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.     

The external financing of investment

This paper investigates the impact of investment characteristics on the financing choice. We investigate instances of seasoned equity, bank debt, straight non-bank debt, and convertible issues by U.S. firms where the stated use of proceeds is capital expenditure and where we are able to hand-collect and classify the characteristics of the investment. Controlling for a firm's existing assets, capital structure and valuation, we document a strong empirical link between an investment's characteristics and the choice between debt and equity financing. Factor analysis indicates that the principal determinant of the financing choice is whether an investment's payoffs can be described as a hit or miss.     

How do firms finance their investments?: The relative importance of equity issuance and debt contracting costs

This paper examines the financing decisions of firms in response to changes in investments and profits. We find that information frictions play important roles in firms' financing decisions. However, we find no evidence that asymmetric information about the value of a firm's assets causes equity to be used only as a last resort. Indeed equity is the predominant source of finance in situations, such as profit shortfalls, investment in intangible assets, and internally generated growth opportunities, where informational asymmetries and agency costs are likely to be high. We also find that firms respond asymmetrically to positive and negative profit shocks. In financing fixed assets, high asymmetric information firms use more short-term debt and less long-term debt, whereas firms with high potential agency problems use significantly more equity and less long-term debt and cash.     

Green credit policy and corporate cash holdings: Evidence from China

In 2012, China implemented a green credit policy (GCP) that restricts bank credits to heavily polluting firms. Using a difference-in-differences research design, we find that polluting firms increased their cash reserves by 9.5% after the GCP's issuance relative to non-polluting firms. We also document that the GCP significantly reduces firms' access to bank finance but increases the value of cash. Cross-sectional analysis shows that the increase in cash holdings is more significant for firms with greater financial constraints, firms with more investment opportunities, and high-tech companies. Overall, our findings are consistent with a constraint explanation: when external financing is restricted, firms retain more cash to meet future investment needs.     

Bank risk-taking and corporate investment: Evidence from the Global Financial Crisis of 2007–2009

In this paper, we explore the relation between the banking sector's risk-taking and a firm's investment (“corporate investment”). Specifically, we ask whether firms' cash holdings moderate the effect of the banking sector's risk-taking on corporate investment. Based on a panel sample of publicly listed non-financial firms in 15 EU countries during the period 1990–2015, we document several key findings. First, both cash holdings and the banking sector's risk-taking are positively associated with corporate investment. Second, bank loan growth, which roughly captures the supply of bank credit, is not related to corporate investment. Third, firms with smaller cash holdings disproportionately invest more than do firms with larger cash holdings during periods of higher risk-taking by the banking sector.     

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.     

Financial constraints on credit ratings and cash-flow sensitivity

This study investigates whether financial constraints, as measured by the level of credit ratings and their migrations would affect the firm's cash flow allocation policies and reflect the main financial constraints on a firm's cash flow sensitivity of cash. For a given credit quality shock, control for firm-level characteristics and endogeneity of cash flow allocation, our results suggest that firms with higher credit financial constraints have significantly higher cash flow sensitivities on cash holding, investment, and debt financing activities. Our results provide evidence that credit rating risk has a larger impact on cash flow allocation and drives the financial constraints on cash flow sensitivity for various reasons, including precautionary motivation and restricted access to external financing.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses 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 emerged was 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 fl exibility 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 by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility 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 fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

Earnings Momentum,Adaptation Value,and Nonlinearities in the Valuation of Chinese Equity Stocks

We demonstrate that when the variables comprising a firm's investment opportunity set depend on their past values then the present value of the cash flows the firm expects to earn will be stated in terms of the levels and the momentum of the affected variables. It is also shown that the market value of a firm's equity is comprised of the present value of the cash flows it expects to earn from operating under its existing investment opportunity set plus the value of the real options the firm possesses to modify or even completely change its existing investment opportunity set. Our empirical analysis, based on both Chinese and US data, shows that earnings momentum and the adaptation and growth options typically available to firms all appear to have a significant impact on equity prices.     

The impact of meeting or beating analysts' operating cash flow forecasts on a firm's cost of debt

Extant literature provides conflicting results with respect to the usefulness and accuracy of analysts' operating cash flow forecasts. Our study empirically examines the importance and influence of meeting or beating analysts' operating cash flow forecasts on a firm's cost of debt. Results indicate that firms meeting/beating analysts' cash flow forecasts have higher initial bond ratings as well as lower initial bond yields. Additionally, based upon an analysis of rating changes, firms meeting or beating cash flow forecasts have a higher probability of receiving a debt rating upgrade and a lower probability of a ratings downgrade compared to firms missing cash flow forecasts. A direct comparison of the importance of meeting/beating cash flow versus earnings benchmarks indicates that debt market participants appear to incrementally value both types of forecasts, and contrary to selected equity market findings, neither forecast subsumes the other for debt market participants.     

A theory of equity carve-outs and negative stub values under heterogeneous beliefs

We develop a theory of new-project financing and equity carve-outs under heterogeneous beliefs. In our model, an employee of a firm generates an idea for a new project that can be financed either by issuing equity against the cash flows of the entire firm (“integration”), or by undertaking an equity carve-out of the new project alone (“non-integration”). While the patent underlying the new project is owned by the firm, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The firm's choice between integration and non-integration is driven primarily by heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders: if the marginal outsider financing the new project is more optimistic about the prospects of the project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding new-project cash flows than that about assets-in-place cash flows, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the firm's financing choice are the cost of motivating the employee to exert optimal effort, and the potential synergies between the new project and assets in place. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the “negative stub values” documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values.     

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.     

