European Financial Management, Vol. 15, No. 1, 2009, 47–65 doi: 10.1111/j.1468-036X.2007.00420.x

Cash Flow Sensitivity of Investment Armen Hovakimian Zicklin School of Business, Baruch College, One Bernard Baruch Way, Box B10–225, New York, NY 10010, USA E-mail: armen [email protected]

Gayan´e Hovakimian Fordham University, Graduate School of Business, 113 West 60th Street, New York, NY 10023, USA E-mail: [email protected]

Abstract

Investment cash flow sensitivity is associated with both underinvestment when cash flows are low and overinvestment when cash flows are high. The accessibility of external capital is positively correlated with cash flows, intensifying investment cash flow sensitivity. Managers actively counteract the variations in internal and external liquidity by accumulating working capital when liquidity is high and draining it when liquidity is low. These results imply that cash flow sensitive firms face financial constraints, which are binding in low cash flow years. Traditional indicators of financial constraints, such as size and dividend payout, successfully distinguish firms that may potentially face constraints, but are less successful in distinguishing between periods of tight and relaxed constraints. These periods are much more clearly separated by the KZ index, which, on the other hand, is less successful in identifying firms that are likely to face liquidity constraints. Keywords: investment cash flow sensitivity, financial constraints, investment, managerial overconfidence JEL classification: G30, G31, G32

1. Introduction

The sensitivity of investment expenditures to internal cash flows is a well-documented phenomenon in the financial economics literature. In a seminal study, Fazzari et al., (1988) show that, after controlling for growth opportunities, corporate investment is sensitive to cash flow and more so for firms with low dividend payout. The authors conclude that the strong positive effect of internal funds on investment is caused by the We would like to thank an anonymous referee, John Doukas (Managing Editor), the participants of European Financial Management Association (2005) and Financial Management Association (2006) annual meetings, as well as the seminar participants at Fordham University and Baruch College for helpful comments.  C 2007 The Authors C 2007 Blackwell Publishing Ltd. Journal compilation 

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Armen Hovakimian and Gayan´e Hovakimian

liquidity constraints faced by firms with significant differences between the costs of external and internal capital. A large body of follow-up literature finds support for this argument. 1 Some other studies, however, show that investment cash flow sensitivity may be observed even in frictionless markets for reasons other than financial constraints. Specifically, because of difficulty of measuring marginal investment opportunities (Tobin’s Q), cash flow may convey information about investment opportunities that is not reflected in the estimated Q. In such cases, the observed cross-sectional variations in investment-cash flow sensitivity may simply be due to variations in Q measurement error. 2 Alternatively, cross-sectional differences in investment cash flow sensitivity may be observed if cash flow is a better proxy for growth opportunities for certain types of firms. 3 Yet another alternative explanation is that cash flow sensitivity of investment reflects the managers’ tendency to overinvest when they have access to internal funds. 4 Our empirical approach is different from those applied in previous studies. Most of the previous studies draw conclusions based on differences in cash flow sensitivities estimated for sub-samples formed using ex ante proxies for financial constraints, such as dividend payout and size. 5 However, such conclusions critically depend on the definition of and the choice of the proxy for financial constraints. For example, using alternative classification approaches, Kaplan and Zingales (1997) and Cleary (1999) find higher levels of cash flow sensitivity for firms that are least likely to be financially constrained. Unlike these studies, we make no assumptions about what causes investment cash flow sensitivity. We examine whether investment cash flow sensitivity is associated with economically significant distortions in the level and timing of investment expenditures in two steps. First, we empirically identify firms with relatively high and low investment cash flow sensitivity. Next, we explore the differences in the dynamics of their investment and methods of financing across periods of high and low cash flows. This analysis, in 1

Higher investment-cash flow sensitivity is also observed for firms that are young or small (Devereux and Schiantarelli, 1990; Oliner and Rudebusch, 1992; Kadapakkam et al., 1998; Shin and Kim, 2002) have low or no credit rating (Calomiris et al., 1996), for independent firms, as opposed to firms affiliated with industrial groups (Hoshi et al., 1991; Shin and Park, 1999). For a more complete survey, see Hubbard (1998) and Schiantarelli (1996). 2 For example, Erickson and Whited (2000) argue that the significance of cash flow disappears when they use measurement-error-consistent GMM estimators. Cummins et al. (1999) control for expected future profits and find insignificant cash flow coefficients. Gilchrist and Himmelberg (1995) find that, at least in some cases, the significance of cash flow is due to its association with investment opportunities. 3 Alti (2003) presents a model where the link between investment and cash flow is stronger for high growth firms because managers adjust current investment in response to cash flow realisations, which reflect current growth opportunities. 4 Jensen (1986) argues that managers would rather invest in negative NPV projects than pay out the free cash flow to investors. Pawlina and Renneboog (2005) find support for this hypothesis and report that investment-cash flow sensitivity is primarily driven by overinvestment by managers with high discretion. Morgado and Pindado (2003) examine the relation between investment and firm value and find evidence of both under- and overinvestment in the data. 5 Among the few exceptions, Hovakimian and Titman (2006) use a switching regression framework to simultaneously estimate the two regimes of the investment regression along with the factors that determine these regimes.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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turn, provides basis for drawing inferences about factors underlying investment cash flow sensitivity. We find that investment cash flow sensitivity is associated with underinvestment when cash flows are low and overinvestment when cash flows are high. Our conclusions are based on two key pieces of evidence. First, we find that, in low cash flow years, cash flow sensitive firms invest less, while in high cash flow years they invest more than otherwise comparable firms. Second, our results imply that, in low cash flow years, managers would like to invest more than the financing sources permit. They act as if marginal investment opportunities are not as low as implied by low market-to-book ratios and cash flows. The shortfall of funds for capital expenditures is covered with funds released by draining financial slack and net working capital to abnormally low levels. In contrast, in high cash flow years, managers invest less than the financing sources permit. Instead, they accumulate excess slack and net working capital, acting as if they anticipate future shortage of funds. These patterns of investment, along with patterns of internal and external financing, imply that cash flow sensitive firms face financial constraints, but that the severity of these constraints varies across the cash flow cycle. The constraints are binding in low cash flow years when the shortage of internally generated funds is exacerbated by lower availability of external capital. Debt is less available because cash flow sensitive firms are significantly overlevered in low cash flow years, implying that the borrowing costs are likely to be high. 6 External equity is also likely to be viewed as expensive since the market-to-book ratios of cash flow sensitive firms are low in these years. While the literature on corporate investment traditionally treats market-to-book ratios as the market’s assessment of firms’ growth opportunities, recent studies of corporate financing decisions increasingly argue that equity-financing decisions are affected by managerial perceptions of mispricing and use market-to-book as a proxy for such mispricing. 7 In contrast, high cash flow levels mark periods of increased availability of not only internal capital but also external capital due to relatively low leverage and high equity valuations. As a result, the significant levels of internally generated funds are supplemented by large quantities of new debt and equity financing, implying that financing constraints are not binding in high cash flow years. While our conclusion that cash flow sensitive firms face financial constraints is consistent with Fazzari et al. (1988) and the supporting literature, the finding that these constraints are not always binding is new. We, next, examine how traditional proxies for financial constraints, such as firm size, dividend payout and investment grade rating, vary across cash flow sensitive and cash flow insensitive firms and across their cash flow cycle. Of particular interest is their comparison with the KZ-index that, when applied as a proxy for financial constraints, does not support the link between financial constraints and investment cash flow sensitivity. 8 We find that size, dividend payout, and investment grade rating do identify firms that are likely to face financial constraints, but do not vary significantly across years of 6

