RESEARCH PROJECT PROPOSAL SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION, UNIVERSITY OF NAIROBI
FEBRUARY, 2013
I hereby declare that the presented research project is my original work and has never been presented either in whole or in part to any other examining body for the award of certificates, diploma or degree.
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The Research has been submitted for examination with my approval as a University of Nairobi;
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1.0 INTRODUCTION OF THE STUDY.. 1
1.2 Background of the Study. 1
1.2.3 Relationship between Corporate Liquidity and Business Divisions. 3
1.3 Statement of the Problem.. 5
1.4 Objectives of the Study. 6
1.6 Importance of the Study. 7
2.2 Link between firm’s cash holding and diversification. 9
2.3 Theoretical/Conceptual Framework. 18
3.6 Validity of Data collection Instruments. 22
3.6 Reliability of Data collection Instruments. 22
3.8 Data analysis and presentation. 23
This section presents a background of the research. It introduces the concepts of corpotare liquidity and diversification and gives an insight into the link that exists between these concepts. It also presents the problem statement relating to the study, objectives of the study, research questions and the purpose of the study.
Recently, there has been an enormous increase in cash holdings among business organizations. In the US, for instance, nonutility and nonfinancial firms reported average cash holding of $1.7 trillion in 2006, representing a ratio of cash to assets of 9.2 percent. Additionally, Bates et al, (as cited in Duchin, 2010) noted that the ratio of cash to assets among listed industrial corporations was 23 percent in 2006, an enormous increase from a record of 10.5 percent in 1980. As Duchin (2010) explains, this trend that has sparked great interest among scholars and the media. However, there has been an equally impressive pattern related to this, but which has received little attention: Stand-alone firms are holding much more of their assets in terms of cash compared diversified firms. According to Duchin (2010), the average cash holdings by stand-alone between 1990 and 2006 was 20.9 percent compared to an average of 11.9 percent held by diversified firms during the same period. This implies that there is a clear link between diversification and corporate liquidity which has an impact on the levels of cash holdings by corporate organizations. In order to clearly understand this issue, it is prudent to briefly examine the concepts of corporate liquidity and diversification or business divisions.
Corporate liquidity refers to the degree to which a corporation’s assets or security can be sold or bought in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. It measures how much cash a company has and how easily it is able to pay its debt. According to Dittmar et al (2003), liquidity may be defined as the ratio of cash and cash equivalent to net assets, where net assets are computed as assets less cash and equivalent. There are two unique theories based upon liquidity namely, trade-off theory and the financing hierarchy theory. The trade-off theory states that firm’s trade off the costs and benefits of corporate liquidity to derive optimal liquidity holdings. The classical version of the hypothesis goes back to Kraus and Lichtenberger who considered a balance between the dead weight costs of bankruptcy and the tax saving benefits of debt. The financing hierarchy theory states that there is no optimal amount of cash, based on arguments similar to the pecking order theory of capital structure. This theory explains the fact that when a company becomes profitable, their debt will decrease as their cash will increase, therefore they will not need as much help with financing from the outside company (Bhat, 2009).
The difference between these two theories is that trade- off theory uses a more optimistic approach and predicts a positive relationship between investment and cash levels, whereas the hierarchy view takes a more pessimistic approach, predicting a negative sign. Despite the differences, these theories indicate that financial manager in any corporate organization has a difficult role in managing the liquidity of a firm because it requires one to keep the firm from reaching a state of deficient liquidity. When a firm has liquidity insufficiency they are unable to control their debt and financial obligations. This is by no means a good sign for a firm and may in turn force them to sell their investments and could possibly lead to bankruptcy. Therefore liquidity needs to be effectively managed in order for a firm to remain profitable and avoid liquidity risk (Duchin, 2010).
