Determinants of corporate cash holdings: Evidence from spin-offs

We study the factors that influence the cash allocation decision around a spin-off, using variables suggested by the trade-off theory, and controlling for the possible endogeneity of leverage and cash ratios. Spin-offs provide an opportunity to examine the determinants of cash allocation at the margin at the time of creation of a new entity. Our results indicate that managers allocate higher cash ratios to smaller firms, and firms with high research and development expense ratio, low net working capital ratio, and low leverage. Thus, higher cash ratios are correlated with difficulty of raising external capital and reduced availability of cash from internal sources. In addition, managers also base the cash allocation on observable immediate growth opportunities instead of on long-term possible growth. An analysis of excess cash ratios, defined as the difference between the actual and predicted cash ratios, indicate that firms are, on average, allocated less cash than suggested by trade-off models, and this deviation in allocated cash from predicted levels is explained only by concurrent profitability of the firms (a pecking order theory implication).     

Is there a pecking order? Evidence from a panel of IPO firms

We test the pecking order model of capital structure by examining the financing of firms that went public in 1983. We estimate a logit to predict external financing, and a multinomial logit to predict the type of financing using data on the IPO firms' security offerings during 1984–1992. Our results indicate that the probability of obtaining external funds is unrelated to the shortfall in internally generated funds, although firms with cash surpluses avoid external financing. Firms that access the capital markets do not follow the pecking order when choosing the type of security to offer.     

Do Portuguese private firms follow pecking order financing?

This paper tests for pecking order behavior in medium-sized private Portuguese firms. In contrast to the usual split between internal funds, debt, and external equity, we separate debt into four components – cheap trade credits (CTC), bank loans (BL), other loans, and expensive credits (EC). We use breakpoint tests to identify when firms switch between funding sources by examining the change in each funding source based on the financing deficit remaining after the previous pecking order funding source has been used. Our tests indicate that Portuguese companies generally move from lower cost to higher cost financing sources, but they do not exhaust each type of debt before moving on to the next funding source in the pecking order. Such behavior is consistent with a loose interpretation of pecking order financing, but not a strict interpretation of the theory. Instead, Portuguese firms may be balancing pecking order financing with a need to maintain some degree of financing flexibility.     

A Dynamic Model of the Firm: Structural Explanations of Key Empirical Findings

We derive a dynamic model of the firm in the spirit of the trade‐off theory of capital structure that explains firm behavior in terms of firm characteristics. We show our model is consistent with many important findings about the cross‐section of firms, including the negative relations between profitability and leverage, and between dividends and investment‐cash flow sensitivities. The model also explains the existence of zero‐debt firms and their observed characteristics. These results have been used to challenge the trade‐off theory and the assumption of perfect capital markets. We revisit these critiques and provide structural explanations for the regularities we replicate.     

The impact of cash flows and firm size on investment: The international evidence

This paper examines the degree to which cash flow availability influences firm investment in six OECD countries. In particular, we are interested in the extent to which the reliance on internal funds is affected by firm size, since there is general agreement that smaller firms have less access to external capital markets and, thus, should be more affected by the availability of internal funds. Earlier work has concluded that the documented positive relationship between cash flow and investment is evidence of the existence of financial constraints. We first examine all firms, regardless of size, in each country, and we find that the amount of corporate investment is affected by internal resources in all six countries; that is, internal financing affects firm investment. We then repeat the analysis segmenting the sample using three measures of firm size. Contrary to our a priori expectations, we find that the cash flow-investment sensitivity is generally highest in the large firm size group and smallest in the small firm size group. We deduce that the explanations for these findings are grounded in managerial agency considerations, and in the greater flexibility enjoyed by large firms in timing their investments. Thus, we conclude that the degree of sensitivity of a firm's investments to its cash flows cannot be interpreted as an accurate measure of its access to capital markets (as do Kaplan, S., Zingales, L., 1997. The Quarterly Journal of Economics 169–215), since small firms are known to have less access to external markets.     

Capital structure in new technology-based firms: Evidence from the Irish software sector

Using a sample of 117 Irish software companies, we examine the capital structure of new technology-based firms. Consistent with the findings on financing for other small businesses, internal funds are the most important source of funding in new technology-based firms. However, in apparent contradiction to the pecking order hypothesis, the use of debt is rare and equity financing is the prime source of external finance. By questioning chief executive officers via survey on their perceptions and opinions on various financing issues, we are able to conclude that in many cases software firm founders prefer outside equity to debt. The dearth of debt in the capital structure of new technology-based firms cannot be wholly explained by financing constraints due to information asymmetries in the banking sector.     

