cash hoards and changes in investors' outlook

CASH HOARDS AND CHANGES IN INVESTORS’ OUTLOOK

Ebenezer Asem and Shamsul Alam

University of Lethbridge

Abstract

Declining markets reflect declines in investors’ outlook for firm prospects, increasingtheir expectation that firms will waste excess cash. In contrast, excess cash is useful inmitigating financial distress associated with poor earnings. We find an inverted U‐shapedrelation between stock return and excess cash in declining markets, suggesting thepositive effect of excess cash dominates at low levels of cash, while the negative effectdominates at high levels. We also document an inverted U‐shaped relation for firms withweak shareholder power and firms with high information asymmetry in advancingmarkets. These suggest investors’ desire for cash reserves is limited.

JEL Classification: G30, G35

I. Introduction

Jensen’s (1986) influential excess cash theory suggests that excess cash reduces firmvalue because managers tend to waste it. Accordingly, an unexpected increase (decrease)in a firm’s excess cash increases (reduces) the market’s estimate of the amount of cash thefirm will misuse, reducing (increasing) the firm’s value. However, there is evidence thatfirms continue to accumulate cash reserves and that investors might actually condone thisbehavior.1 There is evidence that firms hoard cash to cushion shortfalls in future cashflows and mitigate the effects of economic downturns (e.g., Bates, Kahle, and Stulz 2009;Palazzo 2012) or to provide cheap funds for growth (e.g., Simutin 2010). We test whetherinvestors sanction these cash hoards by investigating the relation between stock return andcash reserves when investors expect declines in future cash flow or when they expectincreases in growth opportunity. We document an inverted U‐shaped relation betweenstock return and excess cash when investors expect declines in future cash flow. Wheninvestors expect improvements in investment opportunity, we generally find a positiverelation, but firms with high information asymmetry or poor governance display anegative relation at high levels of excess cash. These results suggest that investors’support for cash hoards is not ubiquitous.

We are grateful to Sattar Mansi (associate editor) and Jesus Salas (referee) for valuable suggestions that greatlyimproved the paper. We also thank seminar participants at the University of Lethbridge, University ofSaskatchewan, and the 2009 participants at the Financial Management Association meetings for very constructiveand helpful comments. Ebenezer gratefully acknowledge the financial support from the University of LethbridgeResearch Fund #13136 and the Faculty of Management Seed Fund. Any mistakes are ours alone.

1 In an article entitled “What Will It Take for Companies to Unlock Their Cash Hoards?” in the Wall StreetJournal onMay 28, 2011, Jason Zweig noted that the payout ratio for companies in the S&P 500 index has droppedto 28.9%, the lowest since 1936.

The Journal of Financial Research � Vol. XXXVII, No. 1 � Pages 119–137 � Spring 2014

119

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Prior research suggests that managers hold cash reserves to cushion future cashflow shocks or to fund future investments. However, it is not clear if investors sanctionthese cash reserves. One approach to investigating this is to study the behavior of stockreturns around changes in excess cash, but unlike other corporate events (e.g.,announcements of dividend changes), it is difficult to determine the timing of changes in afirm’s excess cash. An alternative is to study stock returns when investors’ outlook aboutfirms’ future cash flows or investment opportunities change. If investors desire that firmshoard cash to mitigate future financial distress, the returns of the firms with high excesscash should decrease at a slower rate than the returns of firms with low excess cash wheninvestors expect declines in future cash flows. If investors desire that firms hoard cash tofund investments, the returns of firmswith high excess cash should increase faster than thereturns of firms with low excess cash when investors expect increases in investmentopportunity. We proxy changes in investors’ outlook for future cash flow or investmentopportunity by the market’s movement. A firm’s stock price captures its expected cashflow or investment opportunity, and therefore, a decline in the price reflects a decline inexpected cash flow or growth opportunity. Similarly, an increase in the stock pricesreflects an increase in expected cash flow or growth opportunity. Thus, a decline(increase) in the market’s return is a reflection of a decrease (an increase) in aggregateexpected cash flow or growth opportunity.2 Accordingly, we study the relation betweenstock return and excess cash in advancing and declining markets to shed light on whetherinvestors condone cash hoards to mitigate future cash shocks or fund investments.

The authors of two articles examine firms with excess cash when economicconditions change. Harford, Mikkelson, and Partch (2003) report that firms with cashreserves generate stronger (weaker) earnings than their industrial peers in the year of andthe years following industrial downturns (nondownturns). Simutin (2010) reports thatfirms with high excess cash earn lower (higher) returns than firms with low excess cash inmonthly market downturns (upturns). Following Mikkelson and Patch (2003), wemeasure market movement over one and two years because changes in investorperception about a firm’s growth prospect likely take longer than a month, and wedocument new results.3 First, we document an inverted U‐shaped relation between stockreturn and excess cash in declining markets. Second, we find an inverted U‐shapedrelation for firms with weak governance or high information asymmetry in advancingmarkets, as well. This suggests that the positive effects of excess cash at low levels of cashand the negative effects at high levels of cash are present in both declining and advancingmarkets.

Declining markets reflect a decline in expected future cash flows or invest-ment opportunities from investors’ perspective. A decline in perceived investment

2 It is well known that market movements affect investor behavior. For instance, Docking and Koch (2005)document different market reactions to dividend changes in advancing and declining markets, and Cooper,Gutierrez, and Hameed (2004) and Asem and Tian (2010) find that investor asymmetric behavior in advancing anddeclining markets generates momentum profits in the former markets but not in the latter markets.

3Alternatively, declining (advancing) market can be interpreted as investor pessimism (optimism) about firmprospects, and this alternative interpretation requires defining the market movement over periods longer than amonth (e.g., Cooper, Gutierrez, and Hameed 2004 measure market movements over one to three years to gaugechanges in investor sentiments).

120 The Journal of Financial Research

opportunities should result in discounting the value of the firms with high excess cashmore than those with low excess cash. In contrast, a decline in expected cash flows shouldadversely affect firms with low excess cash more than firms with high excess cash, asexcess cash can cushion the effects of depressed cash flows. Thus, the overall effect of adecline in investor outlook for firm prospects on the value of high‐ versus low‐excess‐cashfirms is ambiguous.

