Investment-cash Flow Sensitivity Research Articles

What is CEO overconfidence? Evidence from executive assessments

We use detailed assessments of CEO personalities to explore the nature of CEO overconfidence as it is commonly measured. Longholder, the option-based measure of CEO overconfidence introduced by Malmendier and Tate (2005a) and widely used in the behavioral corporate finance and economics literatures, is significantly related to several specific characteristics that are associated with overconfident individuals as well as individuals with lower ability. Similar relations hold for overconfidence measures based on CEOs’ earnings guidance. Investment-cash flow sensitivities are larger for both Longholder and less able CEOs. After controlling for ability and other characteristics, Longholder CEOs’ investments remain significantly more sensitive to cash flows. These results suggest that overconfidence, as measured by Longholder, is correlated with lower ability but still reflects empirically distinct aspects of overconfidence.

Related party transactions and corporate environmental responsibility

We examine the effect of related party transactions on corporate environmental responsibility and find that firms with more related party transactions tend to have more controversial environmental reports, less emissions reduction, and less environmental expenditures. This relationship is more significant for firms with a high investment-cash flow sensitivity and those with a low ESG score. Overall, the results corroborate the hypothesis that the marginal costs of corporate environmental responsibility outweigh the benefits for financially constrained firms, thus deterring these firms from engaging in corporate environmental responsibility activities.

Good for your fiscal health? The effect of the affordable care act on healthcare borrowing costs

We study the effect of the US Affordable Care Act (ACA) on healthcare borrowing costs. The ACA provides insurance subsidies to low-income enrollees. States could accept funding to expand Medicaid, although many declined, citing the cost burden. The ACA significantly reduced healthcare yields after a favorable 2012 Supreme Court ruling. Furthermore, hospital investment spending increased, and investment-cash flow sensitivities decreased. The yield effect was double in Medicaid expansion states, and insignificant in rural areas of non-expansion states. Our results highlight how the municipal market can be used to evaluate the heterogeneous effects of public policy and guide a targeted policy approach.

CEO’s educational background, economic policy uncertainty and investment-cash flow sensitivity: evidence from India

ABSTRACT This study investigates the impact of Economic Policy Uncertainty (EPU) on Investment-Cash Flow Sensitivity (ICFS). Further, this study investigates whether CEO’s educational backgrounds moderate the effect of EPU on ICFS for Indian manufacturing firms from 2005 to 2019. Using the system-GMM, this study finds that EPU increases the role of cash flow for corporate investment and reduces corporate investment. Additionally, CEOs with an educational background in the finance domain (technical area) do (not) moderate the negative impact of EPU on ICFS. The finding of this study suggests that EPU considerably affects ICFS, and CEO’s educational backgrounds moderate the effect of EPU on ICFS. Overall, this study adds new insights into the research fields and the implications of this study are beneficial for economies, firms, managers, and investors.

Unexpected investment, tunnelling and financial constraints

PurposeBased on a sample of 1,435 Vietnamese listed firms over the period from 2005 to 2017, this study examines the sensitivity of unexpected investment to free cash flow and its mechanism.Design/methodology/approachWe tested three hypotheses using two-step system-GMM to investigate investment–cash flow sensitivity for various firm scenarios while accounting for confounding variables.FindingsFirms with negative free cash flow are more likely to engage in underinvestment; conversely, overinvestment is found primarily in firms with positive free cash flow. In terms of the mechanism, while underinvesting decisions are caused mainly by financial constraints, overinvesting behaviour primarily resulted from agency problems, typically in the form of principal-principal conflicts. Interestingly, under the impact of negative cash flow observations, financial constraints tend to decrease investment–cash flow sensitivity. Conversely, the agency costs hypothesis reveals that agency problems are more likely to increase investment–cash flow sensitivity.Originality/valueThese findings not only contribute to the current corporate literature but also provide some important practical implications for stock market investors, corporate managers, and policy-setting bodies, specifically in the Vietnamese market.

Collateral menus and corporate employment: Evidence from China's Property Law

We investigate whether introducing the collateral menus of liquid assets (e.g., inventory and accounts receivable) influences corporate hiring decisions. Our identification scheme treats the enactment of China's Property Law in 2007 as a quasi-natural experiment and then conducts a difference-in-differences estimation. The results show that firms with less net fixed assets hire more workers, particularly for firms with tighter financial constraints, higher labor intensity and those located in cities with stricter law enforcement, greater fiscal pressure and lower bank density. Further analysis shows that liquid assets help firms obtain more debt, save less cash, decrease the cash flow sensitivity of cash and investment and invest more in fixed assets, consistent with the collateral channel. In addition, a significant convergence of labor productivity across firms illustrates that the Property Law also has a labor reallocation effect. Our findings shed light on the importance of expanding collateral menus in maintaining employment during the COVID-19 pandemic.

