Lead independent directors and investment efficiency

I show that the presence of a lead independent director on the corporate board is positively associated with investment efficiency. The result is more pronounced for firms with weaker corporate governance standards, less transparent financial disclosure, and greater financial constraints. The lead director presence is negatively associated with overinvestment (underinvestment) for firms with large cash balances and low leverage (high cash flow volatility). Moreover, the lead director investment-related committee membership as well as CEO power matter in this setting. The lead director board role is also positively associated with future firm performance.     

Cash Flow Risk Management in the Property/Liability Insurance Industry: A Dynamic Factor Modeling Approach

This study proposes and demonstrates a dynamic factor model that can be empirically carried out by the utilization of a factor-augmented autoregressive technique to explain and forecast the time-varying patterns of cash flows of insurance companies in the United States. A principal component approach is employed in the Factor-Augmented Autoregressive Model (FAARM) to capture the augmented factors that are to be utilized for forecasting. We describe the cash flow statistical model by a dimension-reduction technique that can depict the dynamic patterns of the cash flows of insurance firms and then measure the FAARM model. Results from the first step (principal component analysis) help capture the macroeconomic variables and the variables pertaining to insurance companies' cash flows, namely, cash flows from investment, underwriting, and risk management activities. Results from the second step offer evidence supporting that the FAARM improves the out-of-sample forecasting accuracy assessed by a forecasted root-mean-squared error (FRMSE). This article presents a set of feasible FAAR models from which an insurance firm can choose one that can be a better fit to the firm corresponding to its specific firm characteristics, such as firm size. Consequently, the chosen FAARM(s) can improve the accuracy of cash flow forecasting and thus can help insurers to manage risk via cash-flow–matching techniques.     

The usefulness of operating cash flow and accrual components in improving the predictive ability of earnings: a re‐examination and extension

We examine whether the components of accruals and operating cash flows improve the predictive ability of earnings for forecasting future cash flows. Unlike most previous studies, we avoid data estimation errors and sample self‐selection bias because we exploit data from Australia where reporting of actual cash flow components had been mandatory since 1992. We show that accrual components and operating cash flow components together are more useful than (i) earnings, (ii) operating cash flows and total accruals and (iii) the combination of operating cash flows with accrual components in forecasting future cash flows. These results are robust to several contextual factors, including the length of the operating cash cycle, industry membership, firm profitability and firm size.     

Effect of ownership structure on underinvestment and overinvestment: empirical evidence from Spain

This paper investigates how ownership affects the investment‐cash flow sensitivity by taking into account the non‐linearities of ownership with respect to firm value, and using a free cash flow index and a criterion for financial constraints to disentangle underinvestment and overinvestment. Interesting results are provided by estimating using the Generalized Method of Moments to eliminate the endogeneity problem. The alignment of interests between owners and managers and the monitoring by concentrated ownership both alleviate the sensitivity of investment to cash flow both in underinvestor and overinvestor firms. However, in the presence of controlling owners, underinvestment and overinvestment are exacerbated.     

Firm life cycle and idiosyncratic volatility

This paper investigates the association between idiosyncratic volatility and firm life cycle stages. Since firm performance and availability of information vary across life cycle stages, and such variation affects uncertainty about future cash flows and stock returns, we argue that idiosyncratic volatility also varies across firm life cycle stages. Using US data, this study shows that idiosyncratic volatility is significantly higher in the introduction and decline stages, and significantly lower in the growth and mature stages, when compared to that in the shake-out stage. Our study also reveals that the roles of both cash flow volatility and information uncertainty in affecting idiosyncratic volatility vary depending on firm life cycle stages. Our results are robust to alternative specifications of life cycle proxies and idiosyncratic volatility, and to an alternative regression specification.     

Firm age and realized idiosyncratic return volatility in China: The role of short-sales constraints

This paper investigates how realized idiosyncratic return volatility changes with firm age in the Chinese stock market. By employing a sample of 26,676 firm-year observations of 2798 A-share listed Chinese firms from 2001 to 2019, we find that realized idiosyncratic return volatility is negatively associated with firm age. Further, we find that loosening short-sales constraints strengthens this negative association, and that heterogeneity of investor beliefs is the most likely mechanism driving the negative relation, rather than the alternative explanations of cash flow volatility and growth options. Our results are fairly consistent under two different measures of firm age, and are robust to a choice of two multiple-factor models (the Fama-French three-factor and five-factor models) as well as two data frequencies (daily and monthly) used to estimate realized idiosyncratic return volatility.     

