Study On Free Cash Flow And Capital Spending
The aim of this study was to analyze the relationship between free cash flow and capital-spending; evidence from the Automobile industry of Pakistan. Capital spending is strongly and positively associated to the level of free cash flow, and free cash flow's influence on capital spending increases as firm size decreases and as insider ownership increases.
Free cash flow is determined by integrating the cash receipt and disbursement items from the income statement with the change in each balance sheet item; the sum of the cash inflows equals the sum of the cash outflows.
Capital spending is an amount a company spent buying or upgrading fixed assets, such as equipment, during the year and acquiring subsidiaries, minus government grants received.
The free-cash-flow (FCF) hypothesis suggests that excess cash flow is wasted on value destroying capital spending because managers have a personal reason to raise the asset base of the firm rather than give out cash to shareholders. (Jensen, 1986)
Free cash flow has always been somewhat of a puzzle in the literature on the determinants of investment. In a strictly neoclassical world, cash flow does not belong in an investment equation, and yet empirical studies dating back over 40 years almost invariably find that cash flow and investment are positively related. (Klaus Gugler, 2004)
CHAPTHER ONE: INTRODUCTION
To Study the Impact of Free Cash Flow on Capital Spending
Free cash flow, is explained as operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends. FCF is a coverage ratio representing the amount to which current period generated free cash flow (defined above) is sufficient to cover next period's capital expenditures. (Vogt, 1997)
Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Negative free cash flow is not inevitably an indication of a bad company, however, since many young companies put a lot of their cash into capital spending, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments. While free cash flow doesn't receive as much attention as earnings do, it is considered by some experts to be a better indicator of a company's financial health. (Vogt, 1997)
In finance, (FCF) is cash flow in hand for giving out among all the securities holders of an organization. Those include equity holders, debt holders, preferred stock holders, convertible security holders, and so on. (Poulsen, 1989)
The FCF hypothesis predicts that the capital market will react unfavorably to capital spending. The FCF hypothesis also explains that undistributed cash flow will be positively related to capital spending, but the significance of cash flow to capital spending will be positively related to firm size and negatively related to insider ownership. (Vogt, 1997)
Free cash flow is a cash flow in surplus of that necessary to fund all projects that have positive net present value when discounted at the appropriate cost of capital. When FCF is present and shareholder monitoring is imperfect, the typical manager-shareholder agency problem arises. Managers have a tendency to overinvest (i.e., invest in negative-NPV projects) in order to capture the financial and non-financial benefits of increased firm size. (Jensen, 1986)
The free-cash-flow hypothesis suggests that excess cash flow is wasted on value destroying capital spending because managers have a personal reason to raise the asset base of the firm rather than give out cash to shareholders. (Jensen, 1986)
The objective of this paper is to find the relationship between free cash flow and capital spending.
H1: Free Cash flow has a positive relationship with capital spending or investment.
REVIEW OF THE RELATED LITERATURE
The aim of this study is to observe whether free cash flow is important in the firm's capital spending decision or not.
The internally generated cash flow on financing capital investment spending is well recognized. Less well understood is the cause behind this influence. Modigliani and Miller’s (1958) insignificance suggestion asserts firms to carry out all positive net present value (NPV) investments regardless of the financing source. (Modigliani & Miller, 1958)
Free cash flow as cash in surplus of that necessary to fund all positive net present value projects. Free cash flow tempts managers to expand the scope of operations and the size of the firm, thus increasing managers' control and personal compensation, by investing free resources in projects that have zero or negative net present values. These unprofitable spending is an aspect of the basic conflict of interest between owners and managers. Free cash flow is inconsistent with the goal of owner wealth maximization. Expenditures wasted by management instead could have been distributed to the owners of stock insurers as cash dividends or to the policyholders of mutual or stock firms in the form of lower premiums, higher policy dividends, or higher investment returns. While regulators primarily focus on insurer solvency, they also are concerned with maintaining premium rates that are not excessive. To the extent that regulators monitor life and health insurance rates, dividends, and surrender values, free cash flow should be of concern to them.