Hovakimian et al. (2001) find that firms are reluctant to issue debt when their debt ratios are relatively high, since excessive leverage increases the probability of financial distress. 7 Baker and Wurgler (2002) argue that firms are reluctant to issue equity when their marketto-book ratios are relatively low because managers perceive their shares as undervalued. 8 KZ-index is an index based on the estimation of the determinants of the constrained vs. unconstrained financial status from Kaplan and Zingales (1997). The index is discussed in detail later in the paper.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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binding and non-binding liquidity constraints. In contrast, KZ index distinguishes between years with binding and non-binding constraints, but is less helpful in identifying firms that are likely to face financial constraints. Thus, the traditional proxies for financial constraints and the KZ index reflect two distinct aspects of financial constraints. Our results help explain why many studies (e.g., Almeida et al. 2004) find that, unlike other indicators of financial constraints, higher levels of KZ index are associated with lower cash flow sensitivity of cash. Specifically, we find that fixed effects regression estimates of cash flow sensitivity are the highest in high cash flow periods of cash flow sensitive firms. Yet, based on KZ index, these are the least constrained firm-years in our sample. These results are not surprising in the light of our finding that financial constraints are not binding in high cash flow periods allowing CF-sensitive firms to overinvest. We also find that fixed effects regression estimates of cash flow sensitivity are the lowest in low cash flows periods of cash flow sensitive firms, which KZ index identifies as the most constrained firm-years in our sample. Our results indicate that this effect arises because when cash flows are too low, the variation in their level has no significant effect on capital investment. The paper proceeds as follows. Section 2 describes the sample and separates cash flow sensitive and cash flow insensitive firms. Section 3 examines the dynamics of investment and financing behavior of cash flow sensitive and cash flow insensitive firms. Section 4 examines the traditional proxies of financial constraints and the KZ index for cash flow sensitive and insensitive firms and across the firms’ cash flow cycle. Section 5 summarises our conclusions. 2. The Sample Description

Our sample is drawn from COMPUSTAT and covers the 1985–2003 time period. 9 We exclude financial institutions (SIC codes 6000–6999) and firms with book values of assets, net fixed capital, or sales less than one million dollars. To minimise the influence of outliers in our analysis, we replace extreme observations of all ratio variables with missing values. 10 Since our analysis uses variables formed on the basis of time series of firm-level observations, only firms with at least two years in the time series are kept in the sample. 11 The sample does not have other survival requirements and includes a substantial number of firms that no longer exist. The final sample is an unbalanced panel dataset of 60,285 observations representing 7,176 firms. 2.1. Separating cash flow sensitive and cash flow insensitive firms Our goal in this section is to split the sample into subsamples of firms with relatively high and relatively low cash flow sensitivity of investment. 12 We identify cash flow 9

Compustat starts reporting Standard and Poors’ credit ratings in 1985. Extreme observations include values in the 99th percentile and, for variables with negative values, also those in the first percentile. 11 We have performed an analysis of the sensitivity of our results to the exclusion of firms with less than five and, alternatively, less than ten observations in the time series. Our results remained qualitatively the same. 12 Investment is defined as capital expenditures (Compustat Item 128) divided by the beginning-of-period net capital (Item 8). 10

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51

sensitive firms in two steps. First, for each firm in our sample, we gauge the firm level investment cash flow sensitivity (CFSI) by calculating the difference between the cash flow weighted time-series average investment of a firm and its simple arithmetic timeseries average investment. 13 This value is higher for firms that tend to invest more in years with relatively high cash flows and less in years with low cash flows. To account for the possibility that investment may be financed with cash flows from the previous fiscal year, we also calculate the CFSI based on cash flow that is lagged relative to investment. CFSI attempts to capture the economic significance of the variation in investment associated with variation in cash flow. CFSI will be low, for example, if there is little variation in cash flows, even if the response of investment to a dollar change in cash flow is significant. Similarly, CFSI will be low if the variation in investment induced by variation in cash flow is small relative to the average level of investment. 14 To see whether our indicator variable correctly classifies firms in the traditional regression framework, we estimate cross-section time-series investment regressions with fixed firm effects for our full sample and for firms with CFSI above 0.05 (hereafter, CF-sensitive firms) and with CFSI below 0.05 (hereafter, CF-insensitive firms), based on current or lagged cash flow: Invit = αi + β1 MBit + β2 CF it + β3 CF it−1 + εit

(1)