The influence of cash flow volatility on capital structure and the use of debt of different maturities

The empirical literature on the relationship between capital structure and firm cash flow volatility is inconclusive. We explore this relationship using several measures of a firm's cash flow volatility and econometric methods that account for the non-linear relationship of proportional variables. Overall, our evidence indicates that ceteris paribus a one standard deviation increase from the mean of cash flow volatility implies an approximately 24% decrease in the long-term debt ratio, a 26% decrease in probability of holding debt with over 10 years to maturity, and a 39% increase in the probability of holding neither short nor long term debt.     

Earnings Volatility and Earnings Prediction: Analysis and UK Evidence

This paper confirms that US evidence of a negative relationship between earnings persistence and earnings volatility applies to UK firms over the period 1991–2010. Our analytical framework highlights the possibility that this result may reflect downward estimation bias in earnings persistence (and persistence of cash flow and accruals components of earnings) related to transitory earnings elements. Out‐of‐sample forecasts, based on models estimated for earnings volatility quartiles, suggest significant improvement in earnings forecasts for lower volatility firms. The results also suggest that the negative association between earnings persistence and volatility may be due to both estimation bias and variation in core earnings persistence.     

Consolidating Corporate Control: Divisional Versus Whole-Company Leveraged Buyouts

We examine the empirical relation between firm characteristics and the likelihood of choosing a restructuring choice between two types of leveraged buyouts: a whole‐company leveraged buyout (WLBO) and a divisional leveraged buyout (DLBO). Our findings suggest that firm characteristics such as volatility of cash flow and growth potential play an important role in determining a firm's restructuring choice between a WLBO and a DLBO. In particular, firms with greater volatility of cash flow and/or greater future growth potential are more likely to adopt a DLBO than a WLBO as their restructuring choice. These results are consistent with the notion that although low‐growth, high‐cash‐flow firms would create the most value for stockholders by paying out cash and tying future cash flows to the firm's debt service through a WLBO, high‐growth, low‐cash‐flow firms would be better off by selling assets if those assets would be better managed under a DLBO.     

Does SEC FRR No. 48 disclosure communicate risk management effectiveness?

We hypothesize that the quality of market risk disclosure mandated by the U.S. Securities and Exchange Commission Financial Reporting Release No. 48 (FRR No. 48) provides useful information for assessing risk management effectiveness. Measuring risk disclosure quality as the degree of modification, we find that higher-than-expected disclosure modification is associated with lower future cash flow volatility. On average, an increase in risk disclosure modification from the lowest to the highest decile is associated with a 5.34 percent decrease in cash flow volatility. Given the significant impact of cash flow volatility on firm value and capital investment, our results highlight the importance of market risk disclosures and should be of interest to investors and analysts.     

Out-of-sample cash flow prediction and cash distributions to shareholders

This study provides empirical evidence that net cash distributions to shareholders provide a noteworthy context for improving the out-of-sample prediction of cash flow. Dechow et al. (2008) suggest that net distributions to shareholders is an indicator for future cash flow, and the current study hypothesizes that the accuracy of out-of-sample forecasts increases with the magnitude of the shareholder distributions. The empirical results are consistent with this hypothesis for one-year-ahead forecasts, and the results are robust to controls for firm size. Moreover, the results indicate that the distributions to shareholders effect largely subsumes the firm size effect for forecasts of free cash flow, but not for operating cash flow. This suggests that firm size is a proxy for operating stability but not investing stability. Overall, the study provides a practical context for analysts, creditors and others to consider when generating cash flow forecasts.     

The information content of option-implied information for volatility forecasting with investor sentiment

This study explores the effect of investor sentiment on the volatility forecasting power of option-implied information. We find that the risk-neutral skewness has the explanatory power regarding future volatility only during high sentiment periods. Furthermore, the implied volatility has varying volatility forecasting ability depending on the level of investor sentiment. Our findings suggest that the effectiveness of volatility forecasting models based on option-implied information varies over time with the level of investor sentiment. We confirm the important role of investor sentiment in volatility forecasting models exploiting option-implied information with strong evidence from in-sample and out-of-sample analyses. We also present improvements in the accuracy of volatility forecasts from volatility forecasting models derived by incorporating investor sentiment in these models.     

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.     

Does cash flow predict returns?

In this paper, we propose the hypothesis that cash flow and cash flow volatility predict returns. We categorize firms listed on the New York Stock Exchange into sectors, and apply tests for both in-sample and out-of-sample predictability. While we find strong evidence that cash flow volatility predicts returns for all sectors, the evidence obtained when using cash flow as a predictor is relatively weak. Estimated profits and utility gains also suggest that it is cash flow volatility that is more relevant as a source of information than cash flow.     

