helps them in achieving the key objective of maximising shareholder value. In order to establish if there is an optimum level of working capital investment that helps to achieve this key objective, the relationship between firm value and working capital investment was analysed in this section. This section also presents some justification for the establishment and pursuit of target working capital investment levels. Firm value was regressed against working capital investment represented by current assets to total assets; CATA, CATA2 and control variables.
CATA and its square were included to help in determining the turning point of the firm value- working capital investment relationship; that is the benefits of working capital investment and the negative effects of investing excessively in working capital.
Table 19 presents the results of the working capital investment-firm value regression (Equation 19) using two different proxies for size. In columns 1 and 2 with CATA and CATA2 are the focus independent variables. Column 3 and Column 4 present the regression results where CAS and its square are the main explanatory variables.
7.7.1 Working capital investment and its square
Table 19 presents the regression results. As hypothesised, CATA is positive and statistically significant at 1% (đ˝1 > 0) in Model 1 and Model 2. CATA2 is negative and statistically significant at 1% and 5% (đ˝2 < 0) in Model 1 and Model 2, respectively. These results support the principal hypothesis of this study; working capital investment and firm value have a non-linear relationship. The concave relationship is the result of the positive and negative effects of investing in working capital. Increasing working capital investment increases firm value up to a certain point (the optimal point), after which further increases in working capital investment compromise the value of the firm. As a result of the positive and negative effects, the relationship between working capital investments and firm value is non-monotonic.
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TABLE 19: WORKING CAPITAL INVESTMENT AND FIRM VALUE ESTIMATION RESULTS (1)
VALUE
(2) VALUE
(3) VALUE
(4) VALUE
CATA 7.187*** 5.737*** - -
(4.87) (4.35) - -
CATA2 -1.907*** -1.524** - -
(-2.75) (-2.46) - -
CAS - - 2.629*** 3.963***
- - (2.59) (4.19)
CAS2 - - -1.480*** -1.806***
- - (-2.98) (-3.44)
SIZE (LNMCAP) -0.292** - -0.231** -
(-2.63) - (-2.45) -
SIZE (LNTA) - -0.268 - -1.159***
- (-1.21) - (-5.93)
LEVERAGE 0.961*** 0.674*** 0.969*** 0.437**
(6.85) (3.97) (7.88) (2.72)
MTB 0.183*** 0.199*** 0.196*** 0.210***
(14.56) (15.63) (13.72) (11.28)
m2 0.424 0.386 0.407 0.508
Hansen 50.58 47.49 45.62 42.82
df 43 43 43 43
p-values 0.199 0.295 0.364 0.479
t statistics in parenthesis. *, ** and *** denote significance at 10%, 5% and 1%, respectively.
Time dummiesâ coefficients not reported for brevity.
Source: Own calculations using a balanced panel over the period 2001 to 2010. Data obtained from the McGregor BFA library.
Columns 3 and 4 in Table 19 provide more supporting evidence for the principal argument of this study. An alternative to CATA; current assets to sales, CAS and its square; CAS2, were used.
The study found that CAS is positive and statistically significant at 1% in both models 3 and 4. In model 1, the natural logarithm of market capitalisation is used to proxy size while model 2 uses the natural logarithm of total assets to proxy size. CAS2 is negative and statistically significant at 1% in both models 3 and 4, which gives more support to the non-linear relationship hypothesized. Therefore, the concave firm value-working capital investment hypothesised in this study is not rejected.
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All four models in Table 19 show that the coefficients of the two different measures of working capital investment (CATA and CAS) are positive and statistically significant, while their squares (CATA2 and CAS2) are negative and statistically significant; this demonstrates the robustness of the findings regarding the quadratic relationship between working capital investment and firm value.
Both CATA2 and CAS2 have a significant economic impact. A one standard deviation increase in both CATA2 and CAS2 results in a reduction in firm value ranging between 20% and 30%. This means that an additional investment of R1 million in working capital beyond the optimal point results in a reduction in firm value by between R200 000 and R300 000. These findings are consistent with Kieschnick et al. (2013b), who used panel data of US corporations from 1990 to 2006 to examine how working capital management affects firm value. Using stockâs excess returns to represent firm value, their study found that on average, a dollar invested in net operating working capital reduces firm value and vice-versa. Their estimation equations showed that excess working capital investment of $1 000 000 reduces firm value by about $120 000 to
$130 0000.
An attempt was made to establish the turning point7 for the sample. The results obtained seem to suggest that the optimal point of working capital investment is when current assets are 88%
of sales (based on model 3). Results obtained from models 1, 2 and 48 provide a turning point that is when current assets are above 100% of total assets (for model 1 and 2) and 100% of sales (for model 4). Such results suggests that although the relationship is non-linear, the turning point is either unattainable or falls with a certain range and is not at a specific point.
These findings in a way provide supporting evidence to the challenges managers face in achieving an optimal working capital investment point.