Financial Constraints across Pakistani Listed Firms

Using Q investment model to scrutinize investment-cash flow sensitivity, a measure of financial constraint, has been a subject of controversy in literature. By using an alternative model called Error Correction model, this study aims to check the sensitivity between firm’s internal finance and investment level for the case of lower middle income country. Literature has shown that firms’ specific characteristics affect the relation between investment and cash flow of the firms. By considering the unique characteristics of Pakistani corporate sector, this study further target to check whether the investment-cash flow sensitivity differs across size of the firms, group affiliation of the firms and dividend policy of the firms. Our findings indicate that Pakistani listed firms are financially constrained. We find a strong relationship between investment and cash flow for small and non-dividend-paying firms; whereas group-affiliation does not affect investment- cash flow sensitivity of firms.

Dynamic multitasking and managerial investment incentives

We study non-contractible intangible investment in a dynamic agency model with multitasking. The manager’s short-term task determines current performance, which deteriorates with investment in the firm’s future profitability, his long-term task. The optimal contract dynamically balances incentives for short- and long-term performance. Investment is distorted upwards (downwards) relative to first-best in firms with high (low) returns to investment. These distortions decrease as good performance relaxes endogenous financial constraints, implying negative (positive) investment-cash flow sensitivities. Our results shed light on how corporate investment policies, liquidity management, and executive compensation structure differ across industries with different returns to intangible investment.

Corporate governance and investment-cash flow sensitivity: Evidence from Russian unlisted firms

This paper investigates how corporate governance of unlisted firms in an emerging market economy affects financing constraints, measured by the sensitivity of investment to cash flow. In order to evaluate the quality of corporate governance, we develop two corporate governance indices based on a large-scale survey of Russian enterprises – one for shareholder protection and one for transparency. We estimate standard investment regressions where the cash flow variable is interacted with our corporate governance indices and variables capturing the ownership structure. The central result is that better shareholder protection diminishes the cash flow sensitivity of investment, particularly in firms with an outside controlling owner. In contrast, we do not find such an effect for transparency, which can be partially explained by the threat of hostile takeovers. We address the problem of the endogeneity of corporate governance by using fixed-effects regressions and a novel instrumental variable based on particular legal provisions for corporate governance in Russia depending on the number of shareholders.

How does the internal capital market influence R&D spending? New evidence

PurposeThe purpose of this study is to examine whether and how internal capital markets mitigate financial constraints and enhance firms' willingness to engage in R&D projects.Design/methodology/approachThe study uses panel data relating to 2,095 publicly traded firms in the Chinese A-share market for the period 2007–2019. The tobit regression method is applied to explore R&D investment–cash flow sensitivity of group affiliates, while the systematic generalised method of moments and dynamic ordinary least squares models are adopted to address the endogeneity problem in the robustness test.FindingsThis study finds that firms affiliated with business groups demonstrate lower R&D investment–cash flow sensitivity than non-affiliated firms do and that R&D investments are significantly influenced by the cash reserves of other group members. In terms of financing channels, this study demonstrates that group firms use internal cash and equity financing to support other members' R&D investments, while debt financing does not influence member firms' R&D investments. In addition, this study discovers that R&D spending harms the stock and operating performance of some group members.Practical implicationsThe findings of this study enable business groups to focus on resource allocation and investment efficiency.Originality/valueAlthough prior studies indicate that internal capital markets can enhance R&D spending, few studies reveal the mechanisms through which internal capital markets benefit R&D. This study uses a unique methodology to test the ability of the internal capital market to enhance R&D spending. In addition, group firms use internal cash flow and equity financing to support partners' R&D projects.

Managerial optimism, investment cash flow sensitivity and agency costs: Evidence from NYSE panel data firms

This study deals with a new survey for the relationship between CEO optimism and investment cash flow (ICF) sensitivity in presence of asymmetric information and agency costs problems. In this paper, we conduct an empirical study of ICF among NYSE manufacture firms during the period 1999–2010. Our results report that the ICF sensitivity exists and is significant especially for firms that run agency costs. This result is robust to a battery of different model including alternative assumptions and different methodologies based on Adjusted Q-model and Euler equation model. For another set of tests, we demonstrate that a large blockholders holding may succeed to reduce investment cash flow caused by CEOs optimism bias.