The existence of free cash flow provides managers with an opportunity to waste cash on unprofitable capital spending. These unprofitable capital spending represents an incremental cost of the owner-manager conflict. (Jensen, 1986)
The majority of existing evidence on the free cash flow hypothesis focuses on changes in financial structure. Jensen suggests that leveraged buyout activities are one way of controlling free cash flow because the debt incurred in such transactions forces managers to pour out excess cash. It examines the cross-sectional relation between free cash flow and ownership structure and finds some evidence that organizational forms specific to the oil industry (corporations, master limited partnerships, and royalty trusts) have different agency costs of free cash flow. Specifically, the Capital spending of free cash flow is lower in royalty trusts and master limited partnerships than in corporations. (Jensen, 1986)
In this study, we test for differences in free cash flow between capital spending automobile insurance industry. Our purpose is to examine whether organizational form affects managerial behavior with respect to the holding of free cash flow rather distributing or investing. (Jensen, 1986)
Jensen's theory predicts that Capital spending of equity is partly driven by free cash flow. Previous research indicates that the agency problems between owners and managers are greater in mutual organizations than in stock organizations, which leads to the expectation that the free cash flow problem will be greater in mutual insurers than in stock insurers.
James A. Gentry (1990) analyzed capital spending with total cash outflow and found out that the percentage of cash outflows going to capital investment (NI/TCF) ranged from an outflow of 60 per cent or more. The giant companies invested a higher percentage of their total outflow in plant and equipment than companies in the other size categories. The small companies invested the lowest per- centage of their total outflows in capital. (James A. Gentry, 1990)
Previous research was applied to agricultural firms by Farrell E. Jensen, (1993) which should that results are consistent with previous studies for nonagricultural firms which show that internal cash flow variables are important in explaining investment. We found that internal cash flow variables are important and that the addition of internal cash flow variables can improve the explanatory power of agricultural investment models. In terms of elasticity, investment was more responsive to internal cash flow variables. (Farrell E. Jensen, 1993)
Vogt’s (1994) explains the relationship of cash flow and capital spending by analyzing the free cash flow theory of Jensen’s (1986) and find outs that, since monitoring is costly, and managers can benefit from over investment, cash flow will significantly influence capital spending after controlling for the cost of capital. Capital spending of firms not paying dividend will be more influenced by cash flow than investment spending of firms that pay dividends. This follows because no-dividend firms are able to retain all cash flow and still not reach the retention constraint. Firms in which cash flow significantly influences capital spending will be associated with low values of marginal Q. In fact, the equilibrium level of Q for these firms is less than one. Finally, firms paying no dividends will not only have capital spending that are strongly influenced by cash flow, but also will be associated with the lowest levels of marginal Q. (Vogt S. , 1994)
Worthington (1995) has found that cash flow measures enter industry level investment equations positively and significantly, even after investment opportunities are proxied by capacity utilization variables. The effect of cash flow is greater in durable goods industries than in nondurable goods industries. (Worthington, 1995)
Klaus Gugler, Dennis C. Mueller, and B. Burcin Yurtoglu in 2004 tested the following hypothesis first asymmetric information (AI) hypothesis which predicted that firms underinvest and have returns on investment greater than their costs of capital, and second the managerial discretion (MD) hypothesis which predicts overinvestment and returns on investment less than the costs of capital, using the ratio of returns on investment to costs of capital for each firm is a natural way to make this identification. (Klaus Gugler, 2004)
Nathalie Moyen in 2004 explained the fact that the cash flow sensitivity of firms described by the constrained model is lower than the cash flow sensitivity of firms described by the unconstrained model can be easily explained. In both models, cash flow is highly correlated with investment opportunities. With more favorable opportunities, both constrained and unconstrained firms invest more. (Moyen, 2004)
Raj Aggarwal in 2005 started a study on four controlling for the investment opportunity set, and he concluded investment levels are significantly positively influenced by levels of internal cash flows. Also, the strength of this relationship generally increases with the degree of financial constraints faced by firms. Overall, these findings seem strong to the nature of the financial system and indicate that most firms operate in financially incomplete and imperfect markets and find external finance to be less attractive than internal finance. These results are also clearly consistent with the pecking order theory of corporate financing. (Raj Aggarwal, 2005)
Bo Becker, and Jagadeesh Sivadasan in 2006 concluded for their research paper that in frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, we find that firms invest more on average when they have higher cash flow. We contribute to the literature by testing formally if the coefficient on internal resources (cash flow) is related to a country’s financial development. Comparing countries, we find that the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. ( (Bo Becker, 2006)
