Cash Retention Strategies: Test of Free Cash Flow Theory

Abstract

This chapter examines financing decisions by firms listed on the Mumbai Stock Exchange. A study by Singh and Hamid of stock market data for the top 100 manufacturing firms in several industrialising countries showed how these firms use internal and external resources to finance investment (Singh and Hamid, 1992). They concluded that variations in corporate financing in developing countries have some common characteristics. They show that although firms in these countries maintain significant retention ratios, they quite often use external funds and shares to finance their investment. This differs from the more commonly accepted pecking order pattern of finance in most industrialised countries where profits and debt are more commonly used than equity as a source of capital. Singh and Hamid focus on large indigenous firms, but many collaborative ventures involving multinationals and smaller local firms also use similar financing measures as evident by their presence in emerging equity markets. Cherian (1996), Cobham and Subramaniam (1995), and Bhaduri (1999) are sceptical of the evidence regarding the level dependence on external finance as presented by Singh and Hamid. This chapter tries to extend this work by considering one of the basic determinants underlying the choice between internal and external finance: cash retention policy.