External Financing Constraints Research Articles

Internal Capital Markets in Family Business Groups During the Global Financial Crisis

This study investigates how family business group members’ investment decisions are affected by an exogenous shock, namely the 2008 Global Financial Crisis (GFC). Specifically, we investigate whether the internal capital markets in family business groups around the world alleviate the financial crisis-induced external financing constraints. We find that during the GFC the family group-affiliated firms on average cut investments by less than similar standalone firms. We also find that investments of group firms during the GFC become less sensitive to their own cash flows and more sensitive to the cash flows of other group members, especially those with greater financial slack, compared to the pre-crisis period. For a subsample of diversified groups, we propose an identification strategy, which shows that the post-crisis change in a group firm’s investment is determined by exogenous variations in its affiliated firms’ cash flows. Finally, we find that groups utilize equity primarily in the form of seasoned equity offerings (SEOs) to channel capital to affiliated firms during the GFC. The evidence highlights the important capital allocation role performed by the internal capital markets of business groups when external markets function poorly.

Revisiting the Bright and Dark Sides of Capital Flows in Business Groups

Prior studies report that the business group structure and the associated intra-group capital flows are prone to conflicts of interest between controlling shareholders and minority investors. Yet business group is a prevalent and stable structure around the globe, particularly where capital markets are underdeveloped. Using data from China, this paper empirically studies the trade-off between the negative and positive roles played by intra-group capital flows and tests the efficiency implications of such trade-off. We find that from the perspective of the whole group, intra-group capital flows are most efficient when the groups are least subject to conflicts of interest between controlling shareholders and minority shareholders and when they face strong external financing constraints.

The real effects of financial constraints: Evidence from a debt subsidization program targeted at strategic firms

Abstract We investigate the rationale and impact of the corporate debt subsidization program implemented by the Russian government during the recent financial crisis. Employing the difference-in-difference approach, we show that the program did not have a significant impact on capital investments of subsidy recipients, contrary to its intentions. We also find that a matched group of non-recipients on average exhibited a higher degree of cash hoarding behavior than subsidy-recipients in the post-program period, which suggests that the program eased external financial constraints of recipient-firms. Consistent with the theory on precautionary cash savings by firms, we further find that firms non-recipients based in cities with low banking development accumulated more cash holdings than recipients based in cities with a high banking development. Overall, our findings indicate that greater cash holdings are positively associated with the level of financial constraints of firms.

Examining the Relationship between Financial Development and Economic Development

Relationship between financial development and economic growth is a long-debated issue. The objective of this study is to determine if a relationship exists between financial development and economic growth. Better functioning financial systems ease the external financing constraints that impede firm and industrial expansion. On the other hand, changes in economic activity and economic growth can influence financial systems. With the help of Principal Component Analysis, we develop two indices - one for ‘financial development’ and the other for ‘economic development’. Through a set regression equations, we find that the elasticity of ‘financial development’ with respect to ‘economic development is 0.37 and elasticity of ‘economic development’ with respect to ‘financial development’ is 1.69. The gains from financial development are much greater.

English

From a sample of 75,854 Slovenian fi rms in the period 1995–2011, we examine the effects of a fi rm’s access to bank credit on its growth. The results suggest that as the external fi nancing constraint relaxes and fi rm gets access to credit, the reliance on internal funds to fi nance growth decreases. By exploring the role of available collateral in gaining access to bank credit, we fi nd that collateral only helps larger fi rms to obtain credit more easily. On the other hand, collateral does not reduce micro fi rms’ dependence on internal funds to fi nance growth, which suggests that even if they have collateral, banks are still unprepared to fi nance them, possibly due to the level of risk. It could also be that in approving credit to micro fi rms, other factors such as liquidity or cash fl ow are more highly considered by banks than the value of collateral. JEL classifi cation: G30, G21, C23

The Conservative Issuer Bias of Corporate Ratings

In contrast to existing literature that relates positive issuer bias in ratings to a conflict of interest, we document a bias in corporate ratings resulting from a conservative rating policy that accounts for the asymmetric impact of a rating downgrade on firms’ access to capital. Specifically, using Moody’s issuer ratings over 1982-2009, firms with greater external financing constraints are less likely to be downgraded. Economically, external financing constraints are more important than the default risk of the firm in determining the outcome of a rating review. Severely constrained firms whose ratings are affirmed or upgraded have long-term positive excess equity returns.

