Impact of Financial Leverage on Investment
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The term Investment is frequently used in jargon of economics, business management and finance. According to economic theories, investment is defined as the per-unit production of goods, which have not been consumed, but will however, be used for the purpose of future production. The decision for investment, also referred to as capital budgeting decision, is regarded as one of the key decisions of an entity.
Leverage is a method of corporate funding in which a higher proportion of funds is raised through borrowing than stock issue. It is measured as the ratio of total debt to total assets; greater the amount of debt, greater the financial leverage. Financial Leverage is the ability of a company to earn more on its assets by taking on debt that allows it to buy or invest more in order to expand.
Nowadays financial leverage is viewed as an important attribute of capital structure alongside equity and retained earnings. Financial leverage benefits common stockholders as long as the borrowed funds generate a return greater than the cost of borrowing, although the increased risk can offset the general cost of capital.
In the past years, a large body of the literature has provided robust empirical evidence that financial factors have a significant impact on the investment decisions of firms. While traditional research on investment was based on the neoclassical theory of optimal capital accumulation (where under the assumption of perfect capital markets, the cost of financing does not depend on the firm's financial position), more recent literature has increasingly incorporated frictions such as asymmetric information and agency problems as a source behind the relevance of the degree of financial pressure faced by the firm in determining the availability and the costs of external financing
This chapter will seek to enclose literature on the impact of financial leverage on investment and other factors that may affect investment in firms.
1.1 Modigliani & Miller (M&M) - 1958 theory with no taxation
In what has been hailed as the most influential set of financial papers ever published, Franco Modigliani and Merton Miller addressed capital structure in a rigorous, scientific fashion, and their study set off a chain of research that continues to this day.
Modigliani and Miller (1958) argued that the investment policy of a firm should be based only on those factors that will increase the profitability, cash flow or net worth of a firm.
The M&M view is that companies which operate in the same type of business and which have similar operating risks must have the same total value, irrespective of their capital structures. It is based on the belief that the value of a company depends upon the future operating income generated by its assets. The way in which this income is split between returns to debt holders and returns to equity should make no difference to the total value of the firm. Thus the total value of the firm will not change with gearing, and therefore neither will its Weighted Average Cost of Capita (Pandey, 1995).
Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. The irrelevance proposition of Modigliani and Miller will be valid only if the perfect market assumptions underlying their analysis are satisfied
Under the original M&M propositions, leverage and investment were unrelated. If a firm had profitable investment projects, it could obtain funding for these projects regardless of the nature of its current balance sheet.
1.2 Modigliani &Miller - 1963 theory with tax
M & M (1963) found that the corporation tax system carries a distortion under which returns to debt holders (interest) are tax deductible to the firm, whereas returns to equity holders are not. They therefore concluded that geared companies have an advantage over ungeared companies, i.e. they pay less tax and will have a greater market value and a lower WACC. Following this research, the consensus that emerged was that tax is positively correlated to debt (Graham 1995, Miller 1977) and is considered a major influence in the debt policy decision.
Modigliani et al (1963) argued that we should not 'waste our limited worrying capacity on second-order and largely self correcting problems like financial leveragingâ€Ÿ. That is firms should not be worried about growth as long as they have good projects in hand, since they will always be able to find means of financing those projects.
1.3 The Trade-Off Models
Some of the assumptions inherent in the M&M model can be relaxed without changing the basic conclusions as argued by Stiglitz (1969) and Rubenstein (1973). However, when financial distress and agency costs are considered, the M&M models are altered significantly. The addition of financial distress and agency costs to the M&M model results in a trade-off model. In such a model, the optimal capital structure can be visualized as a trade-off between the benefit of debt (the interest tax shield) and the costs of debt (financial distress and agency costs) as presented by Myers (1997)
The trade-off models have intuitive appeal because they lead to the conclusion that both no-debt and all-debt are bad, while a 'moderate' debt level is good. However, the 'trade-off models have very limited empirical support', Marsh (1982), suggesting that factors not incorporated in this model are also at work.
Jensen and Meckling (1976) invoked a moral hazard argument to explain the agency costs of debt, proposing that high levels of debt will induce firms to opt for excessively risky investment projects. The incentive for such a move is that limited liability provisions in debt contracts imply that risky projects will provide higher mean returns to the shareholders: zero in low states of nature and high in good states. However, the higher probability of default will induce investors to demand either interest rates premiums or bond covenants that restrict the firm's future use of debt.
