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Corporate Governance And Capital Investment Decisions

Through various studies over the years, different scholars and financial analysts have been able to establish a relationship of cash flow on firms’ investment spending. It was significantly proven by (Modigliani & Miller, 1958) that a firm’s financial status is irrelevant for real investment decisions in a world of perfect and complete capital markets, after controlling for the cost of capital.

In case of managerial discretion, based on (Jensen, 1986) free cash flow theory, firms increase investment (including projects with negative present value) based on the availability of cash flows with incentive of increasing firms’ value beyond level of optimal investment. Moreover, an agency costs also appreciate the borrower net worth by charging a premium on the external financing. The discussion above explains that the firms’ investment decisions are dependent on the availability of internal funds, as cost advantage over external fund is evident.

While choosing an appropriate capital structure, there are certain trade-offs which affects the decision. These trade-offs include tax advantage through acquiring debt against the bankruptcy cost which advocates the use of equity. Keeping this in view, various different models have been supported to explain this corporate capital structure behavior. Pecking Order Theory, initially mitigated by (Donaldson, 1961) describes the financing practice as prioritizing the means of financing, which is necessary for the management to counter against asymmetric information. Either they should generate the funds internally or acquire funds externally through debt rather than equity.

Implications to the pecking order theory involves the positive impact of leveraging on the market price, which means, financing through debt sends a positive signal into the market about the firm’s future prospects. Furthermore, intermediaries also undermine the role of management as the financial intermediaries such as investment banks function as the insider to the firm. Consequently, keeping an eye on the firms operations and influencing the firm’s capital financing decision.

However, Pecking order theory of (Myers, 1984) argues that the firms operating in imperfect or incomplete capital markets where the cost of external capital exceeds that of internal funds, the financial structure may be appropriate to the investment decisions of companies facing uncertain prospects.

Gauging the level of corporate investment in any firm is based on the corporate governance; market position of a firm’s asset against its book value can be termed as Tobin’s q ratio. Identified by (Chung & Pruitt, 1994), Tobin’s q as the ratio of a market value of a firm to the replacement cost of its assets. Tobin’s q can be considered an effective tool for determining financial performance as the data can be collected readily from a balance sheet.

When calculating Tobin’s q ratio, the replacement cost can be determined approximately by the book value of firm’s plant and equipment. Approximate q can be replaced with the actual Tobin’s q to make the calculations unproblematic and data can be readily available without any discrepancies.

Problem Statement

To study the impact of corporate governance on the capital investment decision through cash flow and Tobin’s q interaction in relation with Capital Investment


H0: Firms with capital spending that is influenced by cash flow will be linked with high Q values. (FCF Theory)

HA: Firms with low dividend payout indicating a liquidity constraint will have the most significant investment-cash flow relationship, and will be linked with high Q values in the market. (PO Theory)

Outline of the study

The report contains the contemplation of research data that will study the phenomenon of cash flows and investment discussed earlier in this paragraph. The study categorizes firms according to characteristics (such as dividend payout, size) which will help measure the level of constraints faced by firms.

The study will help readers to understand the complexities of Pecking order theory and Free Cash Flows concept with regard to asymmetric information available and corporate governance which influences decision of the firms.

To measure the effect that cash flow-financed (internally sourced) capital spending and Q has on firms’ investment, Ordinary Least Square Regression model will be used to estimate the function. To compute the influence on the Investment, instruments used are: (1) Cash Flow, (2) Approximate q, and (3) an interaction of both variables are created. Through studying the parameter estimates of interaction variable, positive influence on investment will support the Pecking Order hypothesis and negative influence will govern the Free Cash Flow hypothesis. The equation hypothesized in the next part is linear.


Pecking Order Theory:

(Myers, 1984): “A firm is said to follow a pecking order if it prefers internal to external financing and debt to equity if external financing is used.”

Free Cash Flow Theory

According to (Jensen, 1986), “free cash flow theory, high cash flow and low debt create agency costs associated with conflicts between manager and share holder over the payout of this free cash, which is the cash left after the firm has invested in all available positive net present value projects.”