7 In a quadratic equation the turning point is calculated as âđ˝1 2đ˝2
â
8 The turning points were 188% for both models 1 and 2and 110% for model 4.
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Low levels of working capital investment represent an aggressive working capital management approach, while high levels of working capital investment represent a conservative working capital management approach. Therefore, these findings are consistent with the view that aggressive working capital policy (reflected by a short CCC) creates more shareholder value, while conservative working capital management compromises shareholder value. Wang (2002) found that firms with a Q ratio > 1 had a lower CCC than firms with Q ratio < 1 and concluded that aggressive liquidity management (reduction of CCC) increases operating performance and creates more shareholder value.
Low working capital investments (low inventory levels and low receivables balances), result in a shorter Operating Cycle (OC) and are associated with greater working capital efficiency. Luo et al. (2009) argue that low levels of working capital investment enable the firm to turn over its working capital faster, leading to higher expected cash flows. In addition, money freed up (by investing less in working capital) can be reinvested to generate additional income. Conversely, high working capital investment has opportunity costs of resources that could have been deployed in profitable, long-term investments. It also reduces the chances of a firm getting into financial difficulties or becoming insolvent; this lowers expected financial distress costs thereby lowering the cost of equity and increasing firm value.
These results suggest that at low levels, the firm value-working capital investment relationship of South African firms is positive because the benefits of increasing working capital investments exceed the costs. The benefits include the potential to stimulate sales and achieve higher profitability (Deloof, 2003, Shin and Soenen, 1998). Trade credit induces customers to buy products during times of low demand and âhelp firms to strengthen long-term relationships with their customersâ (Ng et al., 1999, Blinder and Maccini, 1991, Emery, 1987). According to Blinder and Maccini (1991), by holding high stock levels the firm reduces the possibility of costly production process disruptions, loss of revenue due to stock-outs and hedges against price fluctuations. This increases the firmâs borrowing capacity and decreases its default risk, which consequently reduces the required rate of return and increases in firm value (Samiloglu and
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Demirgunes, 2008). Decreasing working capital increases the firmâs liquidity risk and its cost of borrowing which lowers the firmâs value compared with a firm with a higher amount of working capital.
At low levels of working capital investments, South African listed firms benefit from low carrying costs but suffer huge shortage costs. Low levels of inventory shortage costs result in inability to satisfy customersâ needs, loss of goodwill, and loss of sales and revenue. A tight credit policy results in loss of revenue / sales while low levels of cash hamper the firmâs ability to pay maturing obligations on time (Damodaran, 2001, Firer et al., 2012). These reduce the value of the firm. Therefore, there are advantages to increasing the level of working capital investment because the benefits of additional investments exceed the cost of holding working capital investments.
The benefits of increasing working capital investments rise faster than the costs of increases in working capital investments until it reaches a turning point. As these firms continue to invest in working capital beyond its optimal working capital investment point, the costs rise faster than the benefits, causing a reduction in their value. These costs include low or negative returns on cash and marketable securities, the additional cost of financing receivables, handling costs of inventory and the opportunity cost of money locked-up in stocks and receivables. All form of inventory do not earn any income and incur carrying costs like storage, insurance, deterioration, obsolescence and inventory holding opportunity costs (Gitman et al., 2010).
Marketable securities earn low returns on the money market and are at best, a zero Net Present Value investment for a tax-paying firm due to the corporate tax payable on the interest received from such investments (Brealey et al., 2008). The average nominal return on South African money market securities has been around 6% (Firer et al., 2012) and the average cost of capital for an ungeared firm is 15% (Grandes and Pinaud, 2004, Power, 2004) This means that a company holding money market investments suffers a direct loss of 9%. The more money invested in inventory and receivables, the less money a firm has to undertake profitable investments (MartĂnez-Sola et al., 2013b)
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FIGURE 7: OPTIMAL INVESTMENT IN CURRENT ASSETS: BENEFITS AND COSTS
costs of holding current assets
Rand Benefits of holding current assets Turning point
Firm value
CA* Amount of current assets (CA) The optimal amount of current assets
This point minimises total costs Source: Authorâs views
Huge working capital investments reduce firm value because the firm may be relying on external capital which is more costly than internal funds. Shin and Soenen (1998) posit that despite the fact that Wal-Mart and Kmart had the same capital structures, Kmart likely faced additional financing expenses of approximately $200 million annually because its cash conversion cycle was 21 days longer than Wal-Martâs 40 days. Poor working capital investment (as shown by the longer CCC) has been attributed to Kmartâs eventual bankruptcy.
7.7.2 Leverage
Leverage is significantly related to firm value, consistent with Modigliani and Miller (1963) tax shield argument and the free cash flow argument put forward by Jensen (1986). The tax shield theory states that debt is valuable to the firm as interest on debt is tax deductible; this increases the value of the firm. Consequently, a levered firm has a higher value than an otherwise identical unlevered firm. Jensen (1986) contents that debt plays a crucial role in
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improving organisational efficiency by reducing free cash flow agency costs; that is, it reduces resources available for spending at the discretion of managers.
7.7.3 Growth opportunities
The study found a positive relationship between market to book ratio (proxy for growth opportunities) and firm value in all four models, consistent with previous studies (MartĂnez-Sola et al., 2013b, Maury and Pajuste, 2005, La Porta et al., 2002).
7.7.4 Size
Consistent with MartĂnez-Sola et al. (2013a), the study found that both proxies for firm size (LNMCAP and LNTA) are inversely related to firm value, except in column 2 of Table 18.