However, one can deduce whether the growth effect or the cash flow effect willdominate at low levels of excess cash versus at high levels of excess cash. A firm that isexperiencing financial distress will likely use its cash reserves to mitigate the financialdifficulties rather than invest in new projects. In fact, Bates, Kahle, and Stulz (2009) andPalazzo (2012) suggest that firms build cash to cushion future shortfalls in cash flow, andOpler et al. (1999) report that negative operating cash flows are the main reason forreductions in excess cash. Accordingly, if investors expect deterioration in firm prospects,they should expect that firms would use cash reserves to mitigate the effects of poor cashflows ahead of funding new projects. This suggests that at low levels of excess cash, thepositive effect of mitigating financial distress should dominate and result in a positiverelation between stock return and excess cash. As excess cash increases beyond the levelthat investors deem is sufficient to mitigate the effects of the expected decline in cash flow,the negative effect of the perceived decline in investment opportunities should becomedominant, suggesting a negative relation between stock return and excess cash at highlevels of excess cash.4 This predicts an inverted U‐shaped relation between stock returnand excess cash when investors’ outlook for firm prospects declines.

An advancing market reflects an improvement in investors’ outlook for firms’cash flows or investment opportunities. An increase in expected cash flow reduces theusefulness of excess cash as a cushion for poor cash flows, whereas a higher expectedinvestment increases the usefulness of cash reserves as a source for financing growth.Thus, like in declining markets, the relation between stock return and excess cash isunclear in advancing markets. However, at a low level of excess cash it is likely that thegrowth effect will dominate because, in general, firms will use cash reserves to financegrowth more often than the more expensive outside funds (e.g., Myers and Majlaf 1984),suggesting a positive relation between return and excess cash at low levels of excess cash.As cash reserve increases beyond the level deemed necessary given the improvement ininvestor outlook, the negative cash effect should become dominant and stock return andexcess cash should display a negative relation. This also points to an inverted U‐shapedrelation between stock return and excess cash when investor outlook for firm prospectimproves.

Despite the agency costs of excess cash, firms do hoard cash and the literatureoffers various explanations for this phenomenon. Harford, Mansi, and Maxwell (2008)suggest that self‐interestedmanagers hoard cash to increase their acquisition activities andcompensations, suggesting managerial interest drives cash reserves. Others suggest thatexcess cash serves shareholders’ interest. Possible reasons for this include: (1) cash

4Opler et al. (1999) and Denis and Young (2008) report that firms with excess cash actually overinvest whenfaced with limited investment opportunities. Given this, investors will expect excess‐cash firms to overinvest if theyexpect a decline in investment and growth opportunities, as in declining markets.

Cash Hoards and Changes in Investors’ Outlook 121

reserve is a proxy for a firm’s growth option (e.g., Simutin 2010), (2) firms with excesscash invest more and generate higher profits (e.g., Mikkelson and Partch 2003), and (3)excess cash cushions shortfalls in future cash flows (e.g., Bates, Kahle, and Stulz 2009;Palazzo 2012). We study stock returns of firms with different levels of excess cash inperiods when investors’ outlook for cash flows or investment opportunity changes to testwhether investors sanction the practice of hoarding cash to cushion cash flow shocks or tofinance growth. Also, we analyze the effects of growth opportunity, governance, andinformation asymmetry on the return–excess cash relation. Our results shed new light oninvestors’ preference for cash hoards.

We proceed by sorting our sample firms into deciles each year based on excesscash and analyzing the returns of these firms in the subsequent years. The market in thefollowing year is classified as declining if the abnormal market return is negative(aggregate investors’ outlook for firm prospects declines) and as advancing if it is positive(aggregate investors’ outlook for firm prospects increases). Consistent with ourdiscussions, stock return displays an inverted U‐shaped pattern over the excess cashdeciles in declining markets. The direct relation between return and excess cash at lowlevels of excess cash suggests that the positive cash flow effect (mitigating the effects ofdeclines in cash flows) dominates the negative growth effect. The positive relation at lowlevels of excess cash indicates that investors actually condone, at least up to some point,the findings of Bates, Kahle, and Stulz (2009) and Palazzo (2012) that firms hold reservesto cushion possible shortfalls in cash flow. At high levels of excess cash, the negativegrowth effect dominates, and stock return decreases with excess cash. This relation isstronger for firms with growth opportunities or poor governance or high informationasymmetry. These findings suggest that declines in growth opportunity hurt growth firmsmore, and poor governance and high information asymmetry exacerbates the negativeconsequences of excess cash.

In advancing markets, stock return is positively related to excess cash but thisrelation weakens as excess cash increases. In particular, we find that return is negativelyrelated to excess cash at high levels of excess cash for firms with poor governance or highinformation asymmetry. This suggests that the negative effects of excess cash outweigh thepositive effects at high levels of excess cash for these firms. That is, weak governance orhigh information asymmetry exacerbates the negative effects of excess cash in advancingmarkets, as well. These results suggest investors’ preference for cash hoards is limited.

II. Data

Data are extracted for all nonfinancial and non‐real‐estate stocks that have sufficient datato obtain all the variables required to compute excess cash from Compustat files and havereturns in the next year in the Center for Research in Security Prices (CRSP) database. Wewinsorize the stock returns at the 0.5% and 99.5% levels to minimize the effects ofoutliers. Our sample covers January 1971 through December 2010, but because our returnanalysis does not cover the initial year we are left with 13 years of market declines and26 years of market advances. Our sample consists of 23,527 firm years across 8,708 firmsin declining markets and 49,683 firm years across 10,633 firms in advancing markets.


Table 1 provides summary statistics for the sample firms. The results show thatthe average return for our sample firms is negative in declining markets (e.g., the mean is–9.26%) and positive in advancing markets (e.g., the mean is 28.73%). Also, as expected,the average year‐end price level is higher when the markets are advancing than when theyare declining. This shows that our definition for declining (advancing) marketsappropriately captures years when investor expectations about firm growth prospectsdecline (increase). Thus, studying changes in value of the firms across different levels ofexcess cash in these markets should shed light on the changes in investors’ aversion toexcess cash when their expectations about firm prospects change. The standard deviationsof the stock returns and of the stock prices show that returns and prices are more volatile inadvancing markets than in declining markets, contrary to what one might expect.

Volume is more volatile in declining markets than in advancing markets. Theaverage earnings before interest, taxes, and depreciation scaled by the book value of totalassets are similar in declining and advancingmarkets. Although this might be surprising, adecline (increase) in investor expectations about firm prospects does not necessarily implypoor (strong) contemporaneous earnings performance.5 Also, we see that cash holdings

TABLE 1. Summary Statistics.

Variable Mean Median Std. Dev.

