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.
Debt is typically not suitable for R&D funding, especially for firms with volatile cash flow so this firm issues a good deal of shares to meet its financing needs. The firm realizes that there are good times – such as when the economy is booming — and bad times – such as recessions and financial crises — to issue shares. The firm also realizes that it’s hard if not impossible to predict when the bad times will come and how long they will last. The firm does not want to cut its R&D spending in the bad times, as this could cause it to fall behind its competitors. Therefore, the firm issues shares when times are good so it has cash on hand when times are bad.
Can this example explain the increase in share issuance-cash savings that I document? My study suggests that it can. Over the last 38 years, the cash flows of publicly-traded companies have become more volatile. Some economists attribute this to increased competition while others attribute it to firms becoming public at younger ages. In either case, an increase in cash flow volatility is a good reason to increase cash savings.
R&D spending among publicly-traded companies also increased over the last 38 years. My study shows that share issuance-cash savings are greater for firms with high R&D spending and high cash flow volatility. Moreover, these effects vary with the business cycle. A larger portion of share issuance proceeds are saved as cash in economic expansions, and these effects are greatest for firms with high R&D spending and high cash flow volatility.
Greater R&D spending and cash flow volatility are good reasons to increase cash savings. But why not just save from profits? Why issue shares? It turns out that during the last 38 years, profits of public firms have on average declined, which is causing the average publicly-traded firm to be more dependent on issuing equity in order to finance its investments.
In a subsequent study that covers 44 different countries during the period 1988-2010, a co-author and I found similar share issuance-cash saving behaviors in countries with developed economies and financial markets.
While it might appear suspicious to hold large amounts of cash, many companies have legitimate business reasons to do so. A large body of empirical evidence suggests that precautionary cash savings are important. Academic research suggests cash savings help firms compete in competitive product markets, and sustain investment and R&D spending in recessions and periods of financial turmoil.
R. David McLean is a visiting professor at MIT Sloan from the University of Alberta. He’s the author of “Share Issuance and Cash Savings,” which was published in the March, 2011 issue of the Journal of Financial Economics.
Read more: New York Times Dealbook
Share your thoughts