Analysis of the level and market value of foreign cash holdings

Abstract

Multinational entities (MNEs) have increased their profits and cash reserves in foreign locations through globally expanded business activities in recent decades. Many academics and policymakers have expressed concern over the excessive foreign cash holdings of global business players. Recent foreign studies have reported basic findings on the levels, determinant factors and market value of the cash retained by the foreign subsidiaries of MNEs. However, insufficient corporate disclosure of foreign cash holdings hinders the accurate estimation of foreign cash reserves, which results in inconsistent empirical evidence across recent studies. Especially, no empirical study has been carried out on the foreign cash holdings of Korean companies, leaving no reliable factual reference for specific policy-making for the Korean economy. This study estimates the magnitude of the cash held by foreign subsidiaries of Korean companies and provides empirical analysis on the determinants and market level of the foreign cash holdings. I adopt a more direct method of estimating the foreign cash holdings than that used in the prior literature, exploiting the unique practice of simultaneously disclosing the consolidated and separate financial statements in Korea. The baseline idea for the foreign cash estimation is that the difference in the cash balances between the consolidated and the separate balance sheets should be the same as the sum of subsidiary cash balances, considering that the cash and cash equivalents are not subject to intercompany eliminations during the financial consolidation. Then, the foreign subsidiary cash is estimated by subtracting from the entire subsidiary cash the domestic subsidiaries’ cash for which the accounting data is available in the Korean commercial database. I utilize the footnote disclosure on the consolidated financial statements to identify basic information on the subsidiaries, including name, total assets, and location. Utilizing the foreign cash estimation, I conduct relevant empirical analysis on the foreign cash holdings, which is presented in two separate articles. Article 1 addresses the level of foreign cash holdings and the contributing factors and Article 2 analyzes the market value of foreign cash holdings. The test sample comprises Korean listed companies subject to consolidated financial reporting from 2011 to 2016. The main contents of each article are summarised as follows: Primarily, Article 1 shows that the ratio of cash to the other assets for foreign subsidiaries slightly exceeds that for the parent company and significantly exceeds that for domestic subsidiaries. Second, to identify the determinants contributing to the foreign cash holdings, I test for the association between the foreign cash holding ratio and the various tax variables (repatriation tax, tax haven, related party transactions and effective tax rate) as well as other economic factors (the economic development status and the business environment stability for the foreign locations). The test results show that the effect of the tax variables is non-existent or weak in general. Particularly, the repatriation tax and the tax haven variables show no significant or a weakly negative association with foreign cash holdings. This result is not consistent with the prior U.S.-based studies, which indicate that foreign cash holdings are higher in low-tax jurisdictions owing to the additional tax burden to be incurred in repatriating the foreign income to the home country. Meanwhile, the economic development and the business environment stability of the foreign countries have a remarkably positive association with foreign cash reserves. Additional analysis shows that the foreign cash holdings are obviously higher in advanced countries, such as the U.S., Germany, Australia, the U.K. and Japan, than in developing countries, including Russia, India, Thailand and Malaysia. In sum, the level of overseas cash holdings of Korean companies is driven by non-tax, economic factors, rather than tax-related factors, and foreign cash reserves are accumulated more in advanced countries than in developing countries. Considering that the corporate tax rate and the level of additional taxation on foreign-source income are fairly different from those for the U.S., my findings support the notion that non-tax factors can be more important in driving foreign cash holdings than tax variables, unlike in the previous U.S.-based studies. Article 2 analyzes the market value of the cash held by the foreign subsidiaries in comparison to the value of domestic cash holdings. The market value test follows the methodology of Faulkender and Wang (2006), which regresses the abnormal stock returns on the cash increment. The primary test result is that the market value of foreign subsidiary cash far exceeds that for domestic subsidiaries. Further, the value of foreign cash holdings is not lower than that of the complete domestic entities, including the parent company, despite the underlying handicap that subsidiary cash is normally depreciated by the ultimate investors in comparison to the cash directly retained by the parent company. The above results suggest that shareholders appreciate the cash being reserved in foreign locations as a positive sign of firm value. Next, I test for the impact of the tax factors (i.e., repatriation tax and tax haven), the economic and business environment (i.e., GDP per capita, rule of law, political stability and control of corruption), and foreign business growth. However, none of those characteristics of the foreign locations is significantly related to the market value of foreign cash. Additional analysis classifying the major countries of subsidiary residence into three sub-groups based on each of the economic and business environment factors found no specific pattern between the sub-groups and the foreign cash value, however, the market value of foreign cash holdings is outstanding partially for certain subsets of the country groups. This indicates the possibility that the determinant of the foreign cash valuation is not definitely captured by the generic evaluation indices but is related to an unidentified country-specific factor or individual firm characteristics. The main contributions of this study are summarized as follows: First, it provides the first empirical evidence of the magnitude of the foreign subsidiaries of Korean companies, which serves as the basis for future study on the relevant economic issues. Second, new evidence specific to the Korean economic environment is revealed in relation to the contributing factors and the market value of foreign cash holdings. In particular, Korea has a substantially lower corporate tax rate than the U.S., and the foreign subsidiaries of Korean parent firms are located in most cases in the major trading partner countries, rather than in low-tax jurisdictions. Under this Korean economic environment, the foreign cash holdings of Korean companies are mainly driven by the economic and regulatory environment of the foreign locations, not tax-related factors, such as repatriation tax costs incurred from the tax rate difference across jurisdictions. Accordingly, my findings have important implications for tax policies. That is, this study suggests that tax policy alternatives, such as a corporate tax rate reduction or conversion to a territorial tax system, should be reviewed with caution especially for Korea since the alternatives assume that cash reserves in low-tax jurisdictions are prevalent. In addition, the foreign cash holdings are affected by the business and investment environment in foreign countries and are appreciated by market participants. Thus, the takeaway message from a policy perspective is that not merely a technical adjustment of tax rules but also the improvement of the domestic investment environment in substance are required to induce the foreign cash back home.