Investment–cash flow sensitivity measures investment thirst,but not financial constraint

Literature streams disagree about the capacity of investment–cash flow sensitivity (ICFS) to measure both investment thirst and financial constraint. We argue that ICFS measures the former but not the latter. Therefore, we use Fazzari et al.'s study (1988) to develop a model to test the relationship between ICFS and financial constraint, but extend that model using Kornai (1979) to include investment thirst. We demonstrate: because the ICFS–financial constraint relationship varies, ICFS cannot measure financial constraint. Conversely, using a natural experiment of China's Four Trillion Stimulus policy, we show ICFS significantly and positively correlates with investment thirst after controlling for financial constraint.     

The Effect of Venture Capital Financing on the Sensitivity to Cash Flow of Firm's Investments

This work studies the effect of venture capital (VC) financing on firms' investments in a longitudinal sample of 379 Italian unlisted new‐technology‐based firms (NTBFs) observed over the 10‐year period from 1994 to 2003. We distinguish the effects of VC financing according to the type of investor: independent VC (IVC) funds and corporate VC (CVC) investors. Previous studies argue that NTBFs are the firms most likely to be financially constrained. The technology‐intensive nature of their activity and their lack of a track record increase adverse selection and moral hazard problems. Moreover, most of their assets are firm‐specific or intangible and hence cannot be pledged as collateral. In accordance with this view, we show that the investment rate of NTBFs is strongly positively correlated with their current cash flows. We also find that after receiving VC financing, NTBFs increase their investment rate independently of the type of VC investor. However, the investments of CVC‐backed firms remain sensitive to shocks in cash flows, whereas IVC‐backed firms exhibit a low and statistically not significant investment–cash flow sensitivity that we interpret as a signal of the removal of financial constraints.     

CEO inside debt and investment‐cash flow sensitivity

This paper provides a new explanation for investment‐cash flow sensitivity from the perspective of CEO inside debt holdings. We examine the effect of CEO pensions and deferred compensation (inside debt) on investment‐cash flow sensitivity for a sample of U.S. manufacturing firms from 2006 to 2012. We find that the firms with higher relative CEO leverage ratios (CEO's debt/equity ratio scaled by the firm's debt/equity ratio) generate higher investment‐cash flow sensitivity. Moreover, one standard deviation increase in the logarithm of the relative CEO leverage ratio enlarges investment‐cash flow sensitivity by 50 per cent. This positive relationship still holds even after we take account of endogeneity and financial constraints.     

Payout Policy Relevance and Accounting‐based Valuation

DeAngelo and DeAngelo (2006) (D&D) argue ‘payout policy is not irrelevant and investment is not the sole determinant of value, even in frictionless markets’. Consistent with this view, we argue that the concept of a perfect capital market in Miller and Modigliani (1961) (M&M) and Fama and Miller (1972) can be extended to allow for managerial moral hazard if managers are assumed not to participate in securities trading. An updated version of the M&M valuation model is presented and the possibility of managerial free cash flow (FCF) retention through operating expense manipulation and sub‐optimal investment policies is discussed. Our analysis supports D&D's argument that payout policy is relevant and indicates that value relevance of payout depends on the quality of earnings measurement and the optimality of investment policy. Following this, we develop a framework for analyzing valuation and informational roles of payout in accounting‐based valuation models and apply this framework to the Ohlson (1995) and Feltham and Ohlson (1996) models. This analysis shows how these models permit payout valuation relevance due to managerial FCF retention but not payout informational relevance. Finally, we consider how the Feltham and Ohlson (1996) model can be extended to incorporate time variation in expected profitability of capital investment caused by time variation in managerial FCF retention activities and show that this explicitly affects payout value relevance. We conclude that the development of models where payout plays an explicit valuation role due to issues of moral hazard is an important direction for future research.     

Multi‐period Asset Lifetimes and Accounting‐based Equity Valuation: Take Care with Constant‐growth Terminal Value Models!

