Response to Wall Street Journal Article Entitled: Cash-Rich Firms Feel Pressure to Spend - Essay Example

John Doe Prof. Richard Roe Anthropology 101 15 May 2006 Response to Wall Street Journal Article En d: Cash-Rich Firms Feel Pressure toSpend The object of this paper is to answer certain questions regarding the corporate economic actions and trends set forth in Gregory Zuckerman's article entitled, "Cash-Rich Firms Feel Pressure to Spend" as published in the 11 July 2005 issue of The Wall Street Journal. The questions and answers are stated below. 1. What are the recent trends in corporate cash holdings highlighted in the article What factors have contributed to these trends The article highlighted the fact that corporations are under pressure from market investors, shareholders and from the corporation itself, to divest or to release much of the cash assets that it holds, in the form of dividends, share buybacks, or increased investments. This is a side effect of the prosperity that the growing economy has given to certain companies that have become cash-heavy. Major factors that support such divestiture of cash assets are mainly based on the logic that too much cash on hand can be bad. In fact, it has become recognized that the ideal situation on a corporation's financial statements and balance sheets is to have some debt. For the company itself, the having less cash and more debt decreases significantly the chance of takeovers and buyouts, because excess cash is occasionally used as a portion of financing the acquisition. Thus, as Zuckerman states in the article, "[there is] increasing pressure on executives at some companies to make use of their extra cash to avoid becoming takeover candidates." 2. Is there an optimal level of cash holdings for a firm What factors should a company consider when determining its level of cash holdings Support your answers. It is my opinion that indeed there is an optimal level of cash holdings for a company or firm. This is very similar to the economic concept of utility, where the usefulness of a thing increases however, at some point, reaches a peak and begins to become less useful, even to the extent of becoming a burden. It is my belief that the same goes for cash. In a working study by Pinkowitz and Williamson, they state that there are a myriad of factors or situations which dictate a firm's actions towards its cash assets. Thus, these factors play a big role in the company determining what would be the optimal level of cash holdings, and is viewed from a number of points-of-view. They state: In general, shareholders value a marginal dollar of cash at approximately face value. However, we find large cross-sectional differences consistent with existing theory. We document that the quality and volatility of the firm's investment opportunity set, the probability of financial distress, and access to capital impact the value of cash. Firms with good growth options have their cash valued at a premium to those with poor growth prospects. Additionally, cash is less valuable in firms with stable investment programs and those nearer financial distress. Finally, access to capital decreases the value of holding cash. Overall, it appears that both the investment and financing opportunity sets of the firm affect the value shareholders assign to cash holdings. (2) Thus, one can now see that indeed see that the direction a firm will take in managing its cash assets depends not only on circumstances or factors, but also on what is the driving force of a firm. However, most firms are commonly affected or directed by factors that include, " investment opportunities, agency costs, and market frictionsaccess to capital, and size of a corporation" (Pinkowitz and Williamson) 3. Can a firm hold "too much" cash What are the downsides of excessive cash holdings Support your answers. As earlier stated, I am in concurrence with many views that cash may be excessively held by a firm has a tendency to be counterproductive rather than productive. As stated earlier and in Zuckerman's article, having cash levels that may be viewed as "too-much" for a particular firm makes that firm more attractive to competitor firms, and thus making it more susceptible to takeover and buyout attempts. Other factors include possibility of squandering internal corporate acts such as excessive perks for executives and careless use of the cash assets by managers, among others. A 2005 study by Dittmar and Mahrt-Smith adds corporate governance to the list of ill effects of a firm having too much cash assets thus: Although it is optimal for firms to hold some cash to finance day-to-day operations and as a buffer against the cost of externally financing their investments, holding excessive cash resources may have negative value implications if managers use these liquid resources inefficiently. In other words, a dollar may not be worth a dollar if there is a chance that it is going to be wasted. (1-2) 4. What options does a company have for reducing its cash holdings What are the tradeoffs between these options Zuckerman has already outlined common corporate practices that have been used by firms in reducing cash holdings, including declaration of higher dividends to shareholders, buyback of shares, increase investments in profitable businesses. It is clear that these measures safeguard the firm from the ill effects of having "too-much cash" as mentioned above, including increased attractiveness to buyouts and takeovers, increased chance of costly acquisitions and erroneous investments by managers, among others. However, there are indeed certain tradeoffs with each mode of reducing cash holdings. Increased dividend payments indeed increases the public view of the stock, and keeps the shareholders happy, but it creates a precedent that will always be looked at in the future. For example, if a firm declares high dividends this year, and for the next five years cannot match that dividend declaration due to economic and financial problems, shareholders and analysts will state that the company is underperforming thus resulting in fewer profits and less dividends in comparison to the one declared this year. Share buybacks are a good way of decreasing the equity of a firm, but by decreasing the size of a firm controlled by investor's equity, puts more power into the control of management which may lead to less checks and balances with regard to corporate acts which normally would alarm a shareholder. Many firms have gone belly up because top management acted in ways that greatly prejudiced the firm despite the voiced out concerns of a minority of shareholders. Indeed, just as the logic underlying this paper is that a balance between cash and debt on a balance sheet is good, so too is a balance between management and shareholder equity in control of a firm. Lastly, increased investments, no matter how profitable, are no guarantee that profit shall continue, and indeed by a firm dumping more cash onto investments, they increase certain risks that the investment may not profit, or fail completely. Works Cited Dittmar, Amy & Mahrt-Smith, Jan. "Corporate Governance and the Value of Cash Holdings." (2005): 45 pages. 14 May 2006. . Pinkowitz, Lee & Williamson, Rohan. "What is a Dollar Worth The Market Value of Cash Holdings" (2002): 39 pages. 14 May 2006. < faculty.msb.edu/williarg/MVofCash-All.pdf >. Zuckerman, Gregory. "Cash Rich Firms Feel Pressure to Spend". The Wall Street Journal 11 July 2005. Read More