1.4 Pecking-Order Theory
Initiated by Donaldson (1961), the Pecking-Order theory argues that firms simply use all their internally-generated funds first, move down the pecking order to debt and then lastly issue equity in an attempt to raise funds. Firms follow this line of least resistance that establishes the capital structure.
Myers noted an inconsistency between Donaldson's findings and the trade-off models, and this inconsistency led Myers to propose a new theory. Myers (1984) suggested asymmetric information as an explanation for the heavy reliance on retentions. This may be a situation where managers have access to more information about the firm and know that the value of the shares is greater than the current market value. If new shares are issued in this situation, there is a possibility that they would be issued at a too low price, thereby transferring wealth from existing shareholders to new shareholders.
1.5 Investment and Leverage
One of the main issues in Corporate Finance is whether financial leverage has any effects on investment policies. The corporate world is characterized by various market imperfections, due to transaction costs, institutional restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems and that may result in under-investment or over-investment incentives. Whenever we refer to investment, it is essential to distinguish between over- investment and under-investment.
In his model, Myers (1977) argued that debt can create an 'overhang' effect. His idea was that debt overhang reduces the incentives of the shareholder-management coalition in control of the firm to invest in positive net-present-value investment opportunities, since the benefits accrue, at least partially, to the bondholders rather than accruing fully to the shareholders. Hence, highly levered firms are less likely to exploit valuable growth opportunities as compared to firms with low levels of leverage.
Underinvestment theory centers on a liquidity effect in that firms with large debt commitment invest less, no matter what their growth opportunities (Lang et al, 1996). In theory, even if debt creates potential underinvestment incentives, the effect could be attenuated by the firm taking corrective action and lowering its leverage, if future growth opportunities are recognized sufficiently early (Aivazian & Callen, 1980). Leverage is optimally reduced by management ex ante in view of projected valuable ex post growth opportunities, so that its impact on growth is attenuated. Thus, a negative empirical relation between leverage and growth may arise even in regressions that control for growth opportunities because managers reduce leverage in anticipation of future investment opportunities. Leverage simply signals management's information about investment opportunities. The possibility that leverage might substitute for growth opportunities is referred to as the endogeneity problem.
Over-investment theory is another problem that has received much attention over the years. It is described as investment expenditure beyond that required to maintain assets in place and to finance positive NPV projects. In these kind of situations, conflicts may arise between managers and shareholders (Jensen,1986 & Stulz,1990). Managers seek for opportunities to expand the business even if that implies undertaking poor projects and reducing shareholder worth in the company. Managers' abilities to carry such a policy is restrained by the availability of cash flow and further tightened by the financing of debt. Issuing debt commits the firm to pay cash as interest and principal, forcing managers to service such commitments with funds that may have otherwise been allocated to poor investment projects.
Thus, leverage is one mechanism for overcoming the overinvestment problem suggesting a negative relationship between debt and investment for firms with weak growth opportunities. Too much debt also is not considered to be good as it may lead to financial distress and agency problems.
Cantor (1990) explains that highly leveraged firms show a heightened sensitivity to fluctuations in cash flow and earnings since they face substantial debt service obligations, have limited ability to borrow additional funds and may feel extra pressure to maintain a positive cash flow cushion. Hence, the net effect would be reduced levels of investment for the firm in question.
Accordingly, Mc Connell and Servaes (1995) have examined a large sample of non financial United States firms for the years 1976, 1986 and 1988. They showed that for high growth firms the relation between corporate value and leverage is negative, whereas that for low growth firms the relation between corporate value and leverage is positively correlated. This trend tends to indicate that to maximise corporate value, it is preferable to keep down leverage to a low level and to increase investment.
Lang, Ofek and Stulz (1996) used a pooling regression to estimate the investment equation. They distinguish between the impact of leverage on growth in a firm's core business from that in its non-core business. They argue that if leverage is a proxy for growth opportunities, its contractionary impact on investment in the core segment of the firm should be much more pronounced than in the non-core segment. They found that there exists a negative relation between leverage and future growth at the firm level. Also they argued that debt financing does not reduce growth for firms known to have good investment opportunities. Lang et al document a negative relation between firm leverage and subsequent growth. However, they find that this negative relation holds only for low q firms, i.e. those with fewer profitable growth opportunities. Thus, their findings appear to be most consistent with the view that leverage curbs overinvestment in firms with poor growth opportunities.
Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Therefore, high leverages may result in liquidity problem and can affect a firm's ability to finance growth. Under this situation, debt overhang can contribute to the under-investment problem of debt financing. That is for firms with growth opportunities, debt have a negative impact on the value of the firm.
Peyer and Shivdasani (2001) provide evidence that large increases in leverage affect investment policy. They report that, following leveraged recapitalizations, firms allocate more capital to business units that produce greater cash flow. If leverage constrains investment, firms with valuable growth opportunities should choose lower leverage in order to avoid the risk of being forced to bypass some of these opportunities, while firms without valuable growth opportunities should choose higher leverage to bond themselves not to waste cash flow on unprofitable investment opportunities.
Ahn et al. (2004) document that the negative relation between leverage and investment in diversified firms is significantly stronger for high Q segments than for low Q business segments, and is significantly stronger for non-core segments than for core segments. Among low growth firms, the positive relation between leverage and firm value is significantly weaker in diversified firms than in focused firms. Their results suggest that the disciplinary benefits of debt are partially offset by the additional managerial discretion in allocating debt service to different business segments within a diversified organizational structure.
Childs et al (2005) argued that financial flexibility encourages the choice of short-term debt, thereby dramatically reducing the agency costs of under-investment and over-investment. However the reduction in the agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set.
Aivazian et al (2005) analysed the impact of leverage on investment on 1035 Canadian industrial companies, covering the period 1982 to 1999. Their study examined whether financing considerations (as measured by the extent of financial leverage) affect firm investment decisions inducing underinvestment or overinvestment incentives. They found that leverage is negatively related to the level of investment, and that this negative effect is significantly stronger for firms with low growth opportunities than those with high growth opportunities. These results provide support to agency theories of corporate leverage, and especially to the theory that leverage has a disciplining role for firms with weak growth opportunities
1.6 Investment, Cash Flow and Tobin's Q
It was traditionally believed that cash flow was important for firms' investment decisions because managers regarded internal funds as less expensive than external funds. In the 1950s and 1960s, this view led to numerous empirical assessments of the role of internal funds in firm investment behaviour. These studies found strong relationships between cash flow and investment.
Considerable empirical evidence indicates that internally generated funds are the primary way firms finance investment expenditures. In an in-depth study of 25 large firms, Gordon Donaldson (1961) concludes that: "Management strongly favoured internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable 'bulges' in the need for new funds."
Another survey of 176 corporate managers by Pinegar and Wilbricht (1989) found that managers prefer cash flow over external sources to finance new investment; 84.3% of sample respondents indicate a preference for financing investment with cash flow.
Researchers have also discovered the impact of cash flow on investment spending in Q models of investment. Fazzari, Hubbard, and Petersen (1988) find that cash flow has a strong effect on investment spending in firms with low-dividend-payout policies. They argue that this result is consistent with the notion that low-payout firms are cash flow-constrained because of asymmetric information costs associated with external financing. One reason these firms keep dividends to a minimum is to conserve cash flow from which they can finance profitable investment expenditures.
Fazzari and Petersen (1993) find that this same group of low-payout firms smooths fluctuations in cash flow with working capital to maintain desired investment levels. This result is consistent with the Myers and Majluf (1984) finding that liquid financial assets can mitigate the underinvestment problem arising from asymmetric information.
Whited (1992) also extended the Fazzari, Hubbard, and Petersen (1988) results in a study of firms facing debt financing constraints due to financial distress. She found evidence of a strong relationship between cash flow and investment spending for firms with a high debt ratio or a high interest coverage ratio, or without rated debt.
Himmelberg and Petersen (1994) in a study of small research and development firms find that cash flow strongly influences both capital and R & D expenditures. They argue that the asymmetric information effects associated with such firms make external financing prohibitively expensive, forcing them to fund expenditures internally, that is by making use of cash flows.
An alternative explanation for the strong cash flow/investment relationship is that managers divert free cash flow to unprofitable investment spending. One study assessing the relative importance of such an agency problem was performed by Oliner and Rudebusch (1992), who analysed several firm attributes that may influence the cash flow/investment relationship. They find that insider share holdings and ownership structure (variables that proxy for agency problems) do little to explain the influence that cash flow has on firm investment spending.