Table 1 shows the results of estimation of two versions of regression model (1). The dependent variable in both regressions is investment. The independent variables in the first regression, presented in Panel A, are the beginning of period market-to-book ratio of assets, MB t , as a proxy for Tobin’s Q, and cash flow, CF t . 15 The second regression, presented in Panel B, contains previous period’s cash flow, CF t −1 , as an additional regressor to account for the possibility that investment may be financed with cash flows from the previous fiscal year. The reported statistics reflect standard errors robust to heteroscedasticity and clustering by year. Both sets of results confirm the evidence of cash flow sensitivity of investment for our full sample. However, the relation between investment and cash flow is significantly positive for firms classified as CF-sensitive (0.101) and insignificant for firms classified as CF-insensitive (−0.001). The differences in CF-sensitivity are significant not only statistically, but also economically. The threshold of 0.05 used for CFSI is ad hoc. However, our sample separation does not aim to reflect any particular economic phenomenon such as, for example, 13

CFSI is calculated as

n t=1

(Iit × C Fit /

n  t=1

C Fit ) −

1 n

n 

Iit , where, n is the number of

t=1

annual observations for firm i, and t is the time period. CF is the cash flow, as defined earlier. I is the investment, as defined earlier. To avoid negative and extreme weight values, negative cash flows in this formula are set to zero. 14 CFSI can alternatively be expressed as CFSI = ρσ I σC F /C F = [ρσ I ] × [σC F /C F]. The first term in brackets is the portion of investment volatility that is due to its correlation with cash flow. The second bracketed term is the coefficient of variation of cash flow. 15 Market-to-book is (total assets (Item 6) – book value of equity (Item 60) – deferred taxes (Item 35) + market value of equity (Item 199 × Item 25)) / total assets. Cash flow is defined as (income before extraordinary items (Item 18) + depreciation and amortisation (Item 14)) divided by the beginning-of-period net capital.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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Armen Hovakimian and Gayan´e Hovakimian Table 1 Investment regressions

Fixed firm effects panel regressions of investment. Investment is capital expenditures scaled by lagged net capital. Market-to-book is (total assets − book value of equity − deferred taxes + market value of equity)/total assets. CF is cash flow, defined as (earnings before extraordinary items + depreciation) over lagged net capital. CF(−1) is lagged cash flow. The reported statistics reflect standard errors adjusted for heteroscedasticity and clustering. Coefficient estimates significantly different from zero at 5% and 1% level are marked ∗ and ∗∗ , respectively.

Full sample Coeff.

t-stat.

CF-insensitive

CF-sensitive

Coeff.

t-stat.

Coeff.

t-stat.

0.043∗∗ −0.001

16.4 −0.1

0.110∗∗ 0.101∗∗

15.9 10.9

Panel A: Market-to-book CF R-sq. Observations

0.084∗∗ 0.074∗∗

16.2 12.4

0.467 60,285

0.632 39,752

0.440 20,533

Panel B: Market-to-book CF CF(−1) R-sq. Observations

0.072∗∗ 0.060∗∗ 0.062∗∗

14.5 12.2 14.5

0.484 60,285

0.043∗∗ −0.001 0.004 0.632 39,752

15.2 −0.3 0.9

0.090∗∗ 0.087∗∗ 0.074∗∗

14.5 11.6 15.0

0.467 20,533

financial constraints. Our goal is simply to split the sample into two subsamples that differ significantly in terms of cash flow sensitivity of investment. The coefficient estimates for cash flow variables in Table 1 imply that we have clearly achieved this limited goal. That said, we have experimented with threshold values as low as 0.02 and as high as 0.1. 16 The qualitative patterns reported in the paper have not changed. Table 2 reports the mean values of investment, cash flow, and other firm characteristics, separately for CF-sensitive and CF-insensitive firms. 17 Overall, the results are consistent with the findings of earlier studies. Cash flow sensitive firms have higher rates of investment, but lower cash flows, they are smaller, less likely to pay dividends, and have somewhat lower leverage ratios, but higher tangibility, market-to-book, and R&D expenses. These firms also raise more external funds and keep higher levels of slack. 3. Investment and Financing Behaviour of CF-Sensitive and CF-Insensitive Firms

In this section, we examine whether investment-cash flow sensitivity is associated with economically significant distortions in firm investment and financing behaviour and 16 17

The mean and the median values of CFSI in our sample are 0.054 and 0.041, respectively. The reported values are the cross-sectional means of the firm-level mean values.

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Table 2 Average firm characteristics by cash flow sensitivity type The reported means are cross-sectional averages of time-series averages for individual firms. Cash flow is (earnings before extraordinary items + depreciation) over lagged net capital. Investment is capital expenditures scaled by lagged net capital. Net equity issued is the difference between equity issued and equity repurchased, scaled by net capital. Net debt issued is the change in the book value of long-term and short-term debt scaled by net capital. Financial slack is cash and marketable securities over net capital. Dividend payout indicator is set to 1 if a firm pays dividends. Leverage is the sum of short-term and long-term debt divided by total assets. Market-to-book is the (total assets − book value of equity − deferred taxes + market value of equity)/total assets.

Variable

Full sample

CF-insensitive

CF-sensitivity Investment Cash flow Equity issued Debt issued Financial slack Dividend payout indicator Leverage Market-to-book Sales (in million $)