“One person’s decision” or “collective voting”: Evidence of overconfident investing in Chinese listed companies

This study explores the collective voting of Chinese listed companies by examining whether the overconfidence of the board chairperson could affect the relationship between overconfidence and investment–cash flow sensitivity by the board of directors. On average, the board of directors’ overconfidence leads to increased investment–cash flow sensitivity. However, this influence is driven by state-controlled listed companies only if the chairperson is overconfident. The results suggest that the chairperson’s overconfidence may impact the relationship between the board of directors’ overconfidence and investment–cash flow sensitivity. Furthermore, the investment distortion due to the board’s overconfidence behavior may be alleviated by supervising the chairperson.

Investment decisions of family firms in the three largest euro countries: the role of the financial crisis

This study aims to investigate the impact of family ownership on the investment-cash flow sensitivity relationship. Our main hypotheses are tested through fixed effects regression analysis on panel data of French, German, and Italian listed firms over the 2007-2015 timeframe. The main findings suggest that family ownership is more likely to reduce the investment-cash flow sensitivity, suggesting more family firms’ more efficient investment behaviors. Moreover, during the financial crisis, family firms are particularly able to collect external funds to undertake investment projects, even if the internally generated cash-flow is not adequate to sustain investment policies.

The Effect of Financing Constraints on Corporate Investment: The SA-Index Approach

This study aims to analyze how the company's internal funds and investment opportunities impact the company’s investment decisions conditional to the financing constraints experienced. We classify companies into three categories based on the SA Index; low, neutral, and high-financing constraints. We analyze 278 non-financial companies listed on the Indonesia Stock. Exchange during 2014-2018 using multiple regression methods. There is an indication that companies experiencing a financing constraint have a higher investment-cash flow sensitivity than companies with a low financing constraint. We found that internal funds and investment opportunities positively and significantly affect companies' investment with high financing constraints and companies with the neutral category. Meanwhile, we did not find a statistically significant relationship between independent variables - the internal fund and investment opportunity - and investment for companies with low financing constraints.

CEO's education and investment–cash flow sensitivity: an empirical investigation

PurposeThe purpose of this study is to examine the impact of financial and technical education of chief executive officer (CEO) on investment–cash flow sensitivity (ICFS) of Indian manufacturing firms.Design/methodology/approachThe study uses the dynamic panel data model and more specifically, the system-generalized method of moments (GMM) technique to investigate the effect of CEOs' education on ICFS of Indian manufacturing firms during the period 1998–1999 to 2016–2017.FindingsThe study shows that financial (technical) education of CEOs does (not) affect ICFS. The results explain that the role of the CEO's education in ICFS is highly significant during the crisis period. The robustness test depicts that the influence of financial education on ICFS is less (more) for group-affiliated and large-sized firms (stand-alone and small-sized firms). Further, the CEO's education is significantly associated with corporate investment decisions.Research limitations/implicationsDue to the unavailability of the CEO's compensation data for the selected sample, future research could explore the impact of CEO's education with respect to CEO's compensation on ICFS.Practical implicationsFirst, the authors find that financially educated CEOs affect ICFS; therefore, firms should take care of CEO's education during recruitment of CEOs. Second, lending agencies should also consider the educational background of the CEO before approval of funding to make it safe. Third, investors should keep in mind the educational background of the CEO for the growth of their investment as it may be easier for financially educated CEOs to borrow from the market at the time of requirement.Originality/valueThis study contributes to the existing literature by providing empirical evidence through analyzing the impact of a CEO's education on ICFS in the context of India. This study is very unique in itself as it uses the sample of manufacturing sectors of India, which are growing very fast and attracting global investors to create a global hub of manufacturing in India. This study also considers different types of education such as financial and technical education of CEOs in the context of a developing economy like India. This study made its findings robust across company characteristics and periods based on the financial crisis.

Investment–cash flow sensitivity around the crisis: are African firms different?

PurposeThis paper examines the contentious relationship between investment and cash flow using the 2008–2009 credit supply shock as a form of the quasi-natural experiment.Design/methodology/approachPanel threshold models with unknown sample separation are estimated for a sample of publicly listed firms from nine African countries over the period 2003–2012. Using this approach reduces subjective or ex ante sample-splitting bias that is not accounted for in the extant literature.FindingsThe findings of the study indicate that investment–cash flow sensitivity is decreasing even during the global financial crisis (GFC) and for firms more likely to be financially constrained. The authors conclude that the usefulness of investment–cash flow sensitivity as a proxy for financial constraints is diminishing over time, even after directly addressing biases from ex ante subjective sample splitting and various forms of endogeneity.Originality/valueThe authors provide new empirical evidence from sharper tests of financial constraints for understudied African firms and highlight the need to relook at the usefulness of investment–cash flow sensitivity as a proxy of financial constraints.

