How firms manage their cash flows: an examination of diversification’s effect

We extend recently documented evidence that diversified firms hold significantly less cash than specialized firms to consider differences in how diversified and specialized firms adjust their cash flows to achieve their target cash balance. We find that diversified firms have higher free cash flows as a result of equal operating cash flows and lower investment in comparison to specialized firms. Diversified firms save less cash by placing less reliance on external financing; by issuing less debt and equity, and distributing higher cash dividends. Our findings support the hypothesis that diversified firms are able to hold less precautionary cash as they are in better position to finance investment opportunities internally from operating cash flows.     

Capital Project Analysis When Cash Flows Evolve as a Continuous Time Branching Process

Optimal capital budgeting criteria now exist for a variety of applications when project cash flows (or present values) evolve in terms of the well-known geometric Brownian motion. However, relatively little is known about the capital budgeting procedures that ought to be implemented when cash flows are generated by stochastic processes other than the geometric Brownian motion. Given this, our purpose here is to develop optimal investment criteria for capital projects with cash flows that evolve in terms of a continuous time branching process. Branching processes are compatible with an empirical phenomenon known as 'volatility smile'. This occurs when there are systematic fluctuations in the implied volatility of a capital project's cash flows as the cash flow grows in magnitude. A number of studies have shown that this phenomenon characterizes the cash flow streams of the capital projects in which firms typically invest. We implement optimal capital budgeting procedures for both the continuous time branching process and the geometric Brownian motion using cost and revenue data for the Stuart oil shale project in central Queensland, Australia. This example shows that significant differences can arise between the optimal investment criteria for cash flows based on a branching process and those based on the geometric Brownian motion. This underscores the need for the geometric Brownian motion broadly to reflect the way a given capital project's cash flows actually evolve if serious errors in valuation and/or capital budgeting decisions are to be avoided.     

The evolution of financial constraints

We demonstrate that the severity of financial constraints has declined over time for two reasons: (i) improved access to external funds as evidenced by a decreased reliance on internal cash flows, and (ii) an inward shifting investment frontier with reduced investment opportunities. The decline in financial constraints coincides with the documented diminishing sensitivity of investment to cash flows, yet we show that cash flows remain a determining factor in helping constrained firms overcome restricted access to external capital. There is a flight-to-quality during economic shocks, where the adverse effects following periods of tightened credit are particularly pronounced for smaller firms, with larger firms appearing largely unaffected.     

Effects of financial constraints on corporate policies in Australia

We jointly study the impact of financial constraints on Australian companies’ investment decisions and demand for liquidity. By examining a large sample of Australian firms over the period 1990–2003, we find that financial constraints not only reduce the sensitivity of investment to the availability of internal funds, but also increase the responsiveness of cash holdings to internally generated cash flows. Further analysis shows that the impact of financial constraints varies across different cash flow states; that is, financial constraints have a small effect on corporate investment and cash policies when cash flows are positive. In contrast, the severity of constraints is high in negative cash flow years in which the cost disadvantage of external finance coincides with deteriorating operating performance.     

The Relationship between Investment and Asset Life

Optimal investment in an asset and its optimal life are shown to be interrelated through operating cash flows and depreciation allowance, as well as book and salvage values upon termination; thus they are determined simultaneously. Asset life and investment are positively (negatively) related if delaying abandonment increases (reduces) the benefit of marginal investment. If investment and asset life are positively related, increased debt financing or allowable depreciation positively impact on them; otherwise, the impact is ambiguous in sign. Further, investment in a zero salvage value asset and its holding period increase with depreciation or leverage when (1) its cash flows form an annuity or (2) the firm employing it is tax-exempt.     

Valuación con opciones reales de proyectos con flujos correlacionados con fundamentales económicos y con saltos extremos Viabilidad del caso COMERCI UCB

This paper extends the method of discounted cash flows to value investment projects through incorporating real options. It is assumed the cash flows generated by the firm are correlated with macroeconomic fundamentals, particularly with the interest rate. It is also assumed that the cash flows have jumps whose size is given by an extreme value distribution. The flows are viewed as a portfolio of real options. The options arise from a stochastic dynamic optimization process where the investor (the entrepreneur) seeks to maximize his/her total profit discounted, subject to the wealth he/she possesses. This wealth includes the investment project, a risk-free bond, and a set of real options associated with the project.     