0.054 0.304 0.306 0.156 0.173 0.959 0.288 0.272 1.591 927.4

−0.003 0.244 0.328 0.091 0.142 0.757 0.401 0.281 1.521 1308.0

Observations

7,176

4,169

CF-sensitive 0.132 0.387 0.274 0.245 0.215 1.238 0.130 0.259 1.688 399.8 3,007

why. In order to address these questions, we study firm investment and financing in periods of low and high cash flows. We define a year as low (high) cash flow if the cash flow in that year is lower (higher) than the firm’s time-series average cash flow. The average cash flows are presented in the first row of Table 3, which shows that, for cash flow sensitive firms, the difference between average cash flows in high and low cash flow periods is 2.5 times larger than it is for cash flow insensitive firms. 3.1. Investment across the cash flow cycle Average capital expenditures in low- and high cash flow periods are presented in Table 3. The results show that, in low cash flow years, CF-sensitive and insensitive firms have similar investment rates (0.210 and 0.238, respectively). In high cash flow years, however, the investment rates of CF-sensitive firms (0.507) are almost double those of CF-insensitive firms (0.269). To see whether firms overinvest or underinvest, we calculate three measures of excess investment. The first measure is simply the difference between the capital expenditures of a firm and the average capital expenditures for firms in the same year and industry (based on the two-digit SIC code). In order to control for firm-specific growth opportunities, the second measure is obtained by estimating the following crosssectional regression of investment on market-to-book ratio, separately, for each year and industry: Invi = β0 + β1 MBi + εi  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

(2)

54

Armen Hovakimian and Gayan´e Hovakimian Table 3 Investment across the cash flow cycle by investment-cash flow sensitivity type

A year is defined as low (high) cash flow if the cash flow is less (greater) than the firm’s time series mean. Cash flow is (earnings before extraordinary items + depreciation) over lagged net capital. Investment is capital expenditures scaled by lagged net capital. Net investment is the change in net capital over lagged net capital. Asset growth is the change in assets over lagged assets. Sales growth is the change in sales over lagged sales. Excess value (industry, year) is the difference between the value of the firm characteristic and the average value for firms in the same year and industry (based on the two-digit SIC code). Excess value (industry, year, MB) is the residual of a cross-sectional regression of the firm characteristic on market-to-book ratio estimated separately for each year and industry. Spell length is the average length of low and high cash flow periods excluding truncated cases. Values significantly different from zero at 5% and 1% level are marked ∗ and ∗∗ , respectively. High cash flow year values significantly different from low cash flow year values at 5% and 1% level are marked x and xx , respectively.

CF-insensitive High vs. low cash flow years

Low

CF-sensitive

High

Low

0.944∗∗xx

0.210∗∗ −0.048∗∗ −0.034∗∗ −0.031∗∗

0.269∗∗xx 0.238∗∗ xx −0.003 −0.050∗∗ ∗∗xx −0.012 −0.037∗∗ −0.009∗∗xx −0.040∗∗

0.507∗∗xx 0.191∗∗xx 0.160∗∗xx 0.151∗∗xx

Net investment 0.046∗∗ Excess net investment (industry, year) −0.057∗∗ Excess net investment (industry, year, MB) −0.043∗∗ Excess net investment (ind., year, MB,size) −0.040∗∗

0.156∗∗xx 0.003 0.033∗∗xx −0.097∗∗ 0.024∗∗xx −0.083∗∗ 0.025∗∗xx −0.085∗∗

0.330∗∗xx 0.198∗∗xx 0.165∗∗xx 0.157∗∗xx

Asset growth Excess asset growth (industry, year) Excess asset growth (industry, year, MB) Excess asset growth (ind., year, MB, size)

0.055∗∗ −0.055∗∗ −0.041∗∗ −0.038∗∗

0.179∗∗xx 0.007∗ ∗∗xx 0.050 −0.102∗∗ 0.039∗∗xx −0.088∗∗ 0.040∗∗xx −0.089∗∗

0.298∗∗x 0.160∗∗xx 0.131∗∗xx 0.125∗∗xx

Sales growth Excess sales growth (industry, year) Excess sales growth (industry, year, MB) Excess sales growth (ind., year, MB,size)

0.055∗∗ −0.048∗∗ −0.038∗∗ −0.034∗∗

0.158∗∗xx 0.034∗∗ ∗∗xx 0.035 −0.073∗∗ 0.028∗∗xx −0.063∗∗ 0.031∗∗xx −0.067∗∗

0.271∗∗xx 0.136∗∗xx 0.114∗∗xx 0.104∗∗xx

Investment Excess investment (industry, year) Excess investment (industry, year, MB) Excess investment (ind., year, MB, size)

0.165

0.582

∗∗xx

High ∗∗

Cash flow

∗∗

−0.089

Spell length

3.892∗∗

3.844∗∗xx

3.984∗∗ 3.436∗∗xx

Observations

20,060

19,692

12,042

8,491

The residuals of these regressions are then used to measure excess investment. The third measure of excess investment is similar to the second one, except regression (2) is modified to include size as an additional regressor. 18 The excess investment of CF-sensitive firms is significantly positive in high cash flow years and significantly negative in low cash flow years based on all three measures. The deviations from ‘normal’ investment in Table 3 are economically significant. For 18

Since CF-sensitive firms tend to be smaller, their investment rates may be higher than the average industry rates. Likewise, the investment rates of CF-insensitive firms may be lower than the average industry rates.

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example, the average excess investment of −0.050 implies that in low cash flow years, the investment of CF-sensitive firms is more than 17% lower than their industry mean. The average excess investment of 0.191 implies that in high cash flow years, the investment of CF-sensitive firms exceeds their industry mean by more than 50%. The excess investment of CF-insensitive firms is negative in both low- and high cash flow years. It is possible that CF-insensitive firms are less capital intensive and, therefore, their low investment rates are not really abnormal. We, therefore, also present excess values of investment defined in terms of net investment (change in net capital). This measure is different from capital expenditures because it is net of depreciation and includes the effects of acquisitions and divestitures. If depreciation is a reasonable approximation of the true rate at which the existing fixed assets of a firm have to be replaced in order to maintain the current levels of production, then investment net of depreciation is a better measure of new investment. The results show that the net investment of CF-sensitive firms is not significantly different from zero in low cash flow years, while it is significantly positive in high cash flow years. For CF-insensitive firms, net investment is significantly positive in both low- and high cash flow years. Similar to excess investment, we calculate excess net investment. We find that the underinvestment of CF-sensitive firms in low cash flow years almost doubles when we use net investment. Overinvestment in high cash flow years also increases but not significantly. For CF-insensitive firms, we now observe overinvestment in high cash flow years, though it is less than one sixth of the overinvestment by CF-sensitive firms. The underinvestment of CF-insensitive firms in low cash flow years also becomes larger, though it is only about half of that of CF-sensitive firms. Finally, we check the asset and sales growth rates and the excess growth rates by cash flow sensitivity type and across high- and low cash flow years. 19 The results in Table 3 show that asset and sales growth rates follow patterns similar to capital expenditures and, therefore, confirm the robustness of our findings. We should note that it is likely that cash flows of firms operating in the same industry are positively correlated. Such correlation would imply that when one firm finds itself constrained to invest less than it would like to because of low cash flows, other firms in the industry are likely to find themselves in a similar position. Similarly, in periods when the constraints are relaxed, they are likely to be relaxed for other firms in the industry as well. As a consequence, our measure of excess investment would underestimate the extent of both underinvestment and overinvestment. In other words, the estimates of excess investment reported in Table 3 are likely to be conservative. To summarise, the results reported in Table 3 show that investment cash flow sensitivity is associated with underinvestment in low cash flow years and overinvestment in high cash flow years, both economically significant. The evidence on internal and external financing presented in the following sections is consistent with these findings and sheds more light on their underlying factors. 3.2. External financing across the cash flow cycle The most likely explanation for underinvestment in low cash flow years is that firms cannot obtain sufficient external financing to compensate for the deficit of internal funds because of high costs. The overinvestment in high cash flow years could reflect 19

