Coporate Finance 2

Mid-term test
03_NguyenHoangAnh_11190255
Question 1 (5 marks):
First of all I want to mention about what is the Capital structure. capital structure
is a financial concept that indicates a company's borrowing capital to equity ratio.
Establishing a fair capital structure will assist businesses in lowering their average
cost of capital (WACC) and increasing the value of their assets to shareholders.
Furthermore, a proper capital structure has an impact on the profitability and
business risks that businesses may face. It's challenging to come up with a decent
capital structure for a corporation because there are so many variables to consider.
The author analyzes some basic elements impacting capital structure of firms
within the scope of the article, based on a general impression of capital structure,
in order to assist businesses in determining the most appropriate capital structure
and achieving the best efficiency.
The more the company's scale develops, the more complicated the administration
and operation of the organization gets, according to the increasingly modern
development trend as well as the variety of company types. This is a dilemma for
business owners because they will be unable to successfully manage their
company. The emergence of hypotheses regarding the connection between owners
and agents is based on this (hired company managers - managers). Economic
theory, created by Alchian and Demsetz in 1972 and further expanded by Jensen
and Meckling in 1976, is the foundation of agency theory. Since then, this has
become standard practice when researching agency cost issues. The impact of
agency costs on a firm's capital structure, which will be examined in this article, is
an essential problem highlighted in this theory.
An agency relationship is a contract in which one or more individuals (the
principal(s)) hire another individual (the agent) to perform some service on their
behalf, which includes delegating some decision-making authority to the agent.
The agency costs were defined as the sum of the principal's monitoring expenses,
the agent's bonding expenses, and the residual loss (Jensen and Mecking, 1976).
The costs of a conflict of interest between stockholders and management are
referred to as agency costs. These expenses can be either indirect or direct. An
indirect agency cost represents a missed opportunity. There are two types of direct
agency costs. The first type of corporate expenditure is one that benefits
management but costs stockholders. Perhaps the purchase of a luxurious and
unnecessary corporate jet falls under this category. The second type of direct
agency cost is a cost incurred as a result of the need to monitor management
actions (Stephen A. Ross, Randolph W. Westerfield and Bradford D. Jordan). The
content of these two definitions is very similar, but the arrangement and
classification are not. As a result, we will use both definitions to assess the impact
on a firm's capital structure. Dare and Sola (2010) define capital structure as the
debt-equity mix of business finance. It's a symbol for the proportionate relationship
between debt and equity in a company's financial statements. As a result, in this
context, capital structure refers to the mix of equity and debt in a company's
capital. This is consistent with Chou's (2007) characterization of a company's debt
and equity funding. An optimal capital structure is a company's ideal debt/equity
ratio, which reduces financing costs while increasing the firm's value.
First and foremost, the agency cost theory asserts that an optimal capital structure
can be achieved by lowering the expenses incurred as a result of conflicts between
managers and owners. The leverage level, according to Jensen and Meckling, can
be used to monitor managers' efforts to pursue the overall firm's goals rather than
their own. As a result, costs are lowered, resulting in increased efficiency, which
will ultimately improve firm performance (Buferna et al., 2005). Take a look at the
illustration below.
The expansion path would also be represented by OZBC if the management got
outside money and the agency connection had no expenses (possibly because
monitoring costs were zero). As a result, this approach represents what we would
call "idealized" solutions, or those that would arise if agency costs were not there.
Assume the management has enough personal money to fully fund the company
only up to investment level I1, putting him at point Z. W = I1 at this point. To
expand the firm beyond this point, he will need to get outside finance to cover the
additional investment, which will necessitate a reduction in his fractional
ownership. He incurs agency costs as a result of this, and the lower his ownership
share, the higher the agency costs. However, if the projects that require outside
finance are profitable enough, his net worth will continue to rise.
