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Investment and cash flow sensitivity

There is a large volume of literature that estimates the impact of financial constraints on the investment behaviour of firms beginning with the seminal article by Fazzari, Hubbard and Petersen (1988 - hereafter FHP). FHP (1988) classify firms according to their probability of been financially constrained on the basis of their size, dividend payouts and capital structure and these characteristics determines their sensitivity to the supply of internal funds measured by cash flows. The highest sensitivities to cash flows are found for firms categorized as financially constrained. Many further studies in this strand of literature have followed the same methodology including Chirinko and Schaller (1995), Hubbard et al. (1995), Calomiris and Hubbard (1995).

Recent empirical papers using the investment-cash flow sensitivity approach include Almeida and Campello (2007), Biddle and Hillary (2006), Beatty, Liao and Weber (2007), Cleary, Povel and Raith (2007), Lyandres (2007), Polk and Sapienza (2008), Pulvino and Tarhan (2006), and McNichols and Stubben (2008), among others. While it is has been recognized in the investment-cash flow sensitivity literature that investments in inventory and accounts receivable are part of a firms overall investment (see e.g., Fazzari, Hubbard and Petersen (2000)), the vast majority of studies in this literature do not include working capital investments as part of firms' annual investment, avoiding the purely mechanical problem of including investment in working capital on both the left and right hand sides of the regression. An exception to this is the extant literature examining how financing constraints affect inventory investment (e.g., Carpenter, Fazzari, and Petersen (1994)).

However, more recently the literature has raised several new objections to the approach by FHP; for example, Kaplan and Zingales (1997, 2000) have argued that the classification adopted by Fazzari et al. (1988) tends to assign firms incorrectly. They make use of more detailed information in company financial statements from annual reports to classify the same firms over an identical sample period into three categories as follows; financially constrained. possibly financially constrained. And not financially constrained.. Kaplan and Zingales (1997, 2000) believed that using this classification method is more appropriate and they found that financially constrained firms have the lowest sensitivity of investment to cash flow. Lending support to Kaplan and Zingales (1997, 2000), Cleary (1999) also found that the most constrained firms have the lowest sensitivity. Recently, Allayannis and Mozumdar (2004) also show that the findings of Kaplan and Zingales (1997) can be explained by a few important observations whereas the results of Cleary (1999) can be explained by observations of firms with negative cash flows. One of the main implications of empirical work conducted by Kaplan and Zingales and Cleary is that for firms under financial distress, the cash flow sensitivity might be reduced, so that for severely constrained firms, the usual relationship found in the literature might be reversed.

In reconciling FHP and Kaplan and Zingales, Fazzari, Hubbard, and Petersen (1988) (hereinafter, FHP ) introduce a methodology to identify the presence of financing constraints based on the differential sensitivity of corporate investment to cash flow. Kaplan and Zingales (1997) provide both theoretical arguments and empirical evidence that this differential sensitivity is not a valid measure of financing constraints. Fazzari, Hubbard, and Petersen (2000) criticize those findings. I believe the main arguments in FHP (2000) are, in fact, quite supportive of Kaplan and Zingales (1997) main conclusion, while the specific criticisms in FHP (2000) are unjustified. FHP (2000) admits that financially distressed firms are likely to have lower investment-cash flow sensitivities than less financially constrained firms. This is exactly the point that the Kaplan and Zingales model makes: investment-cash flow sensitivities are not necessarily monotonic in the degree of financing constraints. The only disagreement i think FHP (2000) have with Kaplan and Zingales is how pervasive the non-monotonicity result is. But this is ultimately an empirical question. FHP (2000) also recognizes that the literature on investment cash flow sensitivities has not been based on a solid theoretical foundation. As Kaplan and Zingales point out, the practice of splitting the sample according to a measure of financing constraints and then comparing investment-cash flow sensitivities across groups is justified only if investment-cash flow sensitivities increase monotonically in the degree of financing constraints. Neither FHP (1988), nor any other paper of which i am aware, spells out the sufficient conditions for monotonicity.

The sensitivity of investment expenditures to internal cash flows is a well-documented phenomenon in the financial economics literature. In a seminal study, Fazzari, Hubbard, and Petersen (1988) show that, after controlling for growth opportunities, corporate investment is sensitive to cash flow and more so for firms with low dividend payout. The authors conclude that the strong positive effect of internal funds on investment is caused by the liquidity constraints faced by firms with significant differences between the costs of external and internal capital. A large body of follow-up literature finds support for this argument.

Some other studies, however, show that investment cash flow sensitivity may be observed even in frictionless markets for reasons other than financial constraints. Specifically, because of difficulty of measuring marginal investment opportunities (Tobin's Q), cash flow may convey information about investment opportunities that is not reflected in the estimated Q. In such cases, the observed cross-sectional variations in investment-cash flow sensitivity may simply be due to variations in Q measurement error. Alternatively, cross-sectional differences in investment cash flow sensitivity may be observed if cash flow is a better proxy for growth opportunities for certain types of firms.

