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.     

How common are credit-less recoveries? Firm-level evidence on the role of financial markets in crisis recovery

We study firm recoveries from systemic sudden stops in developing countries, where firms' cash flows suffer exogenous shocks. Contrary to macro studies suggesting that output recovery precedes that of the financial sector, firm-level data shows that only in less than a third of firms, operating cash flows recover without a recovery in external credit, and even these firms have access to other sources of cash. Specifically, firms with high prior short-term debt exposure do experience a sharp reduction in short-term credit but increase operating cash flows during a crisis. Firms with high prior cash holdings experience negative cash flows and deplete their cash holdings. Thus, firms' financial prepositioning predicts recovery in cash flows and is consistent with trade-off theories of capital structure and with precautionary motives for cash holdings. We find no support for the maturity mismatch hypothesis, which predicts that firms with high short-term debt should have harder recoveries post crisis.     

Corporate cash flow and stock price exposures to foreign exchange rate risk

This paper estimates the foreign exchange rate exposure of 6917 U.S. nonfinancial firms on the basis of stock prices and corporate cash flows. The results show that several firms are significantly exposed to at least one of the foreign exchange rates Canadian Dollar, Japanese Yen and Euro, and significant exposures are more frequent at longer horizons. The percentage of firms for which stock price and earnings exposures are significantly different is relatively low, though it increases with time horizon. Overall, the impact of exchange rate risk on stock prices and cash flows is similar and determined by a related set of economic factors.     

A Test of Stulz's Overinvestment Hypothesis

In a world with agency costs and asymmetric information, managers will have difficulty raising external funds since they have incentives to overinvest. Stulz argues that this leads to an optimal level of debt since this is one way to bond cash flows and reduce managerial discretion. However, unexpected cash flows cannot be so easily bonded. Thus, an implication of the Stulz hypothesis is that investment will be affected more by unexpected cash flows. Additionally, Stulz's hypothesis is most compelling for firms with low q ratios. Support is found for Stulz's hypothesis, and the support is strongest for low q firms.     

What lies beneath: Foreign exchange rate exposure,hedging and cash flows

This paper presents results from an in-depth analysis of the foreign exchange rate exposure of a large nonfinancial firm based on proprietary internal data including cash flows, derivatives and foreign currency debt, as well as external capital market data. While the operations of the multinational firm have significant exposure to foreign exchange rate risk due to foreign currency-based activities and international competition, corporate hedging mitigates this gross exposure. The analysis illustrates that the insignificance of foreign exchange rate exposures of comprehensive performance measures such as total cash flow can be explained by hedging at the firm level. Thus, the residual net exposure is economically and statistically small, even if the operating cash flows of the firm are significantly exposed to exchange rate risk. The results of the paper suggest that managers of nonfinancial firms with operations exposed to foreign exchange rate risk take savvy actions to reduce exposure to a level too low to allow its detection empirically.     

What moves international stock and bond markets?

We study the relation between international mutual fund flows and the different return components of aggregate equity and bond markets. First, we decompose international equity and bond market returns into changes in expectations of future real cash payments, interest rates, exchange rates, and discount rates. News about future cash flows, rather than discount rates, is the main driver of international stock returns. This evidence is in contrast with the typical results reported only for the US. Inflation news instead is the main driver of international bond returns. Next, we turn to the interaction between these return components and international portfolio flows. We find evidence consistent with price pressure, short-term trend chasing, and short-run overreaction in the equity market. We also find that international bond flows to emerging markets are more sensitive to interest rate shocks than equity flows.     

Cash holdings,risk, and expected returns

In this paper I develop and empirically test a model that highlights how the correlation between cash flows and a source of aggregate risk affects a firm's optimal cash holding policy. In the model, riskier firms (i.e., firms with a higher correlation between cash flows and the aggregate shock) are more likely to use costly external funding to finance their growth option exercises and have higher optimal savings. This precautionary savings motive implies a positive relation between expected equity returns and cash holdings. In addition, this positive relation is stronger for firms with less valuable growth options. Using a data set of US pubic companies, I find evidence consistent with the model's predictions.     