Panel A. Declining Markets

Return �9.26 �15.54 51.87Price 12.92 6.65 32.02Volume 139.12m 8.04m 749.13mEarnings/asset 10.59% 12.64% 17.26%Cash/asset 20.94% 14.89% 16.89%

Panel B. Advancing Markets

Return 28.73 16.83 66.11Price 15.81 8.63 41.68Volume 126.64m 8.99m 726.10mEarnings/asset 10.93% 12.78% 16.94%Cash/asset 20.82% 14.97% 16.64%

Note: This table presents summary statistics for stocks that have sufficient data to compute equation (1) fromCompustat and returns information for the following year in the CRSP database. The sample covers 1971 through2010. The market in a year is defined as declining (advancing) if the return on the S&P 500 index minus the one‐yearTreasury bond is negative (non‐negative). The market declines in 13 years and advances in 27 years over our sampleperiod. Our sample consists of 23,527 firm‐years across 8,708 firms in declining markets and 49,683 firm‐yearsacross 10,633 firms in advancing markets. Volumes are adjusted for splits. Earnings are earnings before interest,taxes, and depreciation. Assets are the total book value of the firms’ assets, and cash is cash plus cash equivalents(CHE in Compustat).

5Even if returns reflect adjustments in firm value in response to contemporaneous unexpected earningschanges, the contemporaneous relation between returns and earnings may not be direct. In particular, actual earningsmay increase (decrease) but if they are lower than the expected increase (decrease), returns will drop (increase).


per dollar book value of asset in advancing and decliningmarkets are similar. Thus, it doesnot appear that cash holding is sensitive to market movement.

III. Variable Definitions and Research Design

Measuring excess cash is tricky, and the literature offers several proxies, including cashplus marketable securities and undistributed post‐tax cash flows, but these proxies do notaccount for the cross‐sectional differences in investment and other operationalrequirements. Following others (e.g., Harford, Mansi, and Maxwell 2008), we estimateexcess cash using the Opler et al. (1999) model that explicitly addresses these issues.Thus, we estimate excess cash for firm i in each year as the residual the cross‐sectionalregression of equation (1):

CASHi ¼ a0 þ a1CFi þ a2LEVERAGEi þ a3MTBi þ a4SIZEi þ a5NWCi

þ a6CAPEX i þ a7DIV i þ a8R&Di þ a9REGi þ a10INDSIGi þ ei; ð1Þ

where CASH is the natural log of the ratio of cash and marketable securities to net assets(assets minus cash);CF is the ratio of cash flow (EBITDA – Taxes –Dividends – Interest)to net assets; LEVERAGE is total debt scaled by net assets; MTB is the market‐to‐bookratio;6 SIZE is the natural log of assets in 1994 dollars; NWC is the ratio of net workingcapital (net of cash) to net assets; CAPEX is the capital expenditure divided by net assets;DIV is a dummy variable set to 1 if a firms pays dividends, and 0 otherwise; R&D is theratio of research and development expenditure to sales; REG is a dummy variable set to 1if the firm is in a regulated industry, and 0 otherwise; and INDSIG is the mean of thestandard deviations of cash flows scaled by assets over 20 years for firms in the sameindustry as defined by the two‐digit Standard Industrial Classification (SIC) code. Thus,positive residuals from the cross‐sectional regression of equation (1) are the cash holdingsbeyond what the firms require for their normal operations and investments (excess cash).

Each year we sort the firms with excess cash into deciles by their excess cashholdings and study the returns of these decile portfolios in the following years.7 Thus,investors are aware of the firms’ excess cash at the end of each year, andwe study how theyvalue these firms in the subsequent years when their expectations about firm prospectsimprove or deteriorate. In general, declining (advancing) markets capture declines(increases) in investor expectation about firm prospects. We classify the market asdeclining (advancing) in a year if the return on the S&P 500 index in that year minus the

6We are interested in examining the effects of changes in investors’ outlook for growth on value of firms withexcess cash; thus, our excess cash computation includes market‐to‐book ratio, which adjusts for cash requirementsfor normal growth. Accordingly, our excess cash is cash in excess of both operational and growth needs, and weinvestigate how investors value firmswith different levels of this excess cashwhen their outlook for growth changes.Nonetheless, we also exclude the market‐to‐book ratio from the equation and the results, which are not tabulated forbrevity, are similar to the reported results.

7Although the choice of 10 excess cash groups is arbitrary, using fewer groups (e.g., 3 or 5) or more groups(e.g., 20) delivers similar results.


one‐year Treasury bond is negative (positive). Accordingly, we study the relation betweenthe average stock return and excess cash in these markets to ascertain whether investorsprefer firms with excess cash when their expectation about firm prospect changes.

Table 2 provides the means of selected characteristics of the firms by excess cashdeciles during declining markets (Panel A) and advancing markets (Panel B). Asexpected, firms with high excess cash hold high cash relative to their net assets. Market‐to‐book ratio tends to increase with excess cash, indicating growth firms tend to holdmoreexcess cash than nongrowth firms. Research and development does not display asystematic relation with excess cash, and leverage declines with excess cash. Dividend

TABLE 2. Firm Characteristics by Excess Cash Deciles.

Excess Cash CASH CF SIZE MTB R&D LEVERAGE DIV NWC

Panel A. Declining Markets

Low 0.090 0.034 5.033 1.861 0.037 0.888 0.007 0.2082 0.103 0.037 5.019 1.799 0.036 0.714 0.009 0.2243 0.129 0.027 4.944 1.968 0.039 0.745 0.015 0.2434 0.142 0.038 5.061 1.861 0.038 0.855 0.014 0.2505 0.175 0.035 4.884 2.021 0.042 0.659 0.013 0.2686 0.202 0.042 4.904 2.048 0.041 0.524 0.016 0.2957 0.233 0.054 4.856 2.100 0.038 0.698 0.015 0.3078 0.283 0.033 4.740 2.018 0.041 0.499 0.018 0.3469 0.357 0.011 4.544 2.144 0.044 0.501 0.023 0.389High 0.509 �0.093 4.123 2.224 0.041 0.342 0.024 0.47310–1 0.419

(0.00)�0.127(0.00)

�0.910(0.00)

0.363(0.00)

0.004(0.85)

�0.546(0.00)

0.017(0.00)

0.265(0.00)

Panel B. Advancing Markets

Low 0.086 0.041 4.859 1.672 0.033 0.906 0.008 0.2232 0.097 0.042 4.941 1.661 0.033 0.809 0.012 0.2343 0.118 0.041 4.863 1.702 0.035 0.836 0.015 0.2444 0.140 0.048 4.825 1.778 0.037 0.683 0.014 0.2685 0.165 0.047 4.818 1.788 0.038 0.563 0.017 0.2776 0.194 0.054 4.789 1.806 0.039 0.558 0.014 0.2937 0.228 0.054 4.738 1.885 0.038 0.530 0.018 0.3188 0.278 0.004 4.564 1.898 0.038 0.529 0.017 0.3549 0.345 0.054 4.477 1.900 0.039 0.523 0.022 0.394High 0.503 �0.087 4.014 1.992 0.038 0.248 0.024 0.47610–1 0.417