The liquidity constraints explanation of investment cash flow sensitivity implies that firms with higher investment cash flow sensitivity underinvest when cash flows are low and, possibly, on aggregate over long periods of time, because external financing is too costly. On the other hand, if investment cash flow sensitivity is driven by cash flows merely reflecting investment opportunities, then there should be no distortions in the timing and the level of investment expenditures Higher investment-cash flow sensitivity is also observed for firms that are young or small (Devereux and Schiantarelli (1990), Oliner and Rudebusch (1992)), have no bond rating (Whited (1992), have low or no credit rating (Calomiris, Himmelberg and Wachtel (1996)), for independent Japanese firms, as opposed to firms with close ties to banks (Hoshi, Kashyap, and Scharfstein (1991)). For a more complete survey, see Hubbard (1998) and Schiantarelli (1996). For example, Erickson and Whited (2000) argue that the significance of cash flow disappears when they use measurement-error-consistent GMM estimators. Cummins, Hassett, and Oliner (1999) control for expected future profits and find insignificant cash flow coefficients. Gilchrist and Himmelberg (1995) find that, at least in some cases, the significance of cash flow is due to its association with investment opportunities. Alti (2003) presents a model where the link between investment and cash flow is stronger for high growth firms because managers adjust current investment in response to cash flow realizations, which reflect current growth opportunities. Understanding the determinants of a firm's investment behaviour is an important area of research in financial economics. This is reflected in a number of studies that investigate the relationship of corporate investments to cash flows of individual firms. A widely held belief is that the internal funds available to a firm is the principal determinant of its real investments due to asymmetric information and agency problems associated with obtaining additional external funds. The traditional view put forward by Fazzari et al. (1988, 2000) suggests that investments undertaken by firms facing severe financing constraints are more sensitive to its cash flows. Several papers subsequently support their argument. However, studies like Kaplan and Zingales (1997, 2000) and Cleary (1999) find evidence to the contrary: firms that are least financially constrained exhibit greater investment - cash flow sensitivity. Yet, many studies continue to use investment - cash flow relationship to gauge a firm's financing constraints (e.g. Perotti and Gelfer, 2001; Kato et al. 2002; Laeven, 2003; Aggarwal and Zong, 2006). The source of the observed contradictory finding lies, among others; in the disagreement among researchers in identifying appropriate factors to segregate more financially constrained firms from less constrained ones (Moyen, 2004; Cleary et al. 2007). The factors largely used in prior studies to categorize firms into more and less constrained include dividend payout ratio, debt financing, financial distress, debt rating, firm size and age of a firm. These criteria to classify firms are endogenous in the sense that these are not independently determined. Moreover, these factors are time-variant. A company identified as financially constrained now may not remain constrained in the future. These problems do not arise if researchers use exogenous firm-characteristics. One such characteristic is whether or not a firm has affiliation with a business group. Usually, firms are not free to choose joining a business group (Khanna and Palepu, 2000). Similar to Khanna and Yafeh (2005). Hoshi et al. (1991) report that membership in the six largest Japanese groups has been stable for over three decades. Group-affiliated firms are widely believed to have more access to funds relative to independent firms because of their ability to use internal capital market benefits and to tap more financial resources (Deloof, 1998).

Yet, there are some papers that are critical of the measure of cash flow from previous research. Bushman et al (2008) provide compelling evidence that the documented patterns in investment-cash flow sensitivities across a priori partitions for financial constraints are driven by the fact that the primary cash flow measure used in the literature embeds not only cash flows, but also, via the accrual accounting mechanism, changes in working capital. They show that, in essence, the cash flow variable serves as a proxy for investment in non-cash working capital which has a direct relation to fixed capital investment unrelated to financing constraints. Thus, the empirical patterns documented in the literature really reflect capital investment-working capital investment sensitivities, rather than investment-cash flow sensitivities. Their results provides an important message to researchers who continue to use the investment-cash flow sensitivity approach to study financing constraints. They contend that researchers must seriously confront the underlying structure of the cash flow variable used and what it means for the economic interpretation of their empirical results.

It is also very important to point out the role of financial systems in the country and the cash flow sensitivity. The financial system of a country dictates how the common problem of asymmetric information will be handled. Obviously the UK financial system has an important role to play in economic fluctuations, and a much bigger role for firm investment in. (See Gertler (1988) for an overview.) It is a consensus among financial economist that market-oriented financial systems where arms-length lenders offer funds through commercial paper, corporate bond and equity markets are more likely to show greater sensitivity to cash flows. Whereas relationship-oriented systems are likely to foster closer and more transparent arrangements that allow them to exercise greater scrutiny over borrowers, and as a result investors will be less sensitive to internal sources of funds. Rajan and Zingales has offered a comprehensive discussion of the principal differences between market-oriented and relationship oriented financial systems. In the UK, market capitalisation as a percentage of GDP is high relative to other European countries and corporate control is exercised by the financial markets rather than banks. Bond markets are less developed in UK compare to US, but firms in UK rely more heavily on internal funds than US. The impact of these financial system phenomena in UK could significantly affect the sensitivity of investment to cash flows. Analysis of internal funds for UK firms are expected to show investment will be more sensitive to internal funds (cash flows) relative to a country with relationship based financial system. Bond et al (2003) offer extensive comparative studies of the impact of cash flows on investment across several countries with different financial systems. Their results are based on estimates of investment equations for four European countries (Belgium, France, Germany, and the United Kingdom), and pointed out some support for variations between countries that are more market-oriented (United Kingdom) or relationship-oriented. They are quick to acknowledge, however, that other factors may have an important role to play.

