Academic studies have shown that over the past few decades, public firms are increasingly holding large amounts of cash. Curiously, much of this build up in cash savings can be attributed to cash saved from seasoned share issues, which are sales of equity by already public companies.
I examined the share-issuance cash savings of a large number of U.S. firms over a 38-year period. In the 1970s, $1.00 of issuance resulted in $0.23 of cash savings, yet in more recent years, that same $1.00 of issuance resulted in $0.60 of savings. Over my sample period, the amount of cash saved from share issuance increased at an average rate of 2.5% per year.
So what is going on here? My initial reaction was that the firms were issuing shares because their stock was mispriced, thereby taking advantage of naive investors. However, after digging deeper, I found that this was most likely not the case. It turns out that there are good economic reasons for firms to hold onto cash and even to issue shares for the purpose of cash savings.
Consider an emerging pharmaceutical company with a promising pipeline of projects. The company is still early in its lifecycle so its profits are marginal and its cash flows are volatile. The company spends a large amount on R&D and plans to continue doing so in the future. Because the company generates little cash flow, it depends on capital markets to finance its R&D spending.
S.P. Kothari, deputy dean at the MIT Sloan School of Management and a former Barclays fund manager, talks about what investors should look for in choosing an investment adviser to steer them through these turbulent markets.
It started with Greece and its $100-plus billion bailout package last May. Next came Ireland: in November, it accepted a similarly hefty financial rescue. And now the European debt crisis is at risk of spreading like a virus to countries perceived by the markets to have similar vulnerabilities. Other countries that appear at risk for financial problems include Portugal, Spain and Italy.
As I watch these events unfolding across the Atlantic, the economist in me is fascinated to see that financial crises continue to be part of our landscape. I’ve spent a large part of my professional life studying how financial crises spread from country to country and Europe’s sovereign debt predicament is a living and breathing example of my academic research. Theoretical and empirical models help us understand pieces of otherwise complex dynamics that have been, and continue to be, the fundamental drivers of financial crises.
My biggest worry is that contagion often creates a self-fulfilling destabilizing effect that can spread otherwise ‘isolated’ episodes of stress to other markets and countries. It has a momentum of its own. And as the world’s economies are trying hard to pull through from the credit crisis and the global downturn that started in mid-2007, I worry about the immediate and longer-term challenges facing Europe. It’s clear that Europe is struggling mightily to prevent the debt crisis from overwhelming more countries and support a fragile recovery, but containing contagion is not easy. Read More »