Impact of Governance on Corporate Cash: Why $1 Could Be Worth Just 42 Cents
Recent research demonstrates that the value of cash within a company can vary dramatically based on the strength of its governance. In poorly governed firms, a dollar of cash might be worth as little as $0.42. However, in companies with strong governance structures, that same dollar can nearly double in value.
A study by Amy Dittmar from the University of Michigan and Jan Mahrt-Smith from the University of Toronto found a stark contrast in how cash is valued depending on a firm’s governance quality. According to the study, poorly governed companies see their cash holdings valued between $0.42 and $0.88 per dollar. On the other hand, in well-governed firms, the value of cash nearly doubles, reflecting a much stronger alignment between management and shareholder interests.
The concept that poor governance devalues cash isn’t new. Theories of agency costs, dating back to Adam Smith’s observations in the 18th century and later formalized by Jensen and Meckling in 1976, suggest that managers, left unchecked, tend to misuse company resources. This mismanagement becomes especially problematic when it comes to cash, a highly liquid asset with fewer immediate oversight mechanisms.
One of the key findings of Dittmar and Mahrt-Smith’s research is that poorly governed firms dissipate their cash reserves much faster than their well-governed counterparts. This rapid depletion leads to significantly lower operating performance over time.
The study builds on earlier research by Faulkender and Wang, who demonstrated that the value of a dollar in cash reserves is often less than its face value, particularly in firms with weak governance. For example, in companies with substandard governance, investors discount the value of cash because they anticipate inefficient or self-serving management practices.
Shareholder oversight
One of the most effective mechanisms for improving corporate governance is active shareholder oversight. Large institutional shareholders, who have significant financial stakes, often exert pressure on management to act in the best interest of shareholders.
Studies, including those cited by Dittmar and Mahrt-Smith, show that when large shareholders engage in oversight, they help ensure that cash reserves are used efficiently.
By contrast, antitakeover provisions can shield managers from external pressures, leading to entrenchment. This lack of accountability often results in the mismanagement of liquid assets, as managers are less concerned about the consequences of poor financial decisions.
The famous example of Chrysler in the 1990s, when activist investor Kirk Kerkorian pushed the automaker to release some of its $8 billion in cash reserves, highlights how shareholder pressure can force companies to use cash more effectively.
Research has also shown that poorly governed firms tend to spend their excess cash on acquisitions, which often fail to generate adequate returns. A study cited by the research found that firms with large cash reserves were more likely to engage in acquisitions, regardless of their governance quality. However, poorly governed firms are more prone to making bad deals, which leads to further value destruction.
Dittmar and Mahrt-Smith’s study supports this conclusion, showing that even after controlling for acquisitions, poorly governed firms still dissipate cash in ways that reduce overall firm value.
As the study concludes, good governance not only protects against wasteful spending but also nearly doubles the value of a firm’s cash holdings. In today’s complex corporate landscape, governance is not just a theoretical concern—it’s a practical necessity for preserving and enhancing firm value.
Information for this briefing was found via the sources mentioned. The author has no securities or affiliations related to this organization. Not a recommendation to buy or sell. Always do additional research and consult a professional before purchasing a security. The author holds no licenses.
