Expected Holding of Cash, Future Performance and Stock Return

Abstract

This paper examines the determinants of expected level of firms' cash holding, and the implications to future performance and stock return when firms deviate from their expected balances. Extending the model of Opler, Pinkowitz, Stulz and Williamson (1999), this paper provides a more comprehensive model of expected cash balances and finds strong evidence supporting a static tradeoff model of cash holdings. Further tests examine the implications to future return on assets (ROA) when firms deviate from their expected cash balances. The main findings include: (1) higher deviations (in absolute term) are associated with lower future ROA; (2) the aforementioned association is found in both positive and negative deviations; the effect of negative deviation on future ROA is stronger than that of positive deviation; (3) the marginal effect on future ROA increases as the size of deviations increases; (4) When firm deviates from its expected cash balance, its future performance deteriorates in all aspects: leverage increases, return on operating assets (RNOA) decreases, and SPREAD, the difference between RNOA and net borrowing cost (NBC), decreases, which suggests NBC increase. This paper also examines the implications on one year ahead stock returns when firms deviate from their expected cash balance and finds evidences that deviation from expected cash balance can explain future stock return in addition to accrual, firm size, book-to-market ratio (BM) and earnings-to-price ratio (EP).

Keywords: cash balance, ROA, RNOA, stock return

JEL Classification: G12, G14, G31, G32, M41