(0.00)�0.128(0.00)

�0.845(0.00)

0.320(0.00)

0.005(0.79)

�0.658(0.00)

0.016(0.00)

0.253(0.00)

Note: The table reports an unconditional comparison of the means of selected characteristics of our sample firms bytheir excess cash holding as estimated by equation (1).CASH is the ratio of cash and it equivalents to net asset;CF isthe ratio of cash flow to net assets; SIZE is the natural log of assets;MTB is the market‐to‐book ratio; R&D is the ratioof research and development expenditure to sales; LEVERAGE is total debt scaled by net assets; DIV is a dummyvariable set to 1 if a firms pays dividends, and 0 otherwise; NWC is the ratio of net working capital to net assets. Thesample covers 1971 through 2010.


payment and net working capital are directly related to excess cash. These results aregenerally consistent with those in previous studies.More important, it does not appear thatthe patterns in the characteristics are different during declining markets compared toadvancing markets. Thus, comparison of the relation between returns and excess cashduring declining versus advancingmarkets may not be due to differences in the patterns ofthe firm characteristics.

Table 3 presents the mean of the time series of parameter estimates from thecross‐sectional regression of equation (1), along with the means of their t‐values, in theyears preceding declining markets (Panel A) and the years preceding advancing markets(Panel B). The estimates are generally in line with estimates from prior research (e.g.,Opler et al. 1999). Overall, the coefficient estimates from the two panels are notsignificantly different, suggesting the relations between returns and excess cash indeclining and advancing markets should not be influenced by the parameter estimates ofequation (1).

Turning to returns, we examine the raw, size‐adjusted, and Carhart (1997) four‐factor adjusted returns. Size‐adjusted return is computed as the raw return minus thematched value‐weighted NYSE/AMEX/NASDAQ market capitalization decile return.The four‐factor adjusted returns are estimated as follows:

radjt ¼ rt � b1 � RMRFt � b2 � SMLt � b3 � HMLt � b4 �MOMt; ð2Þ

TABLE 3. Model of Expected Firm Cash Holdings.

Variables

Years Preceding Declining Markets Years Preceding Advancing Markets

Mean Coefficient Mean t‐values Mean Coefficient Mean t‐values

Intercept –1.994 –22.64 –1.943 –22.64CF 0.537 4.68 0.498 4.68LEVERAGE –1.286 –13.03 –1.342 –13.03MTB 0.104 5.27 0.145 5.27SIZE –0.102 –7.31 –0.106 –7.31NWC –0.658 –8.95 –0.646 –8.95CAPEX 0.824 3.11 0.903 3.11R&D 3.895 9.19 3.979 9.19DIV –0.181 –2.35 –0.130 –2.35REG –0.125 –2.13 –0.119 –2.13INDSIG 0.342 2.54 0.349 2.54Adj. R2 0.216 0.196

Note: The table reports the average of the time series of the cross‐sectional estimates of equation (1). The dependentvariable is the natural log of the ratio of cash andmarketable securities to net assets;CF is the ratio of cash flow to netassets; LEVERAGE is total debt scaled by net assets; MTB is the market‐to‐book ratio; SIZE is the natural log ofassets in 1994 dollars;NWC is the ratio of net working capital to net assets;CAPEX is the capital expenditure dividedby net assets;R&D is the ratio of research and development expenditure to sales;DIV is a dummy variable set to 1 if afirm pays dividends, and 0 otherwise; REG is a dummy variable set to 1 if the firm is in a regulated industry, and 0otherwise; and INDSIG is themean of the standard deviations of cash flows scaled by assets over 20 years for firms inthe same industry as defined by the two‐digit Standard Industrial Classification code. Each year, we estimateequation (1) for firms with available data in Compustat and report the means of the cross‐sectional coefficientestimates, their corresponding t‐values, and adjusted R2 values from 1971 through 2010.


where rt is the raw return on a stock in year t, RMRFt is the excess of the value‐weightedmarket return over the annualized one‐month T‐bill rate, SMLt is the small‐minus‐big riskpremium, HMLt is the high book‐to‐market minus the low book‐to‐market risk premium,MOMt is the winner‐minus‐loser momentum risk premium, and bi (i¼ 1, 2, 3, 4) is theestimated loading from a time series regression of the equally weighted raw return of anexcess cash decile portfolio on the risk premiums and a constant.8

We study the patterns in average return over the excess‐cash‐decile portfolios indeclining and advancing markets. If investors prefer (dislike) excess cash when theiroutlook for firms’ prospects is declining, we should see a systematic increase (decrease) inthe average returns over the excess cash deciles in declining markets. Similarly, ifinvestors prefer (dislike) excess cash when they expect firms’ prospects to improve, weshould see a systematic increase (decrease) in the average return over the excess cashdeciles in advancing markets.

IV. Evidence on the Relation between Return and Excess Cash

Firm Value and Excess Cash in Declining Markets

This section explores the relation between stock return and excess cash when investoroutlook for firm prospect declines. Panel A (B) of Table 4 presents the equally weighted(value‐weighted) mean returns for our sample firms sorted by their previous year’s excesscash. The results display two key patterns in the relation between stock return and excesscash. First, the returns generally display an inverted U‐shaped pattern across the threealternative measures of return, suggesting firmswith either low or high excess cash tend tolose more value in declining markets compared to those with average excess cash. Forinstance, the mean size‐adjusted returns for the firms in the 1st, 6th, and 10th excess cashdeciles are –0.15%, 3.14%, and –4.18%, respectively. We test the inverted U‐shape bycomparing the average return of the firms in deciles 5 and 6 (Med) against that of those indeciles 1 and 2 (Low) and against that of those in deciles 9 and 10 (High). The results showthat the average return of the firms in deciles 5 and 6 is larger than that of those in deciles 1and 2 as well as that of those in deciles 9 and 10 across all the average returns (p‐values ofthe differences are all less than .01). Thus, firm value increases with excess cash at lowlevels of excess cash but decreases with excess cash at high levels of cash.

Second, the results show that firms with the largest excess cash lose more valuethan those with the lowest excess cash in declining markets. In particular, the averagereturns for the firms in the largest excess cash decile are significantly lower than those forthe firms in the lowest excess cash decile. This suggests that investors penalized firms forholding extreme amounts of excess cash (in the top decile) when they expect a decline infirm prospects. Figure I illustrates these patterns for the four‐factor equally weightedmeanreturns.