A Comparison of Earnings Management Between KSE Firms and KOSDAQ Firms

Abstract:   This study investigates differences in earnings management practices of Korea Stock Exchange (KSE) firms and KOSDAQ (a Korean version of the NASDAQ market) firms during the period of 1996–1997. A sample of 1,256 KSE and 577 KOSDAQ firm‐year observations is used to compare earnings management practices of firms listed in the two different stock exchanges. The results of the study reveal that KOSDAQ firms tend to more actively manipulate earnings to avoid losses than KSE firms. KOSDAQ firms generally tend to increase reported earnings more aggressively than KSE firms when their operating cash flows are poor, and play down their reported earnings more when their operating cash flows are exceptionally good. The results of the study are quite robust in the sense that more aggressive earnings management practices of KOSDAQ firms persist even when operating cash flows are controlled.     

Too much of a good thing? A theory of short-term debt as a sorting device

This paper shows that the liquidity risk associated with short-term debt financing can be used to sort insolvent firms out of financial markets when their solvency risk is private information. Notwithstanding this sorting role of short-term debt, unregulated financial firms tend to choose an inefficiently short debt maturity structure. This inefficiency arises for two reasons. First, by issuing more short-term debt, low-risk firms reduce their expected funding costs. This leads to a misalignment of private and social incentives as firms fail to fully internalize the social costs of becoming illiquid. Second, while the sorting role of short-term debt is reflected in a decline of long-term interest rates when more short-term debt is issued, creditors’ inability to observe firms’ solvency risk leads to an excessive reduction of long-term interest rates. This further distorts firms’ funding choice towards short-term debt.     

On the Determinants of SME Cash Holdings: Evidence from Spain

Abstract:  This work analyses the factors that might explain the level of cash holdings in a sample of 860 small and medium-sized firms from Spain during the period 1996–2001. The empirical results show that firms have a target cash level to which they attempt to converge. The level of this target is higher for firms with more growth opportunities and larger cash flows. In contrast, the target level for cash holdings falls when the use of bank debt and the presence of substitutes for cash increase. Moreover, when the interest rates in the economy increase firms reduce their cash holding.     

INTEREST RATE CHANGES AND COMMON STOCK RETURNS OF FINANCIAL INSTITUTIONS: REVISITED

In this paper the interest rate sensitivity of common stock returns of financial firms is re-examined. Considered here are (1) current, anticipated, and unanticipated changes in interest rates; (2) depository and nondepository firms; and (3) three different-maturity interest rate indices. Results lend strong support for a negative effect of both current and unanticipated interest rate changes. Although some exceptions are observed, stock returns of most subsectors of both financial and nonfinancial firms are not sensitive to anticipated interest rate changes. The findings of this study are robust to the choice of a particular model of interest rate expectations.     

International Evidence on Financial Derivatives Usage

Theory predicts that nonfinancial corporations might use derivatives to lower financial distress costs, coordinate cash flows with investment, or resolve agency conflicts between managers and owners. Using a new database, we find that traditional tests of these theories have little power to explain the determinants of corporate derivatives usage. Instead, we show that derivative usage is determined endogenously with other financial and operating decisions in ways that are intuitive but not related to specific theories for why firms hedge. For example, derivative usage helps determine the level and maturity of debt, dividend policy, holdings of liquid assets, and international operating hedging.     

Do earnings reported under IFRS tell us more about future earnings and cash flows?

We contribute to the debate about the relative benefits and costs of International Financial Reporting Standards (IFRS) adoption by examining whether earnings persistence and the association between current accounting earnings and future cash flows differ for firms reporting under IFRS versus firms reporting under United States Generally Accepted Accounting Principles (U.S. GAAP) and firms reporting under non-U.S. domestic accounting standards (DAS). Using samples comprised of 58,832 firm-year observations drawn from 33 countries from 2002 through 2008, we find that positive earnings reported under IFRS are no more or less persistent than earnings reported under U.S. GAAP but losses reported under IFRS are less persistent than losses reported under U.S. GAAP. Moreover, we find that earnings reported under IFRS are no more or less persistent and are no more or less associated with future cash flows than earnings reported under non-U.S. DAS. However, we find that earnings reported under U.S. GAAP are more closely associated with future cash flows than earnings reported under IFRS. This is important if a key role of reported earnings is to help investors form expectations about future cash flows. These results should be of interest to academics and standard-setters as they debate the merits of transitioning to IFRS, and to parties who use reported earnings to form expectations about future earnings and cash flows.     

