Internal Cash Research Articles

Earnings Management and Future Corporate Investment

This paper examines whether earnings management through accounting manipulation has an impact on subsequent corporate investments. Using a measure of earnings management based on the work of Kothari, Leone, and Wasley (2005), I find that investment level in firms with the most aggressive accounting practices is higher and is less sensitive to internal cash flows, whereas investment in firms with the least aggressive accounting practices is more sensitive to internal cash flows. Furthermore, earnings management induces investment inefficiency in the future. The findings suggest that financial reporting has an impact on real investment patterns and efficiency. This paper also provides cross-sectional evidence that corporate investments respond to the market assessment even when it differs from the managerial own assessment of the fundamentals.

Price Umbrella Strategy Applied to Equipment Lease Pricing Structure

Equipment leasing continues to be a dynamic industry with many companies preferring to acquire equipment through leasing rather than utilizing bank lines or internal cash. Given the omnipresent fragmentation in the industry, it becomes a huge undertaking for a potential borrower to identify an optimal lender that best suits its business requirements. What makes the task more difficult is the variability of lease pricing structure across competing financial institutions namely interest rates (Fixed/Floating), term, level of security deposit and governing covenants. This paper posits that the Price Umbrella strategy presents a practical solution that can be leveraged to ease this gargantuan task.

Does Internal Finance Matter for R&D? New Evidence from a Panel of Italian Firms

This paper investigates the relationship between finance and R&D for a panel of more than 1000 Italian manufacturing firms. While Italian firms obtain a significant share of their financing from debt, the results from a unique survey show that firms use virtually no debt to finance R&D. Because Italian firms typically do not receive external equity, the obvious source of innovation financing is internal cash flow. I estimate the sensitivity of capital investment to cash flow for small and medium-large firms, testing for the presence of informational frictions in the credit market for companies performing R&D activities. I use a GMM method that controls for unobserved firm-specific effects and endogenous explanatory variables. Cash flow plays an important role in explaining capital investment, especially for small firms. Interestingly, when I consider measures of firms' innovative activities, I find significant differences between the sub-samples of small and medium-large firms. While small innovative firms are subject to relevant financing constraints, larger companies investing in R&D have easier access to external financing.

A Flight to Q?: Firm Investment and Financing in Korea Before and After the 1997 Financial Crisis

We examine investment behavior among exchange-listed Korean manufacturing firms before and after the 1997 financial crisis using firm-level panel data. We start with the standard Q-theory of investment, and then augment it by allowing for a sales accelerator and the possibility of cash constraints, categorizing firms based on their age, size and affiliation to the industrial conglomerates (i.e., chaebols). We find that Tobin's Q is a key and robust determinant of firm-level investment in a pooled sample for the period from 1992 to 2001, but that it became more important for small firms and less important for chaebol-affiliated firms after the crisis. Investment by chaebol firms also became more sensitive to the availability of internal cash balances after the crisis. We interpret this as reflecting a shift in the Korean economy to a stronger market orientation after the crisis and to a business climate in which the quality of potential projects became more important relative to capital market imperfections in determining the destination of investment funds.

Financial market development and the importance of internal cash: Evidence from international data

We examine the impact of financial market development on the extent to which firms have to rely on internal capital for making investments. Using international data from 31 countries for the 1987–1997 period, we find evidence of a negative relationship between financial market development and the importance of internal capital. The evidence is consistent across different estimation procedures, alternative measures of financial constraints and cash flow, and the use of bootstrapped standard errors. Finally, we find that the distortionary effect of negative cash flow observations reported earlier for US data extends to international data as well.

Common and fundamental factors in stock returns of Canadian oil and gas companies

We assess the financial determinants of Canadian oil and gas company stock returns. We find that the return of Canadian energy stock is positively associated with the Canadian stock market return, with appreciations of crude oil and natural gas prices, with growth in internal cash flows and proven reserves, and negatively with interest rates. Surprisingly, however, production volume and a weakening of the Canadian dollar against the US dollar have a negative impact. This latter impact is more pronounced for oil producers than for integrated energy companies. Finally, we find that the influence of the exchange rate, the market return and prices of natural gas on Canadian oil and gas stocks changes significantly over the years 1995–1998 and 2000–2002.

RELACIÓN ENTRE VALOR DE LA EMPRESA, DIVERSIFICACIÓN Y GOBIERNO CORPORATIVO

This paper studies the relation between performance, diversification and ownership concentration for Chilean companies. We use balanced panel data for 52 public companies in 1995-2002 time period. We do not find conclusive results for the relation between performance and diversification. When the major owner has more than 40 percent of the company stocks we find a positive relation between this and the number of line of business in which the firm is involved. This last result is consistent with the alignment incentive hypothesis. Analyzing internal cash flows, we find weak evidence for the wealth redistribution hypothesis between major stockholders and minorities. When the major stockholder belongs to the family we observe a positive relation between performance and ownership if the major stockholder has more than 40 percent of the shaies. Once the major owner has more than 65 percent of the stocks this relation is negative. In the case of executives we find a positive relation between ownership and performance if they have more than 65 percent of the stocks. Finally, we do not report any significant relation when the major stockholder is a multinational company.

