Question: If you were the CFO of a firm today planning to

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Question:
If you were the CFO of a firm today planning to have excess cash for a 90–120-day period, what would you do with it keeping in mind your goal of maximizing shareholder wealth? What’s your justification for this decision?

Answer:

The question can be answered in two parts: 1) Why companies decide to hold cash; 2 ) If held excess cash, how to maximize shareholder wealth.

Part 1: As per general notion, the primary motives for a company behind holding excess cash are as follows:

  1. Transaction motive: This refers to organizing day-to-day business related expenses payments to its employees in the form of wages and salaries, interest payments on loans, dividend payment to shareholders, purchase of goods, etc.
  2. Precautionary motive: This can be referred to as holding cash as a safety measure for any unpredictable or unforeseen events such as litigation charges, natural disasters, restructuring requirements, increase in raw material prices, foreign currency fluctuations, losses due to labor strikes etc.
  3. Speculative motive: A firm may decide to hold some cash by postponing some transactions if it predicts some favorable conditions in the future. For example, if the raw material prices are going to fall in the future, it may decide to delay its current purchase of raw material. Similarly, a similar opportunity may arise if interest rates are expected to fall or inventory prices are going to decline.

Part 2: Supposing, none of the above case arises for the company, the CEO can use the excess cash in following ways to increase the shareholders worth:

  1. Investing in a new business opportunity: The cash can be used to expand the current business in new geography or by purchasing a new factory, technology or office space. The CEO may also decide to venture into an unrelated business to diversify the revenue sources. This can increase the shareholders worth in long term.
  2. Pay special dividends: The Company may declare a special dividend to its existing shareholders, thereby shooting the market cap in short-term. The main difference between the current and previous point is the responsibility to decide for reinvestment lies at the Company’s discretion at the former, whereas it gets transferred to the shareholders at the later.
  3. Repurchase of shares: If a CEO predicts the upcoming results of the company are not going to be as expected, then he may choose to keep cash to repurchase the shares from market after the results are announced. This will help in two ways. First, the share prices will be low as the results are below expectations; second, repurchase of shares from market will instantly shoot up the prices for existing shares thereby increasing the shareholders worth.

 

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