The influence of product market dynamics on a firm's cash holdings and hedging behavior

Abstract

Prior work suggests that if a firm shares a larger proportion of its growth opportunities with rivals, an inability to fully invest in these opportunities leads to predatory behavior on the part of rivals and losses in market share. We examine whether firms manage this predation risk. We find inter- and intra-industry evidence that the extent of the interdependence of a firm's investment opportunities with rivals is positively associated with its use of derivatives and the size of its cash holdings. Moreover, an analysis of investment behavior provides evidence that if this interdependence is high, the management of predation risk provides strategic benefits. Our results indicate that predation risk is an important determinant of corporate financial policy choices and investment behavior.

Introduction

A growing body of evidence indicates that when a firm cannot fully take advantage of its investment opportunities, it risks losing these opportunities and market share to rivals. For example, Chevalier (1995) and Campello, 2003, Campello, 2006 find results that suggest when a firm increases its financial leverage, rival firms increase investment in an attempt to gain market share and drive the more leveraged firm out of business. Bolton and Scharfstein (1990) argue that a firm's ability to finance investments with internally generated funds, which can mitigate this risk, is an important determinant of its success in the product markets.

The risk of underinvestment leading to a loss of investment opportunities and market share to product market rivals is referred to as predation risk. In this paper we investigate the role of predation risk on corporate financial policy decisions. As well, we examine how this risk is associated with corporate investment behavior.

The corporate policy choices we focus on are risk management using derivatives and cash holdings. These policies can reduce a firm's predation risk. For example, Froot, Scharfstein, and Stein (1993) show that corporate derivatives usage can protect firms from underinvestment during industry or marketwide downturns. Also, a number of recent papers show that cash holdings provide firms with similar benefits.¹

Froot, Scharfstein, and Stein (1993) argue that a firm's exposure to predation risk largely depends on the interdependence of its investment opportunities with product market rivals. The greater this interdependence, the greater is the predation risk. We consider three factors that affect the interdependence of a firm's investment strategies with industry rivals. First, we consider industry concentration as both Kovenock and Phillips (1997) and Zingales (1998) show that predation is more likely to occur in more oligopolistic industries in which there is greater interdependence in investment decisions. Second, we look within industries and consider the similarity of a firm's operations with its rivals, as measured by the absolute deviation between the firm's capital-to-labor ratio and its industry median for this ratio. In doing so, we follow recent industry equilibrium models that consider the extent to which a firm is at the technological core of its industry.² Companies that are closer to this technological core are assumed to have more similar operations with industry counterparts and greater interdependence in investment opportunities with rivals. Finally, we consider the extent to which a firm's growth opportunities co-vary through time with those of its industry rivals, proxied by the correlation of the firm's stock returns with industry stock returns.

We examine currency swap usage by Standard & Poor's (S&P) 500 manufacturing firms from 1993 to 1997 and corporate cash holdings of Compustat manufacturing firms over the 1993 to 2001 period. We find that corporate financial policy choices are associated with predation risk. Specifically, inter-industry results show that whether a firm uses currency swaps or holds a large cash balance is positively associated with both the firm's industry Herfindahl-Hirschman Index and four-firm concentration ratio. Also, intra-industry findings indicate that a firm is more likely to use derivatives and hold large cash reserves when it is closer to the technological core of its industry or its stock returns are more positively associated with industry stock returns. These results hold after controlling for profitability, the ability to fund investment with internal cash flow, the ease with which firms can access external capital markets, and a host of other control variables.

Furthermore, we find that the association between predation risk and financial policy choices is more important in industries with larger growth opportunities. Because a firm's interdependence of growth prospects with industry rivals matters more when such prospects are larger, this finding suggests it is this interdependence that drives our results. Also, this result is consistent with higher predation risk when there are more investment opportunities at stake.

We also investigate whether the extent to which a firm manages its predation risk affects its investment behavior. Here, we focus on cash holdings because they provide a firm with the ability to make planned investments when cash flow runs short, as well as the ability to make unplanned investments that arise as investment opportunities change. We examine changes in a firm's capital expenditure and research and development expenses during years when these investments decrease at the industry level. We find that a firm's investment behavior depends on its cash holdings and the predation risk it faces. Specifically, firms are more likely to increase investment when industry-level investment decreases if they have larger cash reserves and there is greater interdependence of their investment opportunities with rivals.

These findings are consistent with the Froot, Scharfstein, and Stein (1993) argument that firms that can finance investments internally attempt to gain market share by increasing investment when changes in industry conditions force rivals to underinvest. These results also indicate that managing the exposure of investment opportunities to changes in industry conditions provides two strategic benefits to firms having interdependent investment opportunities with rivals. First, because it allows firms to make planned investments, it enables them to decrease predation by cash-rich rivals that increase investment when aggregate industry investment declines. Second, it allows firms to keep pace with rivals that increase investment at such times and thus prevents these rivals from gaining strategic advantages over the firm.

Finally, we examine the nature of the relation between cash holdings and derivatives usage. Although our findings suggest that these policies provide firms with similar product market benefits, it is not clear whether these policies are substitutes or compliments. Recent theoretical work by Mello and Ruckes (2005) shows that when firms have similar internal capital positions they are less likely to hedge. Based on this argument, we expect that if a firm's rivals hold large cash reserves, either it will also hold a large cash balance (and therefore put itself in a similar financial position) or it will use derivatives, but not both. Supporting this idea, we find that the likelihood a firm uses currency swaps is negatively associated with industry-adjusted cash holdings and positively associated with the standard deviation of cash holdings in its industry. These results suggest that in the product market context there is a substitute relationship between cash holdings and derivatives usage.

Our study contributes in three ways. First, we increase understanding of how a firm's investment and financing policies are linked to its product market environment. Empirical evidence in Chevalier (1995), Kovenock and Phillips (1997), Zingales (1998), and Campello, 2003, Campello, 2006 suggests a firm experiences predatory threats from rivals when financial constraints hinder its ability to invest in growth opportunities. Consequently, in an equilibrium setting, such threats should spur companies to shield their investment policies from changes in market conditions. We fill a gap in the literature by showing that firms take actions in response to the likelihood of predation risk. In addition, we provide insights into why a firm's product market environment impacts its investment and financing decisions. In trying to answer this question, prior empirical work generally focuses on the degree to which an industry is imperfectly competitive. We show that it is also important to consider the extent to which a firm has interdependent investment strategies with industry rivals.

Second, we shed further light on the determinants of corporate risk management activities. Our results suggest that it is important to consider such activities in terms of a firm's overall product market strategy. This is consistent with the Froot, Scharfstein, and Stein (1993), Mello and Ruckes (2005), and Adam, Dasgupta, and Titman (2006) models that show product market considerations are key determinants of corporate hedging behavior.

Finally, our results also contribute to understanding the role of corporate cash reserves. Prior research suggests such reserves are at times manifestations of agency problems in firms that have Chief Executive Officers (CEOs) who make value-decreasing acquisitions (Jensen, 1986; Harford, 1999; Harford, Mansi, Maxwell, 2006). However, Kim, Mauer, and Sherman (1998), Opler, Pinkowitz, Stulz, and Williamson (1999), and Mikkelson and Partch (2003) show that corporate cash reserves are not harmful to firm performance and can benefit shareholders by enabling firms to fully invest in their growth prospects. Our results compliment this research by showing that the management of predation risk increases these benefits.

The remainder of this paper is organized as follows. Section 2 reviews prior work. Section 3 discusses hypotheses and empirical predictions. Section 4 discusses our sample and other methodological issues. Section 5 presents and interprets empirical findings. Finally, Section 6 concludes.