Financial Frictions and Investment Dynamics in Multi-Plant Firms

Using confidential Census data on U.S. manufacturing plants, we document that most of the dispersion in investment rates across plants occurs within firms instead of across firms. Between firm dispersion is almost acyclical, but within-firm dispersion is strongly procyclical. To investigate the role of firms in the allocation of capital in the economy, we build a multi-plant model of the firm with frictions at both levels of aggregation. We show that external financing constraints at the level of the firm can have important implications for plant-level investment dynamics. Finally, we present empirical evidence supporting the predictions of the model.

Corporate Investments in Asian Emerging Markets: Financial Conditions, Financial Development, and Financial Constraints

Motivated by the literature on the finance – growth nexus, this paper explores the mechanisms through which finance affects corporate investments and capital accumulation. We separate the effects of financial conditions from those of financial development. Based on a sample of firms from five Asian emerging economies, we find that (1) financial conditions and financial development affect corporate investments through different channels. Financial conditions affect firms’ growth opportunities and investment demand. Financial development primarily affects firms’ external financing constraints. (2) Large firms benefit more from improved financial conditions, while small firms benefit more from financial development. (3) The effects of financial conditions and the level of financial development are asymmetric: they are stronger when the global financial crisis was unfolding and weaker during the subsequent rebound.

Institutional Frameworks, Venture Capital and the Financing of European New Technology‐based Firms

AbstractManuscript TypeEmpiricalResearch Question/IssueWe first study how cross‐country differences in shareholder protection against self‐dealing and personal bankruptcy laws affect the financing of new technology‐based firms (NTBFs). Second, we study how venture capital (VC) investors – as expert monitors and initiators of “good” governance practices in firms – moderate aforementioned relationships.Research Findings/InsightsUsing a unique longitudinal dataset of 6,813 NTBFs from six European countries, we find that better shareholder protection rights increase the probability of raising external equity financing and allow firms to raise larger amounts of equity financing. Less forgiving personal bankruptcy laws decrease the probability of raising debt financing and limit the amount of debt financing that is raised. VC ownership strengthens the aforementioned relationships.Theoretical/Academic ImplicationsThis study is one of the first to provide evidence on the relationship between national legal systems and the financing of private NTBFs. We further address a recurring call for more research on the interaction between country‐level legal systems and firm‐level corporate governance. In particular, we show that expert monitors, such as VC investors, strengthen the relationship between national legal systems and NTBF's access to external financing.Practitioner/Policy ImplicationsPolicy makers often focus on increasing the supply of VC financing as a panacea for external financing constraints experienced by NTBFs. This study shows that VC ownership is particularly effective at increasing firms' access to external financing in countries with strong investor protection rights and entrepreneur‐friendly personal bankruptcy laws.

The speed of adjustment in working capital requirement

This paper analyzes the determinants of working capital requirement (WCR) and examines the speed with which firms adjust toward their target WCR. The findings indicate that firms adjust relatively quickly, which supports the hypothesis that current balance sheet items are easier to manipulate and could be changed quite easily, even in the short run. Moreover, we find that the speed of adjustment is not equal across all firms and varies according to their external finance constraints and their bargaining power. Firms with better access to external capital markets and greater bargaining power adjust faster due to their lower costs of adjustment.