A text book treatment of calculating returns on non-traditional portfolios

This paper addresses a gap in traditional portfolio literature by providing techniques for identifying returns on non-traditional portfolios.Futures contracts require daily cash flows over the holding period; these cash flows determine the rate of return. The security deposit represents a tied investment since the funds are not available for other uses and do not earn a risk adjusted return. To initiate a short option or a short stock position also requires a cash outflow. The cash outflow or equity deposit effectively constitutes an investment since the trader postpones consumption in a risky medium that does not guarantee the return of the funds.By identifying the amount of the investment and rates of returns, it is possible to extend normative investment analysis to non-traditional portfolio holdings. This paper introduces four propositions to aid in this process.     

Determinants of Investment Cash Flow Sensitivity

I classify firms into groups of high, low, and negative sensitivity. I find that investment-cash flow sensitivity is nonmonotonic with respect to financial constraints, cash flows, and growth opportunities. Firms classified as negative cash flow sensitive have the lowest cash flows, highest growth opportunities, and appear the most financially constrained. Cash flow insensitive firms have the highest cash flows, lowest growth opportunities, and appear the least financially constrained. To a large extent, the negative relationship between cash flow and investment is driven by the opposite trends followed by investment and cash flow, as firms grow through stages of their life cycle.     

Duration-Driven Returns

We propose a duration-based explanation for the premia on major equity factors, including value, profitability, investment, low-risk, and payout factors. These factors invest in firms that earn most of their cash flows in the near future and could therefore be driven by a premium on near-future cash flows. We test this hypothesis using a novel data set of single-stock dividend futures, which are claims on dividends of individual firms. Consistent with our hypothesis, the expected Capital Asset Pricing Model alpha on individual cash flows decreases in maturity within a firm, and the alpha is not related to the above characteristics when controlling for maturity.     

A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks

Traditional real options models demonstrate the importance of the “option to wait” due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional “option to learn.” The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows.     

Do prices reflect market fundamentals in real estate markets?

The purpose of this article is to examine prices on land and REIT shares for possible evidence of deviations from market fundamentals, the underlying economic forces. Models of market fundamentals are developed from the intertemporal capital asset pricing model so that risk aversion and a stochastic investment opportunity set can be incorporated in the analysis. The approach in this article is to compare ex post values of actual discounted cash flows with prices and to test whether the price series are unbiased predictors of the future discounted cash flows. Several tests of the relationship are presented, and the results suggest that prices of real estate investment trusts and prices of farm land do not always reflect fundamental value.     

Financing constraints, cash-flow risk, and corporate investment

Using an analytically tractable two-period model of a financially constrained firm, we derive an investment threshold that is U-shaped in cash holdings. We show analytically the relevant trade-offs leading to the U-shape: the firm balances financing costs for present and future investment, respectively. Our main argument is that financing costs today are more important than the risk of future financing costs. The empirically testable implications are that low-cash firms facing financing costs today are more reluctant to invest if they have less cash, or if their future cash flows are more risky. On the other hand, cash-rich firms facing no financing costs today invest in less favorable projects (i.e., forgo their real option to wait) if they have less cash, or if their future cash flows are more risky. The magnitude of these effects is amplified by the degree of market frictions that the firms are facing.     

The cash flow–investment relationship: International evidence of limited access to external finance

In efficient and complete financial markets, internal cash flows should have no impact on investment levels; but in inefficient and incomplete markets, the pecking order theory contends that there should be a positive relationship. Further, some studies show that investments of financially constrained firms are more sensitive to internal funds than those of less constrained firms but other studies show the opposite. Using comparable recent data on firms in the four largest industrialized countries (US, UK, Japan, and Germany), this study documents that in all four countries, controlling for the investment opportunity set, investment levels are significantly positively influenced by levels of internal cash flows, indicating that firms face limitation in access to external finance and may operate using a pecking order. Further, international differences in investment level sensitivities to opportunities indicate closer outside monitoring of firms in the bank-centered countries.     

