Catering and cash savings

• Published date: 01 June 2024
• Author: Hsuan‐Chi Chen,Robin K. Chou,Chien‐Lin Lu
• Date: 01 June 2024
• DOI: http://doi.org/10.1111/eufm.12438

DOI: 10.1111/eufm.12438

ORIGINAL ARTICLE

Catering and cash savings

Hsuan‐Chi Chen

1

|Robin K. Chou

2

|Chien‐Lin Lu

3

1

Anderson School of Management,

University of New Mexico, Albuquerque,

New Mexico, USA

2

Department of Finance, National

Chengchi University, Taipei City, Taiwan

3

Department of Applied Economics and

Management, National Ilan University,

Yilan City, Yilan County, Taiwan

Correspondence

Chien‐Lin Lu, Department of Applied

Economics and Management,

National Ilan University, No. 1, Sec. 1,

Shennong Rd., Yilan City, Yilan County

260, Taiwan.

Email: cllu@niu.edu.tw

Funding information

Ministry of Science and Technology,

Grant/Award Number: MOST 110‐2410‐

H‐197 ‐001 ‐MY2

Abstract

We examine the catering of managers to investors'

preference for cash holdings. We find that cash is

positively related to the cash‐holding premium as

represented by the difference in the market‐to‐book

ratios between cash‐rich and noncash‐rich firms. This

positive effect can be attributed to different sources

such as internal and external financing, and firms may

switch their sources for holding cash when catering to

investors' preference. Issuing firms benefit from cater-

ing to cash holdings by obtaining higher valuations

from the stock market. The catering theory helps

explain cash savings especially for firms without a good

timing window or financing need.

KEYWORDS

cash holdings, catering

JEL CLASSIFICATION

G30, G31, G32

1|INTRODUCTION

Corporate cash management is an important issue when an economic downturn hits the

market (e.g., the 2008 financial crisis and the 2020 Covid‐19 pandemic). In addition to the

characteristics that drive within‐firm differences in cash holdings, two secular trends in cash

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The authors thank Dien Giau Bui, Yibing Du, Keng‐Yu Ho, Kuan‐Cheng Ko, Chih‐Yung Lin, Vivian W. Tai, and Ching‐

Yu Hsu, as well as seminar participants at the 2022 International Conference of the Taiwan Finance Association, 2020

TFA Symposium on Corporate Finance, the 28th Conference on the Theories and Practices of Securities and Financial

Markets, the 2020 Southwestern Finance Association annual meeting, and the 2019 Annual Meeting of Taiwan

Econometric Research for their helpful comments. Hsuan‐Chi Chen gratefully acknowledges the support from the Rich

Research Grant Program and the Anderson School of Management at the University of New Mexico. The authors also

thank editor John Doukas and an anonymous referee for their valuable comments and suggestions.

holdings exist in the United States. First, firms with higher precautionary concerns are not

alone in piling up cash. Faulkender et al. (2019) show that multinational firms are responsible

for most of the increase in cash even though they do not have financial constraints. Cunha and

Pollet (2020) and Acharya et al. (2021) also find that financially unconstrained firms save cash

when the costs of external capital are low. Second, the compositions of cash saving have

changed to a specific source during different periods (David McLean, 2011). The second trend

may result from the relative time‐varying cost of capital for external financing such as equity or

debt (Acharya et al., 2021; Eisfeldt & Muir, 2016; McLean & Zhao, 2014). McLean and Zhao

(2014) show that equity and debt issuances are more sensitive to Tobin's qduring expansions

and periods of high investor sentiment when the costs of capital are relatively low.

In this paper, we examine the managerial catering behaviour as a potential explanation for

the changes in corporate cash holdings. We argue that investors' preference for corporate cash

holdings can help clarify the aggregate cash‐saving behaviour of public firms. Why would

investors prefer cash held in a firm's assets rather than in their own pocket? According to Deb,

David and O'Brien (2017), cash can create value for shareholders when a firm uses it to adapt to

an uncertain environment. When facing economic turbulences, investors value cash higher

than its fundamental value when external financing is costly because financial slack allows

firms to facilitate innovation and buffer financing contingencies in more scenarios than they

otherwise would (Bates et al., 2018; Denis & Sibilkov, 2010; Pinkowitz & Williamson, 2002).

The 2008 financial crisis provides a great example. When entering the crisis with a cash

cushion, firms were able to continue their operations, pay down borrowings, maintain payout

ratios, or even repurchase their own shares. The valuation of cash, therefore, creates a price

premium for firms that hold more cash during specific periods. Simutin (2010) finds that the

difference in the returns of portfolios of high and low excess cash firms can be up to 6%

annually after a three‐factor risk adjustment. Palazzo (2012) theoretically shows that such a

premium is more pronounced for firms with high expected profitability.

