Corporate cash holdings:

An empirical investigation of UK companies

Aydin Ozkan*
University of York, UK

Neslihan Ozkan
University of Liverpool, UK

Abstract

This paper investigates the empirical determinants of corporate cash holdings for a sample
of UK firms over the period 1984-1999. We present evidence of the significant relation
between managerial ownership and cash holdings. The results also suggest that the way in
which managerial ownership exerts influence on cash holding decisions differs between firms
with ultimate controllers and those that are widely-held. The results reveal that growth options
of firms, cash flows, liquid assets, leverage and bank debt are important in determining cash
holdings. In contrast, there is much less evidence that larger firms hold less cash. Our analysis
also suggests that unobserved firm heterogeneity and endogeneity are crucial in analysing the
cash structure of firms.

JEL classification: G3; G32

Keywords: Cash holdings; Ownership structure; Firm heterogeneity; Panel data.

*
Corresponding author. Department of Economics and Related Studies, University of York, Heslington, York,
YO10 5DD, UK. Tel.: + 44 (1904) 434672. Fax: + 44 (1904) 433759. E-mail: ao5@york.ac.uk.

1
1. Introduction

Why do firms hold large amounts of cash and cash equivalents? Various explanations have

been put forward in an attempt to provide some answers to this question. One major

explanation is that cash provides low cost financing for firms. According to this view, raising

external finance costs more in the presence asymmetry of information between firms and

external investors (Myers and Majluf, 1984); costly agency problems such as underinvestment

and asset substitution (Myers, 1977; and Jensen and Meckling, 1976); and adjustment costs

and other financial restrictions. Therefore, managers trying to minimize the costs associated

with external financing in imperfect capital markets may find it optimal to maintain sufficient

internal financial flexibility. However, there are also potential adverse effects of cash

holdings. Central to this view is the argument that agency conflicts existing between

shareholders and managers can be most severe when firms have large free cash flows (Jensen,

1986). Managers can pursue their own interests at the expense of shareholders and cash serves

the interests of managers more than those of shareholders in this respect.

Recently the investigation of cash holdings of firms has gained a great deal of attention in

the empirical literature. An important strand of this literature has focused on the determinants

of corporate holdings of cash. 1 For example, Kim et al. (1998) analyse the determinants of

cash holdings for a sample of US companies. They report that firms facing higher costs of

external financing and having more volatile earnings and firms with relatively lower returns

on assets have significantly larger proportions of liquid assets to total assets. For similar

firms, Opler et al. (1999) provide evidence that firms with strong growth opportunities and

riskier cash flows, and small firms hold larger amounts of cash. Finally, in a related paper,

Pinkowitz and Williamson (2001) examine the cash holdings of firms from the United States,

Germany, and Japan. In addition to finding which are similar to those in Opler et al. (1999)

1
The other important strand of this literature examines the relationship between cash holdings and corporate
performance. See, for example, Harford (1999), Mikkelson and Partch (2002), and also Opler et al. (1999).

2
they document that the monopoly power of banks in Japan has a significant impact on cash

balances of Japanese firms.

The purpose of our paper is to contribute to this literature by examining the empirical

determinants of cash holdings for a sample of UK companies over the period 1984-1999. The

UK and US are often described as being similar with respect to ownership and control

structures of companies. They are also characterised as having similar institutional and legal

framework. It is, however, our view that there are distinct features of the corporate

governance system in the UK, which may lead to different inferences than those in the US

with regard to the cash holding behaviour of firms. To take an example, to the extent that

large cash holdings serve managers’ interests, it is more likely in the UK that cash holdings

will increase with managerial shareholdings. This is because, as we will argue, managers in

the UK appear to entrench themselves considerably against external market discipline.

As a first contribution to this literature, we investigate the role of ownership structure in

determining corporate policies on cash holdings. More specifically, we first empirically

analyse the nature of the relationship between managerial ownership and cash holdings.

Furthermore, we investigate whether the presence of ultimate controllers in the firm has a

significant impact on the amount of cash it holds. In addition, we extend our analysis by

addressing the potential interactions between managerial ownership and ultimate controllers.

In particular, we examine the extent to which the presence and identity of the controlling

shareholder affect the managerial behaviour towards cash holdings. We argue that the

presence of a controlling shareholder can affect cash holding decisions of firms. For instance,

if large holdings of cash serve controlling shareholders’ interests one would expect to observe

higher cash holdings in firms with controllers. Also, to the extent that the incentive and ability

to monitor managers change with the identity of controllers, the relationship between

managerial ownership and cash holdings may depend on who the firm’s ultimate controller is.

Our second contribution is that, distinct from previous empirical studies, the analysis of

this paper explicitly deals with the endogeneity problem in testing the cash holdings

hypotheses. We think that the endogeneity issue in this context is important for several

3
reasons. First, it is highly likely that observable as well as unobservable shocks affecting cash

holdings can also affect some of the firm-specific characteristics such as market value of

equity. Second, it is possible that observed relations between cash and its potential

determinants reflect the effects of cash on the latter rather than vice versa. To control

efficiently for the potential endogeneity problem we utilise panel data and the Generalised

Method of Moments (GMM) estimation procedure, the combination of which allows us to

optimally choose instruments as well as to deal with firm heterogeneity.

Our last contribution lies in the dynamic analysis of the cash holding decision. We

incorporate the view that market imperfections such as adjustment costs may prevent firms

from adapting to new circumstances. We utilise a partial target-adjustment model that allows

for the possibility of delays in response of firms in adjusting their cash holdings. We are not

the first to investigate the question whether firms have target cash holdings. Opler et al.

(1999), for example, estimate different target-adjustment models relating the firm’s actual

cash holdings to its target cash holdings. Their results provide evidence that firms have target

cash levels. Our dynamic analysis is an attempt to complement rather than substitute the

analysis of Opler et al. (1999). Our model incorporates all the firm-specific factors described

in the paper as relevant in determining cash holdings. More importantly, in estimating the

target-adjustment model we also control for unobservable fixed effects as well as time effects.

To the extent that these effects are significant in the underlying target cash model and not

controlled for, estimated coefficients of the target-adjustment model will be biased. As noted

above, the approach adopted in our dynamic analysis also controls for the potential biases that

may arise from endogeneity of regressors as well as random measurement errors.

Our analysis reveals that ownership structure of firms plays an important role in

determining levels of cash UK companies hold. We find evidence for the non-monotonic

relationship between managerial ownership and corporate cash holdings. In addition, the

nature of the relationship changes with the presence of ultimate controllers. We also provide

evidence of significant dynamic effects in the determination of firms’ cash holdings.

Moreover, there is evidence that cash flow and growth opportunities of firms exert a positive

4
influence on cash holdings. There is significant evidence for the negative impact of liquid

assets. The results also suggest that higher cash holdings are associated with lower levels of

bank debt and leverage in firms’ capital structure.

The paper is organised as follows. In Section 2 we briefly discuss the main features of the

ownership and control structures of companies in the UK as distinct from the US. Section 3

reviews the relevant theory and derives the empirical hypotheses. Section 4 describes the

alternative estimation methods used in the paper. Section 5 describes the construction of the

data set. Section 6 presents the empirical results and finally Section 7 offers our conclusions.

2. UK Institutional Features

Companies in both the UK and US are often described as being similar with respect to their

ownership structures and as characterised as having similar regulatory systems. For example,

both the UK and US are often described as “market-oriented” countries with similar capital

markets and financial institutions.2 Also, the type of ownership and control structures in both

countries are described as “outsider” systems in which ownership is dispersed amongst a large

number of outside investors. However, there exist important differences in the corporate

governance system and in the patterns of share ownership, which makes the conduct of an

analysis of cash holdings of UK companies interesting.

The main features of the prevailing corporate governance system in the UK as distinct

from those in the US can be summarised as follows. First, the concentration of institutional

stock ownership is higher in the UK than in the US. Nestor and Thompson (2000) report that

financial institutions in the UK hold 68 percent of the all shareholdings in 1994 as compared

to 46 percent in the US in 1996. Goergen and Renneboog (2001) argue that financial

institutions adopt a passive stance towards disciplining firms’ management. This, in turn,

2
The so-called market-oriented countries include Canada, United Kingdom and United States; and the bank
oriented countries include France, Germany, Italy and Japan. See for a detailed discussion, for example, Hoshi et
al. (1991), and Rajan and Zingales (1995).

5
coupled with significant shareholdings by directors, further increases in the power of directors

and creates its own type of agency problems, i.e. high managerial discretion. They argue that

the passive stance of financial institutions is mainly due to the fact that they are not major

players from the agency perspective. Goergen and Renneboog (2001) report that the average

of the largest shareholding owned by financial institutions is only 5.5 percent for their sample

of firms in 1992. We also report in Section 5 that 6.5 percent of non-financial firms in the UK

is controlled by widely-held financial institutions at the 20 percent ultimate control threshold

for a sample of 780 firms. Also, we find that the average value of control rights of the largest

controlling financial institution is 20.2 percent. This compares with the average values of

38.35 and 26.67 percent for those firms that are ultimately controlled by widely-held

corporations and families respectively.

