According to financial literature, agency problem has been a controversial issue. Many studies show that firms with weaker corporate governance structure have severe agency problem (Core, Holthausen, and Larcker, 1999). Due to separation of ownership and control in modern corporations, agency problem exists between managers and shareholders when they have conflicting interests (Berle and Means, 1933). Jensen (1986) suggests that firms with excess cash are forced to pay out funds to finance all positive net present value (NPV) investments to minimize the agency cost of free cash flow. In other words, firms keep less cash holdings to avoid agency problem between managers and shareholders.
However, Hillier et al. (2011) show that agency problem is less sensitive to corporate cash holdings of firms with better country-level governance. Harford, Mansi, and Maxwell (2008) suggest that country-level governance is more important than firm-level variation determinants of managerial incentives in controlling agency conflicts, and demonstrate that firms with weaker corporate governance structures have smaller cash reserves because the weakly controlled manager chooses to spend cash quickly on acquisitions and capital expenditures, rather than hold it. Therefore, we expect that country-level governance may reduce the impact of agency problem on corporate cash holdings.
Different countries have different views on what the aims should be, and the different legal rules protecting the investor and the quality of their enforcement result in different corporate governance structures. Researchers contrast two dichotomous model of Anglo-American and continental European corporate governance (Becht and R el, 1999;
Bergl f, 1991; Hall and Soskice, 2001; La Porta et al., 1998). Anglo-American countries are labeled common-law countries and shareholder-centered, whereas Continental European countries are considered civil-law countries and stakeholder-centered (Aguilera and Jackson, 2003; Shleifer and Vishny, 1997).
From Figures 1 and 2, we can observe that the United States (US) and the United Kingdom (UK), which are common-law countries, both maximize shareholder wealth, whereas Germany and France, which are civil-law countries, both maximize firm value. Thus, we divide our samples into two groups, common-law and civil-law countries, in order to examine the impact of the country-level governance on cash holdings.
Figure 1: Whose Company Is It? Source: Yoshimori, 1995.
Figure 2: Job Security or Dividends? Source: Yoshimori, 1995.
In addition, developed debt and equity markets contribute to economic growth (King and
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Levine, 1993; Levine and Zervos, 1998). Rajan and Zingales (1998) and La Porta et al. (2002) find that countries with lower financial constraints have more active capital market. Pinkowitz, Stulz, and Williamson (2004) show that cash is worth less in countries with low investor protection. Similarly, Mikkelson and Partch (2003) find that persistent extreme cash holdings do not lead to poor performance and do not represent conflicts of interests between managers and shareholders. Furthermore, La Porta et al. (1998) suggest that the common-law countries with better legal protections against expropriation by insiders provide more external finance to investors in positive capital. Thus, the common-law countries with better legal protections provide more external finance to investors in positive capital markets, thereby enabling firms to raise funds easily with lower financial constraints and pursue better investment opportunities and enhance their firm value. Therefore, the common-law countries with better country-level governance and lower financial constraints have much more investment opportunities so that their cash value is higher, and they can hold more cash holdings for precautionary motive.
Moreover, stockholders of firms have higher shareholder rights, they can monitor managers and reduce agency problem between managers and stockholders. According to the free cash flow hypothesis, agency problem is positively related to cash holdings. However, Hillier et al. (2011) show that higher country-level governance can decrease sensitivity between agency problem and corporate cash holdings. Hence, firms can use cheaper internal funds (i.e. cash holdings) to make investment, without worrying about agency problem, and it also can reduce the idiosyncratic risk for lower leverage.
Many studies focus on the country-level governance to cash holdings. For example, La Porta et al. (2002) find evidence of higher valuation of firms in countries with better protection and higher cash flow ownership by the controlling shareholder. Dittmar, Mahrt-Smith, and Servaes (2003) evaluate country-level governance to examine the corporate cash holdings among 45 countries, including the emerging, the developing and the developed
countries, and find that firms with poor corporate governance structure hold up to twice as much cash as those with good shareholder protection. Cross-country evidence shows that firms in countries with greater shareholder rights are associated with lower cash holdings (Lins and Kalcheva, 2007; Pinkowitz, Stulz, and Williamson, 2006).
To conclude, we learn that the agency problem is significantly negative to cash holdings;
however, firms with better country-level governance can reduce the sensitivity between corporate cash holdings and agency problem with higher shareholder rights to monitor managers and lower financial constraints to raise funds easily. Although cross-country evidence, including both the emerging and the developed countries, shows that shareholder rights are negatively related to cash holdings (Dittmar, Mahrt-Smith, and Servaes, 2003; Lins and Kalcheva, 2007; Pinkowitz, Sulz, and Williamson, 2006), the top four economic markets (i.e., US, UK, Germany and France) we choose in this paper have so strong external capital markets that the investors have more protection than emerging countries; thus, the country-level governance in these four developed countries is much better and they could hold more cash to enhance firm value without worrying about agency problem when they face good investment opportunities. Therefore, we expect that the country-level governance is positively related to cash holdings.
The remainder of the present paper is organized as follows. Section 2 describes the methodology, including the sample selection and research models. Section 3 presents and discusses the results. Section 4 provides the conclusions.