such cash as well as the cost of holding them.

Managerial Agency Theory

This theory states that managers can make decisions that benefit them rather than the shareholders or the organization itself. Therefore, they will use cash holding to chase their own interests, private goals, and thus hurting the firm as well as its shareholders value.

Free Cash Flow Theory

This theory claims that managers would prefer to hold high cash levels in firms so as to enhance the volume of total asset that are in their control (Hillier, Grinblatt and Titman 2012, p. 84). This makes them to gain some distinctive powers in investment decisions of the firm as well as in financial decisions.

Information Asymmetry Theory

Information asymmetry theory is the view that firms hold large cash assets to help avoid the possibility of increase in external financial cost that are usually the result of information asymmetry and can increase the company’s value.

The Agency Costs of Debt

The agency cost of debt theory claims that corporate should hold cash to finance their most urgent debts (Hillier, Grinblatt and Titman 2012, p. 98). In addition, this theory states that firms hold cash so as to take advantage of risky actions that can benefit shareholders who wants a higher rate of return.

The Financing Hierarchy Model

The financial hierarchy model claims that the amount of cash that a firm should hold is positively related to its external financing as well as volatility to future cash flow and also should negatively relate to its returns on physical assets.

Question Two

Table 2 shows the differences between tradeoff and the financial hierarchy model. The variables presented in both Table 1 and 2 can be said to substantially agree due to various reasons. One, the variables in the first table, Table 1, shows the changes in variation in cash holdings in terms of mean, percentiles, deciles among other (Hillier, Grinblatt and Titman, 2012, p.88). On the other hand, the variation in second table is shown in terms of size and sigma, mean target, pecking order, it is the same variables in Table one that have been used in the second table.

In Table 2, target adjustment is the differences between the target levels of cash/assets from the previous years. This is shown in Table one as cash/ assets and presented in percentile and mean. Also, in Table 2, the size and sigma target adjustments are just calculations of values of cash/net assets on real size and industry sigma from Table 1. Further, sophisticated target presented in table two is also a calculation of regression from the first table (Hillier, Grinblatt and Titman 2012, p. 56). In other words, it is the variables in Table 1 that have been used to calculate or give regression analysis that are presented in Table 2. This proves that variables in table one and those in table tow are the same.

Mean

25th percentile

Median

75th percentile

N

Target adjustment/

0.170

0.025

0.065

0.174

87,117

Size

4.586

3.291

4.504

5.821

87,117

Sigma

0.121

0.056

0.086

0.168

87,117

Pecking order/ payout to share holders

0.017

0.000

0.006

0.024

87,117

Question Three

a). Firms in the fourth quartile of cash holdings differ from the firms’ first quartiles for ten percent or the whole variable that we are considering.

From the data on the excel document, the work focuses on univariate comparison of descriptive variables by cash.net cash quartiles. This work looks at the first and fourth quartiles differences. In order to test the hypothesis, that the first and fourth quartile firms are slightly different, t-test is applied (Hillier, Grinblatt and Titman, 2012, p. 38). The analysis shows that the firms that are in the first quartile have less slack and thus the significant differences with the ones with most slack and found in the fourth quartile.

The size of the firm changes significant as one move across the quartiles. Firms in the first quartile have larger size and thus less slack as compared to the ones in the fourth quartile.

b). Firms with smaller size holds more cash than the ones with big size. This can be explained that the smaller the size the lower the risk and the more the urgency of using cash.

c). The firms in the first thee quartiles of cash holding are similar in size, but those of the fourth quartiles are significantly smaller in size.

Firms’ sizes for the first three quartiles are similar in cash holdings, this is because the first three quartiles pay similar dividends and have significantly higher profit than the ones in the fourth quartile.

d). Variables like market-to book value as well as research and development increases monotonically with cash holdings and this suggests that the firm financial constraints reduces as the firm matures and becomes bigger.

e). Large firms, or the ones rated high in financial hierarchy hold less cash because these firms have higher working capital which can be turned easily into cash and therefore they have no reason for holding more cash. This also means that they would have less cash flow. This explains why there is a positive relationship between cash flow and cash holding with financial hierarchy model.

f). Financial hierarchy model predicts a negative relationship with the cash holding and capital expenditure. Expenses increases with the increase in cash to asset ratio. Large firms would not transact with cash but with cheque or bank transfer and therefore does not have to hold more cash. Also, they invest a lot on various projects with aim of gaining more market share. This is the reason why it is inconsistent with the financial hierarchy model.

g). Companies with volatile cash flows stated in the trade-off theory face higher chances of experiencing cash shortage and thus this makes them forgo some investment projects.

Question Four

a). The highly levered companies usually face higher cost during when they are investing in liquid asset and therefore should have less cash holding. Also the cash holding reduces with leverage because the internally generated funds are not enough.

b). Smaller firms usually are involved in lots of small transactions and therefore they hold cash most of the time as compared to the larger firms. These bigger firms have fat accounts and are usually engaged in capital transactions and therefore do not hold large cash.

c).The tradeoff model suggests that firms that have higher rating in debts usually hold less cash as compared to those with lower ratings. On the other hand, financial hierarchy model says the contrary and its reason is based on the fact that companies that have less debts are usually the ones that have done well and have a higher bond rating(Hillier, Grinblatt and Titman, 2012,p. 54).

d). According to financial and tradeoff theories, leverages of a company increases as fixed assets and firm size increases. However, it reduces with research and development expenditure.

e). The coefficient of working capital variable shows that the firm needs to have some cash to undertake its daily operations and that is why the coefficient of working capital is higher in most of the cases of regression analysis.

f). Financial hierarchy model explains that when a company is in deficit, it uses all of its cash and hence the negative relationship between leverage and cash holding. That is why the sign of the coefficient of cash holding and leverage are negative.

g). The coefficient of the leverage is different from minus one because if there is more cash and less debt, it means that there is little borrowing because the firm can meet its short term expense comfortably. The regression coefficient of debt would therefore be equal to minus one. This is also because of the negative relationship between more cash and debt level.

Reference

Hillier, D., M. Grinblatt, and S. Titman (2012). Financial markets and corporate stratege. Maidenhead, Berkshire: McGraw-Hill Education.