Sales growth is the change in sales over lagged sales. Asset growth is the change in assets over lagged assets.

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Armen Hovakimian and Gayan´e Hovakimian Table 4 External financing across the cash flow cycle by investment-cash flow sensitivity type

A year is defined as low (high) cash flow if the cash flow is less (greater) than the firm’s time series mean. Net equity issued is the difference between equity issued and equity repurchased, scaled by net capital. Net debt issued is the change in the book value of long-term and short-term debt scaled by net capital. Market-to-book is (total assets − book value of equity − deferred taxes + market value of equity)/total assets. Industry-adjusted market-to-book is market-to-book minus the mean two-digit SIC industry market-to-book. CAR is the three-day cumulative abnormal return around the announcement of a seasoned equity offering. Leverage is the sum of short-term and long-term debt divided by total assets. Industry-adjusted leverage is leverage minus the mean industry leverage. Values significantly different from zero at 5% and 1% level are marked ∗ and ∗∗ , respectively. High cash flow year values significantly different from low cash flow year values at 5% and 1% level are marked x and xx , respectively.

CF-insensitive High vs. low cash flow years

Low

High

CF-sensitive Low

High

Panel A: Equity Financing Equity issued Market-to-book Change in market-to-book (−2 to −1) Industry Adjusted Market-to-book CAR

0.033∗∗ 1.399∗∗

0.067∗∗xx 1.660∗∗xx

0.091∗∗ 1.494∗∗

0.313∗∗xx 1.930∗∗xx

−0.074∗∗ −0.153∗∗ −0.027∗∗

0.018∗∗xx 0.073∗∗xx −0.029∗∗

−0.201∗∗ −0.174∗∗ −0.040∗∗

0.056∗∗xx 0.221∗∗xx −0.033∗∗

0.088∗∗ 0.284∗∗ 0.010∗∗ 0.013∗∗

0.169∗∗xx 0.248∗∗xx −0.020∗∗xx −0.025∗∗xx

0.060∗∗ 0.273∗∗ 0.025∗∗ 0.032∗∗

0.290∗∗xx 0.221∗∗xx −0.021∗∗xx −0.024∗∗xx

Panel B: Debt Financing Debt issued Leverage (−1) Industry Adjusted Leverage (−1) Industry Adjusted Leverage (0) Observations

20,060

19,692

12,042

8,491

the efforts to compensate for underinvestment by transferring investments from low- to high cash flow periods. These conjectures are supported by the evidence presented in Table 4. The results in the first rows of Panels A and B show that the amounts of net debt and net equity issued are positively correlated with variations in cash flows, 20 implying that external financing may be less available precisely when a firm faces shortage in internal liquidity and vice versa. To further examine this hypothesis, we investigate the leverage and the market-to-book ratios of CF-sensitive firms in low- versus high cash flow years. 21 The literature on capital structure provides substantial evidence showing 20

Net equity issued is the difference between equity issued (Item 108) and equity repurchased (Item 115), scaled by net capital. Net debt issued is the change in book value of long-term and short-term debt scaled by net capital. These definitions follow Hovakimian et al. (2001). 21 Leverage is the sum of short-term (Item 34) and long-term debt (Item 9) divided by total assets (Item 6).  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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that leverage is an important determinant of external financing decisions. Specifically, firms are reluctant to issue debt when their debt ratios are relatively high, since excessive leverage increases the probability of financial distress (see, e.g., Hovakimian et al., 2001). Also, the possibility that managers may have private information about their firm value and may act on it has long been recognised in the corporate financing literature. Lucas and McDonald (1990) show theoretically that overvalued firms may accelerate investment to take advantage of attractive stock prices, whereas undervalued firms may postpone investment to avoid issuing undervalued equity. Loughran and Ritter (1995) find that equity issuers’ stocks significantly underperform for up to five years after the issue and conclude that firms take advantage of windows of opportunity by selling equity when it is relatively overvalued. In their survey of CFOs, Graham and Harvey (2001) find that managers consider over- and under-valuation a very important factor in making a decision to issue equity. Using high market-to-book ratios as indicators of overvaluation, Baker and Wurgler (2002) argue that market timing of equity issues is the single most important determinant of observed capital structures. Our results in Table 4 show that, in low cash flow years, CF-sensitive firms have market-to-book ratios that are low by a number of standards. First, the market-to-book ratio in an average low cash flow year (1.494) is significantly lower than it is in an average high cash flow year (1.930). Second, it is also lower than the firm’s past marketto-book ratio as indicated by a statistically significant decline of −0.201 compared to the previous year level. Third, it is significantly lower than the industry average market-tobook. The industry-adjusted market-to-book ratio is a statistically significant −0.174. 22 Low market-to-book ratios are likely to make these firms reluctant to issue equity due to perceived or real costs of issuing undervalued equity. Indeed, these firms raise about three and a half times less equity in their low cash flow years than in high cash flow years. In addition to low market-to-book ratios, CF-sensitive firms face higher indirect issuance costs in the form of a more negative market reaction to equity issue announcements, especially in their low cash flow years. For CF-insensitive firms, the cumulative abnormal returns (CARs) over three days around equity issue announcements are −0.027 and −0.029 in low and high cash flow years, respectively. 23 For CF-sensitive firms, the respective CARs are −0.040 and −0.033. These results are statistically significant. However, only the difference between CF-sensitive and CF-insensitive firms in low cash flow years is statistically significant. In low cash flow years, CF-sensitive firms also have relatively high leverage ratios (Table 3, Panel B). The average leverage ratio in low cash flow years (0.273) is significantly higher than the average leverage ratio in high cash flow years (0.221). It is also significantly higher than the average leverage ratio in the firm’s industry. The industry-adjusted leverage is a statistically significant 0.025, which is also economically significant, since it means that, at the beginning of a low cash flow year, a CF-sensitive