The price premium related to cash holdings can be large because investors may misprice

firms in imperfect capital markets. For example, Polk and Sapienza (2009) argue that if the

market misprices firms based on their levels of investment, managers may try to boost short‐

term stock prices by catering to the investors' current sentiment for investment. Dong et al.

(2012) show that the sensitivities of equity issuances and total financing to misvaluation are

greater among firms with potential growth opportunities.

When the price premium for cash holdings fluctuates over time, firms that were previously

at their individual optimums for cash ratios may increase them because holding cash becomes

relatively more beneficial.

1

Among different financing channels, investors' preferences for cash

holdings are likely to trigger SEO issuances when managers are likely to take advantage of the

overvaluation of cash holdings. Debt financing could be another choice when the cost of debt is

low due to the stimulus of monetary authorities. Finally, internal cash flows also help pile up

cash holdings when external financing is unavailable.

Such catering behaviour is not rare in cash‐related decisions such as capital investment

(Polk & Sapienza, 2009), dividend payouts (Baker & Wurgler, 2004), share repurchases (Jiang

et al., 2013), equity issuance (Baker et al., 2009) and debt issuance (De Jong et al., 2013;

Lugo, 2021). Therefore, the catering theory of cash savings predicts that the cash‐holding

1

Opler et al. (1999) show that firms adjust their cash ratios when they exceed their targets. Dittmar and Mahrt‐Smith

(2007) and Bates et al. (2009) also assume that firms have individual optimums of cash ratios when estimating excess

cash ratios.

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premium would lead to a positive change in cash and in its components such as internal cash

inflows and the proceeds from debt and equity issuances.

We argue that the catering motive is an important determinant of cash savings, which

differs from the other motives that studies have proposed. First, the catering motive differs from

the precautionary motive because firms are not saving cash due to their own future financing

needs that arise from financial distress or investment opportunities. According to the

precautionary motive, firms may hold cash because they face higher costs of external financing

(Almeida et al., 2004) or higher income uncertainty (Riddick & Whited, 2009). Financially

constrained firms, therefore, are more likely to hold cash for precautionary reasons (Almeida

et al., 2004). The catering hypothesis does not assume that firms have such financing needs.

Managers can cater to investors' cash preference even when they are financially unconstrained.

Second, the catering theory is not the same as the market timing theory. In the case of

market timing, managers may decide to issue overvalued securities—in particular equity—to

take advantage of the perceived overvaluation (Warusawitharana & Whited, 2016). In the case

of catering, managers may save cash through different channels to gain benefits in response to

investors' preferences for cash holdings. The catering theory, therefore, is neither entirely

irrational nor needs to rely on equity issuances. Firms may receive benefits, such as higher

valuations, when holding cash to cater to investors' preference; while from the market timing

theory and empirical studies, firms are usually punished by investors after issuing equities by

timing the stock prices.

To test the catering theory of cash holdings, we compute the cash‐holding premium by

measuring the annual firm valuation that investors attach to excess cash holdings that

presumably reflects their preference for cash. Inspired by Baker and Wurgler (2004), we first

apply Bates et al. (2009) model and calculate the amount of expected cash, which controls for

the firm and macroeconomic characteristics, for each firm. Next, similar to Polk and Sapienza

(2009), we define cash‐rich (CR) firms as those with excess cash in the top quintile in each

cohort year, while the firms with excess cash in the bottom quintile are noncash‐rich (NCR)

firms.

2

We calculate the cash‐holding premium as the annual difference in the mean logarithm

of M/B ratios between CR and NCR firms as a proxy for investors' preference for excess cash

holdings.

Alti (2006) points out that M/B ratios can represent both misvaluations and growth

opportunities, so we need to decompose M/B ratios to obtain a more direct measure of

misvaluation. Using Rhodes–Kropf et al. (2005) model (hereafter, the RRV model), we

decompose the cash‐holding premium (M/B ratios) into three components attributed to the

misvaluations and the investment opportunities of firms as well as industry‐level misvalua-

tions. Golubov and Konstantinidi (2019) use the RRV model and show that firm‐specific

misvaluation can drive almost all of the value strategy return. If managers cater to investors'

preference for holding excess cash, then this catering will be reflected in a higher firm‐specific

misvaluation. In this case, the firm‐specific misvaluation is more likely to drive corporate cash

holdings than an investment opportunity. In addition to the differences in M/B ratios, we use

the differences in firm‐specific misvaluations between CR and NCR firms as an alternative

measure of investors' preference for cash holdings.

2

We find similar results by using an alternative measure of the cash‐holding premium in which cash‐rich firms are

firms that hold cash that is 1.5 times greater than the expected ratio projected for 1 year, while the rest of firms are

noncash‐rich firms (Harford, 1999).

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