Second, managerial discretion is higher in the UK. Franks et al. (2001) report that higher

shareholdings by insiders in the UK lead to entrenchment rather than disciplining

management. There are several potential reasons for this. For example, they argue that

substantial directors shareholdings enable managers to hinder monitoring activities sought by

other shareholders such as restructuring the firm’s board. They also argue that in the UK the

role of non-executive directors is quite different from that in the US. Non-executive directors

have a more advisory role rather than performing a disciplinary function.3 Moreover, they

claim that stronger minority investor protection in the UK discourages coalition of

shareholders. This, in turn, coupled with less fiduciary obligations on directors but stricter

rights issue requirements strengthen the discretionary managerial power.4

Finally, there is also a divergence of empirical evidence regarding the disciplining role of

takeovers. Franks and Mayer (1996), in contrast to the findings of Martin and McConnell

(1991) for the US companies, provide evidence that takeovers do not work as a corporate

governance mechanism for disciplining poor managers in the UK.

3
In addition, the board structure of UK companies is also different from that of US companies. Vafeas and
Theodorou (1998) find an average of 39 percent non-executive directors on UK boards, representing a majority
of executive directors. In contrast, the average of outside directors on US boards is 77 percent (Klein, 1998).

6
 To summarise, the agency problem between shareholders and managers seems to be more

severe in the UK than in the US and, with the lack of external market discipline and efficient

monitoring by financial institutions, managers are more likely to be entrenched. And above

all, the significance of managerial ownership would be greater in the UK than in the US and

one would expect that this is reflected in the determination of cash holdings.

3. Theory and Empirical Hypotheses

3. 1. Asymmetric Information, Agency Costs of Debt, Financial Distress

Existence of asymmetric information between firms and investors make external financing

costly. Myers and Majluf (1984) argue that in the presence of asymmetric information firms

tend to follow a hierarchy in their financing policies in the sense that they prefer internal over

informationally sensitive external finance. Smith (1986) provides evidence that is consistent

with asymmetric information problems of external financing, i.e. investors discount the value

of firms when they attempt to sell risky securities. Myers and Majluf (1984) also argue that

asymmetric information problem is more severe for firms whose values are determined by

growth options. If a firm has investment opportunities that would increase its value when

taken and finds itself being short of cash, it may have to pass up some of these investments.

Hence firms with such opportunities would hold greater amounts of cash in attempt to make it

less likely that it will have to give up valuable investment opportunities in some states of

nature. It is also important to note that firms with greater growth opportunities are expected to

incur higher bankruptcy costs (Williamson, 1988; Harris and Raviv, 1990; and Shleifer and

Vishny, 1992). Growth opportunities are intangible in nature and their value fall precipitously

in financial distress and bankruptcy. This would in turn imply that firms with greater growth

opportunities have greater incentives to avoid financial distress and bankruptcy and hence

hold larger cash and marketable securities.

4
Franks et al. (2001) find that factors such as capital structure of firms and new equity financing are more

7
 Growth opportunities are also related to agency costs of debt arising from the conflicts of

interest between shareholders and debtholders. It is argued that growth firms face higher

agency costs because firms with risky debt and greater growth opportunities are likely to pass

up valuable investment opportunities in more states of nature (Myers, 1977). Higher expected

agency costs in turn make external financing expensive. Then it follows that firms with

greater growth options are more likely to accumulate cash to avoid costly external financing

as much as possible and to have financial flexibility.

To proxy for growth opportunities of firms we use the market-to-book ratio defined as the

ratio of book value of total assets minus the book value of equity plus the market value of

equity to book value of assets.

It is also suggested that large firms have less information asymmetry than small firms

(Brennan and Hughes, 1991; and Collins et al., 1981). Therefore, small firms face more

borrowing constraints and higher costs of external financing than large firms (Whited, 1992;

Fazzari and Petersen, 1993, and Kim et al., 1998). To the extent that size is an inverse proxy

for the degree of informational asymmetry and, in turn, cost of external financing, a negative

relation should be expected between size and cash holdings. Finally, size of firms can also be

related to costs of financial distress. Larger firms are more likely to be diversified and thus

less likely to experience financial distress (Titman and Wessels, 1988) and smaller firms are

more likely to be liquidated when they are in financial distress (Ozkan, 1996). If this is the

case, small firms are expected to hold relatively more cash to avoid financial distress.

We use the natural logarithm of total assets in 1984 prices as a proxy for the size of firms.

3.2 Ownership and cash holdings

In this section, we discuss the impact that ownership structure of firms may potentially

have on their choices of cash and other marketable securities holdings

effective in disciplining management especially in poorly performing companies.

8
 Managerial ownership. Jensen and Meckling (1976) show that there are potential conflicts

of interest between managers and outside shareholders when managers own less than 100

percent of the residual cash flow rights. The potential for such problems in turn creates

agency costs that are generally borne by the original shareholders. The agency problem

between managers and shareholders can stem, for example, from managerial shirking and

consumption of perquisites that normally benefit managers. Another potential agency problem

is due to free cash flow the firm generates in excess of the amount required to fund all

valuable investment projects. Jensen (1986) argues that free cash flow presents serious

potential conflicts because large amount of cash reserves can serve mainly managers’

interests. Managers have incentives to increase the amount of funds under their control

because this enables them to spend it as they wish, i.e. squandering funds by consuming

perquisites and/or making inefficient investment decisions.5 On the other hand, shareholders

may prefer that free cash flow be returned to them.

Following Jensen and Meckling (1976) a large body of literature has developed to support

the notion that managerial ownership can help align the financial interests of managers with

those of shareholders. A great deal of this literature concerns the relationship between

managerial ownership and performance of the firm. It has been claimed that, with an

increased managerial ownership, a firm’s performance improves since managers are less

likely to divert resources away from value maximisation. At certain level of managerial

ownership, however, outside shareholders find it difficult to monitor the actions of managers

as management becomes entrenched. Consequently, managers become more capable of

shirking and the consumption of perquisites may outweigh the loss they suffer from a reduced

value of firm (Morck et al., 1988, and McConnell and Servaes, 1990). It is argued that there

exists a non-monotonic relationship between managerial ownership and the alignment of

shareholder and managerial interests.

5
Blanchard et al. (1994) provides evidence that firms experiencing cash windfalls tend to keep the resources
inside and invest them in unattractive projects just to avoid giving up cash or having an outsider lay a claim on it.

9
 Despite the theoretical arguments and some empirical evidence pointing to the significant

relationship between the managerial ownership levels and the alignment of the interests of

shareholders and managers, the extent to which managerial ownership impacts firms’ choices

of cash holdings has not been adequately investigated. In this paper we investigate the extent

to which cash levels change with increasing levels of managerial ownership and whether this

relationship is affected by other characteristics of ownership structure of firms.

Large share ownership or block ownership. We now turn to the question whether corporate

cash holdings are different in the presence of a large shareholder (controller) among the firm’s

shareholders. It is argued that one of the ways of controlling the agency problem between

managers and shareholders is to effectively monitor managers to ensure that they act in the

interests of shareholders. However, monitoring by an average shareholder is not free of

drawbacks. For example, for an average shareholder there may not be enough incentives to

monitor managers as the cost of monitoring is likely to outweigh the benefit. Shareholders

bear all costs related to their monitoring acts while benefiting from monitoring only in

proportion to their shareholding (Grossman and Hart, 1988). In contrast, large shareholders,

having claims on a large fraction of the firm’s cash flows, can monitor managers more

effectively and free riding problems involved in monitoring are mitigated. Consequently, in

the presence of a large shareholder, managerial discretion is curbed to some extent and agency

costs between management and shareholders are reduced (Stiglitz, 1985; Shleifer and Vishny,

1986). To the extent that this argument holds, the cost of external financing would be lower

for firms with large shareholders, impliying less need to hold larger levels of cash.6

While enhanced monitoring by large shareholders can help reduce some of the agency

problems associated with management, there are also private benefits of control accrued to

6
The empirical evidence on the effectiveness of the monitoring by large shareholders is, however, mixed.
Mehran (1995) finds that use of executive compensation declines with the percentage of equity ownership by
outside blockholders, which is interpreted as evidence of a significant role for blockholders in monitoring
executives (see Holderness, (2002) for a detailed survey on the effectiveness blockholders in monitoring
management). Franks et al. (2001), on the other hand, report that large shareholders in the UK do not seem to
discipline the management of poorly performing companies.

10
large shareholders, not necessarily shared by minority shareholders. Recent studies emphasise

the potential conflicts of interest between the controlling shareholder and other shareholders.

Shleifer and Vishny (1997) argue that when large owners gain nearly full control of the

corporation, they prefer to generate private benefits of control that are not shared by minority

shareholders (see also Faccio, Lang, and Young, 2001; and Holderness, 2002). Consequently,

large shareholders might have the incentive and the opportunity to increase the amount of

funds under their control to consume corporate benefits at the expense of minority

shareholders. One way of doing it is obviously to accumulate large amounts of cash. With

higher levels of cash holdings it is less likely that controlling shareholders will relinquish

control and share the efficiency gains with outside shareholders. These arguments suggest a

positive relationship between large shareholders and cash holdings.