Capital Structure

“A careful and systematic analysis of how claims against a corporation's assets can or should be determined, assessed, and accounted for.” (Riahi-Belkaoui, 1999)

Capital Investment Decision

“Capital Investment decisions are those decisions that involve current outlay in return for a stream of benefit in future years.” (Drury, 2006)

Tobin’s q

“Tobin's q is a measure of investors' expectations concerning a firm's future profit potential. It is defined as the ratio of the market value of a firm to the replacement cost of its assets.” (Strecker, 2009)

Literature Review

Vogt (Vogt, 1994) explained the capital spending behavior of companies with respect to change in dividend cash paid, cash flows, sales, and market value of assets. The regression equation models the variables to proportion of fixed assets, and distributes the firms’ data in segments of Dividend Payout Groups and Asset Groups. Primarily, Dividend Cash has a strong negative impact on capital spending; it explains that in order to finance additional fixed investment firm needs to sock cash by reducing their dividend. Cash flow, Sales, and Q Ratio having a positive coefficient demonstrates that with an increase in future cash flows, the firm will improve its capital spending.

A relationship has been developed between the firms’ investment decision and the firm’s financial status by Cleary (Cleary, 1999), financial status has been studied with respect to the liquidity constraints. The data is classified into groups through a discriminant analysis on basis of dividend payout policy. Groups taken into study have made possible to identify firms’ which are more financially constrained more likely to be investment-cash flow sensitive, furthermore, availability of internal sources of funds have a greater impact on firms with high credit worthiness, and vice versa.

It has been proposed that the various ownership structures make managerial decision based on the interaction between investment and the firms’ liquidity constraints. The study conducted by Dedoussis & Papadaki (Dedoussis & Papadaki, 2010) mentioned that the management can be held separate from its ownership, even on basis of the nationality of the company. On the other hand, it also explained that the relative shareholding of CEO and the controlling shareholders can also be the basis of separation. The sample used in the study was separated and grouped on basis of dividend payout, asset size of the firm, age of the firm, source of control, and kind of ownership. On the given sampling criterion; greater asset size firms, older firms, lower Q (high investment opportunity), and high dividend payout firms showed higher cash flow sensitivity towards investment.

Findings support that the Low Q, small, and new firms under the generalized model are facing asymmetric information problems. Indeed these firms are expected a priori to face financing problems that affect the cost of their external financing. On the other hand, low Q, old and low dividend firms are more likely to face managerial discretion problems that result to over-investment.

The impact of Tobin’s Q is mainly used to determine the investment opportunity of the firm. In this article, marginal Tobin’s Q has been taken to evaluate the firms’ investment and Research & Development expenditures. Under the asymmetric information (AI) hypothesis firms with attractive investment opportunities may be unable to finance them because of inadequate internal cash flows and because the cost of external funds is too high due to the capital market's ignorance of the firm's investment opportunities. The agency or managerial discretion (MD) hypothesis links investment to cash flows by assuming that managers obtain financial and psychological gains from managing a large and growing firm and thus invest beyond the point that maximizes shareholder wealth. (Gugler, Mueller, & Yurtoglu, 2004)

Taking in viewpoint the impact of capital structure on the capital investment decision, firms’ investment demands is the more susceptible towards cost-of-capital or tax-based capital incentive. Whereas, capital structure seems irrelevant as against internal sources of funds can be effectively substituted with sources of funds generated externally. The size of the investment project can be a deterministic factor towards it. Fazzari, Hubbard, Peterson, Blinder, & Poterba (Fazzari, Hubbard, Peterson, Blinder, & Poterba, 1988) explicates that cash flow/investment relationship is more sensitive when taken in reference with firms’ dividend behavior. Comparison based on firms having more or less liquidity constraints can be further improved when compared on a division based on the scale of the firms, i.e. young or small firms versus large ones. This way the researchers can address the problem of firms lacking the asymmetric information.

