Corporations hoard cash as a precautionary measure

Visiting Asst. Prof. David McLean

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.

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LinkedIn: When the party ends–MIT Leadership Center director discusses recent IPO

MIT Sloan Prof. Deborah Ancona

From the Washington Post

LinkedIn’s recent IPO is generating tremendous buzz in the world of high-tech and the financial markets. Doubling your stock price doesn’t happen every day, so company euphoria is completely understandable. In fact, passing around the champagne and caviar is a good thing. Company employees should be able to party when good news abounds; celebrating success helps build morale and team cohesion. It also lays the groundwork for Read More »