The Value of Financial Flexibility

We develop a model that endogenizes dynamic financing, investment, and cash retention/payout policies in order to analyze the effect of financial flexibility on firm value. We show that the value of financing flexibility depends on the costs of external financing, the level of corporate and personal tax rates that determine the effective cost of holding cash, the firm's growth potential and maturity, and the reversibility of capital. Through simulations, we demonstrate that firms facing financing frictions should simultaneously borrow and lend, and we examine the nature of dynamic debt and liquidity policies and the value associated with corporate liquidity.     

A note on a semiparametric approach to estimating financing constraints in firms

In this paper, we present a novel approach to modeling financing constraints of firms. Specifically, we adopt an approach in which firm-level investment is a nonparametric function of some relevant firm characteristics, cash flow in particular. This enables us to generate firm-year specific measures of cash flow sensitivity of investment. We are therefore able to draw conclusions about financing constraints of individual firms as well as cohorts of firms without having to split our sample on an ad hoc basis. This is a significant improvement over the stylized approach that is based on comparison of point estimates of cash flow sensitivity of investment of the average firm of ad hoc sub-samples of firms. We use firm-level data from India to highlight the advantages of our approach. Our results suggest that the estimates generated by this approach are meaningful from an economic point of view and are consistent with the literature.     

Why do firms save cash from cash flows? Evidence from firm‐level estimation of cash–cash flow sensitivities

We construct firm‐level estimates for the cash flow sensitivity of cash (CCFS) by modelling heterogeneous slopes in reduced‐form cash equations. This approach allows identifying firms with a high, low or even negative savings propensity. We find that high CCFS firms have higher income variation, suggesting cash buffering is triggered by income shocks. High CCFS firms do not suffer from financing constraints measured by a wide selection of indicators. Our results suggest that the CCFS is not an adequate indicator to capture financing constraints. Rather, a higher CCFS indicates smoothing of income fluctuations by installing a cash buffer that successfully prevents future income shortfall.     

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.     

The relationship between a firm’s information environment and its cash holding decision

This study directly investigates the relationship between the firm’s information environment and its cash holding decision using two separate country-level events as proxies for a general improvement of the information environment: the initial enforcement of new insider trading laws and the mandatory adoption of International Financial Reporting Standards. Analysing a large international sample, we find that firms reduce their cash holdings after both exogenous information shocks. We also find that the reductions are greater for firms facing greater financing constraints and agency issues, and for those for which the informational shocks are stronger. Further analyses reveal a reduction in firms’ average cash savings rate, an increase in performance, an increase in the use of external debt, a decrease in abnormal investment, and an increase in the value of cash holdings. Taken together, our results suggest that an improvement in the information environment mitigates both the adverse selection and moral hazard problems thereby, leading to a reduction in cash reserves held for transaction and precautionary motives, and the likelihood of entrenched managers building large cash balances for private benefit.     

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.     

Cash holdings and R&D smoothing

The sharp increase in R&D investment in recent decades has important but unexplored implications for corporate liquidity management. Because R&D has high adjustment costs and is financed with volatile sources, it is very expensive for firms to adjust the flow of R&D in response to transitory finance shocks. The main contribution of this paper is to directly examine whether firms use cash reserves to smooth their R&D expenditures. We estimate dynamic R&D models and find that firms most likely to face financing frictions rely extensively on cash holdings to smooth R&D. In particular, our estimates suggest that young firms used cash holdings to dampen the volatility in R&D by approximately 75% during the 1998–2002 boom and bust in equity issues. Firms less likely to face financing frictions appear to smooth R&D without the use of costly cash holdings. Our findings provide new insights into the value of liquidity and the financing of intangible investment, and suggest that R&D smoothing with cash reserves is now important for understanding cash management for a substantial fraction of publicly traded firms.     

The effects of accounting restatements on firm growth

Do restatements result in lower firm growth? One argument in support of this contention is that accounting restatements hurt contracting relations between the firm and outside parties such as a firm’s customers and suppliers, negatively impacting firm cash flows. The negative impact on cash flow reduces the level of internal cash holdings available for investment. Another argument is that restatements dampen firm growth by increasing the firm’s cost of external financing. We empirically evaluate these arguments by using the standard sales growth based financial planning model. In carrying out our analysis, we distinguish the effects of restatement on overall firm growth as well as its components of internally and externally financed growth. Our findings suggest that overall firm growth rates decline following a restatement. Furthermore, we find that accounting restatements have a greater adverse impact on externally financed growth rates. We also find that not all restatements yield identical effects: the impact of restatements is more pronounced for the subsample of firms identified to have undertaken the more egregious fraudulent reporting than the subsample of firms that reported restatements to correct previous accounting errors. We also find that firms with severe restatements, measured based on announcement period market reactions, have lower externally financed growth. Overall, our evidence highlights the adverse impact of restatement on firm growth, particularly through external financing.     

Corporate Control and the Choice of Investment Financing: The Case of Corporate Acquisitions

We test the proposition that corporate control considerations motivate the means of investment financing—cash (and debt) or stock. Corporate insiders who value control will prefer financing investments by cash or debt rather than by issuing new stock which dilutes their holdings and increases the risk of losing control. Our empirical results support this hypothesis: in corporate acquisitions, the larger the managerial ownership fraction of the acquiring firm the more likely the use of cash financing. Also, the previously observed negative bidders' abnormal returns associated with stock financing are mainly in acquisitions made by firms with low managerial ownership.     