Identity of ultimate controllers. Finally, it is possible that identity of a controlling

shareholder can determine the nature of monitoring that is provided by that shareholder. That

is, the incentives to monitor the management may depend on the category of controlling

shareholders. For example, the direct involvement of controlling family owners in the

management of the firm is more likely than that of financial institutions. It can be argued that

this would lead to higher agency costs regarding the relationship between managers and

outside shareholders. In particular, they may want to keep their control over the firm

inefficiently long from the outside shareholders’ perspective. In the context of our analysis

this means that family controlled firms would hold more cash and marketable securities than

other controlled firms. On the other hand, to the extent that they are run by managers who are

not entrenched through a controlling ownership and have superior monitoring abilities,

control by financial institutions may imply more and cost-effective monitoring of the

management. This may lead to a reduction in the frictions between managers and shareholders

including outside shareholders. This could in turn make the agency costs associated with

higher levels of managerial ownership lower. However, this could also lead to higher costs if

large institutions do not exert sufficient monitoring and there are not other controlling

11
shareholders of the firm. There is evidence, for example, in the UK of a passive stance taken

by financial institutions (Franks et al., 2001). Also, Faccio and Lasfer (2000) provide

evidence that pension funds do not add monitoring value.

3.3 Bank Relationship

It is often argued that bank financing is more effective than public debt in reducing

problems associated with agency conflicts and informational asymmetry (see, e.g., Diamond,

1984; Boyd and Prescot, 1986; and Berlin and Loeys, 1988). This is mainly because of the

comparative advantage of banks in monitoring firms’ activities and in collecting and

processing information. Fama (1985) argues that banks have a comparative advantage as a

lender in minimizing information costs and can get access to information from a firm’s

decision process not otherwise publicly available. Therefore, banks can be viewed as

performing a screening role employing private information that allows them to evaluate and

monitor borrowers more effectively than other lenders. Thus, a bank’s willingness to provide

a loan or renew a loan to a firm can signal positive information about that firm.7 Moreover, by

providing signals about the borrowing firms’ credit worthiness, existence of a bank

relationship would enhance the ability of firms to have access to external finance. To the

extent that these arguments hold, firms with more bank debt in their capital structures are

expected to have easier access to external finance. This would, in turn, imply that such firms

should have less cash and marketable securities. Another reason why bank debt financing

might have a negative impact on firms’ cash holdings is that bank debt is more easily

renegotiated when firms need to (see, e.g., Chemmanur and Fulghieri, 1994). By providing

flexibility through renegotiation, bank debt can serve as a substitute for holding high levels of

cash and marketable securities.

7
James (1987) and Mikkelson and Partch (1986) document that the announcement of a bank credit agreement
conveys positive news to the stock market about the borrowing firms’ credit worthiness. Billett et al. (1995)
reconfirms that, unlike public debt issuance, bank loan announcements are associated with positive borrower
returns. Additionally, Slovin and Young (1990) demonstrate that the presence of a banking relationship lessens
the degree of expected underpricing associated with the initial public offerings of client firms.

12
3.4 Liquidity constraints and cash substitutions

The greater the firm’s cash flow variability, the greater the number of states of nature in

which the firm will be short of liquid assets. As noted earlier, it may be costly to be short of

cash and marketable securities if the firm has to pass up valuable investment opportunities.

There is evidence that firms with cash shortfalls do indeed fail to take up some of the valuable

growth opportunities. For example, Minton and Schrand (1999) show that firms with higher

cash flow volatility permanently forgo investment rather than reacting to cash flow shortfalls

by changing the discretionary investment timing. They also argue that a higher frequency of

cash flow shortfalls in the presence of capital imperfections increases a firm’s cost of

accessing external capital. This also adversely affect the level of investment. Thus, firms with

more volatile cash flows are expected to hold more cash in an attempt to mitigate the expected

costs of liquidity constraints.

To the extent that there are substitutes for holding high levels of cash firms can use them

when they have cash shortfalls. For example, firms can use borrowing as a substitute for

holding cash because leverage can act as a proxy for the ability of firms to issue debt (John,

1993). Moreover, Baskin (1987) argues that the cost of funds used to invest in liquidity

increases as the ratio of debt financing increases, which would imply a reduction in cash

holdings with increased debt in capital structure. We therefore predict that there is a negative

relation between the firm’s cash holdings and its leverage. However, one should note that

higher debt levels can increase the likelihood of financial distress. In that case one would

expect a firm with a high debt ratio to increase its cash holdings to decrease the likelihood of

a financial distress. This would induce a positive relation between leverage and cash holdings.

Another substitution effect is due to other liquid assets besides firms may have. It is

reasonable to assume that the cost of converting non-cash liquid assets into cash is much

lower as compared with other assets. To the extent that the firm has these assets it may not

have to use the capital markets to raise funds when it has a shortage of cash. The proxy we

use for non-cash liquid assets is the ratio of net working capital minus cash to total assets.

13
 Finally, we include a dividend dummy in our regressions to control for the potential impact

of the firm’s dividend policy on its cash holdings. It takes a value of one if firms pay

dividends and zero otherwise. To the extent that firms that pay dividends can raise funds

relatively easily by cutting their dividends, a negative relationship is expected between

dividend and cash holdings (Opler et al., 1999). However, it is possible that ceteris paribus

dividend-paying firms can also hold more cash than firms that do not as they may want to

avoid a situation in which they are short of cash to support their dividend payments. If this is

the case a positive relation can be observed.

4. Empirical Specifications

In the following, we describe the empirical methods used in the paper to investigate the

relation between corporate cash holdings and firm-specific characteristics including

ownership structure, growth opportunities, size and leverage.

4.1 Cross-sectional analysis

We begin our analysis by examining the relation between ownership structure and cash

holdings by focusing on the question whether managerial ownership and characteristics of

ultimate controllers of firms affect cash levels. For this purpose, we estimate a cross-sectional

cash model using the average values of each of the firm characteristics (except variability and

ownership variables) over four years in an attempt to mitigate problems that might arise due

to short-term fluctuations or extreme values in one year. We measure cash holdings (the

dependent variable) in 1999 and the explanatory variables preceding the sample year in which

cash holdings are measured over the period 1995-1998. This is done to control for the

problem of endogeneity. Using past values reduces the likelihood of observed relations

reflecting the effects of cash holdings on firm-specific factors (Rajan and Zingales, 1995).

14
4.2 Static panel data model

The static model of cash holdings takes the following general form

CASH it = β 1CFLOWit + β 2 LIQit + β 3 LEVit + β 4 BANKDEBTit + β 5 MKTBOOK it +

(1)
β 7 SIZEit + β 6 DIVIDENDit + α i + α t + ε it

where firms are represented by subscript i=1,...,N, and time by t=1,...,T . αi and αt represent

time-constant firm-specific effects and firm-constant time effects respectively. It is assumed

that firm-specific effects αi (firm-heterogeneity term) are unobservable but have a significant

impact on cash holdings. They change across firms but fixed for a given firm through time. In

contrast, "t varies through time but is the same for all firms in a given year, capturing mainly

economy-wide factors that are outside the control of firms such as prices.

We estimate the static cash model by controlling for unobserved heterogeneity, αi. To the
extent that there are time-constant fixed effects in the underlying model, estimated
coefficients in a cross-sectional regression will be biased due to the correlation generated
between the regressors and error term. The extent to which these unobserved effects remain
relatively stable over time, one could control for them by using a fixed-effects (within)
estimator and obtain consistent coefficient estimates (see, e.g., Wooldridge, J.M., 2002).

4.3 Dynamic panel data model

We now proceed to motivate the dynamic model. The static cash holding model implicitly

assumes that firms can instantaneously adjust towards the target cash level following changes

in firm-specific characteristics and/or random shocks. In this paper, we adopt a more realistic

approach recognising that an adjustment process takes place, involving a lag in adjusting to

changes in the target cash structure. The possibility of delays in the adjustment process can be

justified by the existence of adjustment costs causing the current cash structure not to be

immediately adjusted to a new desired cash structure (for a discussion in a capital structure

15
context see, e.g., Myers, 1984 and Fischer et al., 1989). We investigate these issues by

modelling the firm’s behaviour as a partial adjustment to a target cash ratio.

Suppose that the unobservable target cash holdings ratio of firms, CASH*it, is taken to be a

function of several variables, K, suggested by theory and a disturbance term git.

CASH it* = ∑ β k xkit + ε it (2)

k

Firms adjust their cash holdings in order for their current cash ratio to be close to the target

one. This leads to a partial adjustment mechanism given by

CASH it − CASH i ,t −1 = λ (CASH it* − CASH i ,t −1 ) (3)

where CASHit is the actual cash ratio. (CASH*it-CASHi,t-1) can be interpreted as the target

change whereas only a fraction λ of it is achieved. The value of the adjustment coefficient λ

lies between 0 and 1, capturing the ability of firms to adjust to their target cash levels. If λ=1,

it follows that firms are able to adjust immediately, i.e. CASHit = CASH*it, implying that

adjustment costs are zero. On the other hand, if λ=0, the model implies that adjustment costs

are so large that firms cannot change their existing cash structures, i.e. CASHit = CASHi,t-1.

Combining (2) and (3) yields

CASH it = γ 0 CASH i ,t −1 + ∑ γ k xkit + uit (4)

k =1

where γ0=1-λ, γk=λβk, and uit=λεit. (where uit has the same properties as git). Finally, also

including αi and αt, the dynamic specification takes the following form

16
CASH it = γ 1CASH it −1 + γ 2 CFLOWit + γ 3 LIQit + γ 4 LEVit + γ 5 BANKDEBTit +
(5)
γ 6 MKTBOOK it + γ 7 SIZEit + γ 8 DIVIDENDit + α i + α t + uit

The presence of the lagged dependent variable in (5) makes allowance for the adjustment

of the dependent variable to the target cash ratio. Similar to the static model, fixed effects αi

are allowed to be correlated with the regressors. Firm-constant time effects αt are controlled

by including time dummies in all panel data estimations.

