The contracting hypothesis suggests firms granting managers high vega compensation are more likely required to maintain greater liquidity by creditors because the high vega compensation may encourage managers to conduct more risk-taking activities.
Liu and Mauer (2011) find consistent results that firms granting managers higher vega compensation tend to hoard more cash assets on hands. Accordingly, one may argue the positive effect of excess cash holdings on the ESOs-induced M&As is merely attributed to the contracting hypothesis. Given Liu and Mauer (2011) find the contracting effect of vega compensation on cash policy is more sensitive in highly levered firms, we thus expect the positive effect of excess cash on ESO-induced M&As would be more profound in highly levered firms if the contracting hypothesis dominates. Otherwise, the precautionary motive of cash holdings may dominate if the positive effect is observed in firms with low leverage. Following Liu and Mauer (2011), we define our sample as a highly levered group if a firm’s leverage is above the sample median of the leverage ratio. Meanwhile, we also use the Z score to identify firms with high default risk because these firms are also likely to maintain a high level of liquidity due to the covenant requirement. According to the rule of Altman (1968), we define firms as high (low) -default-risk groups when their Z score are below (above) 1.8. The results are shown in Table 9.
Panel A exhibits the results based on the leverage measure. Obviously, we only find the positive and significant coefficients of Vega×Cashrich in the low leverage group.
When firms are highly levered, the effect of excess cash holding on the ESOs-induced M&A decisions becomes insignificant because these highly levered firms hoard the excess cash to meet the covenant requirement rather than to support their precautionary demand.
Through the difference test, we find consistent results that the effect of excess cash on the ESOs-induced M&A decisions is significantly greater in low-leverage firms than that in highly levered firms. These results indicate the higher likelihood of cash-rich firms conducting ESOs-induced M&As is more associated with precautionary motives instead of with the contracting hypothesis. In panel B, the analysis is based on a Z score measure.
The results are consistent with Panel A that the effect of excess cash on the ESOs-induced M&As is more sensitive in low-default-risk firms, while there is no significant difference in the effect of excess cash between high-default-risk and low-default-risk firms.
5. Conclusion
This study examines whether excess cash holdings can enlarge the incentive effect of ESOs on idiosyncratic risk taking by analyzing corporate M&A activities. There are three critical points to build our arguments. First, the risk incentive of ESOs (vega) could increase managerial risk taking, especially for systematic risk but not for idiosyncratic risk because CEOs can only trade the market portfolio to hedge systematic risk. However, idiosyncratic risk is highly related to a firm’s long-term development. Second, while M&As are one type of critical investments for a firm’s economic growth, the greater concern about the post-merger idiosyncratic risk relative to systematic risk may make managers more risk averse and then hesitate to conduct M&A activities. Third, excess cash holdings enable firms to bear greater idiosyncratic risks and pursue more persistent investments because cash assets can serve as the precautionary buffers to defend against
Table 9 Robustness Test: The Contracting Effect
Panel A: Leverage
Dep: MA t Highly Levered Firms Low-Leverage Firms
(1) (2) (3) (1) (2) (3)
Cashrich t-1
.
Vega×Cashrich
P-value on the diff. in High vs. Low Delta×Cashrich
Year fixed effect Number of observations R-squared
Panel B: Z-Score
Dep: MA t High-Default-Risk Firms Low-Default-Risk Firms
(1) (2) (3) (1) (2) (3)
Cashrich t-1
.
Vega×Cashrich
P-value on the diff. in High vs. Low Delta×Cashrich
Year fixed effect Number of observations R-squared Note: This table examines whether the effect of excess cash on the ESOs-induced M&A decision is more attributed to the
contracting hypothesis or the precautionary motive. All variables are defined in the same way as shown in the Appendix.
Panels A and B demonstrate the analyses base on different measurements. The results are shown in the marginal effect of probit model that controls for the time fixed effect. The t-statistics are reported in parentheses. ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively.
unexpected shocks. Thus, we argue excess cash holdings might amplify the risk incentive effect of ESOs (vega) on M&A decisions.