This makes sense because high agency costs indicate that the owner-agency
manager's conflict with outside shareholders, which stems from the manager's
proclivity to steal perquisites from the firm's resources for his own consumption, is
raging. Indeed, the most substantial dispute is likely to stem from the fact that as
the manager's ownership claim diminishes, so does his desire to commit major
effort to innovative activities like finding new profitable projects. He may avoid
such enterprises since managing or learning about new technology needs too much
work or effort on his behalf. Avoidance of these personal costs and the anxieties
that go with them also represent a source of on-the-job utility to him and it can
result in the value of the firm is substantially lower than it otherwise could be.
I will look at the model of Hayne E. Leland (1998) as a second example to show
how agency costs affect firm value. Agency costs are the percentage difference in
firm value between optimal ex-ante asset choice, where the firm cannot transfer
value from creditors to shareholders through asset substitution, and ex-post asset
choice, where creditors face costs from asset substitution. Even when a firm's risk
policy can be committed ex-ante to maximize firm value, the firm increases risk
when asset value is low; when the risk choice is made after assets are in place, the
firm has significantly higher average risk, illustrating the asset substitution
problem. The existence of bankruptcy and reorganization expenses, which helps to
explain why debt does not entirely dominate capital structures. The costs of the
agency are quite low, at around 1.37 percent - less than a sixth of the tax benefits
associated with debt. Creditors, on the other hand, are concerned about the
possibility of asset substitution. With no agency charges, the yield spread is 69
basis points (bps); with agency fees, the yield spread rises to 108 bps. In
comparison to an otherwise equivalent firm (one that can precontract risk levels
before debt is granted, avoiding asset substitution risk for the creditor), the firm
with agency expenses has lower optimal leverage and a shorter loan maturity.
When the risk policy of the company is established once the loan is in place, the
company will switch to a high-risk level with a considerably higher asset value.
Contrary to popular belief, asset substitution occurs even when agency costs are
absent, but to a smaller extent than when they are present.
v VS VU EM max EM min VB LR YS AC
(yrs) (yrs) (% (bp (%
) ) )
Base Case: Ex Ante 108. 44. 20 5.65 5.53 33. 49. 69 -
6 7 1 6 4
Base Case: Ex Post 107. 79. 18 5.26 5.14 29. 45. 108 1.3
2 1 7 9 8 7
107. - 19 5.52 5.52 32. 42. 48 -
4 6 4 7

The third section discusses the impact of agency costs on debt. The enterprise's
financial situation will have a direct impact on its capital structure. In the event of
a lack of capital and the desire to increase working capital, the enterprise must
decide which source to supplement, if the enterprise chooses to use The capital
structure of the business will be in favor of using debt, but if the business has
accumulated capital to provide for business activities, the enterprise will use
additional capital without borrowing capital. Thus, whether or not to borrow will
be determined by the business's financial capacity. Whether or not to employ debt
is decided by the manager's point of view. In reality, some managers are eager to
take on debt in order to boost profitability, while others are wary. As a result, the
manager's perspective is critical in producing a profit. Make this choice. The entire
wealth consequences of the agency costs of debt are borne by the owner-manager,
and he captures the advantages from decreasing them. In the absence of other
mitigating variables, the agency costs associated with debt discourage the use of
corporate debt. What about the factors that make it more likely to be used? One
factor is the interest payment tax credit. Even if these tax benefits were not
available, debt would be used if the owner's capacity to exploit potentially
profitable investment possibilities was limited by his or her resources. From a
sociological standpoint, this method is ideal.
 The final impact of agency costs that I need to specify is the impact on the sum of
cash the company holds, which comes from traditionalist administration. A risk –
averse executive will attempt to store a part of cash fair in case of instabilities that
will happen to the company's operations when there are truly no speculation
openings. The shareholders at that point need the executive to pay more profits or
purchase back offers of the trade.
To summarize, both the law and the sophistication of contracts applicable to
modern corporations are the result of a historical process in which people have
great incentives to reduce agency costs. The representative, in theory, should be
able to handle the agreement's objects better than the firm owners. However,
because business ownership and management are separated, "the directors of these
businesses become the financial managers of others... carelessly and wastefully,"
rather than "really seriously as business owners handle their own capital," "the
directors of these businesses become the financial managers of others... carelessly
and wastefully" (Smith, 1776). This is a problem that all businesses have faced and
will continue to encounter.