8See Fama and French (1993) and Carhart (1997) for full descriptions of the risk premiums. The time series ofthese risk premiums are obtained from Kenneth French’s website at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Estimating the capital asset pricing model by solely using the RMRF factor orestimating the Fama–French three‐factor model delivers similar results.


http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

TABLE 4. Average Stock Return and Excess Cash in Declining Markets.

Excess CashDeciles

Panel A. Equally Weighted Returns Panel B. Value‐Weighted Returns

RawReturns

Size‐AdjustedReturns

Four‐FactorReturns

RawReturns



Lowest �9.11 0.15 4.86 �8.37 �0.13 6.702 �8.45 0.82 5.43 �7.89 0.62 7.383 �6.58 2.55 8.52 �6.15 2.07 9.924 �6.38 2.68 8.86 �5.74 2.39 11.135 �6.43 2.71 7.59 �6.42 2.14 10.746 �6.07 3.14 8.40 �6.65 2.64 10.827 �9.18 0.37 6.69 �7.54 0.85 9.308 �10.45 �1.15 6.38 �7.92 0.48 8.269 �11.15 �1.26 5.82 �10.86 �2.07 8.09Highest �14.08 �4.18 2.41 �13.60 �5.47 2.9310–1 (.00)�� (.00)�� (.03) (.00)�� (.00)�� (.00)��

Low – Med (.00)�� (.00)�� (.00)�� (.00)�� (.00)�� (.00)��

High – Med (.00)�� (.00)�� (.00)�� (.00)�� (.00)�� (.00)��

Note: The table presents the mean returns for firms with available data in CRSP and Compustat to compute excesscash as defined by equation (1) for the previous year. The sample covers 1971 through 2010. The stocks are sortedindependently by their previous year’s excess cash. The market is down in a year when the return on the S&P 500index in excess of the return on the one‐year Treasury bond is negative. Size‐adjusted return is computed as thestock’s return minus the matched value‐weighted NYSE/AMEX/NASDAQ market capitalization decile portfolioreturn. The four‐factor risk‐adjusted returns are computed as radjt ¼ rt � b1 � RMRFt � b2 � SMLt � b3 �HMLt � b4 �MOMt; where rt is the raw return on a stock in year t, RMRFt is the excess market return over the T‐bill rate, SMLt is the small minus big risk premium,HMLt is the high book‐to‐market minus the low book‐to‐marketrisk premium, MOMt is the winner minus loser momentum risk premium, and b i (i¼ 1, 2, 3, 4) is the estimatedloading for the risk factor. Low consists of stocks in deciles 1 and 2, Med consists of stocks in deciles 5 and 6, andHigh contains stocks in deciles 9 and 10. The p‐values based on t‐tests for differences in means are reported inparentheses.��The Kruskal–Wallis test is significant at the 1% level.

Figure I. Mean Four‐Factor Equally Weighted Returns by Excess Cash Decile.


The inverted U‐shaped relation between return and excess cash suggests that atlow levels of excess cash, investors’ awareness that excess cash can temper the effects ofdeclines in cash flow dominates the negative effects of reduced outlook for profitableprojects, resulting in a positive relation between stock return and excess cash. As excesscash level increases and exceeds the amount that investors deem is necessary to mitigatethe expected declines in cash flow, concern that excess cash will be wasted because of thediminished investment outlook dominates, and stock return decreases with excess cash.This finding is consistent with the ex ante economic reasoning and sheds new light on therelation between excess cash and stock return.

Firm Value and Excess Cash in Advancing Markets

In this section, we investigate the relation between stock return and excess cash wheninvestor outlook for growth prospect improves. Table 5 presents the average returns inadvancing markets for our sample firms sorted by their previous year’s excess cash. Ingeneral, returns tend to increase with excess cash. In particular, tests show that the averagereturn for the firms with the highest excess cash (deciles 9 and 10) is generally higher thanthat of those with the average excess cash (deciles 5 and 6), which in turn is higher thanthat of those low excess cash (deciles 1 and 2)—with the exception of the raw equally

TABLE 5. Average Stock Return and Excess Cash in Advancing Markets

ExcessCashDeciles

Panel A. Equally Weighted Returns Panel B. Value‐Weighted Returns

RawReturns



RawReturns



Lowest 25.48 �1.34 3.66 26.51 0.19 4.992 24.55 �2.43 3.27 26.58 0.61 3.693 28.07 1.23 5.91 29.52 3.41 7.434 27.43 0.69 5.59 29.13 2.87 7.355 26.33 0.79 5.53 28.07 2.05 6.596 27.24 1.57 5.94 28.03 2.07 7.077 27.16 0.94 5.78 28.26 2.40 6.498 28.84 2.53 6.91 29.11 3.31 6.129 28.15 2.14 6.07 30.08 3.96 8.61Highest 28.45 1.89 7.16 29.57 3.17 7.6010–1 (.00)�� (.00)�� (.00)�� (.00)�� (.00)�� (.00)��

Low – Med (.00)�� (.00)�� (.00)�� (.00)�� (.00)�� (.00)��

High – Med (.15) (.00)�� (.00)�� (.00)�� (.00)�� (.00)��

Note: The table presents the mean returns for firms with available data in CRSP and Compustat to compute excesscash as defined by equation (1) for the previous year. The sample covers 1971 through 2010. The stocks are sortedindependently by their previous year’s excess cash. The market is up in a year when the return on the S&P 500 indexin excess of the return on the one‐year Treasury bond is non‐negative. Size‐adjusted return is computed as the stock’sreturn minus the matched value‐weighted NYSE/AMEX/NASDAQ market capitalization decile portfolio return.The four‐factor risk‐adjusted returns are computed as radjt ¼ rt � b1 � RMRFt � b2 � SMLt � b3 � HMLt � b4 �MOMt ;where rt is the raw return on a stock in year t, RMRFt is the excess market return over the T‐bill rate, SMLt isthe small minus big risk premium, HMLt is the high book‐to‐market minus the low book‐to‐market risk premium,MOMt is the winner minus loser momentum risk premium, and b i (i¼ 1, 2, 3, 4) is the estimated loading for the riskfactor. Low consists of stocks in deciles 1 and 2, Med consists of stocks in deciles 5 and 6, and High contains stocksin deciles 9 and 10. The p‐values based on t‐tests for differences in means are reported in parentheses.��The Kruskal–Wallis test is significant at the 1% level.


weighted returns, p‐values of the differences are all less than .01. This finding is consistentwith the monthly results of Simutin (2010) in up markets, and is in line with Myers andMajluf (1984) and others who argue that financial slack is valuable for firms that face costsof external financing and have positive investment opportunities. We find that financialslack is valuable when investors’ outlook for growth opportunity improves (an increase ininvestment opportunities from investors’ perspective).