In the case of capital spending, the observed results tend to support the free cash flow description of the cash flow/capital spending relationship. Actions that supports the FCF assumption, however, it is found in small firms paying low dividends. In the case of R&D spending, results are more reliable with the FCF assumption. These results together suggest that the effect that cash flow-financed investment has on firm value depends on asset size, dividend behavior, and the type of capitalspending. (Vogt S. , 1994)
FCF assumption indicate that cash flow should influence capital spending. The firms not paying dividends should demonstrate the strongest relationship between cash flow and capital spending, while those paying high dividends should show the weakest relationship. (Vogt S. , 1994)
Free cash flow, however, is still an significant variable in the capital spending behavior of small, low-payout firms. The constraint predicts, less than those associated with the larger firms in the low-payout group, is still highly significant. Consequently, the asymmetric information induced FCF assumption explanation cannot be dismissed. The most reasonable argument is that both free cash flow and asymmetric information are important factors contributing to the influence of cash flow on capital spending. (Vogt S. , 1994)
The different incentives that R & D and capital spending may generate for managers over time R&D represents an expenditure on intangible assets whose impact on the asset size and future cash flows of the firm is (1) extremely uncertain and (2) no likely to be realized in the near future. Fixed plant and equipment spending is likely to produce more certain cash flows in the near future (in part because of accelerate depreciation allowances) as well as increase the tangible asset base of the firm. The effect of plant and equipment spending is to generate free cash flow that can be used in the next period. Consequently, capital spending may be more susceptible to free cash flow problems than research and development spending. (Vogt S. , 1994)
Many researchers suggests that cash flow-financed capital spending is marginally inefficient and provides primary evidence in support of the FCF hypothesis. The negative relationship found in the aggregate data isconcentrated in firms paying low dividends over the sample period, in large firms, and most strongly in large firms paying low dividends. (Vogt S. , 1994)
Some researchers have important implications for both investors and managers. While the study shows that cash flow-financed capital spending is marginally unproductive for some firms, the potential sources of this inefficiency have also been identified. Cash flow-financed growth by large, low-dividend firms tends to be value-destroying, while cash flow-financed growth is value-creating for small, low-dividend firms. The importance of dividends as a method of mitigating agency costs of free cash flow, moreover, is confirmed. Managers of cash flow-rich companies may consider increasing dividend payouts as a method of increasing the efficiency of their capital spending decisions. A continued high-dividend-payout policy may also signal to shareholders that additional and costly monitoring of capital spending decisions is unnecessary. (Vogt S. , 1994)
The relationship between cash low and investment in all but a few papers are based on sample-splitting between constrained and unconstrained firms taken from a single country. This paper seeks to explain why the the degree of sensitivity appears to be greater. It extends the literature by examining from a number of perspectives the behaviour of firms. The paper proposes several hypotheses that are explored in turn. A first possible reason is that firms in market-oriented financial systems show greater sensitivity to cash flow because borrowers and lenders operate at arms length compared to those in relationship-oriented systems. A second possible cause for differences in response to cash flow across countries is that the samples of firms taken from each country might differ in composition with respect to particular characteristics, for instance size. 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. (Mizen, 2005)
The strong influence that free cash flow has on capital spending is well documented. However, the reason for this dependence is not well understood. On the free-cash-flow hypothesis of Jensen (1986) as explanations for the importance of free cash flow on capital spending. Initial results expose relations similar to those uncovered in previous studies. Capital spending is associated with positive and statistically significant with free cash flow. Firms with favorable investment opportunities are responsible for much of the positive, excess returns. Also, for firms announcing spending increases, the level of announced capital spending is positively and strongly related to the level of cash flow. The power of this relation increases for firms with profitable capital spending opportunities, as firm size declines, and as the proportion of insider ownership increases. Further analysis suggests that considerable diversity exists in the capital market's response to cash-flow-financed capital spending. The positive and statistically significant excess returns found in the sample of firms announcing increases is concentrated in the smallest of the sample firms, in firms with low cash flow relative to capital spending, and, to a lesser extent, in firms with high levels of insider stock ownership. Tests