Accounting measures of unfunded pension liabilities and the expected present value of future pension cash flows

The associations between three alternative measures of the unfunded pension obligation discussed in the accounting literature and a measure that reflects the present value of expected cash flows (economic liability) are examined in this study using simulated data. The sensitivity of the correlations to funding methods, growth rates of the plan population, interest rates, plan initiation dates, and extent of sweetening are also studied. It is shown that all the accounting measures of the pension obligation are highly correlated with the total economic liability when funding is excluded, but the correlations decrease significantly when the net (unfunded) liability is examined. Furthermore, it is shown analytically that one cannot predict ex ante which measure of the unfunded liability will be most highly correlated with the economic liability. The implication for accounting standard-setting bodies is that both the pension plan assets and pension obligations should be disclosed to facilitate users in making predictions about changes in the economic liability. A recent official pronouncement, SFAS 87, provides for such disclosure in most circumstances.     

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.     

The impact of labor unions on investment-cash flow sensitivity

This paper empirically examines how labor unions affect investment-cash flow sensitivity using samples from the US covering the period of 1984–2009. We find a significant positive union effect using a q model of investment. The capital expenditures of firms are 1.71 times more sensitive to internal cash flows when unionization rates increase one standard deviation from the mean. This effect holds when we control for other proxies of financial constraints. In addition, unionized firms are associated with lower cash–cash flow sensitivity, which suggests that the higher investment-cash flow sensitivity in unionized firms is primarily driven by the incentive of these firms to reduce liquidity and enhance bargaining power against the union. We also show that the above union effects become more pronounced during labor contract negotiation years.     

Flexibility in cash-flow classification under IFRS: determinants and consequences

International Financial Reporting Standards (IFRS) allow managers flexibility in classifying interest paid, interest received, and dividends received within operating, investing, or financing activities within the statement of cash flows. In contrast, U.S. Generally Accepted Accounting Principles (GAAP) requires these items to be classified as operating cash flows (OCF). Studying IFRS-reporting firms in 13 European countries, we document firms’ cash-flow classification choices vary, with about 76, 60, and 57% of our sample classifying interest paid, interest received, and dividends received, respectively, in OCF. Reported OCF under IFRS tends to exceed what would be reported under U.S. GAAP. We find the main determinants of OCF-enhancing classification choices are capital market incentives and other firm characteristics, including greater likelihood of financial distress, higher leverage, and accessing equity markets more frequently. In analyzing the consequences of reporting flexibility, we find some evidence that the market’s assessment of the persistence of operating cash flows and accruals varies with the firm’s classification choices and the results of certain OCF prediction models are sensitive to classification choices.     

Debt Financing under Asymmetric Information

We analyze the optimal design of debt maturity, coupon payments, and dividend payout restrictions under asymmetric information. We show that, if the asymmetry of information is concentrated around long-term cash flows, firms finance with coupon-bearing long-term debt that partially restricts dividend payments. If the asymmetry of information is concentrated around near-term cash flows and there exists considerable refinancing risk, firms finance with coupon-bearing long-term debt that does not restrict dividend payments. Finally, if the asymmetry of information is uniformly distributed across dates, firms finance with short-term debt.     

The term structures of equity and interest rates

This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market, and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis, and the poor performance of the capital asset pricing model.     

Further analysis of the expectations hypothesis using very short-term rates

Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] finds support for the expectations hypothesis at the very short end of the repurchase agreement (repo) term structure while other studies find calendar-time-based regularities cause rejection of the expectations hypothesis. Using Longstaff’s methods on a sample of repo rates that pre-dates Longstaff’s sample, we reject the expectations hypothesis for every maturity. The pre-Longstaff-sample repo data comes from a time period where the behavior of short-term interest rates is similar to the long-run average behavior of short-term interest rates. Our results imply that expectations hold when rates are less volatile and/or that we may be entering a period of lower volatility.