Net working capital investment and capital budgeting analysis: Some pedagogical insights

Net working capital (NWC) investment, as a factor in discounted cash flow (DCF) analysis, receives little attention in the capital budgeting literature and accounting textbooks. The purpose of this paper is to explore the ways in which this important component of the analysis can be intregrated into the classroom and thus add to the student's overall understanding of capital budgeting. Four areas are discussed: (1) the significance of NWC investment in capital budgeting analysis, (2) the opportunity cost nature of the NWC investment, (3)measurement of the components of the NWC investment, and (4) use of the NWC investment to help restore the bottom line in DCF analysis to a pure cash flow basis. Integration of the fourth point into the topic of capital budgeting is found to be a convenient way to reinforce the student's understanding of the statement of cash flows.     

Organizational Capital and Investment‐Cash Flow Sensitivity: The Effect of Management Quality Practices

This paper examines the influence of organizational capital, as evident in management quality practices, on the response of firm investment to internal cash flows. We provide novel and strong evidence that investment sensitivity to internal cash flows decreases in the presence of superior management practices. We also find that superior management practices reduce the firm's financing frictions, evident in lower capital constraints. Our results are robust to numerous tests. Overall, our findings suggest that intangible organizational capital is important for investment decisions and that superior management practices contribute to value‐maximizing behavior.     

Cash Flow Sensitivity of Investment

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.     

Corporate investment,government control,and financing channels: Evidence from China's Listed Companies

We investigate the relation between the internally generated cash flows and fixed asset investments of Chinese firms and find that it is U-shaped. Cash flow and investment are negatively related for low levels of cash flow but positively related for high levels of cash flow. We find that government controlled listed firms have greater investment–cash flow sensitivities than do privately controlled listed companies, especially on the left-hand side of the U-shaped curve where cash flow is negative. However, the difference in sensitivities appears only among firms that possess few profitable investment opportunities. We attribute this finding to the government having multiple socio-economic objectives, which leads to increased capital expenditures by the firms it controls when internal funds are abundant and when internal funds are negative. There is no evidence that access to finance and soft budget constraints explain the differences between the investment–cash flow sensitivities of government controlled and privately controlled listed firms.     

Real and Financial Industry Booms and Busts

We examine how product market competition affects firm cash flows and stock returns in industry booms and busts. Our results show how real and financial factors interact in industry business cycles. In competitive industries, we find that high industry-level stock market valuation, investment, and financing are followed by sharply lower operating cash flows and abnormal stock returns. Analyst estimates are positively biased and returns comove more. In concentrated industries these relations are weak and generally insignificant. Our results are consistent with participants in competitive industries not fully internalizing the negative externality of industry competition on cash flows and stock returns.     

Cash Flow Immediacy and the Value of Investment Timing

In a model with stochastic interest rates, irreversible investment, and two investment dates, the value of investment delay has two components: the expected gain from committing now to investment at a future date and the potential gain from the ability to reverse this commitment. Holding net present value constant, we show that the values of both these components are increasing in the proportion of project cash flows that accrue in the more distant future. Our results emphasize the importance of the interaction between cash flow immediacy and interest rate uncertainty for the optimal investment policy.     

Cash Flow Risk Management in the Property/Liability Insurance Industry: A Dynamic Factor Modeling Approach

This study proposes and demonstrates a dynamic factor model that can be empirically carried out by the utilization of a factor-augmented autoregressive technique to explain and forecast the time-varying patterns of cash flows of insurance companies in the United States. A principal component approach is employed in the Factor-Augmented Autoregressive Model (FAARM) to capture the augmented factors that are to be utilized for forecasting. We describe the cash flow statistical model by a dimension-reduction technique that can depict the dynamic patterns of the cash flows of insurance firms and then measure the FAARM model. Results from the first step (principal component analysis) help capture the macroeconomic variables and the variables pertaining to insurance companies' cash flows, namely, cash flows from investment, underwriting, and risk management activities. Results from the second step offer evidence supporting that the FAARM improves the out-of-sample forecasting accuracy assessed by a forecasted root-mean-squared error (FRMSE). This article presents a set of feasible FAAR models from which an insurance firm can choose one that can be a better fit to the firm corresponding to its specific firm characteristics, such as firm size. Consequently, the chosen FAARM(s) can improve the accuracy of cash flow forecasting and thus can help insurers to manage risk via cash-flow–matching techniques.