Carpenter (1993) focused on the relationships among debt financing, debt structure, and investments pending to test the free cash flow theory. He finds that firms that restructure by replacing large amounts of external equity with debt increase their investment spending compared to non-restructured firms. He sees these results as inconsistent with free cash flow behavior, because cash flow committed to debt maintenance should be associated with reductions in subsequent investment spending.
Findings by Strong and Meyer (1990) and Devereux and Schiantarelli (1990) support the free cash flow interpretation.
Strong and Meyer (1990) disaggregate the investment and cash flow of firms in the paper industry into sustaining investment (i.e., productive capacity maintaining) and discretionary investment, and total cash flow and residual cash flow (i.e., cash flow after debt service, taxes, sustaining investment, and established dividends). Residual cash flow and discretionary investment are found to be positively and strongly related. This evidence suggests that residual cash flow is often used to fund unprofitable discretionary investments pending.
Devereux and Schiantarelli (1990) find that the impact of cash flow on investment spending is greater for larger firms. One explanation they provide for this result is that large firms have more diverse ownership structures, and are more influenced by manager/shareholder agency problems.
The Q model of investment relates investment to the firm's stock market valuation, which is meant to reflect the present discounted value of expected future profits, Brainard and Tobin (1968).
In the case of perfectly competitive markets and constant returns to scale technology, Hayashi (1982) showed that average Q, the ratio of the maximised value of the firm to the replacement cost of its existing capital stock, would be a sufficient statistic for investment rates.
Tobin's Q, further assumes that the maximised value of the firm can be measured by its stock market valuation. Under these assumptions, the stock market valuation would capture all relevant information about expected future profitability, and significant coefficients on cash-flow variables after controlling for Tobin's Q could not be attributed to additional information about current expectations.
However if the Hayashi conditions are not satisfied, or if stock market valuations are influenced by 'bubbles' or any factors other than the present discounted value of expected future profits; then Tobin's Q would not capture all relevant information about the expected future profitability of current investment. If that is the case, then additional explanatory variables like current or lagged sales or cash-flow terms could proxy for the missing information about expected future conditions.
The classification of q ratios into high and low categories is based on a cut-off of 'one' Lang, Stulz, and Walkling (1989). The latter's motivation for this cut-off is partially based on the fact that under certain circumstances firms with q ratios below one have marginal projects with negative net present values (Lang and Litzenberger, 1989). However, q is also industry specific and one may argue that managers should not be held responsible for adverse shocks to their industries. As such, the industry average may be a useful alternative cut-off point to separate high q firms from low q firms.
Hoshi, Kashyap, and Scharfstein (1991) regressed investment on Tobin's q, other controlling variables, and cash flow. They interpreted differences in the importance of cash flow between different groups of firms as evidence of financing constraints.
Results obtained by Vogt (1994) indicate that the influence of cash flow on capital spending is stronger for firms with lower Q values. This result suggests that cash flow-financed capital spending is marginally inefficient and provides initial evidence in support of the FCF hypothesis. The stronger the influence cash flow had on capital spending in this group, the larger the associated value of Tobin's Q.
After the results presented by Kaplan and Zingales (1997 and 2000), several studies have criticised the empirical test based on the cash flow sensitivity as a meaningful evidence in favour of the existence of financing constraints. The significance of the cash flow sensitivity of investment, it was argued, may then be the consequence of measurement errors in the usual proxy for investment opportunities, Tobin's Q, and may provide additional information on expected profitability rather than being a signal of financing constraints.
Gomes (2001) showed that the existence of financing constraints is not sufficient to establish cash flow as a significant regressor in a standard investment equation, while Ericson and Whited (2000) demonstrate that the investment sensitivity to cash flow in regressions including Tobin's Q is to a large extent due to a measurement error in Q. Likewise, Alti (2003) shows that investment can be sensitive to changes in cash flow in the benchmark case where financing is frictionless.
2.3 Investment and Profitability
The idea that investment depends on the profitability of a firm is amongst the oldest of macroeconomic relationships formulated. The sharp fluctuations in profitability in the average cost of capital since the 1960s revived interest in this relationship (Glyn et al, 1990). However the evidence for the impact of profitability on investment remains sketchy.
Bhaskar and Glyn (1992) concluded that profitability must be regarded as a significant influence on investment, though by no means the overwhelming one. Their results indicated that 'enhanced profitability is not always a necessary, let alone a sufficient condition for increased investment'.
