By Adam Ozimek
Karl has been blogging about Apple’s (NASDAQ:AAPL) large cash holdings for some time now. His point is that management is taking advantage of shareholders by holding too much cash instead of paying dividends. My initial reaction when he first blogged this was “no way”. Then after the second or third post on it I had been converted to a “maybe”. Karl isn’t alone in arguing that cash holdings are too high, and Apple isn’t alone in guilt; there is a good bit of literature arguing corporations hold too much cash and trying to explain why. While the agency problem may not explain excess cash holdings overall, I do think it is at least one possible explanation, and that it may apply for some firms, especially Apple.
One uncontroversial fact is that cash holdings have been going up over time for firms. There are several explanations for why, and Karl’s agency problem is just one. For instance, one theory is that taxes provide firms with incentives to hold cash, and another is that there are frictions in access to capital markets so firms should hold more cash when shocks become more likely. A 2006 NBER working paper from Bates, Kahle, and Stulz provides a good overview and some interesting empirical insights. Here is how they summarize the literature on Karl’s agency problem theory of cash holdings:
As argued by Jensen (1986), entrenched managers would rather hold on to cash when the firm has poor investment opportunities than increase payouts to shareholders. Dittmar, Mahrt-Smith, and Servaes (2003) find cross-country evidence suggesting that firms hold more cash in countries with greater agency problems. Dittmar and Mahrt-Smith (2006) and Pinkowitz, Stulz, and Williamson (2006) show that cash is worth less when agency problems between insiders and outside shareholders are greater. Dittmar and Mahrt-Smith (2006) and Harford, Mansi, and Maxwell (2006) provide evidence suggesting that entrenched management actually spends excess cash quickly.
The paper provides some empirical tests of the agency problem explanation and do not find the evidence in support of it:
Agency theory predicts that cash holdings will increase for firms with high free cash flow. Our evidence on the changes in cash holdings for subsamples of firms is largely inconsistent with the agency explanation. In particular, we find that cash holdings increase more in firms that are financially constrained, as proxied by negative net income, than for other firms. Further, larger, more established firms are more likely to have agency problems of free cash flow that could lead to an increase in cash holdings. However, the increase in cash holdings is much more significant for smaller and recently listed firms.
I don’t know the literature well enough to say whether or not these results are consistent with most of the research in this area, but they should at least make us somewhat skeptical of the agency explanation. However, while agency problems might not explain the increase in cash holdings overall, Karl could still very well be correct in the case of Apple.
An important and related issue here is that as firms have held more cash they have also decreased net debt, which has implications for the question of whether the corporate income tax is causing firms to have too much leverage. Mihir Desai, for example, has argued:
While excessive leverage is sometimes associated with the tax code because of a presumed debt bias for corporations, concerns over the role of tax policy in fostering the financial crisis appear unfounded…. For the non-financial corporate sector where the presumed debt bias is thought to exist, the startling fact is how unlevered that sector was prior to the crisis. In particular, the rise of cash balances and the decline of net debt is the dominant corporate finance trend of the last decade.
He provides the following graph showing that leverage for non-financial corporations is not high by historical standards:
Reading the literature on leverage and the corporate income tax I have moved recently from thinking this is obviously a big problem to thinking that perhaps this isn’t as big of a problem as we commonly think, or perhaps it is not a problem at all. Points to Karl and Tyler Cowen who have both been arguing this.
For his part, Desai argues that there are three main explanations for the excess cash holdings issue:
1. Weak product market demand
2. Regulatory and macroeconomic uncertainty
3. A coordination problem leading managers to be frozen into not spending
Desai proposes a tax that could fix the coordination problem if in fact that is the cause. Karl’s explanation of an agency problem implies some possible solutions relating to changing shareholder rights, and a tax might help here too. But the relationship between excess cash and low corporate leverage raises the question of whether it is in fact a problem at all. Desai argues:
“…the remarkable underleverage of the non-financial sector prior to the financial crisis was a saving grace in ensuring that the financial crisis was not nearly as severe as it could have been.”
The overleveraging of banks is a persistent problem that regulators seem unwilling or unable to fix, and this creates serious macroeconomic risks. Perhaps we should just be glad for the corporate sector’s opposing bias against leverage and not worry about taxing it away. Excess cash may be a problem at the firm level, but it could be a boon at the macro level.
This also raises the question of whether we should be reconsidering the wall between commerce and finance. If non-financial firms have a bias against leverage, than allowing them to take banking business from financial firms is one way to eat away at leverage in the financial system. Letting Walmart (NYSE:WMT) get into retail banking would be one obvious way to do this.
On the other hand, perhaps allowing non-financial firms into the banking business will just remove their bias against leverage and infect that currently safer sector with the leverage problem. It’s an issue worth discussing more.