Despite its appeal, the dynamic specification in (5) involves several estimation problems.

Even when unobservable firm-specific effects are not correlated with regressors, it is still

necessary to control for them in the dynamic framework. This is because CASHi,t-1 will be

correlated with αi which does not vary through time even if the idiosyncratic component of

the error term are serially uncorrelated. However, the first-difference transformation to

eliminate fixed effects introduces correlation between the lagged dependent variable and

differenced errors, i.e. ∆CASHi,t-1 and ∆uit are correlated through terms CASHi,t-1 and ui,t-1, and

hence OLS does not consistently estimate the coefficient parameters.8

Another estimation problem that is not necessarily specific to the dynamic specification

arises because the firm-specific variables are unlikely to be strictly exogenous. That is, shocks

affecting cash structure choices of firms are also likely to affect some of the regressors such

as market value of equity, liquidity, and leverage. Moreover, it is likely that some of the

regressors may be correlated with the past and current values of the idiosyncratic component

of disturbances.

Finally, it is worth mentioning that, the regressors including the lagged dependent variable

may be subject to random measurement errors, which also induce biases in the estimates.

This problem may be particularly relevant for all the variables in our analysis that are

8
The alternative to first-difference transformation is the within transformation that is commonly used in the
literature. Although controlling for the fixed effects, it introduces correlation between the lagged dependent
variable and time-averaged idiosyncratic error term, leading to biased estimates. It is shown that the bias falls
with the number of years T (see Nickell, 1981; and Chamberlain, 1982). This would however not be the case in
our analysis as T is fairly small ranging from 5 to 16. Moreover, the bias induced by within transformation will
remain in the presence of measurement errors even if T is large.

17
calculated from company balance sheet data and market data (see, Baltagi, 1995 for a detailed

discussion of measurement error and panel data).

The problems outlined above advocates the use of an Instrumental Variables (IV)

estimation method, where the lagged dependent variable and endogenous regressors are

instrumented using an appropriate set of instrumental variables. This paper therefore employs

the GMM method of estimation which provides consistent parameter estimates by utilizing

instruments that can be obtained from the orthogonality conditions that exist between the

lagged values of the variables and disturbances (see Arellano and Bond, 1991). It allows both

for an MA(1) error structure and the heteroskedasticity of the disturbances across firms in the

sample. It is obviously subject to an optimal choice of instruments where the validity of

instruments depends on the absence of higher-order serial correlation in the idiosyncratic

component of the error term. Therefore, a test for the second-order serial correlation is

reported. In this context, we also report the statistic for the Sargan test of overidentifying

restrictions, indicating whether the instruments and residuals are independent.

5. Data Description

For our empirical analysis of corporate cash holdings we use a sample of publicly traded

UK firms from 1984 to 1999. Our initial sample is the set of all firms for which data are

available on the Datastream database. Datastream provides both accounting data for firms

and market value of equity. The panel data set for this study has been constructed as follows.

First, financial firms were excluded from the sample. Second, missing firm-year

observations for any variable in the model during the sample period were dropped. Finally,

from these firms, only those with at least five continuous time series observations during the

sample period have been chosen. These criteria have provided us with a total of 1,029 firms,

which represents 12,960 firm-year observations. We obtain information regarding the equity

ownership structure from two different sources. Data for the shareholdings of directors were

18
collected from Datastream, consisting of beneficial as well as non-beneficial directors’

holdings, in which the latter refers to holdings by directors on behalf of their families and

charitable trusts. Although managers do not obtain benefit from these holdings directly, they

usually have control rights (the mean value of non-beneficial managerial holdings in our

sample is 1.7 percent). Given that ownership data were only available for the period 1999-

2000 we only included data for 1999 in our analysis. Data for the ultimate controllers of firms

were obtained from Faccio and Lang (2002) and merged with the managerial ownership.

Consequently, we were left with 780 matched firms for our cross-sectional analysis.

Table 1 presents descriptive statistics for the main variables used in our analysis. It reveals

that the mean cash ratio is 10.3 percent and the median value is 5.8 percent. It seems that

these values are in line with those reported for the US firms. For example, Kim et al. (1998)

report that the mean and median values of the cash ratio, defined as the ratio of cash plus

marketable securities to total assets, are 8.1 and 4.7 percent respectively. However, in the

analysis of Opler et al. (1999), the mean ratio is reported as 17 percent whereas the median

cash ratio is 6.5 percent. The higher mean value in their analysis is most probably due to

normalizing cash and marketable securities by total assets minus cash and marketable

securities rather than total assets.

[INSERT TABLE 1 HERE]

As reported in Table 1, the average managerial ownership for our sample of firms is 11.9

percent (the median is 3.5 percent). Table 2 analyses the ultimate controllers of UK

companies in our sample. Companies are mainly divided into those that are widely held in the

sense that they have no owners with significant control rights and those that have controlling

owners. We report results for two different cut-off levels, namely 10 and 20 percent

thresholds. The reported results rely on voting rights that may differ from cash flow rights for

a variety of reasons such as pyramiding or issuing different classes of shares (for a detailed

discussion see Faccio and Lang, 2002). Controlling owners in Table 2 are further classified

19
into six categories: widely held corporation, financial institution, family, unlisted companies,

state, and miscellaneous.

[INSERT TABLE 2 HERE]

In Panel A of Table 2 we present percentage and number of firms controlled by different

categories of owners at two different cut-off levels. At the 10 percent level, only 24.36

percent of firms are widely-held. Family-controlled firms comprise 26.67 percent of firms in

our sample, which makes it the most important category. 20.38 percent of firms are controlled

by widely-held financial firms. Another important category is the unlisted companies that

control 18.72 percent of firms at the 10 percent threshold. Control by widely-held

corporations and state is trivial (0.64 and 0.13 percent respectively). As expected, the control

structure of firms at the 20 percent threshold is significantly different than that at the 10

percent level. At this more conservative cut-off, 67.44 percent of companies have no

controlling owner. The characteristics of controllers are, however, similar. More specifically,

family is still the most important category though it decreases to 15.64 percent. Financial

institutions now control only 6.53 of firms. However, the decrease in the control of financial

institutions at the higher cut-off level is more significant than that in family control. The

percentage of companies controlled by unlisted companies also drops dramatically from 18.72

percent to 6.41 percent.

In Panel B of Table 2 we report summary statistics on the control rights of the largest

controlling owner in each category of controller. The findings reveal that the average values

of control rights of the largest controlling shareholder are 38.25 percent and 29.52 percent

when firms are controlled by widely-held corporations and family respectively. The average

control rights is only 0.72 percent for the widely-held firms.

Finally, Panel C reports descriptive statistics on the discrepancy between ownership and

control rights. The statistics are based on firms where the largest ultimate controller owns at

least 5 percent of control rights. The largest ultimate shareholder’s average ratio of cash-flow

20
to voting rights is 86.12 percent (not reported in Table 2). This is in line with Faccio and Lang

(2002) who report the ratio as 86.80 for 1,628 UK firms. Panel C shows that the separation of

ownership and control is highest in firms in which the largest controller is a widely held

corporation with a ratio of cash-flow to voting rights of 68.28 (ignoring miscellaneous

category that has a ratio of 64.45). The evidence also suggests that firms that are controlled by

families, with the exception of state that controls only one firm, are less likely than those with

other controllers to have separation between ownership and control.

6. Results

In what follows we first present the results for our cross-sectional regressions by focusing

on the question whether ownership characteristics influence cash levels of firms in addition to

our specified firm-specific determinants. Section 6.2 provides results on both the static and

dynamic panel data models.

6.1. Cross-sectional model

Table 3 presents the first set of estimation results for the cross-sectional cash model. In

column (1), we report the regression results where the dependent variable and managerial

ownership are measured in 1999 and all the regressors (except VARIABILITY) are four year

averages over the period 1995-1998. In column (2) we also include a dummy variable

(CONTROLLER) which takes a value of 1 if the firm has a controller with an ultimate

ownership over 10 percent.

[INSERT TABLE 3 HERE]

In general, the estimated coefficients in both of the regressions are in line with the

hypothesized signs. The notable exception is the coefficient of cash flows (CFLOW), which is

21
negative and significant at the 1 percent level. Another result which is not in line with the

predicted sign is due to the estimated coefficient of the variability of firms’ cash flows

(VARIABILITY). There is no evidence to support the view that firms with more volatile cash

holdings hold more cash and marketable securities. The estimated coefficient is negative but

insignificant under both specifications. There is strong support liquidity (LIQ) exerts a

significantly negative impact on cash holdings of firms. Similarly, consistent with the

prediction of the theory, the relationship between cash holdings and leverage (LEV) is

negative and significant at the 1 percent level. We also find strong evidence that firms with

more growth opportunities hold more cash and marketable securities. However, the results do

not provide support for the negative relation between cash holdings and size. Although the

sign of the estimated coefficient is negative it is insignificant under both specifications.

Finally, there is some evidence that firms that pay dividends also have larger cash holdings.