explaining the cross-sectional variation in returns reveal that excess returns for medium and small firms in the sample are positively associated with unexpected increases in planned spending. These tests also suggest that the capital market reacts more favorably to announced spending by small firms when the planned spending is more dependent on cash flow. Conversely, excess returns for the largest firms in the sample are negative, though not statistically significant. Cross-sectional regressions indicate that for these large firms, excess returns are negatively related to the extent that undistributed cash flow is available to finance planned spending, and positively related to their capital spending opportunities. These results are consistent with the hypothesis that small firms follow a FCF model like that described by Myers (1984) and Myers and Majluf (1984). Because small firms and high-ownership firms are the most likely to face the liquidity constraints associated with asymmetric information, they are also the most likely to forgo profitable investment spending in times of cash-flow shortages. As cash flow rises, the set of profitable capital investment projects the firm can undertake also increases. Consequently, capital spending is met with positive shareholder reactions, particularly when spending is dependent on cash flow. I find some evidence that is consistent with the free- cash-flow hypothesis. Excess returns are negatively related to large firm’s ability to cover capital spending with cash flow. Furthermore, high-cash-flow coverage firms, large firms, and firms with low-insider ownership all exhibit lower excess returns than their low-cash-flow coverage, small, and high-insider- ownership counterparts. This is consistent with the FCF hypotheses. This apparent diversity in the market's response to capital-spending decisions suggests different capital-spending financing policies for firms that seek to enhance shareholder value. The market values of small firms, firms with substantial insider ownership, and firms that are generally cash-flow-constrained appear to be enhanced, on average, by financing capital spending with cash flow. These firms might consider policies of conserving undistributed cash flow through low payout and leverage policies, thus encouraging new capital spending from internally generated funds. However, all other firms appear to be less dependent on a cash-flow-retention policy to facilitate capital spending. I find no evidence that cash- flow-financed capital spending improves these firms' market values, on average. Further, limited evidence exists that such a financing strategy could reduce market value for large, low-insider-owned, and cash- flow-rich firms. (Vogt, 1997)
Based on the responses of oil companies' nonoil segments, that large decreases in cash flow and collateral value decrease investment. Firms with findings from the literature on cash flow and investment: cash matters. Unfortunately, the sample size is fairly small, so that the investigation is fairly limited in scope; I feel confident only in testing relatively simple hypotheses. While statistical confidence levels are not extraordinarily high, they are moderately robust. I also conclude that corporate segments are interdependent, so that combining different firms into a corporate whole has real consequences. Issues in the theory of the firm emerge naturally from this empirical investigation. If one does not believe that asymmetric information or access to capital markets is likely to be a problem for such firms, one must find other explanations for the correlation of oil cash flow with non oil investment. One explanation, suggested by previous research, is that large diversified companies overinvest in and subsidize underperforming segments. The evidence presented here is consistent with this explanation. The segment data presented here are potentially important for two reasons. First, segment data can provide a useful tool for examining questions of traditional interest in corporate finance. For example, the researcher has explored the correlation of internal funds and investment, while Lang, Ofek, and Stulz(1996) use segment data to find the effect of leverage on investment and growth. Second, segment data will also be useful in exploring empirically novel issues in the theory of the firm, since it allows us to peer into the inner workings of the corporation. (Lamont, 1997)
This paper analyzes the sensitivity of investment to cash flow in the benchmark case where financing is frictionless. Overall, the results indicate that the frictionless benchmark is able to account for the observed magnitudes of the investment-cash flow sensitivity, and the patterns it exhibits. Investment is sensitive to cash flow, even after controlling for its link to profitability by conditioning market. Furthermore, the sensitivity is substantially higher for young, small firms with high growth rates and low dividend payout ratios, as it is in the data. The uncertainty these firms face about their growth prospects amplifies the investment-cash flow sensitivity in two ways. First, the uncertainty is resolved in time as cash flow realizations provide new information about investment opportunities. This makes investment highly sensitive to cash flow surprises. Second, the uncertainty creates implicit growth options, whose values show up in q. Since these options relate to long-term growth potential but not to investment in the near-term, q performs as a noisy measure of short-term investment expectations. Having a weaker relationship with the value of long-term growth options, cash flow acts as a useful instrument in investment regressions. Both factors discussed above contribute to the failure of Tobin's q to control for the investment opportunity set, rendering the economic interpretation of empirical cash flow sensitivity findings difficult. The first issue, that is, the in formativeness of cash flow shocks, is an econometric one, and is relatively easy to handle; one can remove the effects of the surprise component of cash flow by using lagged instruments. The second problem is more fundamental; it illustrates the limitations of q as a composite measure of both short- and long-term investment expectations. Future work could address the issue of providing observable variables that account for different dimensions of growth separately, in effect breaking down q into its components. (Alti, 2003)
