Marginal q, Tobin's q, Cash Flow, and Investment

Abstract

1. IntroductionCash 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.1 A variety of hypotheses have been put forward to account for this empirical regularity including the existence of transaction costs, agency problems, and asymmetric information.2 This paper provides tests of the latter two hypotheses using a sample of 560 U.S. companies over the period 1977 to 1996.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.3 Thus, only firms with large cash flows can finance their attractive investment opportunities, and the puzzle of the relationship between cash flow and investment is resolved. To test this hypothesis, we need to identify those firms that may be subject to AI The very nature of AI makes it difficult if not impossible to cleanly identify firms in this situation. If a researcher can identify a firm with attractive investment opportunities and cash constraints, why can the market not do so? Previous studies have used size, level of dividends, age, concentration of share ownership, and extent of cross-shareholdings to identify firms that are possibly subject to AI problems.4 Although the capital market may have difficulty judging the investment opportunities of small firms, this in itself need not imply that the firm has attractive investment opportunities or that its cash flows are inadequate to finance them, if it does. Similar criticisms can be lodged against the other characteristics used to identify firms subject to AI problems. One of this article's contributions is to use a characteristic of firms that better identifies whether they suffer from AI problems.The AI hypothesis assumes that the firm's managers seek to maximize their shareholders' wealth but are prevented by a shortage of cash from undertaking investments with expected returns above the firm's cost of capital. Any firm caught in this predicament should, therefore, have a return on its investment, r, that is greater than its cost of capital, i. Our procedure for identifying firms subject to such cash constraints is thus to estimate the ratio r/i for each firm over our sample period and to categorize any firm for which this r/i > 1 as possibly cash constrained.6The agency 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.7 When this occurs, a company's returns on investment will be less than its cost of capital. Accordingly we identify firms for which r/i Both the AI and MD hypotheses treat cash flow as a measure of financial constraints. It is possible, however, that current cash flows merely proxy for the profitability of future sales. Thus, in testing for the importance of cash flows as a source of capital it is necessary to control for the investment opportunities of firms (Chirinko and Schaller 1995, p. 528). Many studies have used Tobin's q as such a control. Tobin's q reflects the average return on a company's capital, but what is relevant for investment is the marginal return on capital. What is needed, therefore, is an estimate of marginal q. The existing literature has continued to use measures of average q, even though the conditions under which it equals marginal q are quite stringent (e.g., constant returns to scale, perfect competition in all product markets). …