It seems that levels of managerial ownership exert a significant influence on cash holding

decisions of UK firms. Moreover, the results provide evidence for the possible functional

form of the relationship between managerial ownership and cash holdings. More specifically,

the estimated coefficients of MAN, MAN2 and MAN3 suggest that management move from

alignment to entrenchment, and to alignment again as their shareholdings in the firm increase.

The estimated coefficient of MAN is, however, statistically insignificant. The positive

coefficient of MAN2 can be interpreted as evidence that managers are entrenched at higher

levels of managerial ownership and can hold more cash to pursue their own interests at the

expense of other shareholders and/or protect themselves from outside pressures. Alternatively,

the positive effect can be an indication of managerial risk aversion at higher levels of

ownership. As Opler et al. (1999) point out, managerial ownership can make management

more risk averse and they can accumulate cash as a protection for their human capital. The

negative and significant coefficient of MAN3 possibly suggests that the incentive alignment

effect of increased managerial ownership dominates the entrenchment effect at high levels of

managerial ownership.

22
 Our results differ from those Opler et al. (1999) found for the US firms regarding the

impact of shareholdings of managers on firms’ cash levels. They report a significant (at the 10

percent) relation between cash holdings and managerial ownership at low levels of ownership.

There is, however, no significant influence of managerial ownership on cash holdings at

higher ownership levels, i.e. there exists neither alignment nor entrenchment. The difference

between our findings and those of Opler et al. (1999) can be interpreted as evidence of the

view that managerial discretion is higher in the UK than in the US. For example, as discussed

in Section 2, managers of the UK firms are more likely to be entrenched as a result of

inefficient outside monitoring and lack of external market disciplining. This can in turn

provide some insights into the interpretation of the significantly positive impact of managerial

ownership on cash holdings at somewhat higher levels.

It is reported in column (2) that the estimated coefficient of the control dummy

(CONTROLLER) is positive and significant at the 5 percent level. To the extent that there are

private benefits to controlling shareholders, the positive effect can be seen as support for the

view that controlling shareholders accumulate more cash than widely-held firms in an attempt

to maintain their position. It is also possible that the positive impact may simply be due to the

incentive by controlling shareholders to increase the amount of readily available funds under

their control.

We present two additional regression estimates in Table 4. We interact managerial

ownership variables (MAN, MAN2 and MAN3) with two different control variables. First, in

column (1) we interact ownership variables with a dummy variable (CONTROL DUMMY)

which takes the value of one if there is a controller in the firm and zero otherwise. Second, in

column (2) the dummy variable takes the value of one if the firm is widely held. Interaction

terms enable us to evaluate whether the impact of managerial ownership factors differs

between widely-held firms and those in which there are ultimate controllers. These two

estimations yield similar coefficient estimates to the estimates reported in Table 3. However,

there is evidence that managers behave differently when there are controllers in the firm than

the firm is widely held.

23
 [INSERT TABLE 4 HERE]

The results provided in column (2) reveal that when there are no controllers in the firm

managerial choices of cash holdings are similar to those reported earlier. That is, management

move from alignment, to entrenchment, and to alignment. More interestingly, the significant

coefficient of MAN suggests that the interests of management and shareholders are aligned

even at lower levels of managerial ownership when there is no controller in the firm.

The estimated coefficients of the interaction variables are not significant when ownership

is interacted with the dummy variable for controlled firms, with the exception of that of

(MAN3)CONTROL DUMMY, which is significant at the 10 percent. Although firms with

ultimate controllers in general hold more cash than widely-held firms, revealed by the

estimated coefficient of the controller dummy (CONTROLLER) in Table 3, the influence

controllers exert on the incentives of managers is not clear. It is inconclusive whether the

interests of managers and shareholders are aligned at low levels of managerial ownership and

managers become entrenched at higher ownership levels. There is, however, some evidence

that alignment still occurs to some extent at high managerial ownership levels. That is,

managers switch to alignment when they own large stakes of firms regardless of whether

there are ultimate controllers of their firms.

[INSERT TABLE 5 HERE]

In order to provide more insight into the impact of managerial ownership of equity on cash

holdings we present in Table 5 the results for three additional estimations. First, in column (1)

we replace the controller dummy (CONTROLLER) in Table 3 with two other dummies which

represent the identity of controllers. INSTITUTION is a dummy variable which takes the value

of one if the ultimate controller of the company is a financial institution and zero otherwise.

Similarly, FAMILY is a dummy variable to identify those firms in which the controller is

24
family. The results provide evidence that families and financial institutions as controllers

exert a positive impact on firms’ choices of cash holdings. As noted earlier, this is not

inconsistent with the view that controlling shareholders may want to increase funds under

their control to better defend their privileged position. Second, in columns (2) and (3) we

attempt to isolate the impact of the controller’s identity on management incentives. More

specifically, we interact the managerial ownership variables with the identity of controllers,

namely financial institutions and family. That is, in column (2) IDENTITY DUMMY takes the

value of one if the controller is a financial institution and 0 otherwise. Similarly, it takes the

value of one in column (3) if the controller is a family. We can not find any significant

influence exerted by the controller identity on managerial choice of cash holdings. Although

shareholdings by institutions and families are individually significant in determining cash

holdings of the UK companies, their impact on the behaviour of management with regard to

cash holding decisions is insignificant. These findings are not supportive of the notion that the

impact on managers’ incentives of these two different categories of large owners would be

expected to differ as financial institutions are regarded as passive and families as active in

monitoring and disciplining management.

In summary, the cross-sectional results presented in this section indicate that levels of

managerial ownership matter in determining the amount of cash and marketable securities

they hold. Moreover, the presence of controllers has a positive impact on cash holdings.

However, the identity of large shareholders does not seem to have a negative or positive

impact on managerial attitude towards cash decisions.

6.2. Panel data estimations

In Table 6 we turn to the results of panel data estimations. Time dummies are included

among the independent variables under all specifications. In column (1) the estimation results

of a fixed effects model are presented. All the estimated coefficients are in line with the

hypothesized signs and are significant at 1 percent level.

25
 [INSERT TABLE 6 HERE]

Columns (2) and (3) present GMM estimates of the dynamic cash model. In the first GMM

specification, all variables except the lagged leverage are treated as exogenous whereas all

variables are treated as endogenous in the second one. Also, fixed effects are controlled by

first differencing in both specifications.

We note that the estimation results for both GMM regressions show similarities in terms of

the estimated coefficients and test-statistics. However, there is evidence of misspecification

under the first GMM specification where only the lagged dependent variable is treated as

endogenous. The null hypothesis of valid instruments is rejected at the 1 percent level of

significance. We accordingly conclude that it is inappropriate to assume that the regressors

are strictly exogenous in estimating the dynamic cash-holding model. Consequently, we

restrict our attention to GMM estimates where the dependent and explanatory variables are

assumed to be endogenous and lagged values of regressors are used to instrument them.9

Turning to the estimated coefficients of the preferred GMM specification, the coefficient

of the lagged cash is positive and significantly different from zero. The adjustment coefficient

8, given by 1-(0, is greater than 0.6, possibly providing evidence that the dynamic nature of

our model is not rejected and firms adjust their cash holdings relatively quickly in an attempt

to reach the target cash ratio. One possible explanation for the relatively high value of

adjustment coefficient is that the costs of deviating from the target are significant and firms'

cash holdings are persistent over time. However, as the value of the adjustment coefficient

suggests, this result is also not inconsistent with the view that the adjustment process is

costly.10 We investigate the target-adjustment process further by also estimating a simple

9
We investigate whether the explanatory variables are predetermined with respect to the error term. To
investigate this we start using instruments dated t-2 for each regressor. Later we add the instrument dated t-1 to
analyse the potential bias arising from the correlation between xi,t-1 and the first-differenced error term )uit. We
concluded that no variable is predetermined and thus for all variables instruments dated t-2 are chosen.
10
In the light of the discussion given in Section 4.3, it can be argued that firms trade-off between two different
types of costs: costs of making adjustment towards their target cash holdings and costs of being off target. Then,
the adjustment coefficient would be expected to be close to 1 if the costs of being off target were much higher

26
target-adjustment model similar to those in Opler et al. (1999) and Shyam-Sunder and Myers

(1999). This model implies that changes in cash holdings can be explained by deviations of

current cash holdings from target levels. Unobservable targets are proxied using historical

average values of cash holdings. We find that the estimated target-adjustment coefficient has

a positive value of 0.54 and is significant at the 1 percent level. This value is slightly lower

than what the above GMM results suggest. However, one should be cautious in comparing

these two results. As noted earlier in the paper, the estimated coefficient of the simple target-

adjustment model is likely to be biased as the model does not incorporates those firm-specific

characteristics described as relevant in determining cash holdings. Furthermore, it is also

important to control for unobservable fixed effects as well as firm-constant time effects,

which are assumed to be significant in the underlying target cash model. Finally, the approach

adopted in our dynamic analysis also addresses the potential biases that may arise from

endogeneity of regressors as well as random measurement errors.

The effect of cash flow on cash holdings is positive and significant at the 10 percent level.

The positive coefficient of cash flow (CFLOW) is consistent with the view that firms that

have higher cash flows are expected to hold larger amounts of cash as a result of their

preference for internal over external finance. To the extent that cash flows are also a proxy

for firms’ growth opportunities the positive impact may indicate that firms with high cash

flows also hold high cash amounts to avoid situations in which they give up valuable

investment opportunities in some future states of nature.