This is a strategy that involves increase of products, services, location, customers and market to a corporation so as to reduce risk. According to Chena (as cited in Duchin, 2010), the level of diversification is usually positively related to firm size and negatively related to outside equity ownership. Thus, large firms are usually more diversified compared to smaller firms. According to Ansoff (1965) diversification emphasizes the entry of firms into new markets with new products. His emphasis is in the diversification act rather than the state of diversity .Still more recent attempts of defining diversification have focused on the multinational nature of the diversification phenomenon. Diversification has various benefits to corporate organizations. Benefits arise from the creation of internal capital markets, higher debt capacity and economies of scale. In addition, diversification has been found to affect corporate liquidity within corporate organizations, as explained in the following part.
According to Rajan et al (2000), the key theme in high productivity in developing worlds is the potential cost of mismanagement of internal cash flows which are not always allocated to high growth divisions. In theory, diversified firms hold less cash because diversification reduces ex-ante probability of financing shortages that might lead to under investments. More specifically greater diversification in investment opportunities and cash flows pushes firms to hold less cash. According to Duchin (2010), corporate organizations hold cash partly for precautionary purposes, as explained in the Keynesian theory. According to this theory, firms hold cash to protect themselves against adverse cash flow shocks that might force them to forgo valuable investment opportunities due to costly external financing. Leaders in any corporate organization try to make informed investment decisions from reliable information pertaining to how investment opportunities affect cash holdings.
Duchin (2010) conducted a study to determine the link between corporate liquidity and diversification among firms in the US. During the study, he classified the firms into two categories; standalone firms and multi divisional firms. Diversification was measured directly by the number of different business segments or industries that the firm reported. The findings of this study indicated that diversified firms have imperfect correlation between investment opportunities and their cash flows hence hold low level of cash for precautionary purpose. The study found that multidivisional firms hold approximately half as much cash as that which is held by standalone firms and this difference can be attributed to diversification in investment opportunity and cash flow. The study further shown that diversification is mainly correlated with lower cash holdings in financially constrained firms.
Diversification also insulates corporate organizations from costs and rationing from external markets. According to Duchin (2010), diversification across various divisions within a firm leads to increased cash flow across divisions. When transfers across divisions are abundant, a corporate organization holds less cash. In addition, Duchin (2010) found that increased transfers across business divisions leads to efficiency as cash is usually transferred to the divisions with good investment opportunities. Duchin (23010) further noted that the link between diversification and corporate liquidity is stronger in corporate organizational that are well governed. In these organizations, reduced cash holdings due to diversification leads to efficiency and saves costs associated with cash holding. The impact of diversification on corporate liquidity is also evident during acquisitions. According to Duchin (2010) if there is low correlation between investment opportunities of the target and the acquirer, the latter will record reduced level of liquidity over time.
However, Duchin (2010) noted that firms have responded to this effect by investing in opportunities that have cross correlation to divisions within firms. This response has been steered by the need to hedge against the risks associated with new investment opportunities. Consequently, corporate organizations are able to increase their levels of cash holding over time. Duchin (2010) explains that this trend is evidenced by the increasing percentage of same-industry acquisitions and mergers. In other words, as diversification reduces in terms of cash flow and investment opportunities, precautionary demand for cash increases and hence, the level of cash holding increases.
In this empirical investigation, diversified firms are expected to hold less cash. This is mostly due to the fact that cash is distributed among many investment opportunities across the various divisions. It is expected that low correlation among business divisions in a firm corresponds to low levels of cash holding. This occurs mainly due to the fact that diversification leads to reduced precautionary demand for cash. On the other hand, firms with fewer divisions are expected to hold more cash.
Several studies have been conducted in various parts of the world aimed at determining the relationship between corporations’ levels of cash holding and business divisions. In all the studies, it has been confirmed that diversification decreases the level of exposure of firms to cash flow volatility and liquidity risk. Consequently, high degree of diversification has been found to correspond to low levels of cash holdings by firms. On the other hand, low degree of diversification has been found to correspond to high levels of cash holdings by firms. There are numerous studies focusing on the cash management issues, especially the optimal levels of cash holdings by firms in Kenya. However, studies focusing on the link between cash holding and business divisions are rare, even though the level of cash holdings by Kenyan firms has been found to rise over time (Yego, 2008). Therefore, this study is aimed at bridging this gap through investigating the relationship between cash holdings and business divisions by corporate organizations in Kenya.
