How friends with money affect corporate cash policies? The international evidence

• Author: Tijana Rajkovic,David Javakhadze
• DOI: http://doi.org/10.1111/eufm.12197
• Date: 01 September 2019
• Published date: 01 September 2019

DOI: 10.1111/eufm.12197

ORIGINAL ARTICLE

How friends with money affect corporate cash

policies? The international evidence

David Javakhadze

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Tijana Rajkovic

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Department of Finance, College of

Business, Florida Atlantic University,

Boca Raton, Florida

Email: djavakhadze@fau.edu

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Lucas College of Business, San Jose

State University, San Jose, California

Email: tijana.rajkovic@sjsu.edu

Abstract

We examine the association between managerial social

capital and the cash flow sensitivity of cash in an

international setting. We find that social capital reduces

the marginal propensity to save cash out of cash flows. This

association is stronger for more financially constrained

firms, firms with high hedging needs, and firms with more

uncertain cash flows. The effect of social capital is partially

moderated by the extent of legal protection standards and

financial development. We also show that social capital

matters for valuation. These findings are robust to

alternative model specifications, alternative variable mea-

surement, and tests for endogeneity.

KEYWORDS

cash management, social capital, social networks

JEL CLASSIFICATION

G32, Z13

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INTRODUCTION

In this study, we examine the association between managerial social capital and the marginal

propensity to save cash from current cash flows in a cross-country setting. Over the last three decades,

corporate cash savings have significantly increased worldwide. Bates, Kahle, and Stulz (2009) find that

the cash-to-assets ratio for US industrial firms more than doubled from 1980 to 2006. A similar upward

The authors would like to thank John Doukas (the editor), two anonymous referees, and participants at the 2018 Eastern

Finance Association Annual Meeting for helpful comments and suggestions.

Eur Financ Manag. 2018;1–54. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

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807Eur Financ Manag. 2019;25:807–860. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

trend is documented in all major and emerging economies.

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The phenomenon of excessive piling up of

cash rather than channeling it into investments or payouts to shareholders could distort firm growth and

has implications for the aggregate economy. Consequently, examining what drives cash savings is

essential for the practice of modern corporate finance.

In this context, we focus on one of the important aspects of general corporate cash policy, the issue

of saving cash out of current cash flows. Recent studies (e.g., Bao, Chan, & Zhang, 2012; Khurana,

Martin, & Pereira, 2006; Kusnadi & Wei, 2011; Riddick & Whited, 2009), based on the work of

Almeida, Campello, and Weisbach (2004), emphasize this issue called the cash flow sensitivity of cash.

Financial market imperfections, such as asymmetric information and agency problems, limit firms’

access to external finance. Consequently, for financially constrained firms, investments are more likely

to be limited to available internal resources or cash reserves. However, saving cash today may

cause these firms to pass up current profitable investment opportunities. Hence, constrained firms

derive optimal cash policies from the trade-offs between current investments and potentially profitable

future investments. On the other hand, liquidity management is less significant for financially

unconstrained firms. Thus, understanding what drives the cash flow sensitivity of cash is important for

examining the corporate cash policies from a theoretical perspective.

In this paper, we expand that line of inquiry by studying the association between managerial social

capital and the cash flow sensitivity of cash in an international setting. Following Woolcock (1998), we

define social capital as the information, trust, and norms of reciprocity inherent in a social network.

Social capital is widely discussed in disciplines such as sociology, political science, economics, and

anthropology. There has been a recent spur in the corporate finance literature to examine the effects of

social networks on various corporate finance policies (e.g., Cohen, Frazzini, & Malloy, 2010;

Engelberg, Gao, & Parsons, 2013; Fracassi, 2017; Larcker, So, & Wang, 2013), though researchers are

reluctant to use the term ‘social capital.’The key implication underlying the theoretical view of

the cash flow sensitivity of cash is that the external financial constraint is the determining factor for the

firms’systematic efforts to save cash out of current period cash flows. We posit that managerial social

capital resident in social networks with financiers alleviates financial constraints and through that

channel reduces marginal propensity to save cash.

Social capital eases financial constraints in several ways. First, market imperfections in the form of

information asymmetry are the major impediment for the firms seeking access to outside financing

(e.g., Myers & Majluf, 1984; Rajan & Zingales, 1998; Stein, 2003). Prior research (e.g., Cohen,

Frazzini, & Malloy, 2008; Fafchamps & Minten, 1999; Faleye, Kovacs, & Venkateswaran, 2014;

Hochberg, Ljungqvist, & Lu, 2010; Hong, Kubik, & Stein, 2004, 2005; Kuhnen, 2009; Montgomery,

1991) shows that social capital through social networks opens new channels for the circulation of

information thereby reducing information asymmetry. Ferris, Javakhadze, and Rajkovic (2017)

explicitly document that social capital reduces information asymmetry, which is manifested in more

precise analysts’earnings forecasts and enhanced liquidity of well-connected firms.

