Investigating the Relevance of the Pecking Order Theory and the Agency Costs of Free Cash Flow Theory in the Eyes of Investors

Nowadays companies hold increased amounts of cash (Dittmar 2008; Schauten, van Dijk and Van der Waal 2008). Literature gives two contradictory theories that may influence the valuation of these cash holdings by investors in the market. The pecking order theory predicts that managers have more information about the state of the firm than outside investors and therefore outside investors require a premium on the money they invest in the firm (Myers and Majluf 1984). This premium is referred to as information costs because it reflects the additional amount of money firms are charged for by investors to compensate for the information gap that exists between investors and the managers of the firm. Contrary to the pecking order theory, the agency cost of free cash flow theory predicts that managers do not always have the intention to maximize shareholder value; they rather use the company’s cash to maximize their own utility (Jensen 1986). The costs that arise from agency problems are referred to as agency costs. Although the pecking order theory itself does not predict how the existence of information asymmetry may affect the market value of cash holdings, it can be argued that because firms have to pay a premium in case of external financing, investors will appraise the capital that is internally available to the firm. Therefore, information costs are likely to have a positive influence on the market value of cash holdings. On the other hand, based on the agency costs of free cash flow theory, it can be argued that when investors believe that a firm experiences agency problems they are likely to have a negative perception on the market value of cash holdings. This study aims to investigate the relevance of these contradicting theories in the eyes of the investor by analyzing the impact of information costs and agency costs on the market value of firms’ cash holdings. In an attempt to answer this issue, a longitudinal quantitative study is performed on a sample of firms traded at NYSE Amsterdam Euronext. We performed an extensive literature review to give a clear and logical presentation of the relevant research work done thus far. Based on literature findings we developed a conceptual model. The conceptual model showed the predicted relationships among variables. The operationalization of the variables was established after careful evaluation of suggestions given in the existing literature. Based on the predicted relationships in the conceptual model we developed seven hypotheses which were statistically tested by the performance of various cross sectional multiple hierarchical linear regression analysis.Management of TechnologyInnovation SystemsTechnology, Policy and Managemen