Question 2 (5 points):
Due to the competitive financial environment, the importance of efficient and
effective cash management procedures has been a major research topic in recent
years. Corporate financial policies concerning financial behavior, dividend
distribution, cash flow management, working capital, and investment plans,
according to Opler (1999), play a crucial role in corporate cash management
strategies, particularly in maintaining the appropriate amount of cash. Growth
potential, investment levels, research and development expenditures, cash flow,
and cash flow volatility are all positively related to a company's cash holdings.
Firm size, leverage, net working capital, and a dividend dummy variable are all
negatively related with cash holdings.
I will start by stating what I know and my thoughts on the advantages and
disadvantages of holding cash in the firms. A basic thing we all know is that Cash
is the most common asset that businesses utilize to pay bills, pay their debts and
operating expenditures, such as taxes, employee wages, inventory purchases,
advertising costs, and rentals, among other things. Cash is utilized as a source of
investment capital for long-term assets including property, plant, and equipment
(PP&E) and other non-current assets. Excess cash after expenses is frequently used
to fund dividend distributions. To ensure adequate company stability, companies
with a variety of cash inflows and outflows must be carefully handled.
I. Motives and benefits of holding cash in the corporate
So what are the motives and benefits of holding cash in the business?
1. Motivations of holding cash in the corporate
John Maynard Keynes, in his classic work The General Theory of Employment,
Interest, and Money, identified three motives for liquidity: The speculative motive,
the precautionary motive, and the transaction motive.
THE SPECULATIVE AND PRECAUTIONARY MOTIVES
The speculative motive is the desire to keep cash on hand in order to take
advantage of opportunities such as bargain purchases, low interest rates, and (in the
case of foreign companies) beneficial exchange rate changes. Reserve borrowing
ability and marketable securities can be leveraged to satisfy speculative purposes
for most businesses. Thus, keeping liquidity may have a speculative motivation,
but not necessarily storing cash. Consider this: If you have a credit card with a high
credit limit, you may likely take advantage of any extraordinary offers that arise
without having to carry any cash.
This is also true, to a lesser extent, for precautionary motives. The necessity for a
backup supply to serve as a financial reserve is the precautionary reason.
Maintaining liquidity, once again, is most likely motivated by prudence. However,
because the value of money market instruments is reasonably predictable, and
products like T-bills are extremely liquid, there is no actual need to keep large
sums of cash on hand as a safety net.
THE TRANSACTION MOTIVE
The transaction incentive, the requirement to have cash on hand to pay bills,
necessitates the use of currency. The firm's usual disbursement and collection
activities generate transaction-related needs. Wages and salaries, trade debts, taxes,
and dividends are all examples of cash disbursement.
Cash is obtained by product sales, asset sales, and fresh loans. Because cash
inflows (collections) and outflows (disbursements) are not completely coordinated,
certain cash holdings are required as a buffer.
With the continued development of electronic funds transfers and other high-speed,
"paperless" payment mechanisms, the transaction demand for cash may all but
vanish. Even if it does, there will still be a need for liquidity and an efficient
management of it.
COMPENSATING BALANCES
Another reason to keep cash is to compensate for balances. Cash balances are kept
at commercial banks to compensate for banking services received by the firm, as
discussed in the previous chapter. A minimum compensating balance requirement
may impose a lower limit on a company's cash holdings.
2. Benefits of holding cash in the corporate
So of course we can see that holding cash brings a lot of benefits to businesses.
Ensuring normal and continuous production and business activities, preventing all
uncertainties occurring in the business process, maintaining solvency,
demonstrating financial stability and soundness of the enterprise, abling to take
advantage and realize the advantages when there are good additional investment
opportunities are those benefits that can be clearly seen when the enterprises hold
cash.