The cash flow–investment relationship: International evidence of limited access to external finance

In efficient and complete financial markets, internal cash flows should have no impact on investment levels; but in inefficient and incomplete markets, the pecking order theory contends that there should be a positive relationship. Further, some studies show that investments of financially constrained firms are more sensitive to internal funds than those of less constrained firms but other studies show the opposite. Using comparable recent data on firms in the four largest industrialized countries (US, UK, Japan, and Germany), this study documents that in all four countries, controlling for the investment opportunity set, investment levels are significantly positively influenced by levels of internal cash flows, indicating that firms face limitation in access to external finance and may operate using a pecking order. Further, international differences in investment level sensitivities to opportunities indicate closer outside monitoring of firms in the bank-centered countries.

Investment, cash flow, and corporate hedging

We examine the underinvestment rationale for corporate hedging and test the hypothesis that if firms hedge to reduce both their reliance on external funds and the volatility of internal cash flow, then their investment spending should be less sensitive to prehedged cash flow. Our results are consistent with this hypothesis and indicate that investment spending is less sensitive to cash flow for hedgers than for nonhedgers. We also find that among hedgers, investment spending is less sensitive to cash flow when the extent of hedging is higher. Our results are generally robust to five different measures of cash flow.

The Effect of Financial Deficit and Target Leverage on Capital Structure and Debt Characteristics: Evidence from First-time Debt Issuers

I investigate the motives for issuance and the debt choices of 427 firms which issue long-term debt for the first time in their history between 1971 and 1999. Their first debt issues are very large relative to firm size and represent a permanent shift in firm financing policy. The amount issued is strongly related to deficits in internally generated funds needed to finance investments and only weakly related to deviations from target leverage structure. In the three (or five) years following the initial issuance, the firms remain significantly underlevered, and their deviations from target leverage are only weakly related to subsequent issues of debt and equity. However, firms finance their external deficits with large amounts of external equity as well - while internal cash flows provide 80% of the their funds and subsequent debt issues track deficits more closely than equity issues, equity issues fund approximately 40% of the initial and subsequent deficits. Financial deficits also affect strongly the likelihood of issuance of debt and equity together. I also examine the source and maturity of new debt. Consistent with Diamond's (1991) life-cycle hypothesis, initial debt issues have relatively short maturity and are overwhelmingly not rated, with the number of rated issues increasing afterwards. Firms with large financial needs are more likely to issue rated debt and longer maturity debt, controlling for other determinants of those choices. Overall, financial deficits appear to be an important determinant of the decision to issue debt and of the choice of its characteristics.

Structuring the IPO: Empirical evidence on the portions of primary and secondary shares

We empirically study the determinants of the portions of primary and secondary shares offered in IPOs. The data show that young, small growth firms tend to issue primary shares. Limited internal cash generation and a debt mix that largely consists of bank loans have a significant positive impact on the primary portion. The data also reveal that if financing needs warrant a relatively small primary portion, companies add secondary shares to increase the offering size, which enhances post-IPO stock liquidity. Furthermore, these growth firms are more likely to issue seasoned equity in the aftermarket. Conversely, established firms tend to offer only secondary shares. The diversification motive does not drive the size of the secondary portion but adverse selection costs have an impact. Also, firms selling only secondary shares show higher post-IPO control turnover.

The Cash Flow-Investment Relationship: International Evidence of Limited Access to External Finance

In efficient and complete financial markets, internal cash flows should have no impact on investment levels; but in inefficient and incomplete markets, the Pecking Order theory contends that there should be a positive relationship. Further, some studies show that investments of financially constrained firms are more sensitive to internal funds than those of less constrained firms but other studies show the opposite. Using comparable recent data on firms in the four largest industrialized countries (US, UK, Japan, and Germany), this study documents that in all four countries, controlling for the investment opportunity set, investment levels are significantly positively influenced by levels of internal cash flows, indicating that firms face limitation in access to external finance and may operate using a pecking order. Further, international differences in investment level sensitivities to opportunities indicate closer outside monitoring of firms in the bank-centered countries.

Pyramidal Discounts: Tunneling or Overinvestment?

Owners exploit the strong separation between ownership and control in pyramiding to establish control over several firms' internal cash flows via a very small capital investment. We establish that the large discounts on the pyramid holding company as well as on the portfolio firms at the bottom are directly linked to costs from overinvestment that increase with the separation between ownership and control. In an economy where pyramids are transparent and the tax system regulates the flow of dividends within the pyramid and to shareholders, the primary cause of the discounts is not tunneling but overinvestment costs.

Costly External Financing, Investment Timing, and Investment-Cash Flow Sensitivity

This paper examines the effects of costly external financing on the optimal timing of a firm's investment. By altering the optimal investment timing, costly financing affects current investment and the sensitivity of investment to internal cash flow. Importantly, the relation between the cost of external funds and investment-cash flow sensitivity is non-monotonic. Investment-cash flow sensitivity is decreasing in the cost of external financing when it is relatively low and is increasing in the financing cost when it is high. Empirical tests examining investment-cash flow sensitivities within groups of firms classified by proxies for their costs of external funds provide evidence consistent with the model. The model and the empirical results complement recent studies by Cleary, Povel and Raith [Cleary, S., Povel, P. and Raith, M., 2007. The U-shaped investment curve: theory and evidence, Journal of Financial and Quantitative Analysis 42, 1-39.] and Almeida and Campello [Almeida, H. and Campello, M., in press, Financial constraints, asset tangibility and corporate investment, Review of Financial Studies.] that show a non-monotonic relation between firms' investment and the availability of internal funds.