The main objective of this study is to establish the link between cash holdings and diversification in corporate organizations in Kenya.
The specific objectives of this study are:
i. What is the trend in level of cash holding by Kenyan firms for the last 10 years?
ii. What are the differences in average levels of cash holding by less and more diversified firms in Kenya?
iii. What are the factors that affect the average levels of cash holding by less and more diversified firms in Kenya?
The main purpose of this study is to establish the relationship or the link that exists between cash holding and diversification among Kenyan firms. Researchers and academicians have expressed the need for corporate management to gain understanding of issues related to the interaction between corporate liquidity and corporate diversification. Information on the link between firm’s cash holding and diversification is particularly useful for managers who want to set the stage for enjoying coinsurance associated with diversification which leads to reduced exposure to risk associated with reduced cash holding. Therefore, this study will provide valuable information for firms targeting corporate liquidity diversification particularly in Kenyan firms. Additionally, the study plays a crucial role, in theory and practice, as it endeavors to be part of the contribution to the precautionary saving theory by Keynes (1936). To some extent, this study is aimed at determining the extent to which diversification is related to cash flows within firm. Further, the study will help to establish whether availability of investment opportunities in Kenya has an impact on cash holdings of corporate organizations in Kenya.
This section provides an overview of previous studies that have focused on the relationship between cash holding and diversification by corporate organizations. Various studies pertaining to the average levels of cash holding by less and more diversified firms and the causes of differences in cash holding by firms are examined. The conceptual and theoretical frameworks are also presented.
According to the Agency theory, diversification may be motivated by the pursuit of managerial self-interests at the expense of the company’s stakeholders (Chen, 2010). Managers in some cases may seek to diversify a firm to increase their compensation (Jensen, 1986). This happens when managers involve cross-subsidization through allocating too much to divisions with high investment opportunities and vice versa, ensure their positions within a firm are more solid and secure, or have a reduced risk in their instatement portfolio. However, looking at a firm form a resource based angle, a diversified firm is one of the best and more efficient way of organizing economic activities within a business (Chen, 2010). Consequently, market diversification leads to a market power in the global market (Villalonga, 2000). Often, the internal capital market of a company might be more efficient in allocating capital compared to the external capital market; the top management of a diversified firm has better understanding of the available investment opportunities compared to the external investors (Williamson, 1975).
Currently, research is gradually shifting attention from cash holding, which is the culture of saving cash from being spent in the current cash flows, with a view of spending the cash into the future predicated investment or to cushion against cash constraints. For example, a firm with cash problems today will tend to save cash with a view of funding future investment opportunities (Campello, Almedia, Weisback, 2004). However, such a decision may make a company to lose on profitable ventures today, which may prove costly and a loss to the company in the future. Moreover, Pereira, Khurana & Martin (2006) in a research on liquidity markets revealed that the sensitivity of a company’s cash flows will decrease as financial development increases. Therefore, as a company develops and expands its capital base to increases cash flows, such a company will have less need to hold high liquidity with a view of spending it into the future. This implies diversification may be a security measure for companies to avoid high liquidities in times of cash constraints. Moreover a study by Sibilkov & Denis (2010) expounded that in companies with hedging needs, high levels of investments have a high relation to a greater tendency of holding cash, with constrained companies having a higher association between value and investment compared to unconstrained firms.
Duchin (2010) argues that while cash holding in many companies is currently increasing for both public and private firms, the growing trend has revealed interesting dynamics in the corporate world. As Duchin explains, in the increasing tendency of cash holding among companies, the amount of cash holding by standalone firms has been found to be more than double that of diversified firms. For example, between 1990 and 2006 in the US, diversified firms were on record as having 11.9% corporate liquidity compared to 20.9% liquidity in standalone firms. This difference leads to a clear difference in financial policies between standalone firms, and the diversified firms. Therefore, as Dutchin concludes, diversified firms have better chances of smooth investment opportunities, and the accrued cash flows driven by lack of correlation between their divisions and the division’s outcomes and opportunities. Tong (2009) explained that the trend of cash holding is much lower in diversified firms compared to a single segment firm. Such low levels of cash holding are both in cases of financially constrained and unconstrained firms. This culture according to Tong has a direct effect on a firm’s value. However, Campa & Kedia (2002) had a contrary argument that firm’s diversification discount is affected by endogenous problems, in that most firms performing poorly in the market will choose to diversify.