If businesses do not keep a penny, they will not be able to maintain production,
have no money to buy input materials, no money to pay salaries and wages, no
money to hire or buy assets,... That case will be terrible, the entire production and
business activities of the enterprise will freeze, and the consequences will be…,
because without production, where does the business get products to sell? If you
don't sell products, where do you get revenue and profit? Can the business be
maintained? There is a proverb: “Money is the blood of a business, a bad director
is the director who has no money for his business”. Therefore, keeping money
helps businesses help businesses circulate production and business activities,
maintain production lines, or even expand production whenever there are
opportunities in the market.
Once again I want to emphasize that businesses keep money to maintain liquidity
and then, to maintain solvency, demonstrate financial stability and soundness of
the enterprise. Liquidity of an enterprise is the solvency of that enterprise at each
point in time. This manifests in the use of current assets such as cash, inventory,
accounts receivable, securities and current assets to meet current liabilities. Excess
cash (that coporate holding) presenting on the balance sheet helps a coperation
manage its cash flow efficiently. The excess cash comes to the rescue if there is a
sudden dip in revenue or delays in account receivables. The excess cash ensures
that the organization is able to meet its obligations, such as pay bill, payroll, rent,
administration expenses and loan payments, even if it doesn't generate any revenue
for a specified period.
Make the case that you are a newly launched business. New entrepreneurs are
encouraged to keep excess cash on hand as a buffer to meet day-to-day obligations
in case the onboarding of new clients takes time. The excess cash on the balance
sheet ensures that the organization isn't forced to borrow money. Since borrowing
costs are high, organizations should maintain some excess cash on hand to avoid
taking short-term loans. Excess cash on hand is an indication of the short-term
financial well-being of the business.
Moreover, let's say on a good day the market presents you with a super bargain,
super profitable investment. But at that time, you were the director of the business,
you didn't hold a penny of cash in your hand. So you missed an opportunity. Sorry
isn't it? So as I mentioned above, holding cash help corporate with the ability to
take advantage of and realize the benefits when there are good additional
investment opportunities.
Holding cash also help the corporate in early payment to the supplier to enjoy the
trade discount. The cost of not accepting commercial discounts is often very high,
so businesses need to have enough money to take advantage of payment
opportunities to enjoy discounts.
Another benefit of holding cash is that Help businesses maintain a better credit
rating than peers thanks to higher current and quick ratios. A high credit rating
allows businesses to enjoy more favorable purchasing conditions and maintain low
credit costs from banks.
Businesses should keep cash to respond to emergencies such as strikes, fires or
launching stronger marketing campaigns than competitors, and when the business
cycle is down due to seasonality or because the decline of the economy.

 I want to talk about another issue, I will temporarily call the benefit of
holding money in attracting investors.
First, it seems that investors are always looking for businesses with abundant cash
on the balance sheet, because they believe that a lot of cash will help businesses
handle easily if the The business plan is deteriorating and it also gives the business
more choice in finding investment opportunities in the future.
Investors are not inside the business, so usually seeing a lot of cash items on the
balance sheet is always more reassuring than businesses with less cash. Especially
when over the quarters, or over the years, the amount of cash increases steadily and
stably, it is a signal that the business is doing very well and is developing very
strongly. Cash accumulates so quickly that managers do not have time to plan how
to use it most effectively.
Microsoft is an example. In the software manufacturing industry, perhaps the name
of Microsoft is known worldwide. Microsoft is doing so well that its annual cash
flow is always more than $40 billion. As revenue continued to grow strongly and
cash kept growing rapidly. Other successful businesses in industries such as
software and service production, entertainment, and media typically do not require
as much capital expenditure as companies in capital-intensive industries.
II. Cost of holding cash in the corporate
That's not to say it's always good to have more cash than the theory suggests.
Everything has a cost, and so does the business holding cash. So in the next part I
will give my researches and views on the cost of holding cash that businesses have
to face.
We will focus on the following 3 main problems that when holding cash,
businesses will face:
- Incurring management costs.
- Affected by inflation and exchange rate changes.