By examining the S&P 1500 firms from 1992 to 2014, we find the likelihood of managers conducting ESOs-induced M&As is greater in cash-rich firms than in non-cash-rich firms, indicating excess cash holdings encourage managers with greater vega compensation to conduct idiosyncratic risk taking via M&As. Such a positive effect of excess cash on the ESOs-induced M&A decisions is more pronounced in firms with low leverage and those in the old economy. Further, we find marginal evidence that the market
Table 9 Robustness Test: The Contracting Effect (cont.)
may respond favorably to ESOs-induced M&A decisions in cash-rich firms than in non-cash-rich firms, especially for firms in the old economy. When further investigating future profitability, we find consistent results that cash-rich firms undertaking ESOs-induced M&A activities would have better profitability than those not conducting ESO-induced M&As. Overall, the role of excess cash holdings in firms conducting ESOs-induced risk taking is more associated with precautionary motives than agency incentives, but how the market values cash-rich firms conducting ESO-induced M&As still depends on a firm’s governance environment.
This study verifies the link between ESO incentives and corporate cash holdings by simultaneously analyzing their impacts on corporate idiosyncratic risk taking. Our results not only contribute to the literature of ESOs compensation, corporate cash holdings and M&As, but also help corporations make appropriate decisions in their compensation and cash policies that can effectively encourage managers to conduct risk-taking activities and then enhance their future profitability.
Appendix
Table A The Table of Variable Definitions
Variable Definition
MA A dummy variable that equals to one if the firm undertakes an acquisition, otherwise zero.
Vega The change in the dollar value of the CEO’s options holdings for one percentage change in the stock return volatility.
Delta The change in the dollar value of the CEO’s stock and options holdings for one percentage change in the stock price.
Cash/TA Cash and short-term investments scaled by total assets.
Cashrich
An indicator that equals to one if the firm owns excess cash holdings, otherwise zero. Excess cash holdings are defined as cash ratios (Cash/TA) minus predicted cash ratios. The predicted cash ratio is estimated by the modified cash model, which is based on the model of Bates et al. (2009) and takes into account net financing.
Sales The logarithm of sales in 1990 dollars.
Market leverage
The book value of debt over the market value of total capital. Book debt is calculated by total assets minus book equity. Book equity is defined as total assets minus liabilities plus balance sheet deferred taxes and investment tax credit minus preferred stock. Market value of capital is defined as liabilities minus balance sheet deferred taxes and investment tax credit plus preferred stock plus market value of common equity.
Stock return A firm’s annual stock returns.
Market_to_Book The market value of assets over the book value.
EBITDA/TA The ratio of operating income before depreciation over total assets.
Industry M&A
liquidity The ratio of overall M&A transaction values divided by total assets of all COMPUSTAT firms with the same three-digit SIC code for each signal year.
Herfindahl index
The sum of the squares of market shares for all firms sharing the same three-digit SIC code. Market shares are estimated by sales of a firm over total sales within the same industry.
InsideOwn The percentage of insider ownership, which is measured as the ratio of shareholdings owned by top-five managers.
Variable Definition
CAR (-2, +2 ) the acquirer's cumulative abnormal return over a five-day event window (two days before and two days after the announcement date)
Relative Size
the natural logarithm of the ratio of M&A transaction value to total assets of the acquirer at the end of the fiscal year prior to the acquisition announcement.
Private Target A dummy variable equals one if the target is a private firm defined by the SDC M&A database, and zero otherwise.
Within-industry
acquisition An indicator that equals to one if the acquirer and the target have the same three-digit SIC code, and zero otherwise.
All Cash An indicator that equals to one if the M&A is fully paid with cash, and zero otherwise.
Competed A dummy variable that equals to one if there is more than one bidder, and zero otherwise.
Hostile A dummy variable that equals to one if M&A is identified as hostile by the SDC M&A database, and zero otherwise.
IAROA
Industry-adjusted profitability represents a firm’s annual return on assets (ROA) net of the industry median. The return on assets (ROA) is operating income before depreciation scaled by total assets. The industry medians are estimated based on a yearly basis using all firms with the same two-digit SIC codes in COMPUSTAT database.
IAM/B
Industry-adjusted book ratio represents a firm’s annual market-to-book ratio net of the industry median. The industry medians are estimated based on a yearly basis using all firms with the same two-digit SIC codes in COMPUSTAT database.
Aveleverag the average leverage over the prior two years Avesalegrowth the average of sale growth over the prior two years
Tenure the number of years that the current CEO has served in that capacity as reported in ExecuComp database.
Taxloss An indicator that equals to one if a firm has tax-loss carry-forwards in any of the past three years, and zero otherwise.
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