In this strand of literature, often the size of the firm is invoked as a major variable to consider in cross-section analysis of investment-cash flow sensitivity. Firm size has been used as an indicator of access to external finance (Gertler and Gilchrist, 1994). For example, it is widely accepted that small firms are generally younger, with higher levels of firm-specific risk, and less collateral, making them less likely to attract external finance. Previous empirical evidence suggests that small firms are more sensitive to monetary policy tightening than larger firms. Gertler and Gilchrist (1994) document that indicators of monetary tightening are highly significant explanatory variables in time series estimates of small firm's sales, inventory accumulation and short-term debt, in direct contrast to estimates for large firms.

Equally, the industrial type may be an important determinant of investment sensitivity to cash flow since industries differ considerably in terms of the size of firms, capital-intensity, borrowing capacity, openness and the durability of their output.

Gilchrist and Himmelberg (1995) also found excess sensitivity for small firms, and those with out a bond rating or commercial paper issue in their sample. Schaller (1993) has also documented the excess investment cash flow sensitivity for small firms. However, it must be borne in mind that not all evidence on size goes in the same direction. In their seminal study Fazzari, Hubbard and Petersen (1988) point out that when they divide samples according to size, small firms have relatively low cash flow coefficients. In addition, Hu and Schiantarelli (1998) found that larger firms are more likely to be financially constrained

They explain their result by arguing that (at least in their sample of listed firms), firm size may be inversely related to concentration of ownership, which tends to mitigate agency problems. Against the size argument was the study conducted by Chirinko (1997), by arguing that firm size are not appropriate criteria for identifying financially constrained firms.

Whether size matters largely depends on the country and the financial system of that country. For example, in the US studies, the larger firms are quite different from the small firms in that the large firms have access to bond markets and the commercial paper market. The size classification selects firms into those that obtain external finance from financial intermediaries compared to those that obtain external finance from the markets. In contrast, in the UK, bond markets and commercial paper markets are much less developed than in the US implying that a large-small firm sample split is less likely to generate a partition between financial intermediaries compared to market financed firms. Rather both small and large firms will be mostly financed by financial intermediaries. Chatelain et al. (2003) has documented an excellent cross country differences with respect to size and investment-cash flow sensitivities. Recent evidence provided in Bond et al. (2003) and Chatelain et al. (2003) does make a comparison between cash flow sensitivity of investment in a range of European countries. Bond et al. (2003) shows investment of UK firms to be more sensitive to cash flow fluctuations than the investment of .firms in other European countries.


A large empirical literature in accounting, economics and finance studies the relation between corporate investment and internally generated cash flows to test for the existence and significance of financing constraints. The main idea is that if a wedge exists between the cost of internal and external funds, then the capital investment decisions of financially constrained firms will be sensitive to internally generated cash flows, even after controlling for investment opportunities. Following Fazzari, Hubbard, and Petersen (1988) (hereafter FHP), many empirical studies document that investment-cash flow sensitivities are higher for firms a priori classified as being more financially constrained. However, there is significant disagreement over the validity of this approach, and deep questions remain as to whether estimated investment-cash flow sensitivities actually capture financing constraints. Despite such disagreement, this approach continues to be widely used to identify firms whose investment decisions are more heavily impacted by financing constraints. Resolving questions concerning the validity of using investment-cash flow sensitivities to study financing constraints and institutions that alleviate such constraints is thus an important research priority. Hubbard (1998) discusses numerous studies that have documented this result across a range of different a priori partitions for financial constraints. As discussed in more detail below, investment-cash flow sensitivities are estimated as the coefficient on cash flows from reduced-form regressions of capital investment on Tobin's q (to control for investment opportunities) and cash flows. In this paper, we will focus on three common a priori partitions: dividend payout ratio, firm age and a measure developed in Cleary (1999).

Papers critical of the investment-cash flow sensitivities as a measure of financial constraints include Poterba (1988), Cleary (1999) Erickson and Whited (2000), Kaplan and Zingales (1997, 2000) and Alti (2003). Fazzari, Hubbard, and Petersen (2000) vigorously dispute both the theoretical claims of Kaplan and Zingales (1997 and 2000) and their empirical conclusions.


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