Under the impression where capital investments decisions mainly pertains to the capital structure or choosing the appropriate source of investment, Schaller (Schaller, 1993) conducted three different empirical tests to determine that information asymmetries have a huge influence on the firms’ investment behavior. Differences among the informational base of investors and creditors was also considered a capital market imperfection. Ownership status and age of the firms has an impact on the cost of equity financing, mature firms pay comparatively less price for it than young firms. Same aspect goes for the firms with concentrated with comparison to dispersed ownership.

Borrowing is considered a more rational source for investment-projects. Pledgeable assets generate greater borrowing capacity, which afterwards makes firms invest more in pledgeable assets. As suggested by Almeida & Campello (Almeida & Campello, 2007), such a phenomenon can be termed as a credit multiplier. In case of financially constrained firms, a multiplier relates to the sensitivity of firms’ investment-cash flow relationship that is reflected as the increase in the tangible assets of the firm. Therefore, it is proposed that with fewer tangible assets firms are more likely to be financially constrained. The sensitivity of investment-cash flow relationship is evidently influenced by the tangibility of a firm, as latter discussed.

Managers while making capital investment decision considers externally-sourced funds costlier, therefore, overconfident managers over assessing the profitability of an investment-project invests more when having abundant internal funds to utilize. However, deciding not to source externally in case where they are short of internal funds to generate. There has been an evidence of significant relationship between the managerial discretion and investment-cash flow sensitivity. Equity concentrated firms are more likely to be influenced by overconfident managers, unless compensation tools can be used to reduce the effects of managerial overconfidence.(Malmendier & Tate, 2005)

Goyal & Yamada (Goyal & Yamada, 2004) have explained the impact of asset pricing in the stock market against investment-cash flow sensitivity. Overvalued stock prices triggers an increased in investment spending and are cut back when stock are being undervalued, consequently, inflated prices collateral assets attract higher level of external financing. Inflationary pressures primarily determined by the economic monetary policy impacts on the variation of cost on external financing, though it reflects highly on cost of external financing, marginally impacts less on the investment-cash flow sensitivity.

It has been observable that less financially constrained firms have significantly higher investment-cash flow sensitivity. Characterizations of firms based on financial constraint can sometimes create confusion. Firms having unusually high cash holdings can either be characterized as unconstrained based on the opportunities it has to invest or constrained based on the assumption that it needs to have a precautionary savings to invest in future investment projects. Therefore, financial constraints cannot be used as an influential determinant for investment-cash flow sensitivity. (Kaplan & Zingales, 1997)

Hu & Schiantrlli (Hu & Schiantarelli, 1998) put into picture the effect of general economic factors and various firms’ characteristics on the value of the firms’ net worth. Mainly financial status is the most important determinant for the level of asymmetric information problem that managers face. A strong balance sheet position can reflect good sign of firms’ performance which enhances the market value of the firms’ asset to its stake holders, mainly investors and creditors. Q models assumption also assists in determining the sensitivity of the investment-cash flow relationship, where the indicators determine the investment opportunity and the sources of funds to choose from.

Understanding the market influence in proxy of q can also give a clear picture to the movements in the firms’ investment over a period. Net worth of firms helps manager determine if the sourcing of funds externally is a viable option in contrast to the investment opportunity which underlies. (Hubbard, 1998)

Research conducted on the investment-cash flow sensitivity addresses many aspects of the firms’ financial strength. Further study by Calomiris & Hubbard (Calomiris & Hubbard, 1995) shows that when firms’ tax taken under investigation also reflected a significant influence on the volume of spending on investment-projects. They explored the impact of surtax margin, as a tax experiment, on the cost of internal and external funds. Surtax when levied on undistributed profits, obligate the firms to incur certain cost on the internal funds. This effects the managers’ decision to invest and is also reflected on the investment-cash flow sensitivity against the surtax margin. As a result to evade burden of higher cost on internal funds, firms with high surtax-margin exhibits elevated sensitivity in investment-cash flow relationship.

Quan (Quan, 2002) discusses the Pecking Order theory with reference to the Modigliana-Miller proposition that works under the assumption of perfect market. Here it is stated that value of the firm is irrelevant and based on a few limitations the choice of financing can be determined via gauging the strength of the firm. These factors pertain to the imperfect market and influence the managers to make their capital investment decision. Once the assumptions are released the financing structure shows a clear picture.