The aim of this analysis has been to test the cause of the well-documented relationship between cash flow and investment spending. Two hypotheses about the source of this relationship are considered: the free cash flow (FCF) hypothesis, which assumes managers overinvest free cash flow in unprofitable investment projects. Which suggests that managers under invest because of an asymmetric information-induced liquidity constraint. Results from several empirical specifications 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 negative relationship found in the aggregate data is concentrated in firms paying low dividends over the sample period, in large firms, and most strongly in large firms paying low dividends. At the same time, the asymmetric information-induced FCF explanation advanced by Fazzari, Hubbard,and Petersen (1988) and others cannot be dismissed. Small firms that paid low dividends over the sample period relied heavily on cash flow and changes in cash to fund capital spending. The stronger the influence cash flow had on capital spending in this group, the larger the associated value of Tobin's Q. Consequently, large, low-dividend firms exhibit free cash flow behavior, while small, low-dividend firms exhibit FCF behavior. The influence of dividend policy and firm size sheds some light on the finding that financially distressed firms rely primarily on cash flow because they are denied access to the debt markets (Whited (1992)). Although the financial distress argument may explain the strong influence cash flow has on capital spending for low-Q firms found here, it cannot explain why only large firms exhibit this behavior and small firms do not. Thus, the interaction between dividend-payout behavior and firm size appears to distinguish free cash flow and FCF behavior rather than support the financial distress view. These results may have important implications for both investors and managers. While the study shows that cash flow-financed capital spending is marginally unproductive for this sample of firms, the potential sources of this inefficiency have also been identified. Cash flow-financed growth by large, low-dividend firms tends to be value-destroying, while cash flow-financed growth is value-creating for small, low-dividend firms. The importance of dividends as a method of mitigating agency costs of free cash flow, moreover, is confirmed. Managers of cash flow-rich companies may consider increasing dividend payouts as a method of increasing the efficiency of their capital spending decisions. A continued high-dividend-payout policy may also signal to shareholders that additional and costly monitoring of capital spending decisions is unnecessary. The value-decreasing findings associated with cash flow-financed capital spending do not arise in the case of R&D spending. Cash flow-financed R & D spending is associated with high-Q firms. Additionally, high-Q firms following a low-dividend-payout policy exhibited the strongest influence of cash flow on R & D. One implication of these results is that firms with growth opportunities closely tied to research and development are not able to rely on the external capital markets as the primary source of financing, because information costs make external financing excessively costly. Therefore, an appropriate dividend policy for these firms is to pay no dividends and to finance research and development with cash flow. An explanation for the differing results between capital spending and research and development spending involves the incentives managers have to expand a firm's tangible asset base. Since capital expenditures typically add to the amount of assets under managerial control and generate more predictable future cash flows, such expenditures create the opportunity to exploit free cash flow in subsequent periods. Research and development spending, however, produces less certain cash flows and increases the firm's tangible asset base only if successful. Rather, because R & D spending represents investment in intangible and highly uncertain assets, it is more likely to be associated with the asymmetric information problems that create a financing FCF. Finally, the secular behavior of firms may play an important role in determining the strength of free cash flow versus pecking order behavior. This study analyzed a balanced panel of firms for which data were available during an 18-year sample period. Thus, low-dividend-payout firms must be interpreted as having consistently low-dividend-payout behavior. The large, non-financially distressed firms in this study that consistently do not pay out income to shareholders are a priori most likely to be associated with free cash flow behavior. Newer firms for which complete data were not available over the sample period may have greater asymmetric information problems, and thus show pecking order behavior. General conclusions about the overall behavior of firms must be drawn considering the sample. The research does provide important insight, however, into the behavior of firms that survive the competitive pressures of the marketplace. (Vogt S. , 1994)