Board secretary’s financial experience, overconfidence, and SMEs’ financing preference: Evidence from China’s NEEQ market

ABSTRACT This article explains the impact of the board secretary’s financial experience on the financing preference from the perspectives of executive behavior and psychology. We use small and medium-sized enterprises (SMEs) listed on China’s National Equities Exchange and Quotations (NEEQ) market as an empirical research sample and confirm that SMEs who have board secretaries with financial experience prefer external financing, thus lowering the investment-cash flow sensitivity. Additionally, the empirical conclusions are robust after changing the measurement of financing, expanding the scope of financial experience definition, and removing state-owned SMEs from the sample for robustness testing. We also control for the endogeneity using a placebo test, PSM-DID, and instrumental variables. In further research, we find that overconfident secretaries prefer external financing; secretaries with financial experience can reduce information asymmetry to promote external financing, albeit mostly short-term loans.

Do financial restricted companies use the cash flow for investment or for cash holdings?

The present paper aims to verify whether the most financially restricted companies use their cash flow for investment or for cash holdings. To this end, the cash flow sensitivity of investment as well as the cash flow sensitivity of cash for Brazilian publicly traded companies through the Threshold method is tested, given its classification in restricted and unrestricted companies. In this context, the models of Fazzari, Hubbard and Petersen (1984) and Almeida, Campello and Weisbach (2004) were applied, using as structural breaks the Dividends Paid, Total Assets, Z-score and KZ-index. The result of the analysis was not clear in relation to which behavior is predominant in Brazilian companies. Using the Total Asset as a Threshold, the model that was most representative was the one referring to investments in capital goods. But, considering the Z-score as a Threshold, the most representative model indicates that companies use more Cash Flow results for cash holdings. Dividends and KZ-index were not significant in the analysis.

Financial conditions, financial constraints and investment-cash flow sensitivity: evidence from Saudi Arabia

PurposeThe purpose of this paper is to examine whether the sensitivity of investment to cash flow varies with exogenous financial conditions.Design/methodology/approachA dynamic model of investment based on the Euler equation approach is employed to investigate the impact of macro-financial factors on the sensitivity of investment to cash flow. The sample comprises data from 84 non-financial firms listed on Saudi stock market over the period 2007–2018.FindingsThe results show that the sensitivity of investment to cash flow is positive, implying the presence of financing constraints for Saudi firms. Evidence also reveals that better financial conditions relax firms' financing constraints. However, contractionary monetary policy, poor financial development and liquidity crisis strengthen the dependence of firms on internally generated funds when undertaking new investment projects.Practical implicationsThe empirical results have useful policy implications. First, policymakers should pay attention to the importance of policymaking based on the monetary demand of microeconomic entities. In monetary contraction periods, firms face greater challenges in accessing external finance. These firms are likely to experience under-investment which at a macro level would translate into lower investments and economic growth for the country. Second, policymakers are encouraged to implement complementary measures that, coupled with existing financial reforms, may promote efficiency, competitiveness and transparency in firms' operations. Finally, managers and investors should consider financial structure and condition as important factors in their investment decision.Originality/valueThis study extends previous research by investigating whether the widely reported positive investment and cash flow relationship can be observed using data from an emerging market, specifically Saudi Arabia. It also sheds light on the investment-cash flow debate under a macroeconomic perspective and provides further evidence on the impact of financial crisis on the investment-cash flow (ICF) sensitivity.

Marking to Market Corporate Debt

Models of capital structure and credit risk make predictions about market valuations of debt, but are routinely tested on the basis of book debt from common data sources. In this paper, we propose to close this gap. We construct a rich data set on firm level debt market valuations by carefully matching data on corporate bond and loan secondary market transactions. We document significant discrepancies between market and book values, especially for distressed firms. We use our dataset to i) provide novel rules of thumb on how to adjust leverage and unlever returns using standard datasets, and ii) to revisit a number of prominent empirical patterns involving corporate debt. Using a market-based measure of Tobin's Q, we find little evidence for investment cash-flow sensitivity in our data. We find that using market debt values significantly improves default prediction, and do not detect a credit spread puzzle. In asset pricing tests, we find a leverage premium, but no evidence for a value premium after controlling for market leverage. Moreover, a novel measure of financial distress, namely market-to-book debt, predicts stock returns positively in the cross-section, inconsistent with a financial distress puzzle.