Liquidity (LIQ) as expected exerts a negative impact on firms’ cash-holding decision,

though the estimated coefficient is significant at the10 percent level. This result can possibly

indicate that firms can use their non-cash liquid assets, defined as net working capital minus

cash and marketable securities, as substitute to cash holdings.

There is strong support for the negative relation between leverage (LEV) and cash

holdings. The coefficient of leverage is negative and significant at the 1 percent level.

than those of adjustment. Alternatively, it would be close to 0 if the costs of adjustment were much higher than
the costs of being off target.

27
Consistent with John (1993), Baskin (1987), and Fazzari et al. (1996), our results provide

evidence that firms with higher debt ratios have lower cash holdings. Moreover, as we

discussed earlier, to the extent that high leverage is a proxy for the ability of firms to issue

debt, firms may use borrowing as a substitute for holding larger amounts of cash and

marketable securities. Also, the negative coefficient of leverage may indicate that the cost of

holding high levels of cash is higher with debt financing.

Our regression results show a significant positive relation between growth opportunities

(proxied by the market-to-book ratio, MKTBOOK) and cash holdings. This is consistent with

the view that firms with higher levels of growth opportunities prefer to hold more cash to

avoid situations in which they give up profitable investment opportunities because they are

short of cash. This finding also lends support to the prediction that firms with higher market-

to-book ratios would wish to hold more cash and marketable securities to avoid financial

distress because costs are substantially higher for such firms. Finally, the positive coefficient

is in line with the hypothesis that firms with greater growth opportunities are likely to have

higher agency costs and hence to resort to internal financing when possible.

Our findings also provide strong evidence that bank-debt financing exerts a negative and

significant influence on cash and marketable holdings of firms. The estimated coefficient is

significant at the 1 percent level. This is in line with the above arguments that predict a

negative relation between cash holdings and bank debt financing. More specifically, the

negative coefficient for total bank debt (BANKDEBT) provides support for the view that bank

financing can be effective in reducing costs associated with agency relations and asymmetric

information, which normally make external financing more costly. It also provides support for

the view that bank debt conveys positive news to the market about the borrowing firms’ credit

worthiness. According to this view, firms with higher bank debt would be expected to have

easier access to external finance (see, e.g., James, 1987; and Mikkelson and Partch, 1986). It

is possible that the observed negative relation between cash holdings and bank debt reflects

the effect of cash on bank debt rather than vice versa. In fact, Cantillo and Wright (2000)

provide evidence that firms with high cash flows prefer to issue traded obligations rather than

28
bank debt. However, our analysis control for this potential problem by instrumenting bank

debt variable using its lagged values.

One interesting result stems from the estimated coefficient of size variable (SIZE) that is

positive but insignificant. This finding does not lend support to the view that larger firms hold

lower levels of cash and marketable securities because they are less likely to experience

financial distress, more diversified and have better excess to external financing. However, the

positive finding suggest that there may be other factors affecting the way in which size of

firms exerts influence on their cash-holding decisions. For example, it may be that larger

firms are more successful in generating cash flows (and profit) so that they can accumulate

more cash and marketable securities. Also, to the extent that large firms have greater growth

opportunities and smaller liquid assets besides cash and marketable securities large they may

choose to hold higher levels of cash. This is because they have lower amounts of substitutes

for cash and marketable securities and they wish to avoid situations in which they give up

profitable investment opportunities due to cash shortfalls. However, none of these effects

seem to prevail.

7. Conclusions

In this paper we investigate the empirical determinants of corporate cash holdings by using

a panel of UK firms during the period 1984-1999. There are several important features of our

analysis, which, we believe, extend the literature on the empirical determinants of cash

holdings of firms. Our analysis incorporates ownership structure of firms into the empirical

analysis of cash holdings, namely managerial ownership and ultimate controllers of firms.

Second, distinct from previous empirical studies, it effectively controls for the endogeneity

problem that is likely to arise in the empirical analysis of cash holdings. Last but not least, our

analysis incorporates the dynamic nature of the response of firms to changes in their target

29
cash levels, where the target adjustment coefficient is estimated by controlling for firm

heterogeneity as well as endogeneity and measurement errors.

Our results suggest that ownership structure of firms plays an important role in

determining levels of cash UK companies hold. We find evidence of a non-monotonic

relationship between managerial ownership and cash holdings in the sense that cash holdings

are negatively impacted at low levels of ownership but the impact is reversed at higher levels

of ownership. The relationship becomes negative again at high levels of managerial

ownership. More importantly, the nature of the relationship changes with the presence of

ultimate controllers. We provide evidence that firms with controllers hold higher levels of

cash and marketable securities. However, we do not find evidence of a strong relationship

between managerial ownership and cash holdings of firms that have ultimate controllers and

this result does not depend on the identity of controllers. However, the significant impact of

managerial ownership and the non-monotonic relation prevail in widely-held firms.

Our analysis also reveals that there are significant dynamic effects in the determination of

firms’ cash holdings. Moreover, it provides evidence that cash flow and growth opportunities

of firms exert a positive impact on their cash holdings. There is significant evidence for the

negative impact of liquid assets. The results suggest that higher cash holdings are associated

with lower levels of debt in firms’ capital structure. The source of debt proxied by the ratio of

bank debt to total debt has a significant negative impact on the firm’s decision. Finally, our

findings also reveal that unobserved firm heterogeneity, as reflected in the time-constant fixed

effects, is significant in affecting cash-holding decisions of firms.

30
References
Arellano, M. and Bond, S., 1991. Some tests of specification for panel data: Monte Carlo
evidence and an application to employment equations. The Review of Economics Studies
58, 277-97.

Baltagi, B.H., 1995. Econometric Analysis of Panel Data (Wiley, Chichester).

Baskin, J., 1987. Corporate liquidity in games of monopoly power. Review of Economics and
Statistics 69, 312-319.

Berlin, M., Loeys, J., 1988. Bond covenants and delegated monitoring. Journal of Finance 43,
397-412.

Billett, M., Flannery, M., Garfinkel, J., 1995. The effect of lender identity on borrowing
firm’s equity return. Journal of Finance 50, 699-718.

Blanchard, O., Lopez-de-Silanes, F., Shleifer, A., 1994. What do firms do with cash? Journal
of Financial Economics 36, 337-360.

Boyd, J., Prescott, E.C., 1986. Financial intermediary-coalitions. Journal of Economic Theory
38, 211-232.

Brennan, M., Hughes, P., 1991. Stock prices and the supply of information. Journal of
Finance 46, 1665-1691.

Cantillo, M., Wright, J., 2000. How do firms choose their lenders? An empirical investigation.
Review of Financial Studies 13, 155-189.

Chamberlain, G., 1982. Multivariate regression models for panel data. Journal of
Econometrics 18, 5-46.

Chemmanur, T.J., Fulghieri, P., 1994. Reputation, renegotiation and the choice between bank
loans and publicly traded debt. The Review of Financial Studies 7, 475-506.

Collins, D., Rozeff, M., Dhaliwal, D., 1981. The economic determinants of the market
reaction to proposed mandatory accounting changes in the oil and gas industry. Journal of
Accounting and Economics 3, 37-71.

Diamond, D.W., 1984. Financial intermediation and delegated monitoring. Review of

Economic Studies 51, 393-414.

Faccio, M., Lang, H.P., 2002. The ultimate ownership of western European corporations.
Journal of Financial Economics, forthcoming.

Faccio, M., Lang, H.P., Young, L., 2001. Dividends and expropriation. American Economic
Review 91, 54-78.

31
Faccio, M., Lasfer, A. M., 2000. Do occupational pension funds monitor companies in which
they hold large stakes? Journal of Corporate Finance 6, 71-110.

Fama, E., 1985. What’s different about banks? Journal of Monetary Economics 15, 29-39.

Fazzari, S.M., Hubbard, G.R., Petersen, B., 1996. Financing constraints and corporate
investment. NBER working paper, no. 5462.

Fazzari, S.M., Petersen, B., 1993. Working capital and fixed investment: New evidence on
financing constraints. Rand Journal of Economics 24, 328-342.

Fischer, R.H., Heinkel, R., Zechner, J., 1989. Dynamic capital structure choice: Theory and
tests. Journal of Finance 44, 19-40.

Franks, J., Mayer, C., 1996. Hostile take-overs in the UK and the correction of managerial
failure. Journal of Financial Economics 40, 163-181.

Franks, J., Mayer, C., Renneboog, L., 2001. Who disciplines management in poorly
performing companies? Journal of Financial Intermediation 10, 209-248.

Goergen, M., Renneboog, L., 2001. Strong managers and passive institutional investors in the
UK. In The control of corporate Europe, eds. Barca, F. and Becht, M., Oxford University
Press.

Grossman, S.J., Hart, O., 1988. One share-one vote and the market for corporate control.
Journal of Financial Economics 20, 175-202.

Harford, J., 1999. Corporate cash reserves and acquisitions. Journal of Finance 54, 1969-
1997.

Harris, M. and Raviv, A., 1990. Capital structure and the informational role of debt. Journal
of Finance 45, 321-49.

Holderness, C.G., 2002. A survey of blockholders and corporate control. FRBNY Economic
Policy Review, forthcoming.

Hoshi, T., Kashyap, A., Scharfstein, D. 1991. Corporate structure, liquidity and investment:
evidence from Japanese panel data. Quarterly Journal of Economics 106, 33-60.