22

Industry-adjusted market-to-book is market-to-book minus the mean market-to-book ratio of firms in the same industry as defined by the two-digit SIC code. 23 These CARs are generated by the market model based on the CRSP value-weighted index and estimated using a 120-day period ending on day -11 relative to the registration filing day. Seasoned equity offerings are obtained from Thomson Research. The number of SEOs with available CARs in our sample is 1,579.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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firm has more than 10% higher leverage than its industry peers. 24 Furthermore, at the end of an average low cash flow year, these firms become even more overlevered, with an industry-adjusted debt ratio of 0.032. The increase in leverage is due to the combined effects of relatively low cash flows and a relatively high fraction of debt in new external financing. Overall, these results imply that firms may be unwilling to take on even more debt because they are already overlevered. In contrast, in high cash flow years, CF-sensitive firms enjoy a much easier access to external financing. Their market-to-book ratios are significantly higher than in low cash flow years, higher than the market-to-book ratios of CF-insensitive firms, and higher than the industry average market-to-book. Their leverage ratios, on the other hand, are low compared to the leverage ratios in low cash flow years, leverage ratios of CF-insensitive firms, and industry average leverage ratios. As a result, they are able to raise almost five times more debt in high cash flow periods. The combined amount of equity and debt raised by CF-sensitive firms in high cash flow years is four times the amount raised in low cash flow years. For CF-insensitive firms, the pattern of changes in external financing between highand low-cash flow periods, although similar to that of CF-sensitive firms, is much less dramatic. This is partially due to the fact that these firms show much less variation in market-to-book and leverage ratios across the cash flow cycle. It is also due to the fact that lower investment rates and more stable cash flows of CF-insensitive firms make their external financing needs more modest than the needs of CF-sensitive firms. To summarise, market-to-book and leverage ratios of CF-sensitive firms covary with cash flows in a way that may amplify investment cash flow sensitivity. In particular, they make external financing less accessible in low cash flow years, exacerbating the shortage of funds, and more accessible in high cash flow years, increasing the potential amount of financing under the managers’ discretion. Both of these potentially contribute to higher investment cash flow sensitivity. 3.3. Internal liquidity across the cash flow cycle To better understand what drives the variation in investment, we next examine how firms accumulate and use internal liquidity across the cash flow cycle. Table 5 reports the changes in financial slack and net working capital, as well as end-of-period values of slack and net working capital, by cash flow sensitivity type and across the cash flow cycle. 25 In low cash flow years, CF-sensitive firms significantly reduce their financial slack and net working capital. These declines are not due to firm downsizing since the firms experience small but positive growth in sales and total assets even in low cash flow years (see Table 3). In fact, excess changes in slack and net working capital are even more negative and significant. Excess changes are estimated as the residuals from cross-sectional regressions of changes in slack and net working capital on changes in 24

Industry-adjusted leverage is leverage minus the mean leverage of firms in the same industry as defined by the two-digit SIC code. 25 Financial slack is defined as cash and marketable securities (Item 1) over net capital. Since we include short-term debt in our analysis of external financing, our measure of net working capital excludes short-term debt and is defined as (current assets (Item 4) – (current liabilities (Item 5) – short-term debt (Item 34)) over net capital. The change in slack is change in cash and marketable securities scaled by lagged net capital. The change in net working capital is calculated similarly.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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Table 5 Internal liquidity across the cash flow cycle by investment-cash flow sensitivity type A year is defined as low (high) cash flow if the cash flow is less (greater) than the firm’s time series mean. Financial slack is cash and marketable securities over net capital. NWC is the net working capital excluding short-term debt. Excess (change in) value is the residual of a cross-sectional regression of the firm characteristic on (change in) sales estimated separately for each year and two-digit SIC industry. Values significantly different from zero at 5% and 1% level are marked ∗ and ∗∗ , respectively. High cash flow year values significantly different from low cash flow year values at 5% and 1% level are marked x and xx , respectively.

CF-insensitive

CF-sensitive

High vs. low cash flow years

Low

High

Low

High

Change in slack Change in NWC

0.001 0.008

0.070∗∗xx 0.230∗∗xx

−0.012∗ −0.086∗∗

0.150∗∗xx 0.487∗∗xx

Excess change in slack Excess change in NWC

−0.026∗∗ −0.048∗∗

0.026∗∗xx 0.060∗∗xx

−0.044∗∗ −0.121∗∗

0.067∗∗xx 0.147∗∗xx

Excess slack Excess NWC

−0.090∗∗ −0.082∗∗

−0.003xx −0.028xx

−0.008 −0.005

0.235∗∗xx 0.268∗∗xx

Observations

20,060

19,692

12,042

8,491

sales (all variables scaled by net capital), estimated separately for each year and industry as follows: Liquidityi = γ0 + γ1 Salesi + εi

(3)