Fixed investment, liquidity, and access to capital markets: New evidence

We re-evaluate the cash flow–investment relation from a new angle in a setting where the firm can access capital markets and faces different investment opportunity sets. Instead of replying on cash flow, we introduce other forms of finance to interact with investment. We find that financial variables enter significantly into the investment regressions at different timing. The cash flow effect reduces after the IPO and especially after the SEO, but remains positive for the firm with greater investment opportunities. Similar reductions in the long-term debt effect and especially in the working capital effect are also identified. The reductions are more pronounced in SMEs than in large firms. We draw the following conclusions. First, the cash flow–investment relation is not constant but evolves. Different forms of finance play concomitant roles covering cash flow shortfalls, jointly determining the dynamics of investment. Second, the investment–cash flow sensitivities do not constitute evidence of external financial constraints. Rather, the excess sensitivities are a response to the investment policy that is to drive asset growth or to maintain business operations. Essentially, growth opportunities are not in the cash flow terms but are embedded in the investment policy. Our study offers an alternative explanation for the investment–cash flow sensitivities.

How and When Venture Capital Affects the Investment of Portfolio Firms

This work studies how and when venture capital (VC) affects the investment of its portfolio firms. We estimate an Error Correction Model that takes into account the non-linearity of the investment curve on a sample of 361 young high-tech firms in 6 European countries. The direct effect of VC on firm's investment is positive and significant only when internal financial constrains are limited. The indirect effect of VC determines a structural change in the investment curve through the reduction of external financial constraints. This effect is particularly significant when firms receive follow-on rounds.

Investment and financing constraints in China: Does working capital management make a difference?

We use a panel of over 116,000 Chinese firms of different ownership types over the period 2000–2007 to analyze the linkages between investment in fixed and working capital and financing constraints. We find that those firms characterized by high working capital display high sensitivities of investment in working capital to cash flow (WKS) and low sensitivities of investment in fixed capital to cash flow (FKS). We then construct and analyze firm-level FKS and WKS measures and find that, despite severe external financing constraints, those firms with low FKS and high WKS exhibit the highest fixed investment rates. This suggests that an active management of working capital may help firms to alleviate the effects of financing constraints on fixed investment.

INTERNAL FINANCIAL CONSTRAINTS, EXTERNAL FINANCIAL CONSTRAINTS AND INVESTMENT CHOICE: EVIDENCE FROM PAKISTANI FIRMS

The purpose of this study is to analyze the impact of internal and external financial constraints on investment choice. The data have been taken from 9 major sectors (52 listed firms in the Karachi Stock Exchange) namely; Pharmaceutical & Bio Technology, Textile, Sugar, Tobacco, Chemicals, Oil and Gas, Fixed line Telecommunication, Industrial metal and Mining, and Cement sectors for the time period 2004 to 2010 on annual basis. Multiple regression analysis has been done to examine the relationship among firm’s size, dividend payout ratio, firm’s age, and investment. The empirical findings show that there is positive relationship between the firms’ size and investment while a negative relationship exists between firms’ age and investment. It also reports that there is negative relationship between dividend payout ratio and the investment. This shows that if a firm grows old or high dividend payout ratio then it will tend to spend less for expansion as compared to the young firms.

Trade Liberalization and Corporate Financing Decisions

This paper provides robust empirical evidence that trade liberalization significantly impact corporate financing decisions. Trade liberalization results in changes in tariff schedules in both domestic and foreign markets, which are most likely exogenous to individual firms. Our empirical strategy exploits this exogenous shock to identify the effect of trade liberalization on corporate financial structure. Examining a panel of firms in 37 developed and developing markets over 1996-2008, we find that both outward tariffs and inward tariffs are significantly and em positively associated with firm leverage, suggesting that firms tend to use more equity and less debt when international trade barriers are reduced. Using China's entry to the World Trade Organization (WTO) as a natural experiment, we find consistent empirical evidence: the Chinese listed firms significantly reduce their leverage ratios in the post-WTO period. Further analysis shows that the effect of trade liberalization on capital structure is more pronounced for firms whose technologies are distant to the technological frontiers, firms that are more sensitive to exports, and firms facing a higher level of external financing constraint. Our findings shed light on the economic consequences of trade liberalization and highlight the importance of international trade to corporate financing decisions.