James, C., 1987. Some evidence on the uniqueness of bank loans. Journal of Financial
Economics 19, 217-235.

Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance and takeovers.
American Economic Review 76, 323-39.

Jensen, M.C., Meckling, W.H., 1976. Theory of the firm: Managerial behavior, agency costs
and ownership structure. Journal of Financial Economics 3, 305-360.

32
John, T.A., 1993. Accounting measures of corporate liquidity, leverage, and costs of financial
distress. Financial Management 22, 91-100.

Kim, Chang-Soo, Mauer, D.C., Sherman, A.E., 1998. The determinants of corporate liquidity:
Theory and evidence. Journal of Financial and Quantitative Analysis 33, 335-359.

Klein, A., 1998. Firm performance and board committee structure. Journal of Law and
Economics 41, 275-303.

Martin, K.J. and McConnell J.J., 1991. Corporate performance, corporate take-overs, and
management turnover. Journal of Finance 46, 671-688.

McConnell, J.J., Servaes, H., 1990. Additional evidence on equity ownership and corporate
value. Journal of Financial economics 27, 595-612.

Mehran, H., 1995. Executive compensation structure, ownership, and firm performance.
Journal of Financial Economics 38, 163-184.

Mikkelson, W.H., Partch, M.M., 1986. Valuation effects of security offerings and the
issuance process. Journal of Financial Economics 15, 31-60.

Mikkelson, W.H., Partch, M.M., 2002. Do persistent large cash reserves hinder performance?
Unpublished manuscript. Lundquist College of Business, University of Oregon.

Minton, B.A.and Schrand C., 1999. The impact of cash flow volatility on discretionary
investment and the costs of debt and equity financing. Journal of Financial Economics 54,
423-460.

Morck, R., Shleifer, A., Vishny, R., 1988. Management ownership and market valuation: An
empirical analysis. Journal of Financial Economics 20, 293-315.

Myers, S.C, 1977. Determinants of corporate borrowing. Journal of Financial Economics 5,

147-175.

Myers, S.C., 1984. The capital structure puzzle. Journal of Finance 39, 575-92.

Myers, S.C., Majluf, N.S., 1984. Corporate financing and investment decisions when firms
have information that investors do not have. Journal of Financial Economics 13, 187-221.

Nestor, S. and Thompson, J.K., 2000. Corporate governance patterns in OECD economies: is
governance under way? OECD.

Nickell, S., 1981. Biases in dynamic models with fixed effects. Econometrica 49, 1399-1416.

Opler. T., Pinkowitz, L., Stulz, R., and Williamson, R., 1999. The determinants and
implications of cash holdings. Journal of Financial Economics 52, 3-46.

33
Ozkan, A., 1996. Corporate bankruptcies, liquidation costs and the role of banks. The
Manchester School 64, 104-119.

Pinkowitz, L., Williamson, R., 2001. Bank power and cash holdings: Evidence from Japan.
Review of Financial Studies 14, 1059-1082.

Rajan R.G., Zingales, L., 1995. What do we know about capital structure? Some evidence
from international data. Journal of Finance 50, 1421-1460.

Shleifer, A., Vishny, R.W., 1986. Large shareholders and corporate control. Journal of
Political Economy 95, 461-488.

Shleifer, A., Vishny, R.W., 1992. Liquidation values and debt capacity: A market equilibrium
approach, Journal of Finance 47, 1343-1366.

Shleifer, A., Vishny, R.W., 1997. A survey of corporate governance. Journal of Finance 52,
737-784.

Shyam-Sunder, L., Myers, S.C., 1999. Testing static trade-off against pecking order models of
capital structure. Journal of Financial Economics 51, 219-244.

Slovin, M., Young, J., 1990. Bank lending and initial public offerings. Journal of Banking and
Finance 14, 729-740.

Smith, C.W., 1986. Investment banking and the capital acquisition process. Journal of
Financial Economics 15, 3-29.

Stiglitz, J., 1985. Credit markets and the control of capital. Journal of Money, Credit and
Banking 17, 133-152.

Titman, S., Wessels. R., 1988, The determinants of capital structure choice. Journal of
Finance 43, 1-19.

Vafeas, N., Theodorou, E., 1998. The relationship between board structure and firm
performance in the UK. The British Accounting Review 30, 383-407.

Whited, T., 1992, Debt, liquidity constraints, and corporate investment: Evidence from panel
data. Journal of Finance 47, 1425-60.

Williamson, O., 1988, Corporate finance and corporate governance. Journal of Finance 43,
567-91.

Wooldridge, J.M., 2002. Econometric analysis of cross section and panel data. MIT Press.

34
Table 1
Descriptive Statistics
Mean Min 25 % Median 75% Max
CASH 0.103 0 0.012 0.058 0.142 0.967
CFLOW 0.088 -0.542 0.056 0.106 0.157 6.067
LIQ 0.056 -0.505 -0.053 0.060 0.179 0.828
LEV 0.197 0 0.065 0.167 0.271 1
BANKDEBT 0.591 0 0.185 0.722 0.960 1
MKTBOOK 1.608 0.459 0.991 1.303 1.809 10
SIZE 10.828 6.637 9.561 10.636 11.936 17.141
VARIABILITY 0.188 0.009 0.034 0.069 0.146 2.119
MAN 0.119 0 0.004 0.035 0.168 0.876
This table shows the sample characteristics for 1029 firms (except VARIABILITY and MAN, for which
870 firms are available for calculations) from over the period 1984-1999. CASH is the ratio of total cash
and equivalent items to total assets. CFLOW is the ratio of pretax profit plus depreciation to total assets.
LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is the ratio of
total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt. MKTBOOK is the
ratio of book value of total assets minus the book value of equity plus the market value of equity to book
value of assets. SIZE is the natural log of total assets in 1984 prices. VARIABILITY is the standard
deviation of cash flow divided by average total assets. MAN is the total percentage of equity ownership
by company directors.

35
Table 2
Ultimate Controllers of UK Companies

PANEL A: Percentage of Controlled Firms and Controllersa

Widely Widely Held Financial Unlisted
Family State Misc.
Held Corporation Institution Company
10 % Cutoff 24.36 0.64 20.38 26.67 18.72 0.13 9.10
No. of Firms 190 5 159 208 146 1 71
20 % Cutoff 67.44 0.51 6.53 15.64 6.41 0.00 3.47
No. of Firms 526 4 51 122 50 0 27

PANEL B: Descriptive Statistics of Ultimate Ownership by Different Categoriesb

Widely Widely Held Financial Unlisted
Family State Misc.
Held Corporation Institution Company
Mean 0.72 38.35 20.20 29.52 24.71 13.87 21.31
Min 0 11.07 10.09 10.13 10.25 13.87 10.30
25 % 0 20.60 11.40 15.65 15.74 13.87 14.08
Median 0 29.79 16.18 24.46 15.74 13.87 15.1
75 % 0 65.01 23.10 40.09 26.01 13.87 33.28
Max 9.48 65.30 89.90 84.50 86.88 13.87 58.90

PANEL C: Ratio of Cash Flow to Control Rightsc

Widely Widely Held Financial Unlisted
Family State Misc.
Held Corporation Institution Company
Mean 99.39 68.28 81.09 94.84 88.62 1 64.45
Min 93.94 0.24 4.01 16.60 10.45 1 20.23
25 % 1 74.73 70.54 1 75.00 1 33.28
Median 1 83.22 1 1 1 1 52.22
75 % 1 83.22 1 1 1 1 1
Max 1 1 1 1 1 1 1
This table presents summary statistics on ultimate controllers for a sample of 780 UK firms used in our analysis.
a, b: based on the ownership of the largest control holder.
c: the largest controlling holder has at least 5 percent of the voting rights.
Source: Our own calculations based on the ultimate ownership and control data in Faccio and Lang (2002)..

36
Table 3.
Cross-sectional regressions of cash holdings on managerial ownership, controlling shareholder and other
firm characteristics.

Dependent Variable : CASH

Independent Variables Predicted (1) (2)

Sign

CFLOW + -0.383 *** -0.378***

(0.067) (0.803)
LIQ - -0.073*** -0.066**
(0.027) (0.029)
LEV - -0.251*** -0.280***
(0.031) (0.033)
BANKDEBT - -0.057*** -0.048***
(0.012) (0.013)
MKTBOOK + 0.033*** 0.037***
(0.006) (0.007)
SIZE - -0.001 -0.002
(0.003) (-0.003)
VARIABILITY + -0.108 -0.119
(0.082) (0.088)
DIVIDEND +/- 0.038 0.052*
(0.027) (0.029)
MAN - -0.186 -0.241
(0.141) (0.154)
MAN2 + 1.036** 1.220**
(0.523) (0.575)
MAN3 - -1.041** -1.215**
(0.500) (0.557)
CONTROLLER +/- - 0.018**
(0.008)

R2 0.300 0.293
Number of firms 870 780

This table presents cross-sectional regressions predicting cash holdings. The dependent variable in both
regressions is CASH, measured in 1999 as the ratio of total cash and equivalent items to total assets. The
means of the independent variables are measured over the period 1995-1998 (except MAN, MAN2, MAN3,
measured in 1999, and CONTROLLER in 1997). Both regressions include industry dummies. CFLOW is
the ratio of pretax profit plus depreciation to total assets. LIQ is the ratio of current assets minus current
liabilities and total cash to total assets. LEV is the ratio of total debt to total assets. BANKDEBT is the ratio
of total bank borrowings to total debt. MKTBOOK is the ratio of book value of total assets minus the book
value of equity plus the market value of equity to book value of assets. SIZE is the natural log of total assets
in 1984 prices. VARIABILITY is the standard deviation of cash flow divided by average total assets.
DIVIDEND is a dummy variable which takes a value of 1 if the firm paid a dividend in the year, and 0 if it
did not. MAN is the percentage of equity ownership by directors. MAN2 and MAN3 are the square and cube
of the percentage of equity ownership by directors. CONTROLLER is a dummy variable which takes a
value of 1 if there is a controlling shareholder in the firm and 0 if there is not. Standard errors robust to
heteroscedasticity are reported in parentheses. ***, ** and * indicate coefficient is significant at the 1, 5 and
10 percent level, respectively.