The merits of accruals in forecasting cash flows or mitigating the volatility of financials shortly after the valuation date are indisputable. However, the usefulness of accounting in equity valuation is very limited if we step beyond a certain forecasting horizon. In this paper, this limitation is emphasized by shedding new light on the accounting‐based value driver model (VDM), a widely used constant‐growth terminal value tool that uses accounting variables as input. The paper shows that, if the lifetime of a firm's assets is, on average, longer than one period, the VDM works accurately only in an idealized academic environment with an even historical corporate investment activity, a single depreciation method for all assets, and no historical inflation volatility. Artificially adjusting real‐world figures to this steady state is possible in principle, but bloats the valuation model and requires exactly the same information that is used in our cash flow‐driven benchmark model (where no adjustment phase is necessary). Beyond these theoretical shortcomings, the VDM is also prone to being misused in valuation practice due to its reliance on book (rather than economic) rates of return, and to its shortcomings in dealing adequately with the assets with an ex ante indefinite lifetime.     

Managerial hedging,equity ownership,and firm value

Suppose risk‐averse managers can hedge the aggregate component of their exposure to firm's cash‐flow risk by trading in financial markets but cannot hedge their firm‐specific exposure. This gives them incentives to pass up firm‐specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

Is Investment‐Cash Flow Sensitivity Caused by Agency Costs or Asymmetric Information? Evidence from the UK

We investigate the investment‐cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow‐sensitive. Is this sensitivity a result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that investment‐cash flow sensitivity results mainly from the agency costs of free cash flow. The magnitude of the relationship depends on insider ownership in a non‐monotonic way. Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring. Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets. We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.     

Implementing high‐powered contracts to motivate intertemporal effort supply

We characterize the optimal contract between a principal and a risk‐neutral, wealth‐constrained agent when an adverse selection problem follows a moral hazard problem. The optimal contract in this setting often is more steeply sloped for the largest output levels than is the optimal contract in either the standard moral hazard setting or the standard adverse selection setting. The large incremental rewards for exceptional performance motivate the agent to deliver substantial effort both before and after he acquires privileged information about the production environment.     

MORGAN STANLEY ROUNDTABLE ON Capital Structure and Payout Policy

A group of distinguished finance academics and practitioners discuss a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerges is that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial flexibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value both by reducing taxes and controlling the corporate free cash flow problem. In such cases, both leveraged financing and cash distributions through dividends and stock buybacks signal management's commitment to its shareholders that the firm's excess cash will not be wasted on projects that produce low‐return growth that comes at the expense of profitability. As for the choice between dividends and stock repurchases, dividends provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve more flexibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial flexibility: too little can mean lost investment opportunities, but too much can lead to overinvestment.     

财务困境企业资本投资行为的实证研究——来自中国上市公司的经验证据

以2003～2005年因连续两年亏损被ST的79家公司为对象,从投资对现金流敏感度的变化和投资战略的调整两方面对财务困境企业的资本投资行为进行理论分析和实证检验.结果表明,陷入困境后的企业因更严重的信息不对称和代理问题而遭受更严重的融资约束;与缩减投资规模相比,财务困境企业扩大投资规模更有利于其走出困境.     

The Business Cycle,Investor Sentiment,and Costly External Finance

The recent financial crisis shows that financial markets can impact the real economy. We investigate whether access to finance typically time‐varies and, if so, what are the real effects. Consistent with time‐varying external finance costs, both investment and employment are less sensitive to Tobin's q and more sensitive to cash flow during recessions and low investor sentiment periods. Share issuance plays a bigger role than debt issuance in causing these effects. Alternative tests that do not rely on q and cash flow sensitivities suggest that recessions and low sentiment increase external finance costs, thereby limiting investment and employment.     

Investment Horizon and Repo in the Over‐the‐Counter Market

This paper presents a three‐period model featuring a short‐term investor in the over‐the‐counter bond market. A short‐term investor stores cash because of a need to pay cash at some future date. If a short‐term investor buys bonds, then a deadline for retrieving cash lowers the resale price of bonds for the investor through bilateral bargaining in the bond market. Ex‐ante, this hold‐up problem explains the use of a repo by a short‐term investor, the existence of a haircut, and the vulnerability of a repo market to counterparty risk. This result holds without any uncertainty about bond returns or asymmetric information.     