Regression Analysis

In this section, we analyze the relation between returns and excess cash in a regressionsetup.9 Because return and excess cash display a nonlinear relation, we estimate thefollowing equation:

Retp;t ¼ a1 þ a2ðECp;tÞ þ a3ðECp;tÞ2 þ ep;t; ð3Þ

where Retp,t is the value‐weighted return of excess cash portfolio p in year t, and ECp,t is theportfolio’s mean excess cash in the year (the results from the raw and size‐adjusted returnsare similar). Panel A of Table 6 presents the means of the coefficient estimates from yearlycross‐sectional regressions of Fama andMacBeth (1973) for raw, size‐adjusted, and the four‐factor adjusted returns. For decliningmarkets, the estimates ofa2 are positive and significant,and the estimates of a3 are negative and significant. For instance, for the four‐factor adjustedreturns, the estimate ofa2 is 0.046 (t‐value¼ 3.57) and that ofa3 is –0.022 (t‐value¼ –3.07).These estimates imply that the highest return occurs when excess cash is 1.05 (point ofinflexion).10 The mean excess cash for the fifth excess cash decile is 1.03, suggesting anegative relation between return and excess cash after the fifth decile. This confirms theinverted U‐shaped relation between return and excess cash in declining markets.

In advancing markets, the estimates of a2 are again positive and significant, and theestimates of a3 are negative and significant. For instance, for the four‐factor adjusted returns,the estimate of a2 is 0.047 (p‐value¼ 3.01) and the estimate of a3 is –0.013 (p‐value¼–2.45). These results imply that the highest return occurs when excess cash is 1.81 (point ofinflexion). The mean excess cash for the ninth excess cash decile is 1.79, suggesting anegative relation between return and excess cash after the ninth decile. Thus, we do not see ageneral negative pattern over the excess cash deciles in Table 5. However, the results indicatethat returns increase with excess cash but at a diminishing rate, suggesting the negativeeffects of excess cash become stronger as excess cash increases in advancing markets, too.

Panel B of Table 6 reports the estimates for Retp¼a1þa2(ECp)þa3(ECp)2þ

ep, where Retp is the overall portfolio return, and ECp is the overall mean of the portfolio’sexcess cash. The results are similar to those from the Fama–MacBeth (1973) method andthey confirm the return–excess cash relations reported in Tables 4 (declining markets)and 5 (advancing markets).

9We thank the referee for suggesting the regression, governance, and information asymmetry analyses.10For the four‐factor adjusted returns, Ret¼ 0.073þ 0.046(EC)� 0.022(EC)2. Differentiating this equation

with respect to EC and setting the differential to zero gives EC¼ 1.05.


Growth Opportunities and Excess Cash

Lack of growth opportunities should exacerbate the negative consequences of excesscash.11 In this section, we examine whether growth opportunity affects the relationbetween returns and excess cash by estimating the following equation:

Retp;t ¼ a1 þ a2ðDumÞ þ a3ðECp;tÞ þ a4ðECp;t � DumÞ þ a5ðECp;tÞ2þ a6ðECp;t

2 � DumÞ þ ep;t; ð4Þwhere Dum is a dummy variable set to 1 for firms with growth opportunities, and 0otherwise. We proxy growth opportunity by Tobin’s Q, and categorize firms with Qs

TABLE 6. Regression of Returns on Excess Cash in Declining and Advancing Markets.

Declining Markets Advancing Markets

Raw ReturnsSize‐Adjusted

ReturnsFour‐FactorReturns Raw Returns



Panel A. Results Using the Fama–MacBeth Method

a1 �0.119(�2.51)

�0.010(�0.79)

0.073(4.18)

0.272(6.90)

�0.008(�0.77)

0.061(5.58)

a2 0.028(2.26)

0.025(2.01)

0.046(3.57)

0.045(2.59)

0.057(3.44)

0.047(3.01)

a3 �0.016(�2.72)

�0.012(�2.16)

�0.022(�3.07)

�0.018(�2.70)

�0.015(�3.00)

�0.013(�2.45)

Adj. R2 0.22 0.22 0.22 0.20 0.21 0.09

Panel B. Results Using the Overall Portfolio Mean Excess Cash

a1 �0.084(�7.66)

�0.000(�0.06)

0.072(5.23)

0.271(47.10)

�0.007(�1.22)

0.058(4.39)

a2 0.021(1.71)

0.023(1.85)

0.035(1.98)

0.033(3.24)

0.043(4.04)

0.034(2.46)

a3 �0.020(�2.44)

�0.019(�2.51)

�0.019(�2.31)

�0.011(�3.03)

�0.014(�3.73)

�0.010(�2.22)

Adj. R2 0.63 0.62 0.41 0.48 0.61 0.33

Note: The table presents the estimates of the following equation for firms with available data in CRSP andCompustat to compute returns and excess cash using equation (1): Panel A of the table presents the estimate ofRetp,t¼a1þa2(ECp,t)þa3(ECp,t)

2þ ep,t, and Panel B reports the estimates ofRetp¼a1þa2(ECp)þa3(ECp)2þ ep,

where Retp,t (Retp) is the excess cash decile portfolio’s value‐weighted raw, size‐adjusted, or four‐factor adjustedreturns in year t (average return), and ECp,t (ECp) is the portfolio’s mean excess cash in year t (average excess cash).The sample covers 1971 through 2010. Themarket is down (up) in a year if the return on the S&P 500 index in excessof the return on the one‐year Treasury bond is negative (positive). The t‐statistics are reported in parentheses.

11Although our excess cash computation adjusts for normal growth needs, changes in growth opportunitiesshould affect growth firms and nongrowth firms differently. In particular, if growth opportunity improves, thisshould increase the investment opportunities for growth firms more than for nongrowth firms and, therefore, shouldhave different implication for the excess cash holding of the two groups.


above the median as growth firms and those with Qs below the median as nongrowthfirms. Thus, if the positive (negative) relation between returns and excess cash at low(high) levels of excess cash is different for growth and nongrowth firms, the estimate of a4(a6) should be significantly different from zero.