Financial Constraints and Leverage Decisions in Small and Medium-Sized Firms

This paper studies the leverage decisions of small and medium-sized manufacturing firms in the UK. The relationship between debt and cash flow is studied in the light of both internal and overall financial constraints. Internal financial constraints are defined as those constraints internal to the firm that influence its financing decisions. These measures include the cash flow and profitability of the firm. Overall financial constraints account for both internal financial constraints and external financial constraints, which in turn are accounted for by conventionally used measures of financial constraints such as the size of the firm measured by the real assets and the riskiness of the firm. Results obtained indicate that firms follow a financial hierarchy when deciding what sources of finance to use. Internal financial constraints measured by the availability of internal funds are important factors that affect the relationship between debt and cash flow.

Comments on ‘Monetary Policy in Economic Crises: A Simple Model of Policy with External Financial Constraints’ by Devereux and Poon

The recent financial crises have generated interest in the design of optimal monetary policy rules not only for the developed economies, but also for the emerging economies. In particular, many economists have argued that economic models should take financial market frictions more seriously to analyze the propagation of external shocks and to design the optimal monetary policy rules at normal times as well as at economic crisis. Devereux and Poon address this issue by employing a tractable and simple small open economy model.

Monetary Policy in Economic Crises: A Simple Model of Policy with External Financial Constraints

The experience of economic crises in emerging market economies suggests that the operation of monetary policy in these economies is severely limited by the presence of financial constraints. This is seen in the tendency to follow contractionary monetary policy during crises, and the observation that these countries pursue much more stable exchange rates than do high income advanced economies, despite having a more volatile external environment. This paper analyzes the use of monetary policy in an open economy in which exchange rate sensitive collateral constraints may bind in some states of the world. The appeal of the model is that it allows for a complete analytical description of the effects of collateral constraints, and admits a full characterization of welfare-maximizing monetary policy rules. The model can explain two empirical features of emerging market monetary policy described above – in particular, that optimal monetary policy may be pro-cyclical under binding collateral constraints, and an economy with large external shocks may favor a fixed exchange rate, even though flexible exchange rates are preferred when external shocks are smaller.

Is investment–cashflow sensitivity a good measure of financial constraints?

Since Fazzari et al. (1988), investment–cashflow sensitivity has been one of the most important indicators for testing and measuring the external financial constraints of corporations. This study analyzes the effect of changes in the relative cost of internal and external financing on investment decisions in response to tax changes. China’s 2004 VAT reform decreased companies’ effective tax rates, leading to an increase in operating cashflow. This, in turn, reduced the internal cost of financing and the value of the tax shield and increased the cost of debt financing. This study shows that in the case of the VAT reform, investment–cashflow sensitivity increased significantly, whereas cash holdings–cashflow sensitivity and borrowing-slack sensitivity did not significantly change. We conclude that investment–cashflow sensitivity is not an effective measure of financial constraints under information asymmetry, but cash–cashflow sensitivity and borrowing-slack sensitivity may be useful alternatives.

Financing Constraints and the Cost of Capital: Evidence from the Funding of Corporate Pension Plans

We investigate the relation between firms' weighted average cost of capital and internal financial resources, using mandatory pension contributions as a proxy for internal financial resources. Rauh (2006) documents a negative association between mandatory pension contributions and capital expenditures. We find that an increase in mandatory pension contributions increases the cost of capital, but only for firms facing greater external financing constraints. Our results suggest that firms' cost of capital is an intervening variable that can explain Rauh's finding that mandatory pension contributions (i.e., internal financing constraints) result in foregone investment. Overall, we provide evidence consistent with recent studies (Rauh 2006; Almeida and Campello 2007) that conclude that financial market frictions affect real economic activity and, in particular, corporate investment.