Product market competition, cash flow and corporate investments

Abstract

PurposeThe purpose of this paper is to examine the effects of product market competition on capital spending (investments) financed by cash flow (CF), and the role of financial constraints (FC) on these effects.Design/methodology/approachThe Herfindahl-Hirschman index of concentration measures competition. Earnings retention, working capital, the Kaplan and Zingales (1997) index and CF shortfalls measure FC. Regressions relating capital spending to competition are performed for the full sample, as well as financially constrained and unconstrained, and growth and value firms’ sub-samples. For robustness, large reductions in import tariffs are examined to exogenously measure competition, with the impact of these on capital spending tested via the difference-in-difference method.FindingsThe results show that competition fosters valuable investments when firms are financially unconstrained, especially for growth firms, and reduces these investments when they are financially constrained, especially for value firms.Practical implicationsThe role of policy makers in alleviating FC should be focused toward growth firms that operate in competitive industries. As well, increasing financial pressure on value firms in competitive industries can have desirable effects, as it forces these firms to reduce investment inefficiency.Originality/valueMany firm-specific and environmental factors drive the relation between competition and investment. Khanna and Tice (2000) find profitable firms increasing and highly levered firms decreasing investments in response to Wal-Mart’s entry into their markets. Jiang et al. (2015) suggest that environments with predictable growth drive a positive relation between competition and investments. This study claims that another factor that affects this relation is the firm’s level of FC.