Firm value and optimal cash level: evidence from Pakistan

The purpose of this paper is to investigate the relationship between firm value and cash holdings for the period 2003-2008. This study seeks to find if there are costs and benefits associated with holding too much or too little cash, then an optimal cash level exists where marginal benefits are offset by their costs. If this optimal point exists, then firm value will be maximized at that point and deviation from it will affect the firm value negatively.

Optimal cash level between firm value and cash holding is determined by investigating the concave relationship. If concave relationship exists then a residual term is included in the equation to see how deviations from the optimal level affect firm value. A two-step generalized method of moments (GMM) estimator is used in estimating all results. GMM controls for unobserved firm heterogeneity and endogeneity problems.

Results showed that a concave relationship exists between firm value and cash holdings, which confirmed that there is an optimal cash level that maximizes firm value. It was also found that deviations from the optimal level affect firm value negatively.

The paper provides the existence of an optimal point of cash between costs and benefits wherein firm value is maximized. It has implications for firms’ investment and financing decisions when there is limited access to external finance. At higher level of cash the study has implications for agency theory and governance practices.

The study establishes a conclusive relationship between firm value and cash holdings within the context of the Pakistani market.