Internal Funds Allocation and the Ownership Structure: Evidence from Korean Business Groups

We examine the relationship between the controlling shareholder’s cash flow rights and the funds transfer in the internal capital market within Korean business groups (chaebols) during the period from 1998 to 2001. We find that the funds allocation in the firms where controlling shareholders have high cash flow rights is better aligned with the investment opportunities and therefore, more efficient than in the firms where they have low cash flow rights. This effect is stronger when they have controlling powers large enough to expropriate minority shareholders. However, during the financial crisis period, funds simply move toward the firms where controlling shareholders have high cash flow rights. The results evidence the tunneling behavior in the internal capital market within a chaebol that the ownership structure distorts the allocation of internal funds in such a way as to benefit the controlling shareholders.JEL Classification: G31, G30     

Subsidiary debt,capital structure and internal capital markets

I study external debt issued by operating subsidiaries of diversified firms. Consistent with Kahn and Winton's [2004. Moral hazard and optimal subsidiary structure for financial institutions. Journal of Finance 59, 2537–2575] model, where subsidiary debt mitigates asset substitution, I find firms are more likely to use subsidiary debt when their divisions vary more in risk. Consistent with subsidiary debt mitigating the free cash flow problem, I find that subsidiaries are more likely to have their own external debt when they have fewer growth options and higher cash flow than the rest of the firm. Finally, I find that subsidiary debt mitigates the “corporate socialism” and “poaching” problems modeled in theories of internal capital markets.     

The Design of Financial Policies in Corporate Spin-offs

We examine differences in financial leverage between parentand spun-off firms that emerge from corporate spin-offs. Ourtests control for past financing choices and the costs of adjustingcapital structure, factors that can obscure cross-sectionalpatterns among firms' target leverage ratios. We find that firmsthat emerge from spin-offs with more financial leverage havea higher cash flow return on assets, lower variability of industryoperating income, and a greater proportion of fixed assets.The positive relation between profitability and the use of financialleverage, in a setting that is free of pecking order effects,is particularly important because it contrasts with existingevidence. Our results indicate that the ability to cover debtpayments and default-related costs are important determinantsof the use of financial leverage, as implied by the trade-offtheory of capital structure. We find no evidence that managerialincentives or governance characteristics affect the differencein leverage ratios in firms that emerge from spin-offs.     

Financing constraints and internal capital markets: Evidence from Korean `chaebols'

We compare the investment–cash flow sensitivity of Korean chaebols (conglomerates) and non-chaebol firms. We show that investment–cash flow sensitivity is low and insignificant for chaebol firms but is high and significant for non-chaebol firms. On the other hand, a chaebol firm's investment is significantly related to the growth opportunities but that of a non-chaebol firm is not. A chaebol firm's investment is significantly affected by the cash flow of other firms within the same chaebol even though they are independent legal entities. With these findings, we argue that there is an internal capital market in a chaebol and the internal capital market reduces the financing constraints of the chaebol. However, the operation of the internal capital market does not improve the efficiency of allocation of scarce funds in the Korean economy since we find that chaebols invest more than non-chaebol firms despite their relatively poor growth opportunities.     

Financing Preferences of Spanish Firms: Evidence on the Pecking Order Theory

This paper analyses some of the empirical implications of the pecking order theory in the Spanish market using a panel data analysis of 1,566 firms over 1994–2000. The results show that the pecking order theory holds for most subsamples analyzed, particularly for the small and medium-sized enterprises and for the high-growth and highly leveraged companies. It is also shown that both the more and the less leveraged firms tend to converge towards more balanced capital structures. Finally, we observe that firms finance their funds flow deficits with long term debt.     

Business cycles,financial cycles and capital structure

We perform peridogram based cycle analysis of firm capital structure and find evidence that firms’ leverage is both persistent and cyclical. The cyclicality of leverage is supported by the trade-off, pecking order and market timing capital structure theories (Korajczyk and Levy in J Financ Econ 68:75–109, 2003; Bhamra et al. in Rev Financ Stud 23:645–703, 2010). Although market timing theory research supports persistence, previous literature dictates that the trade-off and pecking order theories may predict either persistent or mean reverting leverage. Our tests reject mean reversion in favor of persistent and cyclical leverage. We corroborate pecking order theory literature that predicts leverage is persistent. In these models, when firms’ investment spending is below earnings, leverage decreases. In addition, we examine whether firms change their capital structure as a result of business and financial cycles. Since financial cycles last longer than business cycles, financial cycles should have a long term effect on leverage. Our findings confirm the persistent leverage business cycle models that suggest firms change their capital structure due to financial and credit cycles (Jermann and Quadrini in Am Econ Rev 102:238–271, 2012; Azariadis et al. in Rev Econ Stud 83:1364–1405, 2016). We conclude that leverage is persistent due to the cyclicality of the financing decision.     