Mountain or molehill? Downward biases in the conglomerate discount measure

The Berger and Ofek (1995) excess value measure, comparing a conglomerate’s actual market value to an imputed value based on standalones, has become the standard method to determine value effects of diversification. In this paper, we address a significant bias in this procedure stemming from the difference in cash holdings between diversified and standalone firms. Excess values are based on firm values, including corporate cash positions. As standalones hold significantly more cash, the imputed cash value is higher than the conglomerate’s actual cash value, resulting in a downward biased excess value. We thus propose to calculate excess values based on enterprise values, replacing total debt by net debt. Based on an extensive US sample, we show that there is significantly less evidence of a diversification discount when adjusting for the cash bias. In terms of average dollar losses, the firm value-based models overestimate the conglomerate discount by at least 25%. Apart from removing the cash bias, we propose a second modification to the excess value measure, arguing that standalone industry multipliers should be calculated using geometric mean aggregation instead of median aggregation.     

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.     

Are analysts’ earnings forecasts more accurate when accompanied by cash flow forecasts?

We examine whether analysts’ earnings forecasts are more accurate when they also issue cash flow forecasts. We find that (i) analysts’ earnings forecasts issued together with cash flow forecasts are more accurate than those not accompanied by cash flow forecasts, and (ii) analysts’ earnings forecasts reflect a better understanding of the implications of current earnings for future earnings when they are accompanied by cash flow forecasts. These results are consistent with analysts adopting a more structured and disciplined approach to forecasting earnings when they also issue cash flow forecasts. Finally, we find that more accurate cash flow forecasts decrease the likelihood of analysts being fired, suggesting that cash flow forecast accuracy is relevant to analysts’ career outcomes.     

The impact of firm size on dynamic incentives and investment

Recent studies conclude that small firms have higher but more variable growth rates than large firms. To explore how this empirical regularity affects moral hazard and investment, we develop an agency model with a firm size process having two features: the drift is controlled by the agent's effort and the principal's investment decision, and the volatility is proportional to the square root of size. The firm improves on production efficiency as it grows, and wages are back‐loaded when size is small but front‐loaded when it is large. Furthermore, there is underinvestment in a small firm but overinvestment in a large firm.     

Processes and Accuracy of Cash Flow Forecasting: A Case Study of a Multinational Corporation

Despite its pivotal importance in enterprise management, cash flow forecasting gets little attention from academics perhaps because few of them have access to internal processes and data. In this article, however, the authors explain how cash flow forecasting is organized at Bayer, a large multinational company headquartered in Germany, and which factors influence the accuracy of its forecasts. The research focuses on cash flow forecasts based on the direct method, prepared three times a yearat Bayer, involving about 62,000 individual forecasting items each time. These forecasts form the basis of the company's liquidity and financial risk management, in particular, its foreign exchange risk hedging. The authors explain how local managers in Bayer's entities across the world derive the forecasts, i.e., what information they use as input, how they validate it, and how they deal with potential bias caused by managerial incentive systems. They also analyze whether forecasting processes are affected by characteristics such as business area, size, region, or specific local conditions, and ultimately whether forecasting practices and entity characteristics affect forecast accuracy. The findings show that cash flow forecasting procedures vary substantially across Bayer. While the central finance department gives general guidance on the required cash flow forecasting output and provides direction on the input to be used, there are no detailed instructions on how forecasts are to be prepared. Instead, local managers are free to determine their own forecasting practices. They use different forecasting inputs and validate forecasting inputs and output with different intensities, and they also differ in how they treat possible biases in input data. These findings document the limits of standardization and central control in large multinational corporations resulting from local managers’ need for flexibility to cope with the heterogeneity and dynamism of their environments. At the same time, however, local differentiation increases complexity and may increase errors. Quantitative analysis of forecasting errors shows that forecasts of receipts from customers (cash inflows) are more accurate than forecasts of payments to suppliers (cash outflows). Moreover, forecasting practices affect forecast accuracy. Outflow forecasts are more accurate if managers intensively validate forecasting input; inflow forecasts, if they eliminate input biases that may result from internal target setting or from other managerial incentives, and if they carefully validate their forecasting output. The study provides several insights.

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Corporate precautionary cash holdings

This paper models the precautionary motive for a firm's cash holdings. A two-period investment model shows that the cash holdings of financially constrained firms are sensitive to cash flow volatility because financial constraints create an intertemporal trade-off between current and future investments. When future cash flow risk cannot be fully diversifiable, this intertemporal trade-off gives constrained firms the incentives of precautionary savings: they increase their cash holdings in response to increases in cash flow volatility. However, there is no systematic relationship between cash holdings and cash flow volatility for unconstrained firms. We test the empirical implications of our theory using quarterly information from a sample of U.S. publicly traded companies from 1997 to 2002, and find that the empirical evidence supports our theory.