The association between Free Cash Flow theory and Agency theory has always been under the limelight when there is a question of retaining the undistributed profits. FCF Theory taken under consideration gives out an option to the management to hold on to excess cash sacrificing the shareholders opportunity cost. These excess funds can be generated to better internal operational efficiency or at managers’ discrepancy to source its investment-projects. (Wang, 2010)

Research Methods

The chapter explains the model used in the given research study. The study focuses on analyzing the influence of Cash Flows and Tobin’s q on Corporate Investment. The equation represented by a dependent variable as a ratio of capital spending to the beginning net fixed asset (I/K) predicted by independent variables: (1) ratio of cash flow to the beginning gross fixed asset (CF/K), and (2) beginning Tobin's q (Q).

Method of Data Collection

Main source of collecting the required data is from secondary sources. It includes the Balance Sheet Analysis of Joint Stock Company listed in Karachi Stock Exchange provided by State Bank of Pakistan consisting of data of our relevant variables. The data was taken in annual terms to conduct this research.

Sampling Technique

The Convenience sampling or grab or opportunity sampling would be use in this research. Sample population selected because it is readily available and convenient.

Sample Size

The sample period taken under study covers 8-years period beginning at the start of 2000 and ending at the close of 2008. The data was taken from a sample of 70 (non-banking and non-financial) companies which are listed on Karachi Stock Exchange and included in KSE-100 index.

Research Model

Statistical technique

Ordinary Least Square Regression technique is used to study the impact of variables included in the study. It helps studies the relationship between a dependent variable and several independent variable. It also assumes the relationship to be linear or “straight line,” where the values of predictors lies directly proportional to Criterion variable. SPSS Software is used to develop the regression model and evaluate the influence of predictors on dependent variable.


Findings and interpretation of results

Aggregate Sample:

Table : Represents the model summary of regression estimates for the full sample of 69 firms

The predictors, i.e. main effects of Cash Flow and Tobin’s q and an interaction term of both, included in the model helps explain 78.5% of Investment (Table 1) shown mentioned as R Square. Least variation in Adjusted R Square suggests that the variable to observation ratio in the given model is sufficient. Casewise diagnostic was also conducted to eliminate the outliers in the data to improve the results.

Table : Studies the F-statistics to test whether the model predicts the dependent variable significantly

The F-statistics (Table 2) is significant and it determines the regression model with the given predictors can significantly predict the outcomes at a 0.05 significance level.

Table : The parameter estimation for full sample of 69 firms with respect to dependent variable, t-statistics is used to test the null hypothesis β1 = β2 = β3 = 0

The coefficient values of all predators included in the test are significant at a 0.05 significant level (Table 3), which shows that they have a strong influence on the investment of the firm. The standard coefficient shows that Cash Flows have a much greater impact on Investment than market value on the firm, which is exemplified through Tobin’s q.

Dividend Payout groups:

Table : Presents the sample statistics for 69 KSE listed (non-banking and non-financial) companies which are included in the KSE-100 index. The three rows distribute the statistics into High, Medium, and Low payout policies. Average dividend-to-income ratios of greater than 0.35, between 0.35 and 0.10, and less than 0.10 define High, Low, and Medium dividend-payout firms, respectively.

While studying the dividend-payout groups (Table 4), the descriptive helps to identify characteristics to confirm whether the data being studied has the authenticity and the behavior pattern which commonly related to the groups assigned. The values of Investment, Cash Flow, and Tobin’s q associated with the groups are in complete correspondence with the hypothetical occurrence. Firms having a higher (lower) dividend payout have greater (lower) market value, and lower(higher) level of cash flows and investments.

Table : Represents the model summary of regression estimates of 69 firms split by High, Medium, and Low dividend-payout policies.

The model helps explains 81.9%, 66.7%, and 80% data in High, Medium, and Low dividend-payout firms (Table 5), shown in R Square. Least variation in Adjusted R Square suggests that the number of observations is sufficient with respect to variables in each group separately.