Second, external financing could be prohibitively costly because of expected contracting costs

(such as search, monitoring, and contract enforcement costs). Social capital is a means of creating trust

(e.g., Dasgupta, 1988), which enables economic agents to operate efficiently and economize on

transaction costs. In addition, trust facilitates dispute resolution through voluntary cooperation within a

social network that further diminishes the expected costs of legal interventions. Finally, the risk of

managerial expropriation could also restrict firms’access to external capital. Social capital aggravates

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McKinsey Global Institute (2010) −obtained from http://www.mckinsey.com/industries/private-equity-and-principal-

investors/our-insights/farewell-cheap-capital

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the costs of reputation loss (Kandori, 1992; McMillan & Woodruff, 2000), and thus diminishes

managerial incentives to expropriate. In aggregate, the existing knowledge concerning social capital is

sufficient to suggest that managerial social capital eases financial constraints and through that

mechanism reduces the cash flow sensitivity of cash.

In addition, we propose that the negative effects of social capital on the propensity to save cash out

of current period cash flows are more pronounced for firms with high hedging needs (Acharya,

Almeida, & Campello, 2007), and for firms experiencing greater cash flow uncertainty (e.g., Opler,

Pinkowitz, Stulz, & Williamson, 1999) because these firms have a high need to obtain external capital

for their investments. Further, the issue of financial constraints is not identical across countries. Prior

research shows that legal protection of investors and financial development mitigate market frictions

and consequently reduce the constraints that firms face in gaining access to external capital (e.g., Beck

& Levine, 2005; Hail & Leuz, 2006; Rajan & Zingales, 1998). If managerial social capital alleviates

financing constraints, it should have more pronounced effects on the cash flow sensitivity of cash for

firms in countries with the weak legal protection of shareholders and in underdeveloped financial

markets. Finally, we also propose that because social capital reduces financial constraints, it should

moderate the valuation effects of cash holding.

We empirically test our predictions using a large panel of 70,650 firm-year observations from

39 countries for the period 1999–2012. We measure social connections using the data from the

BoardEx database provided by Management Diagnostics Limited. BoardEx collects information on

work histories, educational background, and participation in various social organizations for top

executives and board members of public companies around the world. A number of recent studies

(e.g., Engelberg, Gao, & Parsons, 2012; Fracassi, 2017; Fracassi & Tate, 2012) use that database to

examine the role of social networks in a variety of corporate finance settings. We measure social

capital by counting the number of social co nnections between executives/directors of financee fir ms

(i.e., publicly traded corporations that demand capital) and those of financier firms (i.e., investment

firms as classified by BoardEx) by their current and past overlap in education, employment, and

other social activities.

Our results are consistent with theoretical predictions. We find that managerial social capital

resident in social networks with financiers is negatively associated with the cash flow sensitivity of

cash. This association is stronger for firms with high hedging needs and more uncertain cash flows. The

paper also provides some evidence regarding the moderating effect of legal protection of investors and

financial development. The financial constraints appear to be the channel through which social capital

exerts its influences. Finally, social capital reduces the value of cash holding. The main findings are

robust to alternative model specifications and alternative variable measurement.

Furthermore, to account for the measurement error in Q, we follow the suggestions of Riddick and

Whited (2009) and use the generalized method of moments (GMM) estimation (Erickson & Whited,

2000), as well as implement the Erickson–Whited correction by using the high-order cumulants

method (Erickson, Jiang, & Whited, 2014). We also control for the asymmetries in the cash flow

sensitivity of cash with respect to positive and negative cash flows (Bao et al., 2012). The results

continue to show strong support for the main hypothesis.

To address the endogeneity concerns of social connections in the baseline regressions, we conduct

a placebo test. Further, we address the potential omitted variable concern of managerial experience/

skill by orthogonalizing our connectedness measure with respect to the human capital index and

estimate the ‘excess connectedness,’defined as the residuals from the regression of social capital on the

managerial human capital measure. Next, we exclude from our social capital estimations the

connections acquired after the individual joined the firm and focus exclusively on educational social

networks formed in the distant past. Using these measures, we obtain results that are qualitatively

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