37
Table 4
Cross-sectional cash holding regressions on interaction terms of managerial ownership and controlling
shareholder, and other firm characteristics.

Dependent Variable : CASH

Independent Variables Predicted (1) (2)

Sign

CFLOW + -0.379*** -0.369***

(0.081) (0.080)
LIQ - -0.067** -0.069**
(0.029) (0.028)
LEV - -0.281*** -0.289***
(0.033) (0.034)
BANKDEBT - -0.047*** -0.049***
(0.013) (0.013)
MKTBOOK + 0.038*** 0.035***
(0.007) (0.007)
SIZE - -0.002 -0.003
(0.003) (0.002)
VARIABILITY + -0.113 -0.115
(0.087) (0.087)
DIVIDEND +/- 0.054* 0.051*
(0.028) (0.029)
(MAN)(CONTROL DUMMY) +/- -0.116 -0.569**
(0.147) (0.236)
(MAN)2(CONTROL DUMMY) +/- 0.847 2.469**
(0.571) (1.231)
(MAN)3(CONTROL DUMMY) +/- -0.916* -2.440*
(0.550) (1.453)

R2 0.289 0.287
Number of firms 780 780
This table presents cross-sectional regressions predicting cash holdings. The dependent variable in both
regressions is CASH, measured in 1999 as the ratio of total cash and equivalent items to total assets. The
means of the independent variables are measured over the period 1995-1998 (except MAN, MAN2,
MAN3, measured in 1999, and CONTROL DUMMY in 1997). Both regressions include industry
dummies. CFLOW is the ratio of pretax profit plus depreciation to total assets. LIQ is the ratio of current
assets minus current liabilities and total cash to total assets. LEV is the ratio of total debt to total assets.
BANKDEBT is the ratio of total bank borrowings to total debt. MKTBOOK is the ratio of book value of
total assets minus the book value of equity plus the market value of equity to book value of assets. SIZE
is the natural log of total assets in 1984 prices. VARIABILITY is the standard deviation of cash flow
divided by average total assets. DIVIDEND is a dummy variable which takes a value of 1 if the firm
paid a dividend in the year, and 0 if it did not. MAN is the percentage of equity ownership by directors.
MAN2 and MAN3 are the square and cube of the percentage of equity ownership by directors. In column
(1) CONTROL DUMMY takes a value of 1 if there is a controlling shareholder in the firm and 0
otherwise. In column (2) CONTROL DUMMY takes a value of 1 if the firm is widely held and 0
otherwise. Standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate
coefficient is significant at the 1, 5 and 10 percent level, respectively.

38
Table 5
Cross-sectional cash holding regressions on interactive terms of managerial ownership and identity of controlling
shareholder, and other firm characteristics.

Dependent Variable : CASH

Independent Variables Predicted (1) (2) (3)

Sign
CFLOW + -0.389*** -0.379*** -0.375***
(0.080) (0.080) (0.080)
LIQ - -0.067** -0.064** -0.073**
(0.029) (0.029) (0.029)
LEV - -0.279*** -0.281*** -0.291***
(0.033) (0.034) (0.033)
BANKDEBT - -0.047*** -0.048*** -0.046***
(0.012) (0.012) (0.012)
MKTBOOK + 0.038*** 0.036*** 0.036***
(0.007) (0.007) (0.007)
SIZE - -0.002 -0.002 -0.003
(0.003) (0.088) (-0.89)
VARIABILITY + -0.129 -0.109 -0.128
(0.087) (0.088) (0.087)
DIVIDEND +/- 0.055* 0.054* 0.053*
(0.029) (0.028) (0.028)
MAN +/- -0.262*
(0.154)
MAN2 +/- 1.279**
(0.574)
MAN3 +/- -1.268**
(0.555)
INSTITUTION +/- 0.034***
(0.012)
FAMILY +/- 0.022**
(0.009)
(MAN)(IDENTITY DUMMY) -0.086 -0.018
(0.172) (0.231)
(MAN)2(IDENTITY DUMMY) 0.764 0.750
(0.715) (0.946)
(MAN)3(IDENTITY DUMMY) -0.902 -0.860
(0.723) (0.874)

R2 0.299 0.287 0.268

Number of firms 780 780 780

39
This table presents cross-sectional regressions predicting cash holdings. The dependent variable in all regressions is
CASH, measured in 1999 as the ratio of total cash and equivalent items to total assets. The means of the independent
variables are measured over the period 1995-1998 (except MAN, MAN2, MAN3, measured in 1999, and control
variables in 1997). All regressions include industry dummies. CFLOW is the ratio of pretax profit plus depreciation
to total assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is the ratio
of total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt. MKTBOOK is the ratio of
book value of total assets minus the book value of equity plus the market value of equity to book value of assets.
SIZE is the natural log of total assets in 1984 prices. VARIABILITY is the standard deviation of cash flow divided by
average total assets. DIVIDEND is a dummy variable which takes a value of 1 if the firm paid a dividend in the year,
and 0 if it did not. MAN is the percentage of equity ownership by directors. MAN2 and MAN3 are the square and cube
of the percentage of equity ownership by directors. INSTITUTION is a dummy variable which takes a value of 1 if
the controller of the firm is a financial institution and 0 otherwise. FAMILY is a dummy variable which takes a value
of 1 if the controller of the firm is a family and 0 otherwise. In column (2) IDENTITY DUMMY takes a value of 1 if
the controller is a financial institution and 0 otherwise and in column (3) it takes a value of 1 if the controller is a
family and 0 otherwise. Standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate
coefficient is significant at the 1, 5 and 10 percent level, respectively.

40
Table 6
Cash holdings regressions: panel data estimation results.

Dependent Variable : CASH

Independent Variables Predicted WITHIN GMM GMM

Sign (1) (2) (3)

CASHit-1 + 0.526*** 0.395***

(0.021) (0.027)
CFLOWit + -0.015*** -0.011 0.035*
(0.005) (0.009) (0.019)
LIQit - -0.094*** -0.099*** -0.043*
(0.006) (0.019) (0.023)
LEVit - -0.069*** 0.006 -0.123***
(0.006) (0.008) (0.030)
BANKDEBTit - -0.025*** 0.002 -0.089***
(0.003) (0.003) (0.011)
MKTBOOKit + 0.007*** 0.0001 0.012***
(0.001) (0.002) (0.003)
SIZEit - -0.025*** -0.016*** 0.007
(0.001) (0.005) (0.006)
DIVIDENDit +/- 0.047*** 0.011** 0.001
(0.003) (0.004) (0.012)

Number of firms 1029 1029 1029

Correlation 1 - -12.970 -13.30

Correlation 2 - 1.120 1.65
Sargan test (df) - 144.44 (104) 118.68 (104)

This table presents panel data regressions predicting cash holdings. The sample period in all regressions is
1984-1999 though the available number of observations for each firm changes across firms. Time
dummies are included in all regressions. Column (1) presents within estimation results for the static cash
model. Column (2) gives the GMM estimates for the dynamic model where only the lagged dependent
variable is treated as endogenous where CASHi,t-2, is used as instrument. Column (3) shows the GMM
estimates for the dynamic model, where CASHi,t-2, CFLOWi,t-2, LIQi,t-2, LEVi,t-2, BANKDEBTI,t-2,
MKTBOOKi,t-2, SIZEi,t-2, DIVIDEND i,t-2 are used as instruments. The dependent variable in all regressions
is CASH, measured as the ratio of total cash and equivalent items to total assets. CASH is the ratio of total
cash and equivalent items to total assets. CFLOW is the ratio of pretax profit plus depreciation to total
assets. LIQ is the ratio of current assets minus current liabilities and total cash to total assets. LEV is the
ratio of total debt to total assets. BANKDEBT is the ratio of total bank borrowings to total debt.
MKTBOOK is the ratio of book value of total assets minus the book value of equity plus the market value
of equity to book value of assets. SIZE is the natural log of total assets in 1984 prices. DIVIDEND is a
dummy variable which takes a value of 1 if the firm paid a dividend in the year, and 0 otherwise.
Three test statistics are reported for the GMM results: (1) and (2) First and second order autocorrelations
of residuals respectively, distributed as standard normal N(0,1) under the null of no serial correlation; (3)
Sargan test of overidentifying restrictions, distributed as chi-square under the null of instrument validity.
Asymptotic standard errors robust to heteroscedasticity are reported in parentheses. ***, ** and * indicate
coefficient is significant at the 1, 5 and 10 percent level, respectively.

41