Corporate Payout Policy,Cash Savings,and the Cost of Consistency: Evidence from a Structural Estimation

We develop a dynamic structural model to better understand how corporate payout policy is determined in conjunction with other corporate decisions. In a first‐best model, a manager maximizes equity value by choosing the firm's optimal financing, investment, dividends, and cash holdings. By using simulated method of moments, we show that, on average, firms excessively smooth their payout while making corporate savings overly volatile and retaining excess cash. We then extend the model to capture the effect of a manager, who perceives a cost to cutting payouts. Estimating the model, we infer the magnitude of this cost. We find that a managerial preference for consistent payout explains the smooth payout and high volatility of cash holdings.     

The Initial Public Offerings of Listed Firms

A number of firms in the United Kingdom list without issuing equity and then issue equity shortly thereafter. We argue that this two‐stage offering strategy is less costly than an initial public offering (IPO) because trading reduces the valuation uncertainty of these firms before they issue equity. We find that initial returns are 10% to 30% lower for these firms than for comparable IPOs, and we provide evidence that the market in the firm's shares lowers financing costs. We also show that these firms time the market both when they list and when they issue equity.     

A theory of operational cash holding,endogenous financial constraints,and credit rationing

This paper develops a theory of operational cash holding. Liquidity shocks due to delayed payments must be financed using cash or short-term debt. Debt holders provide an irrevocable credit line given a firm's expected insolvency risk, and equity holders select optimum cash holding. The model demonstrates the trade-off between cash holding and investing in fixed assets. Introducing uncertain cash flows leads to precautionary cash holding if debt holders impose financial constraints. Precautionary cash holding, in turn, reduces insolvency risk enhancing access to short-term finance. The theory shows that credit rationing can occur in the absence of market frictions. Using U.S. data from 1998 to 2012, empirical findings suggest that the decline in credit lines has contributed to the increase in cash holding in line with theoretical predictions.     

The Relation Between Reporting Quality and Financing and Investment: Evidence from Changes in Financing Capacity

We use changes in the value of a firm's real estate assets as an exogenous change in a firm's financing capacity to examine (1) the relation between reporting quality and financing and investment conditional on this change, and (2) firms’ reporting quality responses to the change in financing capacity. We find that financing and investment by firms with higher reporting quality is less affected by changes in real estate values than are financing and investment by firms with lower reporting quality. Further, firms increase reporting quality in response to decreases in financing capacity. Our findings contribute to the literature on reporting quality and investment, and on the determinants of reporting quality choices.     

A Unified Theory of Tobin's q,Corporate Investment,Financing, and Risk Management

We propose a model of dynamic investment, financing, and risk management for financially constrained firms. The model highlights the central importance of the endogenous marginal value of liquidity (cash and credit line) for corporate decisions. Our three main results are: (1) investment depends on the ratio of marginal q to the marginal value of liquidity, and the relation between investment and marginal q changes with the marginal source of funding; (2) optimal external financing and payout are characterized by an endogenous double‐barrier policy for the firm's cash‐capital ratio; and (3) liquidity management and derivatives hedging are complementary risk management tools.     

Determinants of Managerial Stock Ownership: The Case of CEOs

Research on the determinants of managerial equity ownership in firms is scant. To a limited extent, prior researchers have examined the variations in insider ownership proportions by combining the officers and directors into one group. This paper differs from earlier studies by focusing on the CEO. The evidence suggests that agency costs, free cash flow, and potential non-diversification losses and CEO attributes are important in explaining variations in CEOs' equity proportions in firms. Specifically, the paper finds that the proportion of CEO's ownership is related positively to the firm's debt level, diversification potential of the firm's common stock, free cash flows, and earnings volatility, and related negatively to the firm size.     

State-ownership and financial constraints on investment of Chinese-listed firms: new evidence

We examine how state-ownership affects financial constraints on investment of Chinese-listed firms during 1999–2008. We find that although an average sample firm experiences some degree of financial constraints, state-ownership does not necessarily help in reducing the firm's financial constraints on investment. Further evidence shows that state-ownership does not lead to more borrowing from the Chinese banking sector, implying that state-ownership does not necessarily reduce the firm's financial constraints via the state-controlled banking sector. We consider not only the standard factors in the investment equation, but also the firm's equity financing behaviour explicitly. The result is robust to both the conventional proxy for financial constraints, i.e. the investment–cash-flow sensitivity, and a recently developed proxy for financial constraints, i.e. the KZ index. Our results suggest that China's corporatisation movement is effective in that soft budget constraints once enjoyed by former state-owned enterprises have been removed along with the progress of corporatisation. These firms, although still state-involved, can be seen as modern corporations operating in a market environment.     

The tax incentives and corporate cash holdings: Evidence from a quasi-natural experiment of an accelerated depreciation tax policy for fixed assets

Based on a quasi-natural experiment of an accelerated depreciation tax policy (ADP) for fixed assets in China, we examine the impact of the ADP on corporate cash holdings. Using a multiperiod difference-in-differences model with a sample of Chinese A-share listed firms from 2008 to 2020, we document that firms subject to the ADP exhibit lower cash holdings compared to firms not affected by the policy. The effect is more pronounced for young firms, profitable firms, and firms with less R&D investment. According to our mechanism analysis, the ADP mitigates a firm's financing constraints and financialization and therefore, a firm does not need as much as cash holdings as they did before the implementation of the ADP. The mechanism test results suggest that the ADP lowers the precautionary and speculative demand for cash. The analysis of economic consequences shows that the reduction of cash holdings significantly enhances firm value. Our research results suggest that the ADP is a good policy for firms.