Table : Studies the F-statistics to test the null hypothesis of β1, H = β1, M = β1, L

The F-statistics (Table 6) in each dividend payout group is significant and it determines that each regression model with the given predictors can significantly predict the outcomes at a 0.05 significance level.

Table : Shows the parameter estimation for each payout groups with respect to dependent variable, t-statistics is used to test the null hypothesis β1 = β2 = β3 = 0

The coefficient values of predators in High and Low dividend payout groups are all significant at a 0.05 significant level (Table 7), which shows that they have a strong influence on the investment of the firm. Except for Medium dividend payout group, which has insignificant coefficient values of Tobin’s q, showing no impact on the investment. The standard coefficient shows that Cash Flows have a much greater impact on Investment than market value on the firm, which is exemplified through Tobin’s q.

Hypothesis Assessment Summary


Independent Variables





Firms with capital spending that is influenced by cash flow will be linked with high Q values. (FCF Theory)

Cash Flow × Q

H0: β3 <0

β3,H = .135




β 3,M = .072



β 3,L = .140



Firms with low dividend payout indicating a liquidity constraint will have the most significant investment-cash flow relationship, and will be linked with high Q values in the market. (PO Theory)

Cash Flow × Q

HA: β3 >0

β 3,H = .135




β 3,M = .072



β 3,L = .140



Dependent Variable: Investment (I/K)

Table : Summarizes the results and explains that the hypothesis accepted is directly in correspondence with the aggregate hypothesis.

As illustrated (Table 8) capital spending of low payout firms is positively and strongly influenced by the interaction term, consistent with the PO hypothesis, the parameter estimate for the high payout firms are also positive but marginally significant.

Conclusion, Discussions, Implications And Future Research


The results illustrated above demonstrates that the positive relationship between the degree of the Investment-Cash flow relationship and Q represented latter in the aggregate data (Table 3) is concentrated in low or no dividend paying firms. This finding is in further support with the PO hypothesis.


The objective was to study and test the causes of universal relationship between Cash Flow and Investment Spending. Hence, two hypotheses were included in the research to study the source of this relationship: the free cash flow hypothesis (FCF) hypothesis, which works on the assumption that managers prefer investing its free cash flow excessively into investment projects that are not profitable, and the pecking order hypothesis (PO) purports that managers are prone to investment comparatively less than the opportunity provided due asymmetric information-induced liquidity constraint.

As advocated in favor of Pecking Order Theory by (Fazzari, Hubbard, Peterson, Blinder, & Poterba, 1988) and many others, for groups which consists of small firms with low-dividend payout to fund capital spending, exhibits heavy reliance on cash flow and cash changes. The relationship can be more significantly studied when the impact of larger q value is associated with this group.

Evaluating the impact of corporate governance on investment-cash flow relation requires a critical judgment as to how do the firms’ cash flow and the existing market value influence the investment decision. Financially constraint firms may have a larger impact on liquidity associated matters and managers might take discretion in choosing the right sources to tap. Agency cost may be involved in making such a decision where managers may consider paying dividend as a higher opportunity cost as it reduces the firms’ free cash flow to exploit new profitable investment projects.

Implications and Recommendations

In the current market situation where external pressures existing can also be taken into proxy. When managers making a capital investment decision they need to take in view other non-financial aspects that also influences the decisions to a certain extent. Furthermore, financial intermediaries having a certain level of involvement and sharing information sensitive to the market can also be a major factor that might be giving a varying result against Investment.

Investing in profitable-investment projects can bring in greater resources to the firm in future and it entails a huge decision burden upon the shoulders of the managers. Shareholders expecting to earn a greater return through investing in them can also be undermined when manager decided to have a low payout policy. Funds generated internally is a possibility where there is a healthy cash flow, but it is also preferable if this free cash is invested into marketable security for allocating the resources into a profitable venture for a time being to make it a positive impression.

Future Research

In future studies there may be more aspects of cash flow-investment relationship which can be studied for assessing the degree impact it has on this relationship, i.e. sales, debt performance, capital structure, firm size, etc. The research study may also be improved if the observation of firms are increased that will in turn reflect a more clear picture about the relationship in the current scenario.

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