- Loss of opportunity cost of cash capital.
When a firm holds cash in excess of some necessary minimum, it incurs an
opportunity cost. The opportunity cost of excess cash (held in currency or bank
deposits) is the interest income that could be earned in the next best use, such as an
investment in marketable securities. For example, instead of holding cash, a
business can invest money in profitable financial assets, buy assets, or deposit it in
the bank for periodic interest. Thus, the business not only owns that money, but
also adds a profit from bringing the money to invest or deposit.
Moreover, holding cash will cause businesses to pay more money to manage the
cash in hand, even spend more effort and manpower. “Possession is nine - tenths of
the law.” Anyone who owns money will all preserve and cherish it carefully.
However, the money in the hand of the business is always a very large amount,
which means that the cost of cash management will be large (including the cost of
buying a safe, the cost of hiring a treasurer, the cost of building a warehouse,
money preservation,etc.)
Inflation is undesirable for any business holding cash. Today's 1 dollar is different
from yesterday's 1 dollar. Today's 1 dollar can buy 100 units of input materials but
tomorrow's 1 dollar can only pay 10 units. Therefore, the devaluation of the
currency is the cost that corporates must pay for holding cash.
III. I want to add one more part - Financial theories about behavior of
firm’s cash holding - which will concerned with citing the relationship
between holding money and other components in the part IV
In determining the behavior of firm’s cash holding, grounding theories which
remained more pertinent to cash management practices of firms include trade off,
pecking order and free cash flow theory (Wasiuzzaman, 2014).
1. Trade-off theory
According to the tradeoff theory, firms maintain the optimal level of cash at the
breakeven point where the marginal cost and benefit of holding cash are equal (Al-
Najjar, 2011; Martínez-Sola et al., 2011). As pointed out by Opler (1999), based on
Keynes (1936), benefits of holding cash are derived from two vital motives:
Precautionary and transaction motive. Hence, when firms considered the marginal
benefits and cost of holding liquid assets, trade off perspective in cash management
practices supported the optimal level of cash.
2. Pecking order
In contrast, another significant theory in line with cash management practices of
firms is pecking order. This theory was grounded by the Myers (1984) and Myers
and Majluf (1984). In line with this theory, firms first prefer the internal financing
to finance their investment plans by utilizing the liquid assets and retained
earnings. After that, debt is issued while, issuance of equity is considered as the
last resort. On one side, pecking order theory supported that firms with high profits
would mostly finance the investment plans with internal resources therefore, these
firms tend to hold high cash ratio.
 3. Free Cash Flow Theory
In contrast, the free cash flow theory by Jensen (1986) described that managers
preferred to hold higher cash level to enhance the volume of total assets in their
control. They also tried to gain the distinctive powers in the firm’s investment and
financing decisions. As a result, this behavior affects the shareholder’s wealth
negatively. Therefore, the optimal level of cash holding is considered as a
significant problem in the shareholder-manager situation.

IV. Relationship between cash holdings and growth opportunities,

investment levels, research and development expenditures, cash flow,
and cash flow volatility (positive)

Relationskip between cash holdings and firm size, leverage, net

working capital and a dividend dummy variable (negative)

1. Positive relationship
1.1. Cash holdings – Growth opportunities
Companies with greater growth opportunities hold more cash and value it more
than others, as financial constraints are more costly for these companies (Bates et
al., 2009). As a result, the level of cash is expected to vary positively with respect
to a company's growth opportunity. We used the ratio between market value and
book value (total assets minus net equity, plus company market value, divided by
total assets) as a proxy for growth opportunity, as Bates et al. (2009), Chang and
Noorbakhsh (2009), Ozkan and Ozkan (2004), and Opler et al. (1999) did.
