We’ve posted before about the increasing cash balances at many companies – here and here. The WSJ today has an article about Apple’s large cash hoard and the debate over whether the company should return some of it to shareholders or keep it for future investment. In one of our earlier posts, we emphasized the impact of the Great Recession on the expected returns from new investment. Of course, with the interest rate earned on cash balances at rock bottom, can the return on investment really be even lower? This question highlights the fact that the cash balance decision is about more than just a simple comparison of the immediate return on investment against the return on cash. Cash balances earn an implicit return as a precaution against future events – the so-called convenience yield. The Great Recession has not only recalibrated the forecasted return on investments, but has also recalibrated the convenience yield on cash, increasing the value of larger balances. Here are two ways.
First, the collapse of Lehman and all the troubles in the financial sector made access to external funding more difficult and uncertain. In the last two years, many banks have felt overextended in lines of credit previously granted to corporations, and with weak balance sheets banks have been unable to raise capital to expand their loan portfolios. So companies worry more that external capital is less available, which raises the value of accumulating their own reserves against future cash needs.
Second, anyone following the troubles of the Japanese economy in the last two decades knows that a weak financial system combined with deflation can be deadly to companies that rely on debt. With sales slumping and prices falling, levered companies find trouble servicing their debts given positive real interest rates. Cash reserves are useful not just to repay debt if deflation kicks in, but also as an alternative source of funds when debt needs to be rolled over by a reluctant financial system.
The options facing shareholders, too, have been reshaped by the Financial Crisis and the Great Recession, and this may be another explanation why some are untroubled by companies that are holding onto the cash. Until very recently things were so bleak and uncertain that investors didn’t have a better idea for their savings, and just replicated what corporations were doing. As recently as August 2010, there was talk that the US economy might fall into a double dip recession with the risk of deflation in the horizon, prompting an energetic response by the Fed (the QE2 program); in the Eurozone, a mounting government debt crisis kept many spirits alarmed. Under these conditions, investors put their money in short term assets and repaid their debts. Indeed, this is what the data on the flow of funds reveals.
None of these factors reshaping the corporate cash decisions is easily measured. We lack very useful normative models that can be recommended as reliable tools for guiding corporate decisions on cash; at least not any that are readily benchmarked against measurable factors. All we can really do is watch what individual corporations do and how their shareholders respond. It will be fun to watch the debates at Apple as the company reports its earnings today and begins to discuss its decisions about the future.