How Is This Research Useful to Practitioners?
The issue of “trapped cash” sparks investors’ interest, but its definition and measurement often seem to be misunderstood. The authors provide practitioners with a clear definition of trapped cash, permanently reinvested earnings, and foreign cash.
Trapped cash comprises cash and cash equivalents generated by foreign operations and held outside the United States because of repatriation tax concerns. Defined as an accounting concept, permanently reinvested earnings are foreign earnings reinvested in the company outside the United States for longer-term operations; no income tax accrues for this amount. Foreign cash is simply foreign earnings held as operational cash by the foreign entity. The authors advise that it is hard to determine whether companies hold cash in foreign subsidiaries for reasons of tax avoidance, long-term operations, cash management, or some combination thereof.
To identify companies with trapped cash, the authors develop a model in a two-stage process. First, they identify multinational S&P 500 companies that repatriated cash in 2004, when a one-time repatriation tax reduction occurred. Second, they examine these companies to determine factors that are significant indicators of trapped cash.
The results of the authors’ model show that companies with relatively higher amounts of trapped cash tend to be companies with greater R&D intensity, lower capital intensity, greater foreign growth opportunities, and subsidiary operations in a tax haven country. The authors also find a negative relationship between trapped cash and firm value over 1999–2010. Overall, they provide a better understanding of trapped cash and show how to identify companies with trapped cash and how it can affect firm value.
How Did the Authors Conduct This Research?
The authors first identify companies in the S&P 500 Index that had multinational operations between 1999 and 2010. They then pare down this list to include only companies that repatriated cash in 2004 because of the lower repatriation tax rate under the American Jobs Creation Act (AJCA). Finally, if a company used the AJCA to finance cash repatriation, the authors view the company as not having trapped cash. They assume that the remaining companies in the dataset (which have multinational operations) have trapped cash.
Next, they test potential factors that could lead these companies to have trapped cash. The test results suggest that the most important factors are high R&D spending, low capital intensity ratios, high foreign growth opportunities, and the tax status of individual countries. Using these findings, the authors create a model to determine whether a company is likely to have trapped cash.
They also analyze the relationship between firm valuation and the firm’s amount of trapped cash. The authors find a negative relationship, in which firms with higher amounts of trapped cash have relatively lower equity valuations, and determine that this negative relationship is driven primarily by poor corporate governance policies.
The authors provide a useful understanding of trapped cash. It is important to be able to accurately compute a company’s trapped cash as opposed to its long-term investments and operational cash.
The authors’ model, developed to predict which companies may have trapped cash, shows positive results when applied to a sample of S&P 500 companies over 2010–2012. The model should be tested over longer periods to determine whether it is a consistent predictor of significant trapped cash. If so, the model could prove useful to investors, regulators, and government officials. More research is necessary to verify the negative relationship between trapped cash and firm value.
Finally, the ramifications of trapped cash may not be as large as many investors, regulators, and government officials believe. Caution is needed when attempting to quantify the amount of cash that would be repatriated and the amount of tax revenue that would be generated from such repatriation. Companies with overseas operations should be rewarded for efficiently using cash generated abroad to fund foreign operations or to manage cash. Trapped cash is a topic that definitely merits further research. It does not appear to be as straightforward as many think.