Tong (2009) explains that most of the diversification decisions above are related to agency problems. Managers are in most cases free to hold cash with less monitoring and use such cash discretionary. However, there are many tendencies of too much liquid cash being turned into private benefits at much lower costs by such managers. Though focusing more on capital expenditures, research has been able to focus on problems associated with diversification (Rajan et al, 2000), in examining potential problems that are more related to firm diversification, and ways in which cash holding is a potential means through which firm diversification would have a negative effect on a company’s value. Therefore, some of the agency costs that are related to diversification include increased agency costs, development of an inefficient internal capital market, increasing agency problems resulting from increasing cash holding. However despite the invested interests in managers, research has shown that firm diversification has an effect increasing the value of cash holding in financially constrained firms, largely due to an efficient internal capital market; more resources are allocated and utilized in divisions with better investment opportunities and returns (Stein, 1997). Firm diversification has also been found to reduce corporate liquidity through agency problems. This is mainly because; diversification of a firm may be related to building of an empire and cross subsidization functions (Jensen, 1986).
The relation between cash holding and internal capital markets (ICM) offer a more detailed analysis on liquidity and diversification. Diversification may insulate firms from costs of external capital markets and rationing from the working of ICM (Chun, 2010). This implies cross divisional diversification in any investment opportunity is directly related to transfer of resources across several divisions. Therefore, firms will tend to hold much less resources when transfers are numerous. In other words, having less corporate liquidity may be attributed to efficient cross divisional transfers to those divisions with sound and better investment opportunities (Chun, 2010). This is against the argument by Rajan , Zingales & Servaes (2000) who explained that diversified investment opportunities would most likely lead to improper fund allocation across a firm’s divisions, which means that having less corporate liquidity as a result of diversified opportunities may be attributed to increased cash flows to the better performing divisions. Moreover, the risk aversion theory states that diversification will lead to lower cash flow volatility in affirm, as well as the volatility of related profit streams (Xie & Wang, 2012).
As Xie and Wang explain, such diversification will lead a firm to reduce significantly its financial risks. However, as earlier explained, diversification as a number of studies has shown may increase financial risks in a firm (Subramaniam et al., 2011), which relates to agency problems discussed above as Tong (2008) elaborates. Therefore, as Xie and Wang argue, the decision on whether to diversify will have a positive impact on the company’s cash holdings. Diversification would thus work not only to gain more profits for a firm, but will also increase the operational risk of such a firm. Moreover, the extent of diversification directly affects cash holding positively. This implies a company with a greater degree of diversification increases its investment opportunities. In order to choose the investment opportunities, companies are more likely to hold cash (Xie & Wnag, 2012). Therefore, the effect of diversification and cash liquidity in company will depend on whether the company should indeed diversify, and the degree to which such a firm has to diversify.
Moreover the individual segments in diversified firms may have imperfectly correlated investment opportunities, which further support the role that internal capital market plays in such a case (Khanna & Tice, 2001). Firms may hold cash targeting growth opportunities, and with an aim of correcting under investment problems arising from financial related predicated risks which occurs in imperfect markets (Haushalter et al, 2007). Therefore, the imperfect correlation discussed above means that any diversified firm would require much less cash liquidity in meeting their investment demands any time in their investments. The availability of cash flow from one segment as capital for another segment would also reduce the need to have external capital, and reduces the benefits of holding cash in such cases (Subramaniam et al, 2011). Diversified firms are in most cases at a better place to sell their assets compared to non-diversified firms. Assets may be considered as a potential source of finance.
