The Impact of Capital Market Imperfections on Investment-Cash Flow Sensitivity

Abstract

We examine the investment-cash flow sensitivity of U.S. manufacturing firms as a function of five factors associated with capital market imperfections - fund flows, institutional ownership, analyst following, bond ratings, and corporate governance. If investment-cash flow sensitivity reflects financial constraints, then it should reduce as capital market imperfections as measured by these factors are mitigated and thus, financial constraints are eased. We analyze the relationship using both the traditional OLS and the more recently proposed measurement-error consistent GMM approaches. We find a steady decline in the estimated sensitivity over time, and that this decline cannot be explained on the basis of measurement error alone. The evidence on the impact of the factors on investment-cash flow sensitivity is strong for fund flows and institutional ownership, moderate for analyst following, mixed for bond ratings, and weak for corporate governance. Increased fund flows and institutional ownership decrease investment-cash flow sensitivity. Furthermore, increased fund flows decrease it not only for the firms held by institutions, but for all firms in the market. Since information is priced, increased analyst following should reduce the firm's cost of capital. We find some evidence supporting this hypothesis. Firms with bond ratings are able to access debt markets at lower costs. The cost wedge between internal and external funds, therefore, should be lower for these firms. We find that investment-cash flow sensitivity is lower for firms with investment-grade bond ratings. However, we fail to find a similar effect for junk bonds. When antitakeover amendments are considered as a mechanism of corporate governance, we find weak evidence that firms with a large number of antitakeover amendments have a lower sensitivity of investments to internal funds. Previous work has shown that the cost of debt financing is lower for firms with a large number of antitakeover amendments. Since the firms with amendment data are mainly large firms, and such firms rely primarily on debt for external financing, our finding is consistent with the relaxation of financial constraints through antitakeover measures being reflected in lower investment-cash flow sensitivity. Our findings indicate that investment-cash flow sensitivity decreases when there is a reduction in capital market imperfections. This holds for the overall sample, as well as for most of the samples with different dividend payout ratios. The overall evidence suggests that investment-cash flow sensitivity provides information about financial constraints imposed on firms by capital market imperfections.