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

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). …

Determinants of Corporate R&D Investment: An Empirical Study Comparing Korea's IT Industry with Its Non-IT Industry

In our study, we extracted the market, finance, and government factors determining R&D investment of individual firms in the IT industry in Korea. We collected the financial data of 515 individual firms belonging to IT and non-IT industries between 1980 and 1999 from the Korea Investors Service's database and investigated the empirical relationship between the factors using an ordinary regression model, a fixed effects model, and a random effects model. The main findings of our study are as follows: i) The Herfindahl Index variable representing the degree of market concentration is statistically insignificant in explaining R&D expenditures in the IT manufacturing industry. ii) Assets, which is used as a proxy variable for firm size, have a positive and statistically significant coefficient. These two results suggest that the Schumpeterian Hypothesis may be only partially applied to the IT manufacturing industry in Korea. iii) The dividend variable has a negative value and is statistically significant, indicating that a tendency of high dividends can restrict the internal cash flow for R&D investment. iv) The sales variable representing growth potential shows a positive coefficient. v) The subsidy as a proxy variable for governmental R&D promotion policies is positively correlated with R&D expenditure. This suggests that government policy has played a significant role in promoting R&D activities of IT firms in Korea since 1980. vi) Using a dummy variable, we verified that firms reduced their R&D investments to secure sufficient liquidity under the restructuring pressure during Korea's 1998 and 1999 economic crisis.

Using Spinoffs to Reduce Capital Mis-Allocations

In this paper, we try to show that mis-allocation of capital in a conglomerate can lead to spinoffs. This mis-allocation arises when internal cash is not allocated efficiently between divisions with differences in growth opportunities. We show that differences in growth opportunities can predict subsequent spinoffs. We also show that differences in growth opportunities are better predictors of spinoffs than either the SIC codes that are used in the corporate focus explanation of spinoffs, or the usual estimates of free cash flow as applied to the conglomerate.

Valuation effects of bank financing in acquisitions

In a sample of 115 cash tender offers between 1990 and 1996, banks extend financing in 70% of the tender offers and finance the entire tender offer in half of these takeovers. Bank financing of tender offers is more likely when internal cash reserves are low. Acquisitions that are entirely financed by banks are associated with large and significantly positive acquirer announcement returns. Announcement returns are also positively related to the fraction of the acquisition value financed by bank debt. The benefits of bank financing are most important for both poorly performing acquirers and acquirers facing substantial informational asymmetries. Our results suggest that bank debt performs an important certification and monitoring role for acquirers in tender offers.

Internal Capital Markets, Bank Borrowing and Investment: Evidence from German Corporate Groups

Large German corporations are often suspected to be isolated from organized external capital markets and instead rely on capital sources from within the corporate group or from closely connected universal banks. This paper firstly reviews and discusses the benefits and costs of financing through internal capital markets and close bank relationships. The theoretical analysis shows that there is no clear preference regarding the relative pros and cons of internal capital markets and such bank borrowing. Secondly, the paper empirically investigates the joint effects of internal capital markets and bank borrowing on the internal cash flow dependence of investment (investment-cash flow sensitivity) which is often used to identify firms with financing constraints. For a sample of 220 German corporate groups, empirical evidence is found that the investment-cash flow sensitivity for firms heavily using internal capital markets is higher than for firms relying more on bank financing and that investment-cash flow sensitivities vary greatly depending on the degree of internal capital market activity and bank borrowing intensity. This is directly in contrast to existing empirical evidence documenting that firms that rely more on internal capital markets have lower investment-cash flow sensitivities in tendency. It is suggested that separating samples into firms relying on internal capital markets and firms relying on bank financing gives no unambiguous empirical prediction for the investment-cash flow sensitivities because the latter financing form might stem from a close universal bank relationship which has similar characteristics like an internal capital market. Furthermore, a descriptive analysis of firms with high investment-cash flow sensitivities suggests that not all of these companies appear to be financially constrained. This supports recent research which claims that the investment-cash flow sensitivity is not a useful measure of financing constraints.

Exclusivity and Tying in U.S. v. Microsoft: What We Know, and Don't Know

Research on capital structure attempts to explain how corporations finance real investment, with particular emphasis on the proportions of debt vs. equity financing. There is no universal theory of the debt-equity choice, and no reason to expect one. But three useful conditional theories are reviewed in this paper. The tradeoff theory says that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus, the amount of debt will reflect the firm's cumulative need for external funds. The free cash flow theory says that dangerously high debt levels will increase value, despite the threat of financial distress. Each of these theories “works” for some firms in some circumstances. More general theories will require a deeper understanding of the financial objectives of corporate managers.