Investment-Cash Flow Sensitivity under Changing Information Asymmetry

Abstract

Most studies of the investment-cash flow sensitivity hypothesis in the literature compare estimates of the sensitivity coefficients from cross sectional regressions across groups of firms classified into more or less financially constrained groups based on some measure of perceived financial constraint. These studies often report conflicting results depending on the classification scheme used to stratify the sample and have also been criticized on conceptual and methodological grounds. In this study we mitigate some of these problems reported in the literature by using the insights from Cleary, Povel and Raith (2007) in a new research design. The CPR (2007) model predicts an unambiguous increase (decrease) in investment-cash flow sensitivity when information asymmetry of the firm increases (decreases). Accordingly we test for the significances of the changes in the investment-cash flow sensitivity, in a time-series rather than cross sectional framework, for the same set of firms surrounding an exogenous shock to the firms’ information asymmetry. The two events we study are (i) the implementation of SOX which is expected to decrease information asymmetry from improved and increased disclosure and (ii) the deregulation of industries which is expected to increase information asymmetry largely from the lifting of price controls and entry barriers. We report that information asymmetry indeed decreases following SOX and that there is a commensurate decrease in the investment-cash flow sensitivity, pre- to post SOX. We also report support for the hypotheses that information asymmetry increases following deregulation with a commensurate increase in investment cash flow sensitivity, pre to post deregulation. Overall, the study supports the investment-cash flow sensitivity hypothesis using a research design that corrects for some of the problems identified in the existing literature.