Investment, Uncertainty, and Liquidity

We analyze the dynamic investment decision of a firm subject to an endogenous financing constraint. The threat of future funding shortfalls lowers the value of the firm's timing options and encourages acceleration of investment beyond the first‐best optimal level. As well as highlighting another way by which capital market frictions can distort investment behavior, this result implies that (1) the sensitivity of investment to cash flow can be greatest for high‐liquidity firms and (2) greater uncertainty has an ambiguous effect on investment.     

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.     

Idiosyncratic Cash Flows and Systematic Risk

We show that unpriced cash flow shocks contain information about future priced risk. A positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases firm size and idiosyncratic risk. A simple model can therefore explain book‐to‐market and size anomalies, as well as the negative relation between idiosyncratic volatility and stock returns. Empirically, we find that anomalies are more pronounced for firms with high idiosyncratic cash flow volatility. More generally, our results imply that any economic variable correlated with the history of idiosyncratic shocks can help to explain expected stock returns.     

What Moves Investment Growth?

We use accounting identities to decompose unexpected changes in investment growth into surprises to current cash‐flow growth and stock returns, and revisions of expectations about future cash‐flow growth and future discount rates. Using a vector autoregressive model we find that current cash‐flow surprises account for the largest element of the variance decomposition. Investment growth and current cash‐flow surprises are negatively correlated with news about future cash‐flow growth, which can be expected from persistent productivity shocks and decreasing returns to scale. We find little evidence of a discount rate channel for investment since return terms are small and have unintuitive signs.     

Do Acquisitions Relieve Target Firms’ Financial Constraints?

Managers often claim that target firms are financially constrained prior to being acquired and that these constraints are eased following the acquisition. Using a large sample of European acquisitions, we document that the level of cash that target firms hold, the sensitivity of cash to cash flow, and the sensitivity of investment to cash flow all decline, while investment increases following the acquisition. These effects are stronger in deals that are more likely to be associated with financing improvements. Our findings suggest that acquisitions relieve financial frictions in target firms, especially when the target firm is relatively small.     

Dynamic Agency and the q Theory of Investment

We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history‐dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with idiosyncratic risk, and is positively correlated with past profits, past investment, and managerial compensation even with time‐invariant investment opportunities. Optimal contracting involves deferred compensation, possible termination, and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.     

Time-inconsistent investment,financial constraints,and cash flow hedging

This paper studies the interplay between firm investment and cash flow hedging decisions when the decision-maker has time-inconsistent preferences. We show that cash flow hedging acts as a double-edged sword. In some cases, cash flow hedging enhances firm value because the firm can thus invest at the firm-value-maximizing timing. In other cases, however, cash flow hedging may adversely affect firm value because it loosens the financial constraint that works as a commitment device to mitigate premature investment. Our results thus highlight one unexplored potential dark side of hedging and suggest that the optimal hedging decision is the result of a trade-off between flexibility and commitment.     

Are Multiple Directorships Beneficial in East Asia?

We posit that the benefits and costs of multiple directorships are conditional on firm characteristics. We find firm valuation is positively associated with multiple directorships in (i) firms with high advising needs and (ii) firms with high external financing needs. These beneficial effects of multiple directorships are generally stronger in countries with weak shareholder rights and in firms that are widely held. However, when controlling shareholder hold high voting‐rights to cash‐flow rights, multiple directorships reduce firm valuation, especially in countries with weak shareholder rights and in closely held firms. As multiple directorships increases, cash holdings (capital expenditures) contribute less to shareholder value. The negative association between value of cash (capital expenditure) and busy boards is mitigated in firms with (i) high advising needs, (ii) high external financing needs and (iii) less entrenched ownership structures.     

The effect of financial constraints,investment policy,product market competition and corporate governance on the value of cash holdings

This study empirically investigates the value shareholders place on excess cash holdings and how shareholders’ valuation of cash holdings is associated with financial constraints, firm growth, cash‐flow uncertainty and product market competition for Australian firms from 1990 to 2007. Our results indicate that the marginal value of cash holdings to shareholders declines with larger cash holdings and higher leverage. However, firms that are more financially constrained, that have higher growth rates and that face greater uncertainty exhibit a higher marginal value of cash holdings. These findings are consistent with the explanation that excess cash holdings are not necessarily detrimental to firm value. Firms with costly external financing and that also save more cash for current operating and future investing needs find that the market values these cash hoarding policies favourably. Finally, there is limited evidence of an association between various corporate governance measures and the value of cash holdings for a shorter sample period.     

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.     

Collateral and capital structure

We develop a dynamic model of investment, capital structure, leasing, and risk management based on firms' need to collateralize promises to pay with tangible assets. Both financing and risk management involve promises to pay subject to collateral constraints. Leasing is strongly collateralized costly financing and permits greater leverage. More constrained firms hedge less and lease more, both cross-sectionally and dynamically. Mature firms suffering adverse cash flow shocks may cut risk management and sell and lease back assets. Persistence of productivity reduces the benefits to hedging low cash flows and can lead firms not to hedge at all.