For brevity, we report the estimate of equation (4) only for three‐factor adjustedreturns in Table 7 (the results from the raw and size‐adjusted returns are similar).12 Theestimate of a4 is 0.001 (t‐value¼ 0.04), suggesting the initial positive relation betweenreturns and excess cash is similar for growth and nongrowth firms. This indicates thatexcess cash is equally useful in mitigating the effects of adverse cash flow in economic

TABLE 7. The Effects of Growth Opportunity on the Return and Excess Cash Relation.

a1 a2 a3 a4 a5 a6

Panel A. Growth versus Nongrowth Firms

Declining markets 0.109(6.15)

�0.101(�4.54)

0.066(2.80)

0.001(0.04)

�0.043(�2.89)

�0.029(�1.71)

Advancing markets 0.085(5.89)

�0.072(�3.95)

0.069(3.04)

�0.016(�0.88)

�0.022(�2.93)

0.016(1.04)

Panel B. Strong and Weak Shareholder Power


0.001(0.09)

0.006(0.79)

0.056(1.99)

�0.009(�1.04)

�0.022(�1.91)


�0.044(�2.11)

�0.001(�0.11)

0.045(2.01)

0.003(0.47)

�0.021(�1.83)

Panel C. High‐ and Low‐Information‐Asymmetry Firms


�0.130(�4.93)

0.042(2.50)

0.013(1.03)

�0.023(�2.48)

�0.018(�1.69)


�0.133(�5.52)

�0.015(�1.08)

0.059(2.65)

0.008(0.97)

�0.024(�2.41)

Note: The table presents the results the following equation:

Retp;t ¼ a1 þ a2ðDumÞ þ a3ðECp;tÞ þ a4ðECp;t � DumÞ þ a5ðECp;tÞ2 þ a6ðECp;t2 � DumÞ þ ep;t;

where Retp,t is the value‐weighted four‐factor adjusted return of excess cash portfolio p in year t, ECp,t is theportfolio’s mean excess cash in the year, andDum is a variable set to 1 for firms with growth opportunity (Panel A),for firms with weak shareholder power (Panel B), and for firms with high information asymmetry (Panel C), and 0otherwise. Each year, we group firms in each excess cash decile into growth and nongrowth firms (Panel A), weakand strong shareholder power (Panel B), and high‐ and low‐information‐asymmetry firms (Panel C). The market isdeclining (advancing) in a year if the return on the S&P 500 index in excess of the one‐year Treasury bond return isnegative (positive). The t‐statistics are reported in parentheses.

12Because we are interested in examining the effects of excess cash on firm value for growth versus nongrowthfirms, it is important that we do not adjust the firms’ returns for growth opportunities, as these returns are proxies forthe changes in growth prospects. As such, we use a three‐factor model (i.e., the four‐factor model without the book‐to‐market risk factor). However, using the four‐factor model does not change our conclusions.


downturns for growth and nongrowth firms. However, the estimate of a6 is negative(–0.029) and significant (t‐value¼ –1.71), suggesting the negative relation betweenreturn and excess cash at high levels of excess cash is stronger for growth firms than fornongrowth firms. Intuitively, the expected decline in growth prospect reduces theusefulness of excess cash as a source of fund for investments more for the growth firms,leading to a stronger negative relation for these firms at high levels of excess cash.

In contrast to declining markets, the estimate of a6 is not statistically differentfrom zero in advancing markets, suggesting the negative consequences of excess cash arenot stronger for growth firms than for nongrowth firms in thesemarkets. This is contrary tothe expectation that improvements in investor outlook should reduce the negative effectsof excess cash more for growth firms than for nongrowth firms. However, growth firmshave high prices relative to their book values (high Tobin’s Q) in the previous year, andtherefore, their prices likely already reflect the expected growth.

Governance and Excess Cash

Firms with strong governance or strong shareholder power should mitigate the negativeconsequences of excess cash more than firms with weak governance, suggesting governanceshould influence the relation between returns and excess cash. We measure shareholderpower by the g‐index (Gompers, Ishii, and Metrick 2003 provide details on the constructionof this index).13 A low g‐index indicates strong shareholder power; as such, we classify firmswith a g‐index lower (higher) than the median index as firms with strong (weak) shareholderpower. Requiring thatfirms have a g‐index (which is available from1990) reduces our sampleto 14,058 firm years in declining markets and 28,773 firm years in advancing markets.

Panel C of Table 7 presents the estimates of equation (4) whereDum is set to 1 forfirms with weak shareholder power, and 0 otherwise. The results show that the relationbetween stock return and excess cash is sensitive to shareholder power. In particular, theestimates of a4 are positive and significant while those of a6 are negative and significant inboth declining and advancing markets. For instance, in declining markets, the estimate ofa4 is 0.056 (t‐value¼ 1.99) and that of a6 is –0.022 (t‐value¼ –1.91). This indicates thatweak shareholder power strengths the positive relation at low excess cash and the negativerelation at high excess cash in both markets. That is, excess cash is more beneficial forfirms with weak shareholder power at low levels of excess cash but more damaging forthese firms at high levels. Thus, weak shareholder power exacerbates excess cashproblems at high levels of excess cash.14

Information Asymmetry and Excess Cash

In this section, we investigate whether information asymmetry exacerbates the negativeconsequences of excess cash. We proxy information asymmetry by the relative bid–ask

13We thank Andrew Metrick for providing the g‐index, available at http://faculty.som.yale/andrewmetrick/data.html.

14The point of inflexion for firms with weak shareholder power in advancing market is (0.044/0.036)¼ 1.22,which occurs for the firms in the seventh decile, suggesting a negative relation between return and excess cash forfirms with higher excess cash.


http://faculty.som.yale/andrewmetrick/data.html

http://faculty.som.yale/andrewmetrick/data.html

spread, computed as (ask – bid)/[(askþ bid)/2] (scaling the spread by the closing pricedoes not qualitatively change our results). We use daily closing bid and ask data fromCRSP to compute the yearly average relative spread for each stock, and we classify a firmas a low‐ (high‐) information‐asymmetry firm if its relative spread is lower (higher) thanthe year’s median spread.

Panel C of Table 7 reports the estimates of equation (4) where Dum is set to 1 forfirms with high information asymmetry, and 0 otherwise. From the table, the estimates ofa2 are negative and significant in both declining and advancing markets (e.g., the estimateis –0.130 (t‐value¼ –4.93) in declining markets). Thus, firms with high informationasymmetry earn lower returns than firms with low information asymmetry in bothdeclining and advancing markets, suggesting that investors require higher returns forstocks with high information asymmetry. The results also show an inverted U‐shapedrelation between returns and excess cash for firms with high and those with lowinformation asymmetry in declining markets. In contrast, in advancing markets, therelation is flat for firmswith low information asymmetry (i.e., the estimates of a3 and of a5are not significantly different from zero). Thus, the U‐shaped relation is only relevant forfirms with high information asymmetry in advancing markets (i.e., the estimate of a3þa4is positive and significant (0.044¼ –0.015þ 0.059; t‐value¼ 2.21) and the estimate ofa5þa6 is negative and significant (0.008� 0.024¼ –0.016; t‐value¼ l.99)). In addition,the negative consequences of excess cash are stronger for the firms with high informationasymmetry in both markets (the estimate of a6 is negative and significant in each market).