According to most studies, firms with higher growth opportunities have a higher
level of cash holdings because such firms are more likely to hold more cash
reserves in order to capitalize on opportunities. Kim et al. (1998), for example,
argued that firms with high growth opportunities have larger cash reserves. Bigelli
and Sánchez-Vidal (2012) found comparable results in private firms. They claimed
that because private firms have fewer internal funds, they are more likely to
underinvest. As a result, private firms have more cash on hand for future growth
opportunities. The majority of empirical studies show that growth opportunities
have a positive effect on cash holdings. Therefore, we expect the association
between cash holdings and growth opportunities to be positive.
Growth has a positive effect on cash holdings
1.2. Cash holdings – Investment levels
When corporates hold more cash, they will have the opportunity to invest more.
And the more money they hold, the greater the investment, of course, because
when the investment bargain comes, we already have money in hand, ready to
seize the opportunity.
From a financial perspective, investing is the process by which an investor spends
a certain amount of assets to gain future benefits of the item investment items.
For investing activities, the investment decision of the company is narrowly
defined as the process by which the company spends a certain amount of capital
funding in an investment item such as buying fixed assets or using costs to
invest in any form to obtain benefits or increasing the amount of capital. The
investment decision is a decision related to the value of assets and the value of
each asset component including fixed assets and current assets. In the wide mean,
to achieve a certain benefit in the future with the aim of maximizing profits, the
company is willing to spend capital and spend on human resources to invest.
According to Modigliani-Miller's (1958) study, in a perfect capital market,
domestic capital and external capital are a perfect alternative. The company's
investment decision is independent of its financial status. However, in reality,
internal capital and market capital are not an ideal substitute, but the investment
can be influenced by other factors such as financial leverage, internal cash flow,
company's value, capital size (Arikawa et al, 2003). ZhangChao Lin (2018)
argue that the cash holding ratio of each company has a significant impact
on the company's investment. In the FHP study (1988), asymmetric information
was argued and proved that cash flow strongly influenced investment. Ozkan
(2002) also argued that cash holdings is an essential factor affecting the company’s
development thus the company needs to determine the amount of cash
necessary. Scholars then investigated the relationship between the company's
existing cash and investment decisions. But with different data collection scopes
or different study periods, so the conclusions of the scholars are not the
same: cash holdings has a positive, opposite or U-shaped effect on investment
level.
Therefore, I expect the association between cash holdings and investment level to
be positive.
Cash holdings and investment levels have a positive relationship.
 1.3. Cash holdings – Research and development expenditures
Nowadays, with the demand of foreign market keeps down and the promotion of
fixed-asset investment is limited, technological innovation is increasingly
important. The sound combination of industry and technology is the basis and
guarantee of enterprises’ sound operation. The reform of property and operating
mechanism are continuously deepening and the R&D investment is increasingly
important in listed companies especially high-tech listed companies. It have seen
the significant influence of cash holdings on enterprise’s R&D investment as well
as the positive effect of high amount of cash holdings on R&D investment based
on the theories of New Institutional Economics and accordingly propose
corresponding suggestions for further technological innovation, upgrade of
products and improvement of core competitiveness. So, let’s say that:
R&D investment has a positive effect on cash holdings
1.4. Cash holdings – Cash flow
Companies with higher cash flows accumulate more cash (Bates et al., 2009).
Thus, it is expected that the level of cash will vary positively with a company’s
cash flow. Following Bates et al. (2009) and Opler et al. (1999), we define cash
flow as earnings after interest, tax and dividends, but before depreciation.
The tradeoff theory indicates a negative association between cash holdings and
cash flow, since firms that generate more cash flows from operations require fewer
cash reserves. In contrast, the pecking order theory notes a positive association
between cash reserve and cash flow. It suggests that firms generating more cash
flows are likelier to hold more cash to use for investments and during periods of
financial distress. Extant empirical studies also report both positive (Opler et
al. 1999; Ozkan and Ozkan 2004; Uyar and Kuzey 2014) and negative
(Chen 2008) effects of cash flow on cash holdings. Since most studies document a
positive effect, I agree that:
Cash flow has a positive effect on cash holdings
1.5. Cash holdings – Cash flow volatility
Opler et al. (1999) and Bates et al. (2009) found an association between increased
cash flow volatility and increased levels of cash retained by companies.