In contrast, the availability of both internal and external sources of funds in high cash flow years allows CF-sensitive firms not only to increase their capital investment but also to replenish their net working capital. As can be seen in Table 5, changes in slack and net working capital in high cash flow years are significantly positive, both statistically and economically. Excess changes in these measures are also significantly positive implying that the increases are larger than could be justified based on sales growth, industry affiliation, or year effects. While the patterns for CF-insensitive firms are similar, the magnitudes are substantially lower. We also estimate the excess values of end-of-year levels of slack and net working capital as the residuals from cross-sectional regressions of these variables on sales, estimated separately for each year and industry. These regressions are similar to regression (3), but use levels of rather than changes in dependent and independent variables. The results show that CF-sensitive firms hold excessive amounts of slack and net working capital in their high cash flow years. In low cash flow years, these values drop to levels that are below normal, albeit insignificantly so. For CF-insensitive firms, the levels of slack and net working capital are abnormally low in low cash flow years and are normal in high cash flow years. 26 However, the differences between low 26

The generally lower level of slack and net working capital of cash flow insensitive firms may reflect their lower demand for internal liquidity compared to cash flow sensitive firms.

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and high cash flow years of CF-sensitive firms are 2.5 to 5 times larger than those of CF-insensitive firms. These results imply that, in low cash flow years, CF-sensitive firms need more funds than provided by cash flows and external capital. They also imply that managers anticipate low liquidity in the future, and, given the window of opportunity in high cash flow years, try to mitigate its possible consequences. 3.4. Discussion of the results The combined evidence on firm investment and financing across the cash flow cycle indicates that CF-sensitive firms underinvest because they face liquidity constraints that are binding in low cash flow years. They resort to extreme measures, including depleting their net working capital and raising external capital at potentially higher costs, in order to finance capital expenditures. Despite these efforts, however, managers are unable to fully compensate for the shortage of funds. When the constraints become non-binding and financing is abundant, managers not only significantly increase their investment, but also use the surplus of funds to accumulate internal liquidity in anticipation of future periods of binding constraints. These results suggest that in the absence of binding financial constraints we would most likely observe higher investment levels in low cash flow years and, possibly, lower investment levels in high cash flow years, as well as, lower sensitivity of investment to cash flows. Our findings do not exclude that firm growth opportunities may be lower in low cash flow periods and higher in high cash flow periods, inducing a positive correlation between cash flows and external financing, as in Moyen (2004). In fact, the market’s perception of firm growth opportunities seems to be higher when cash flows are high. However, there is enough evidence to argue that, while responding to possible variations in growth opportunities, managers have to cope with liquidity constraints. In particular, there seems to be a substantial ‘disagreement’ between their desire to invest and the availability of financing, as well as between the managers’ and the markets’ perception of growth opportunities. Underinvestment in low cash flow years and overinvestment in high cash flow years indicate that investment-cash flow sensitivity is associated with a statistically and economically significant redistribution of investment in time. To estimate whether this shift in investment timing is economically significant, we calculate the average spell for low- and high cash flow periods as a proxy for timing distortions. The results indicate that for CF-sensitive firms an average low cash flow period lasts almost four years, and an average high cash flow period lasts 3.4 years (Table 3). A delay of investment by several years implies about significant potential economic losses, even if the profitability of the investment opportunity does not deteriorate with delay. 4. Cash Flow Sensitivity and Traditional Indicators of Financial Constraints

In this section, we examine how traditional indicators of financial constraints vary across our subsamples of CF-sensitive and CF-insensitive firms as well as across years of relatively high and low cash flows. The goal is to reconcile our findings with the findings of the earlier studies of investment cash flow sensitivity. The traditional approach in studies of investment cash flow sensitivity is to estimate investment regressions such as those reported in our Table 1 for groups of firms expected  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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Table 6 Indicators of financial constraints by investment-cash flow sensitivity type and across the cash flow cycle A year is defined as low (high) cash flow if the cash flow is below (above) the firm-level time series mean cash flow. In Panel A, the reported means are cross-sectional averages of time-series averages for individual firms. Dividend payout indicator is set to 1 if a firm pays dividends. Investment grade rating indicator is set to 1 if a firm has an investment grade rating from S&P. KZ index equals −1.002 ∗ (cash flow/lagged net capital) + 0.283 ∗ (market-to-book) + 3.139 ∗ (long-term and short-term debt/total assets) −39.368 ∗ (dividends/lagged net capital) −1.315 ∗ (slack/lagged net capital). Cash flow is (earnings before extraordinary items + depreciation) over lagged net capital. Values significantly different from values in the adjoining column on the left at 5% and 1% level are marked ∗ and ∗∗ , respectively. Cash flow sensitivity estimates significantly different from zero at 5% and 1% level are marked x and xx , respectively.

Panel A.

CF-insensitive

CF-sensitive

1308.0 0.401 0.147

399.8∗∗ 0.130∗∗ 0.021∗∗

Sales (in million $) Dividend payout indicator Investment grade rating indicator KZ-index

−1.503

CF-sensitivity (regression estimate)

−0.001

Observations Panel B. High vs. low cash flow years

−1.419 0.101xx

4,169

3,007

CF-insensitive Low

High

CF-sensitive Low

High

511.9 0.156 0.027

485.2 0.178∗ 0.034∗

Sales (in million $) Dividend payout indicator Investment grade rating indicator

1,867.7 0.511 0.204

1,968.4 0.532 0.225∗∗

KZ index

−1.092

−2.181∗∗ −0.496

CF-sensitivity (regression estimate) Observations

−0.012xx 20,060

0.066xx 19,692

0.000 12,042

−2.391∗∗ 0.270xx 8,491

to face different levels of financial constraints. Among the characteristics most often used for this purpose are dividend payout, firm size, and investment grade rating. More recently, Lamont et al. (2001) use the coefficient estimates from a logit regression estimated by Kaplan and Zingales (1997) to construct a linear combination of five financial ratios, which they label as KZ index. 27 They, as well as a number of subsequent studies (e.g., Baker, 2003; Almeida et al. 2004), use the KZ index to identify financially constrained firms in their samples. Panel A of Table 6 presents average size (as measured by sales), dividend payout indicator, investment grade rating indicator, and KZ index for CF-sensitive and

27

Kaplan and Zingales (1997) classify firms using qualitative information extracted from annual reports and then estimate an ordered logit model relating a firm’s financial constraint status to its characteristics.

