105 NTU Management Review Vol. 31 No. 1 Apr. 2021 4.5 Robustness Test: The Contracting Hypothesis The contracting hypothesis suggests firms granting managers high vega compensation are more likely required to maintain greater liquidity by creditors because the high vega compensation may encourage managers to conduct more risk-taking activities. Liu and Mauer (2011) find consistent results that firms granting managers higher vega compensation tend to hoard more cash assets on hands. Accordingly, one may argue the positive effect of excess cash holdings on the ESOs-induced M&As is merely attributed to the contracting hypothesis. Given Liu and Mauer (2011) find the contracting effect of vega compensation on cash policy is more sensitive in highly levered firms, we thus expect the positive effect of excess cash on ESO-induced M&As would be more profound in highly levered firms if the contracting hypothesis dominates. Otherwise, the precautionary motive of cash holdings may dominate if the positive effect is observed in firms with low leverage. Following Liu and Mauer (2011), we define our sample as a highly levered group if a firm’s leverage is above the sample median of the leverage ratio. Meanwhile, we also use the Z score to identify firms with high default risk because these firms are also likely to maintain a high level of liquidity due to the covenant requirement. According to the rule of Altman (1968), we define firms as high (low) -default-risk groups when their Z score are below (above) 1.8. The results are shown in Table 9. Panel A exhibits the results based on the leverage measure. Obviously, we only find the positive and significant coefficients of Vega×Cashrich in the low leverage group. When firms are highly levered, the effect of excess cash holding on the ESOs-induced M&A decisions becomes insignificant because these highly levered firms hoard the excess cash to meet the covenant requirement rather than to support their precautionary demand. Through the difference test, we find consistent results that the effect of excess cash on the ESOs-induced M&A decisions is significantly greater in low-leverage firms than that in highly levered firms. These results indicate the higher likelihood of cash-rich firms conducting ESOs-induced M&As is more associated with precautionary motives instead of with the contracting hypothesis. In panel B, the analysis is based on a Z score measure. The results are consistent with Panel A that the effect of excess cash on the ESOs-induced M&As is more sensitive in low-default-risk firms, while there is no significant difference in the effect of excess cash between high-default-risk and low-default-risk firms.
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