Limits‐to‐arbitrage,investment frictions,and the investment effect: New evidence

This study comprehensively reexamines the debate over behavioral and rational explanations for the investment effect in an updated sample. We closely follow the previous literature and provide several differences. Our tests include five prominent measures of corporate investment and corporate profitability in q‐theory and recent investment‐based asset pricing models. Both classical and Bayesian inferences show that limits‐to‐arbitrage tend to be supported by more evidence than investment frictions for all investment measures. When idiosyncratic volatility and cash flow volatility are used in measuring investment frictions, the inference is more favorable for the rational explanation.     

S&P 500 index addition,liquidity management and Tobin's Q

This study examines the revision in cash holdings and the market valuation of investment opportunities of 475 firms added to the Standard & Poor's 500 (S&P 500) stock market index from 1980 to 2010. We find that newly indexed firms have evolved to significantly lower cash balances, which we partially explain by the decreasing growth opportunities following index inclusion. Consistent with index inclusion loosening financial constraints, we document a larger decrease in cash for index inclusions in sectors with high financial dependence. We sort S&P 500 inclusions by corporate governance quality but do not find any empirical support that changes in cash and Tobin's Q are related to management entrenchment.     

The impacts of parent’s listing status on subsidiary’s financial constraint and cost of equity capital: the case of equity carve‐outs

We find that listed parents’ carve‐outs have investment‐cash‐flow sensitivities 70 per cent lower than unlisted parents’ carve‐outs, on average. Such a finding is stronger when we consider only equity carve‐outs in technological industries. The finding suggests that listed parents are more capable of alleviating the financial constraint of their carved‐out units than private parents. Our further analysis shows that listed parents’ carve‐outs also have a lower cost of equity than their counterparts, but such difference cannot be explained by corporate transparency, as implied by analyst coverage and analysts’ forecast dispersion. Therefore, we argue that the benefits from affiliation with a listed parent to the carve‐out come mainly from the parent’s financial support rather than an increase in corporate transparency.     

The effect of government quality on corporate cash holdings

We use China as a laboratory to test the effect of government quality on cash holdings. We build on, and extend, the existing literature on government expropriation and its interaction with firm-level agency problems by proposing a financial constraint mitigation argument. We find that firms hold less cash when local government quality is high, which is not consistent with the state expropriation argument, but supports the financial constraint mitigation argument. A good government lowers the investment sensitivity to cash flows and cash sensitivity to cash flows, decreases cash holdings more significantly in private firms, and improves access to bank and trade credit financing. We also test and find support for Stulz's (2005) model on the interaction between government and firm agency problems.     

The joint influence of financial risk perception and risk tolerance on individual investment decision‐making

The increasing complexity of the investment environment has accelerated the need for better quality financial advice services. Central to quality advice is advisers’ accurate assessment of their clients’ risk characteristics. Typically a client's risk characteristic is assessed by measuring the client's risk tolerance but not risk perception. To assess whether this practice fails to fully capture the client's risk profile, we explore both risk tolerance and risk perception in the investment decision‐making context. Using Australian online survey data of financial adviser clients (n = 364), our results reveal that risk tolerance influences risky‐asset allocation directly and indirectly through risk perception. These results thus clarify the joint role of both risk constructs in the investment making decision and highlight the importance of assessing both in the provision of client financial advice services. Importantly, our results validate a new comprehensive risk perception measure applicable in the financial advice context.     

Why Does the Law Matter? Investor Protection and Its Effects on Investment,Finance, and Growth

Investor protection is associated with greater investment sensitivity to q and lower investment sensitivity to cash flow. Finance plays a role in causing these effects; in countries with strong investor protection, external finance increases more strongly with q, and declines more strongly with cash flow. We further find that q and cash flow sensitivities are associated with ex post investment efficiency; investment predicts growth and profits more strongly in countries with greater q sensitivities and lower cash flow sensitivities. The paper's findings are broadly consistent with investor protection promoting accurate share prices, reducing financial constraints, and encouraging efficient investment.     

Information and the hold‐up problem

We examine situations in which a party must make a sunk investment prior to contracting with a second party to purchase an essential complementary input. We study how the resulting hold‐up problem is affected by the seller's information about the investing party's likely returns from its investment. Our principal focus is on the effects of the investment's being observable by the noninvesting party. We establish conditions under which the seller's ability to observe the buyer's investment harms the seller, benefits the buyer, and reduces equilibrium investment and total surplus. We also note conditions under which investment and welfare rise when investment is observable.