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CF-insensitive firms. 28 Panel B presents these variables for CF-sensitive and CFinsensitive firms in their low- and high cash flow years. The results imply that size, dividend payment status, and investment grade debt rating help distinguish between CFsensitive and CF-insensitive firms but are much less successful in distinguishing between years of binding and non-binding constraints. Specifically, on average, CF-insensitive firms are more than three times as large as CF-sensitive firms based on sales, more than three times as likely to pay dividends, and about seven times as likely to have investment grade rated debt. At the same time, the differences between high- and low cash flow years are economically trivial, although they are statistically significant for the investment grade rating and the dividend payout indicators. 29 In contrast, KZ index is more successful in differentiating between high- and low cash flow years than it is in differentiating between CF-sensitive and CF-insensitive firms. The differences between KZ indexes for high and low cash flow years in Panel B are economically large and statistically significant at the 1% level for both CF-sensitive and CF-insensitive firms. However, although in Panel A the KZ index is higher for CF-sensitive firms, indicating that these firms are more constrained, the effect is not statistically significant. Our results help explain why many studies (e.g., Almeida et al., 2004) find that, unlike other indicators of financial constraints, higher levels of KZ index are associated with lower cash flow sensitivity of cash. Specifically, the last row in Panel B of Table 5 reports the cash flow coefficient estimates obtained from traditional fixed effects investment regressions, such as those reported in our Table 1, estimated separately for high- and low cash flow years of cash flow sensitive and cash flow insensitive firms. The results show that the highest investment-cash flow sensitivity is observed for the sub-sample of cash flow sensitive firms in periods when their cash flows are high. Yet, based on KZ index, these are the least constrained firm-years in our sample. These results are not surprising in the light of our earlier finding that financial constraints are not binding in high cash flow periods allowing CF-sensitive firms to overinvest. In contrast, KZ index classifies CF-sensitive firms in their low cash flow years as the most constrained of our four sub-samples. These firm-years demonstrate zero CFsensitivity in the last row of Panel B. This evidence is also consistent with our earlier results indicating that CF-sensitive firms face binding financial constraints in their low cash flow years. As reported earlier in Table 2, CF-sensitive firms have an average cash flow of −0.089 in their low cash flow years. Variations in cash flows at these extremely low levels are not likely to induce significant changes in firm investment. Thus, the traditional proxies for financial constraints and the KZ index reflect two distinct aspects of financial constraints, which can explain the differences in the results of earlier studies that use these alternative indicators.

28

Following Lamont et al. (2001), we construct a KZ index for each of our sample observations as: −1.002 ∗ (cash flow / lagged net capital) + 0.283 ∗ (market-to-book) + 3.139 ∗ (leverage) – 39.368 ∗ (dividends / lagged net capital) – 1.315 ∗ (slack / lagged net capital). Higher levels of the KZ index indicate higher likelihood that a firm is financially constrained. 29 It is not surprising that size, dividend payment status, and investment/non-investment grade credit rating indicators vary much more in cross-section than in time series.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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5. Conclusion

This paper examines previously unexplored aspects of the investment-cash flow sensitivity issue, in particular, the investment and financing distortions associated with investment cash flow sensitivity, their economic significance, as well as their underlying factors. Our findings indicate that the observed investment-cash flow sensitivity is not a purely statistical phenomenon. Firms with high investment-cash flow sensitivity endure binding financial constraints in years when their cash flows are low. Financing is scarce not only because of lower internal liquidity but also lower market-to-book ratios and higher leverage, which make external capital more costly. Thus, the effect of cash flow shortfalls on investment expenditures is compounded by the fact that external capital is significantly less accessible in low cash flow years. As a result, these firms significantly underinvest compared to their industry peers and firms with lower investment-cash flow sensitivity. The span of an average period of low liquidity is 3–4 years, which implies about the possibility of significant economic losses. In high cash flow years, when financial constraints are not binding, cash flow sensitive firms enjoy significant internal liquidity combined with much easier access to financial markets. As a result, they issue significant amounts of debt and equity, although their internally generated cash flows far exceed their investment expenditures. Having ample resources, they are able to overinvest. They also build up their financial slack and net working capital to abnormally high levels in anticipation of less favourable liquidity conditions in the future, when these sources will be drained down to abnormally low levels. The observed patterns of financing and investment imply that managers consider it costly to delay investments that they would like to undertake in years of binding financial constraints. They actively counteract the effects of variations in cash flow on investment as they try to smooth it by taking advantage of temporary releases in financial constraints in high cash flow years. While it is still likely that the variations in cash flows reflect variations in marginal growth opportunities among other things, the observed firm behaviour is very hard to explain without invoking financial constraints. The results also suggest that managers follow their own agenda regarding investment expenditures, as opposed to passively following the market sentiment. Our analysis also shows that firms with higher investment-cash flow sensitivity have characteristics that are traditionally associated with tighter financial constraints, such as smaller size, lower likelihood of paying dividends or having investment grade debt rating. These indicators, often used for distinguishing firms with financial constraints, seem to be less successful for distinguishing between periods of high and low liquidity, since they show insignificant variation across the cash flow cycle of a firm. These periods are much more clearly separated by the KZ index, another indicator of the severity of financial constraints used in the current literature, which, on the other hand, is less successful in identifying firms that are likely to face liquidity constraints. References Almeida, H., Campello, M. and Weisbach, M. S., ‘The cash flow sensitivity of cash’, Journal of Finance, Vol. 59, 2004, pp. 1777–1804. Alti, A., ‘How sensitive is investment to cash flow when financing is frictionless?’ Journal of Finance, Vol. 58, 2003, pp. 707–22.  C 2007 The Authors C 2007 Blackwell Publishing Ltd Journal compilation 

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