However, years later Glyn (1997) provided an empirical study that examined the impact of profitability on capital accumulation. He tested the impact of profitability in the manufacturing sector on investment for the period 1960-1993 for 15 OECD countries. His findings suggested that the classical emphasis on the role of profitability on investment wass still highly significant and had a very tight relationship.
Korajczyk and Levy (2003) investigated the role of macroeconomic conditions and financial constraints in determining capital structure choice. While estimating the relation between firms' debt ratio and firm-specific variables, they found out that there was a negative relation between profitability and target leverage, which was consistent with the pecking order theory. This indicated that if leverage of the firm is low, profitability will be high and the entity will be able to invest in positive NPV projects i.e. increase investment.
Bhattacharyya (2008) recently provided an empirical study where he examined the effect of profitability and other determinants of investment for Indian firms. He found that 'Short-run profitability does not have consistent influence on investment decisions of firms', implying that one should concentrate on the long-run profitability of a firm. This indicates that profitability is still regarded as one of the major determinants underlying investment decisions of firms. However, he suggested that liquidity is relatively more important than profitability when it comes to firms' investment decisions.
2.3 Investment and Liquidity
'Under the assumptions of illiquid capital and true uncertainty, management can never be sure that investment projects will produce sufficient liquidity to cover the cash commitments generated by their financing. Yet failure to meet these commitments may result in a crisis of managerial autonomy or even in bankruptcy. Thus, capital accumulation is a contradictory process. Investment is inherently risky, while the failure to invest will ultimately lead to the firm's marginalization or demise.' Crotty and Goldstein (1992)
Chamberlain and Gordon (1989) used the annual domestic investment of all nonfinancial corporations in the United States between 1952 and 1981 in an attempt to determine the impact of liquidity on the profitable investment opportunities available to the corporation. They have put forward that in their long-run survival model, liquidity variables play an essential role as it captures the firm's desire to avoid bankruptcy. It was also noted that there was a significant improvement in the explanation of investment when liquidity variables were added to the profitability variables of their regression, thereby supporting the view that liquidity is a pre-dominant determinant of investment and that they are positively related.
Hoshi, Kashyap and Scharfstein (1991) attempted to find the relationship between investment and liquidity for Japanese firms. They found that high current profits increase current liquidity, thereby generating further investment from the firm to ensure future profitability and increased output to meet demand.
Myers and Rajan (1998) suggested that liquid assets are generally viewed as being easier to finance and therefore, asset liquidity is a plus for nonfinancial corporations or individual investors. However, Myers and Rajan argued that although more liquid assets increase the ability to invest in projects, they also reduce management's ability to commit credibly to an investment strategy that protects investors.
Johnson (2003) found that short debt maturity increases liquidity risk, which in turn, negatively affects leverage and the firm's investment. Jonson also suggested that firms trade off the cost of underinvestment problems against the cost of increased liquidity risk when choosing short debt maturity
2.4 Investment and Sales
Sales growth targets play a major role in the perceptions of top managers. Using surveys, Hubbard and Bromiley (1994) find sales is the most common objective mentioned by senior managers. Additional explanatory variables like current or lagged sales are very important in the investment equation as they can act as proxy for the missing information about expected future conditions in case such information has not been captured by Tobin's Q.
Kaplan and Norton (1992, 1993, 1996) argue that firms must use a wide variety of goals, including sales growth, to effectively reach their financial objectives. They suggested that 'Sales growth influences factorsâ€¦..all the way to the implied opportunities for investments in new equipment and technologiesâ€¦..'
According to this study of 396 corporations, Kopcke and Howrey (1994) found that the capital spending of many of the companies corresponds very poorly with their sales and profits. These divergences suggest that sales and profits do not represent fully an enterprise's particular incentives for investing. Consequently, these findings do not support generalizations contending that companies with more debt are investing less than their sales and cash flows would guarantee.
Athey and Laumas (1994) using panel data over the period 1978-86, examined the relative importance of the sales accelerator and alternative internal sources of liquidity in investment activities of 256 Indian manufacturing firms. They found that when all the selected firms in the sample were considered together, current values of changes in real net sales and net profit were all significant in determining capital spending of firms.
Azzoni and Kalatzis (2006) considered the importance of sales for investment decisions of firms. They found that sales presented a positive and significant relationship with investment in all cases.
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