Hedging and competition

We consider firms that, all else equal, wish to minimize variability in their internal capital (due to convex costs of raising external funds). The firms can hedge the cash flow risk of the project, but not that of winning or losing the auction. We characterize optimal hedging and bidding strategies in this competition framework. We show that access to financial markets makes firms bid more aggressively, possibly even above their valuation for the project. In addition, hedging increases the variance of bids and makes firm values more dispersed. Further, with hedging, the covariance of internal capital changes with the risk factor is negative, and is more negative, the higher the correlation of the hedging instrument with the risk factor.     

The firm''s leverage-cash flow relationship

Two separate strands of the literature on capital structure under asymmetric information consider the relationship between a firm's financial leverage and cash flow. Signalling theory suggests a positive relationship, while pecking order behavior implies a negative relationship. These contrasting theoretical implications appear contradictory. However, both are supported in different bodies of empirical literature. Leverage-changing event studies tend to support a positive relationship while cross-sectional studies typically reveal a negative relationship. This paper proposes that the appropriate pecking order relationship is contemporaneous — between current leverage and current cash flow, while the relevant signalling relationship is intertemporal-between current leverage and future cash flow. A dynamic simultaneous equations model is built which allows the firm's leverage, cash flow, and risk to interact jointly in the same period, as well as across time. Empirical results reveal that, in the same time period, leverage and cash flow tend to be negatively related, while across time leverage is positively related to future cash flow. Thus the apparent contradictions in the theoretical and empirical literature may be reconciled by considering both the contemporaneous and dynamic aspects of the firm's leverage/cash flow relationship.     

Implications of Internal Funds Surplus for Determining Agency Spending of SEO Proceeds and Timing Incentives

According to the pecking order theory, firms with potential investment projects should raise external capital if and only if sufficient internal funds are not available. The theory can be violated if equity issuers are motivated by market timing and increasing funds for insiders’ benefits, indicating that firms may already have internal funds surplus without including external funds, but still issue equity. By controlling for future funds needs, the analyses show that issuers that engage in market timing and spend the SEO proceeds on value-destroying projects are strongly associated with their internal funds surplus. Moreover, SEO announcement returns are lower for issuers with internal funds surplus. This pattern strongly supports the predictive ability of internal funds surplus to detect the need for external capital and ultimately to determine timing incentives and agency spending of SEO proceeds.     

Corporate control and shareholder activism in Germany: An empirical analysis of hedge fund strategies

Government-initiated reforms of the German financial system two decades ago shifted corporate control activities from universal banks to capital markets. Hedge funds took advantage of these changes by acquiring stakes in weakly governed firms. For 653 hedge fund interventions between 2000 and 2020, this study analyzes the changes in financial and operating performance and firm characteristics before and after the event. We also assess the probabilities that a firm becomes a target and that an attack creates shareholders value. On average, hedge funds increased returns, with the magnitude depending on the period, level of aggressiveness, institutional ownership, and industry. Crisis and non-crisis results differ, as hedge funds strategies are mostly successful in a rising stock market environment. Typically, hedge funds targeted smaller and more visible firms with higher sales growth, lower leverage, and higher institutional ownership. After the attack, firm profitability and cash holdings decreased, leverage increased, while investments in M&A and capex declined. This research offers new empirical evidence on the success of hedge fund strategies in Germany and on the performance of targeted firms.     

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.     

Do Managers Have Capital Structure Targets? Evidence from Corporate Spinoffs

The two main theories of capital structure—the tradeoff theory and the pecking order theory—have opposite predictions about the expected relationship between corporate leverage and profitability. According to the tradeoff theory, companies that earn higher profits will use more debt both to shield their income from corporate taxes and to discipline corporate investment policy. In contrast, the pecking order theory predicts that more profitable companies will borrow less mainly because they have less need to borrow.
Corporate spinoffs provide a unique opportunity to investigate the influence of profitability and other asset characteristics on the design of capital structure. In their study of 98 spinoffs over the period 1979–1997, the authors began by investigating the popular argument that managers routinely assign more debt to subsidiaries than parents in order to leave the parents less encumbered—a possibility they reject after finding that the average leverage ratios of the parents and spunoff units were roughly equal. At the same time, the authors reported large differences in the leverage ratios among both parents and spun-off units, and that the variation was explained primarily by differences in three factors: asset tangibility and the level and variability of cash operating profits. Consistent with the tradeoff theory (but not the pecking order), the study found a significantly positive correlation between a post-spinoff company's cash profitability and its assigned debt load, as well as a negative correlation between debt and the variability of operating cash flow.     

An Empirical Test of Ross's Cash Flow Beta Theory of Capital Structure

This paper empirically investigates Ross's cash flow beta theory of capital structure. Ross hypothesizes that, for firms of similar cash flow variance, there will be an inverse relationship between financial leverage and cash flow beta. This paper provides empirical support for Ross's theory, though the extent of the support depends upon the sample period and the leverage specification.