The tradeoff theory posits that firms with high uncertainty of cash flow are likely
to hold more cash. Therefore, the association between cash flow uncertainty and
cash holdings is positive. Most empirical literature has also reported a positive
association between cash flow and uncertainty thereof (see: Bigelli and Sánchez-
Vidal 2012; Demir and Ersan 2017; Guney et al. 2007; Kariuki et al. 2015; Shabbir
et al. 2016). However, few studies do report a negative effect of volatility on cash
holdings (Ferreira and Vilela 2004; Paskelian et al. 2010). Thus, I agree that:
Cash flow volatility has a positive effect on cash holdings
2. Negative relationship
2.1. Cash holdings – Firm size
Economies of scale favor larger companies, which hold less cash (Bates et al.,
2009; Mulligan, 1997). Moreover, large companies tend to be more diversified
(Titman & Wessels, 1988) and present less asymmetric information when
compared to smaller companies. Thus, a negative relationship between cash level
and company size is expected. Following Chang and Noorbakhsh (2009) and Foley
et al. (2007), the logarithm of total assets was used as a proxy for company size.
The trade-off theory postulates that large firms are stable, more profitable, and
diversified. They have constant stream of cash flows and low probability of
bankruptcy. These features allow large firms to hold fewer cash reserves. This
indicates a negative association between cash holdings and firm size. 
Size has a negative effect on cash holdings
2.2. Cash holdings – Leverage
If the debt is high enough, companies will use cash to reduce leverage, resulting in
a negative relationship between leverage and cash level (Bates et al., 2009). On the
other hand, less leveraged companies are less subject to external monitoring, which
allows management to hold more cash (M. A. Ferreira & Vilela, 2004). Acharya,
Almeida and Campello (2007) demonstrated that holding cash allows companies
with limited access to capital markets to protect themselves against future
uncertainty, but debt reduction is the most efficient way of raising future cash
flows. Therefore, companies with limited access to capital markets prefer to hold
more cash rather than reduce their debts if the need to protect themselves is high,
but they prefer to reduce cash when there is less need for protection.
The trade-off theory postulates that firms with high leverage ratio also have higher
risk and are likely to face bankruptcy. Therefore, high-leverage firms hold more
cash reserves to prevent such situations. In such conditions, we note a positive
association between leverage and cash ratio. In contrast, the pecking order theory
postulates a negative association between leverage and cash flow, suggesting that
leverage can be used as a proxy for issuing debt. Hence, debt can substitute
holding cash, and firms holding more liquid assets can convert these assets into
cash easily. Therefore, leverage and cash flow are characterized by a negative
association (Opler et al. 1999). Majority of studies predict a negative effect of
leverage on cash holdings (see: Chen 2008; Opler et al. 1999; Ozkan and
Ozkan 2004; Shabbir et al. 2016; Uyar and Kuzey 2014). Thus, I agree that:
Leverage has a negative effect on cash holdings
2.3. Cash holdings – Net working capital
Other net assets can be used to replace company cash (Ozkan & Ozkan, 2004) as
long as they can be easily converted to cash. Net working capital is made up of
assets that serve as cash substitutes (Bates et al., 2009). As a result, we anticipate a
negative relationship between net working capital and assets and cash holdings.
Net working capital to assets is defined as current assets minus cash and short-term
investments divided by total assets.Thus, I agree that:
Net working capital and cash holdings have a negative relationship

2.4. Cash holdings – A dividend dummy variable

Companies that pay dividends tend to take fewer risks and have greater access to
capital markets (Bates et al., 2009). Companies that pay dividends can afford to
keep less cash on hand because they are better able to raise funds when needed by
cutting dividends (M. A. Ferreira & Vilela, 2004). We define the dividend dummy
as 1 if the company pays dividends and 0 if it does not, following Bates et al.
(2009), Ozkan and Ozkan (2004), and Opler et al. (1999). Thus, I gree that:
Dividend dummy variable has a negative effect on cash holdings