Cash flow analysis shows that the financial health of a company depends upon its ability to generate net operating cash flows that are sufficient to cover a hierarchy of cash outflows. The profiles generated from a large sample of companies show that relative cash flow components vary across company size and across industry groups. We hope that these profiles will serve as benchmarks for comparing cash flow components and encourage financial analysts to use cash flow analysis. (James A. Gentry, 1990)
In frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, we find that firms invest more on average when they have higher cash flow. We contribute to the literature by testing formally if the coefficient on internal resources (cash flow) is related to a country’s financial development. Comparing countries, we find that the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. The effect is weaker inside conglomerates and is probably not driven by the East-West difference. This is consistent with the idea that conglomerates ease internal financial constraints. Industries with few low liquid assets may experience bigger benefits of financial development (i.e. the cash flow coefficient is reduced more by financial development in low liquidity industries). However, the evidence for this is mixed. Our findings suggest that financial frictions operate in Europe. They suggest that financial development is beneficial because it reduces financial constraints at the firm level and therefore relaxes the correlation between internal resources and investment. (Bo Becker, 2006)
It is hard to identify firms with financing constraints. I examine various criteria: low dividends, low cash flows, the constrained firm model, the constrained model in which a firm's investment exhausts its internal funds, and Cleary's index. If Firms. Figure 1 constrained model criterion or Cleary's index, Kaplan and Zingales's result obtains: Firms identified as experiencing financing constraints exhibit a lower cash flow sensitivity than firms identified as experiencing no constraint. If we use the other three criteria, Fazzari et al.'s result obtains: Firms identified as experiencing financing constraints exhibit higher cash flow sensitivity. Kaplan and Zingales’s result obtains if firms with financing constraints are indeed described by the constrained model. Because cash flow is an excellent proxy for firms' underlying income shocks, higher cash flows lead to more investment. Unconstrained firms also borrow more when they experience more favorable income shocks. Because the regression specification does not account for the effect of these external funds on investment, the cash flow sensitivity of unconstrained firms is magnified. Also, unlike unconstrained firms, constrained firms must choose either to pay dividends or to invest with their cash flows. This weakens the link between constrained firms' cash flows and their investments. Constrained firms therefore have investment policies that are less sensitive to cash flow fluctuations than those of unconstrained firms. In addition, because Cleary’s index identifies financing constraints in line with the models, Kaplan and Zingales’s result also obtains if firms experiencing financing constraints are identified by low Cleary index values. Fazzari et al.’s result obtains if firms with financing constraints are identified as those with low dividends (or low-cash flows). Firms from the unconstrained model maintain a higher debt burden than firms from the constrained model. Unconstrained firms are therefore more likely to be associated with lower dividends (or lower cash flows) than constrained firms. Low-dividend (or low-cash flow) firms, which are mostly unconstrained firms, have investment policies that are more sensitive to cash flow fluctuations than those of high-dividend(or high-cash flow) firms, which are mostly constrained firms. Fazzari et al.'s result also obtains if firms with financing constraints are described not only by the constrained model but also by an investment policy that currently exhausts their internal funds. When constrained firms do not have sufficient funds to invest as much as they desire, their investment equals cash flow and asset sales. In that case, the link between investment and cash flow is very strong. Constrained firms without funds to invest more have investment policies that are more sensitive to cash flow fluctuations than those of other firms. The constrained and unconstrained firm models may prove useful in identifying firms with financing constraints in the data. The investment-dividend correlations generated from the two models differ dramatically: Constrained firms exhibit a negative investment-dividend correlation, while unconstrained firms exhibit a positive correlation. Empirical analysis could help to evaluate different explanations of the observed cash flow sensitivities. For example, Alti shows in his model that learning can generate these sensitivities: Firms uncertain about their quality use their cash flow realizations to resolve their uncertainty; hence younger firms' investments are more sensitive to cash flow fluctuations than older firms' investments. It remains to be seen whether the sensitivities in the data are generated more by learning or by financing constraints. On one hand, young firms should exhibit a higher sensitivity than old firms. On the other hand, firms with negative correlations between investment and equity payout (accounting for repurchases) should exhibit a lower sensitivity than firms with positive correlations. (Moyen, 2004)
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