In summary, we document an inverted U‐shaped relation between stock return andexcess cash in declining markets. The positive relation at low levels of excess cash reflectinvestors’ consideration that excess cash mitigates the effects of financial distressassociated with negative cash flow shocks. The negative relation at high levels of excesscash captures the increased likelihood that excess cash will be wasted. As expected, lack ofgrowth opportunity, weak shareholder power, and high information asymmetry exacerbatethe negative effects of excess cash. In advancing markets, we also find an invertedU‐shaped relation but the point of inflexion occurs at the ninth excess cash decile, and hence,there is a positive relation over most of the excess cash range. Furthermore, the relation is flatfor firms with strong governance and firms with low information asymmetry.15

V. Robustness

Excess Cash Measure and Sample Selection

This section examines whether the information required to estimate equation (1) results inignoring a large number of observations that might affect our results. In addition, it is

15 It is possible that the patterns in return and excess cash in declining and advancingmarkets reflect the patternsin profitability, as returns also capture current profits. Consequently, we compute the mean return on assets (ROA)and the industry‐adjusted counterparts for firms in each excess cash decile in declining and advancing markets. Thepatterns show that ROA increases with excess cash and then declines at high levels of excess cash in each market.However, the changes are not statistically significant (in particular, unlike the return tests, tests that ROA for firms inthe fifth and sixth deciles are equal to ROA for firms in the extreme deciles are not rejected). Thus, the return patterncannot be explained by current profits.


possible that investors use less sophisticated measures for excess cash than equation (1)suggests. To address these concerns, we define firms with excess cash in each yearas those whose cash ratios (the ratio of cash and its equivalents to net assets) exceedthe median cash ratio in that year.16 We then sort the excess‐cash firms into deciles eachyear based on their cash ratios and analyze the returns of these decile portfolios in thefollowing year. The results, which are not reported for brevity, are generally in linewith our earlier results, suggesting our conclusions are not driven by the definition ofexcess cash.

Contemporaneous Excess Cash and Returns

Our tests are based on excess cash computed from the previous years. Thus, it is possible ourexcess cash information is stale, as investors can receive information on a firm’s cashposition each quarter. To ensure that our results are not unduly influenced by stale excesscash information, we reestimate equation (3) using the current year’s excess cash, and theresults, which are not tabulated for brevity, are consistent with our conclusions.

Accruals and the Relation between Stock Return and Excess Cash

Ou and Penman (1989) report that accruals are linked to a firm’s performance and its stockreturn.17 To ensure that our results are not driven by these relations, we estimate thefollowing cross‐sectional regression each year;

ri ¼ a0 þ a1CATi þ a2CSALEi þ a3CCAPEXi þ a4CPROFi þ a5ROEi þ a6ROAi

þ a7DEi þ a8CASHFi þ a9DIVi;þei; ð5Þ

whereCATi is the change in total assets for firm i,CSALEi is the change in sales,CCAPEXi

is the change in capital expenditure, CPROFi is the change in net income, ROEi isnet income dividend by the beginning book value of equity, ROAi is net incomedivided by the beginning total assets, DEi is the debt‐to‐equity ratio, CASHFi is cashflow, DIVi is dividend scaled by net income, and ei is the error.18 To adjust for theseeffects, we compute ex ri ¼ a0 þ ei; where a0 and ei are the estimates of a0 and ei fromequation (5) for each firm each year. After computing these accrual‐adjusted returns,we also adjusted for the four factors by replacing rt in equation (2) with ex_ri andreestimating the model. The results, which are not tabulated for brevity, are similar to ourearlier results, suggesting our conclusions are not driven by effects of accruals on stockreturns.

16This increases the number of firm‐years to 28,178 across 10,234 firms in declining markets, and to 56,283across 12,495 firms in advancing markets.

17Ou and Penman (1989) identify 28 accrual variables that influence performance.We remove the insignificantvariables to obtain a more parsimonious regression.

18We compute changes in the variables as (Vt�Vt�1)/Vt�1, where Vt is the value of the relevant variable at theend of the year t. Cash flow (CASHF) is computed as (EBITDA – Taxes)/Sales.


Market Movement Measure

In this section, we check that our results are robust to alternative definitions for marketmovements. In particular, we define the market as declining (advancing) in a particularyear if the return on the CRSP value‐weighted index minus the returns on the one‐yearTreasury bond is negative (positive). This results in 12 declining markets and 27advancing markets. The results, which are not tabulated for brevity, show that ourconclusions are not influenced by our market definition.

VI. Conclusion

Despite the well‐established link between accumulating excess cash and destroying firmvalue, firms continue to hoard cash. Prior research suggests firms hoard cash to mitigatefuture cash flow problems or finance future growth. We analyze whether investorssanction this practice by investigating the relation between return and excess cash indeclining markets (when investors expect declines in future cash flow) and in advancingmarkets (when investors expect increases in future cash flow). Accordingly, we sort oursample firms into excess cash deciles and study the returns of these decile portfolios whenthe market advances and when it declines.

In declining markets, we find that stock return displays an inverted U‐shapedrelation with excess cash. In addition, firms with the highest excess cash underperformthose with the lowest excess cash. The U‐shaped relation suggests that at low levels ofexcess cash, the potential that excess cash will mitigate the effects of reduced cash flowsduring difficult economic times outweighs the concerns that excess cash will be wasted onunprofitable projects, resulting in a positive relation between return and excess cash. Asexcess cash increases beyond the levels that investors deem are necessary given theexpected decline in cash flows, concerns that excess cash will be wasted dominate, andreturn and excess cash display an inverse relation. This negative relation is stronger forfirms with growth opportunities or poor governance or high information asymmetry.

In the advancing market, we again find an inverted U‐shaped relation betweenreturn and excess cash, but the positive relation dominates up to the ninth excess cashdecile. Themore dominant positive relation supports the notion that excess cash is a cheapsource of funds for growth, and firms with excess cash generate stronger returns wheninvestors expect improvements in growth opportunity. The negative relation at high levelsof excess cash concentrates among firms with poor governance or high informationasymmetry. This indicates that poor governance and high information asymmetryexacerbate the negative effects of excess cash in advancing markets, too. Overall, thefindings suggest that investor preference for cash hoards is not ubiquitous.

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cash hoards and changes in investors' outlook

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