A firm that can easily convert its assets into cash in short time and at a low cost would stand a better chance than one that cannot. Therefore, considering the size and amount of assets owned by diversified firms, they are more likely to raise funds through sale of such assets compared to non-diversified firms. This reduces the need for cash holding within diversified firms. In such cases, diversified firms would at any time have lower levels of liquidity compared to single segment firms (Subramaniam et al, 2011). However, there are major risks involved in diversified firms. Many firms may face agency problems from segment managers willing to fiercely compete for a firm’s resources (Rajan et al, 2000). This implies that those segments with more influence in a company may stand to win more resources, leading to overinvestment in these segments, which implies more dead weight costs (Milgrom & Roberts, 1990).Therefore, the marginal costs for holding liquid assets and cash in diversified companies, which leads to these agency costs, are much higher compared to those of focused firms. Consequently, diversified companies would be expected to hold less cash and liquidity as a mitigating measure to avoid such agency costs.
In diversified related to agency problems, empire building due to increased corporate liquidity may cause managers to spend the cash available excessively on projects that may not be profitable (Jensen, 1986), leading to negative market reactions, especially when engaged in diversification activities not related to the core business, and cross subsidization which include moving of corporate resources from divisions performing excellently, to poorly performing divisions (Rajan et al., 2000). Such a move amounts to inefficient subsidization in some diversified firms, and a perfect way in which managers take advantage of the liquidity within a firm to derive private benefits much easily. Therefore, agency problems in many firms will reduce the amount of corporate liquidity in diversified firms, as shareholders develop increasing anticipation towards the inefficient use of cash, making firm diversification to reduce corporate responsibility through agency problems. Moreover, Ochanda (2011) in a study on cash holding in companies listed under Nairobi stock exchange Market revealed that preservation of capital was among the most important factors considered when selecting the most marketable security to invest despite the size of the firm. This is related to cash holding in that the investment opportunities available in any decision within a diversified firm may be perfectly correlated with cash holding, which implies that the internal capital market in such firms plays a major role (Tang, Yue & Zhou, 2010).
Diversified companies are at a much better position to hold minimal cash due to the coinsurance affect that happens across investment opportunities in various divisions in such a company (Chun, 2010). Therefore, the key determents of cash holding include cash flow and the cross directional correlations in different investments and the degree of correlation between available business opportunities and cash flow in a particular business division (Churn, 2010). This theory implies that if a diversified firm has less liquidity due to lower demand for cash, such a behavior should be in most cases stronger for any firm that is constrained financially. This argument follows the assumption that a firm would not finance all its activities and investments form external funds. Moreover as Churn (2010) argues that the benefits of having a diversified investment and coinsurance leading to lower cash holdings assumes presence of incentives aligned to an efficient internal capital market. This implies that such cash balances as exhibited in diversified firms should be supplemented by improved governance and cross divisional transfers that are more efficient towards the more effective and productive divisions of such a company. The above argument leads to the question whether the internal markets of a firm are efficient.
The firm’s internal capital markets in a diversified company allows a firm to fund profitable and efficient projects that may not be funded by external capital markets due to increase of agency costs, and information asymmetries (Shin & Stulz, 1998). It would be expected that a segment of any diversified firm would be able to invest despite its cash flows when having various investment opportunities, and with sufficient reserves to do so.
A credit constrained firm will ensure the cash flow of a segment will only have an impact on its investments through its effects in the company’s cash flow. Hence, many researchers from this have argued that a diversified firm with efficient internal capital market would lead to creation of value to the shareholders (Shin & Stulz, 1998). However, there are a number of research studies indicating that diversification may not necessarily be successful. Morck, Shleifer & Vishny (1990) explain that particularly in the 1980s, diversified acquisitions lead to a decrease in shareholders wealth. However, the internal capital market would not normalize the results created by cash flow reduction equally across all segments in a diversified business. This is mainly because; other segments will be more susceptible to its cash flows than on the overall cash flow of the firm (Shin & Stulz, 1998). On the contrary, as Shin & Stulz elaborate any segment will be affected equally by a shortfall of cash flows in the other segments despite the value of the investment opportunities available.
This conclusion contradicts the different interna