2012/12/16 2 Comments
This is a continuation of Part 1.
Option Value of Cash on the Balance Sheet
This theory of the cash anomaly posits that the returns from R&D are high, but also highly uncertain. Every once and awhile, the R&D of a company will produce a really high value project that requires massive investment and possibly acquisitions to use in combination with the asset. The problem with R&D as an economic asset is that it is very difficult to sell or even be exploited by organizations other than the organization that developed it. Unlike discovering oil, it is not clear even after discovery of a project that another firm could develop the project to create economic returns.
Because exploitation relies on unique capabilities inside the firm that are only poorly understood outside the firm, their economic value is harder to forecast. This violates the costless symmetric information condition of efficient markets is violated, unlike the projects of old economy companies, where the market has a reasonable expectation that it will understand the value of the project. This uncertainty introduces huge frictions if projects need to raise new capital. Therefore, if a company has R&D projects, the value of that project stream is greatly enhanced if the company also has a means of financing the projects that does not require subjecting those projects to the friction of market financing. These frictions are both directly financial in the form of more returns to new investors and intermediaries, and also temporal. In winner takes all markets, which many technology markets are, temporal costs are huge.
The option value of cash on the balance sheet could be huge, however, we would expect more tech companies to at least on occasion, expend all their cash and perhaps even borrowing capacity when they exercised options if this were the case. This is common in growing technology companies. Mature tech companies, rarely, if ever come close to expending their investment capacity.
I’m skeptical of this explanation. Why does Google need to hold enough cash to buy Yahoo or Facebook in cash, if they are never exercise the option to do so? When was the last time you heard that a company was undertaking a project with more than a billion dollars of expenditures in year one of the project? These kinds of companies can make acquisitions with stock, invest over time out of future cash flows, and they even have relatively low cost borrowing capacity should it be required.
Cash Poor at Home
Recently, much has been made of the U.S. companies that are parking cash overseas to avoid the tax when they repatriate it. Many companies are cash poor in their U.S. entity, but their consolidated balance sheet shows a lot of cash. This cash can’t be repatriated for distribution without a large tax bill. This is the worst of all possible worlds from a policy perspective, but it doesn’t seem to afflict tech companies as much as industrial conglomerates.
(BTW, Congress doesn’t need to capitulate to corporate demands for no tax on foreign earnings. All it has to do charge the companies income tax on their cost of capital for any overseas investments, then true up when the companies bring cash home. Particularly if the law slightly over estimated the cost of capital, or ignored the cost of capital on financial assets in the WACC calculation, so that repatriating funds usually triggered a small refund rather than a small bill, you could just sit back and relax and watch them all bring their cash home while still paying tax.)
The final explanation I’ve heard offered is the idea that since most of the investments of a technology company are in workforce and R&D, the costs of financial distress are huge. Not only that, but the costs of financial distress can manifest themselves long before bankruptcy is close. If managers are cutting benefits or tightening R&D activites, and the costs are not properly captured by accounting frameworks. New talent goes elsewhere, the best old talent leaves, R&D becomes less creative, less real economic capital employed stealthily decreases without the accountants noticing. However, CFOs are smart, they know this–even if the accountants don’t. They keep cash on the balance sheet, employee benefits generous, and 10% time meaningful. This prevents the stealthy erosion of the real assets of the company, by the prospect of distress, which the intelligent and savvy workforce is acutely aware of even if they don’t conduct formal analysis.
But there is one more reason…
In part 3, I will outline how holding cash creates economic value, regardless of and in addition to, all these explanations. Go to Part 3.