Net External Financing Research Articles

Carbon disclosure policy, external financing needs and the cost of capital: Does financial market quality matter?

AbstractWe investigate whether the quality of financial markets matters for the relationship between net external financing, voluntary carbon disclosure and firms' cost of capital. External financing needs may create incentives for firms to engage in environmental strategies, such as disclosing their carbon emissions in response to demands from stakeholders. In countries with low financial market quality, firms may build a reputation when complying with stakeholders' demands. In these countries, firms disclosing carbon emissions and with high external financing needs may be rewarded with a lower cost of capital. Using an international sample of 24,253 firm‐year observations from 35 countries, we show that the higher firms' net external financing in the previous year, the more likely they are to disclose their carbon emissions in the current year. Moreover, the positive association between the likelihood of carbon disclosure and net external financing needs is stronger in countries with low financial market quality. We further show that disclosing firms with high external financing needs have a lower cost of capital as compared to disclosing firms with low external financing needs. This evidence also differs between countries with high versus low financial market quality.

Does Limited Liability Matter? Evidence from a Quasi-Natural Experiment

We use the enactment of limited liability legislation across Canadian provinces to examine the effect of the change in liability status on firm outcomes for a group of public firms known as income trusts. We show that the switch from unlimited to limited liability increases trusts’ institutional ownership, net external financing, investments, profitability, payouts, and riskiness. Our results are stronger for energy trusts, which are more capital-intensive and face potentially greater liability risks. Our event study shows positive cumulative abnormal returns around the legal changes. Overall, we present a novel approach to test the impact of limited liability on firms.

External Financing, Access to Debt Markets, and Stock Returns

This paper offers a novel understanding of the cause of the external financing anomaly, a well established observation that net overall external financing activities and future stock returns are negatively related. Recent studies argue that the external financing anomaly is driven by earnings management and/or investment growth. However, we find that about half of the anomaly remains unexplained by these interpretations. The remaining predictability is not due to exposures to conventional risks and firm characteristics, the accrual factor, the asset growth factor, the wealth transfer hypothesis, or the issuer risk hypothesis, and is not driven by performance delistings or delistings associated with negative returns or unknown risks. Instead, it is attributed to the overvalued young and small unprofitable firms that lack internal funds and have limited access to public debt markets rely heavily on equity and modestly on private debt external financing to pursue their ambitious growth strategies through heavily investing in research and development.

The q-theory explanation for the external financing effect: New evidence

Several studies document a robust negative association between net external financing and average stock returns, which is referred to as the external financing effect. Using total asset growth as a comprehensive measure of overall corporate investment and total profitability gross of R&D expenditures as a measure of true economic profitability, we provide new evidence in support of the q-theory explanation for the external financing effect. We also test the market timing explanation for the external financing effect but fail to document supportive evidence.

The impact of cash holdings and external financing on investment-cash flow sensitivity

Purpose – This paper aims to propose several factors which can explain the negative relationship between financial constraints and investment-cash flow sensitivity. Design/methodology/approach – The author uses traditional fixed effects model and minimum distance panel estimation by Erickson and Whited (2000) to estimate investment-cash flow sensitivity in the cash flow-augmented investment equation. In addition, principal component analysis is used to construct a financial constraints measure. Findings – First, it was found that substitutability between cash holdings and free cash flow can partially explain why financially constrained firms do not depend on cash flow as heavily as we expect. Second, it was confirmed that the level of net external financing can also partially explain the investment-cash flow sensitivity puzzle. Furthermore, it was argued that the influence of cash holdings and external financing on investment-cash flow sensitivity is caused by the low level of internal cash flow for financially constrained firms. This argument is supported by our findings from an examination of investment-cash flow sensitivity for bank-dependent firms during the recession periods. Originality/value – This paper contributes to the literature by suggesting possible partial explanations for the contradictory relationship between investment-cash flow sensitivity and financial constraints.

The External Financing Anomaly beyond Real Investments and Earnings Management

Several studies document a robust negative association between net external financing and average stock returns, which is referred to as the external financing effect. Using total asset growth as a comprehensive measure of overall corporate investment and total profitability gross of R&D expenditures as a measure of true economic profitability, we provide new evidence in support of the q-theory explanation for the external financing effect. We also test the market timing explanation for the external financing effectbut fail to document supportive evidence.

Value Relevance, Idiosyncratic Risk, and External Financing Activities

This paper first examines the effects of value relevance of earnings and incremental value relevance of cash flows on net external financing, net equity financing and net debt financing. The investors, in general, suffer beta risk and idiosyncratic risk of a firm. The former is the main determinant of risk premium, and the latter can be controlled by the manager. If the firm has better control of idiosyncratic risk, it implies the manager has larger influence on stock returns. Under control accruals, value relevance of earnings and incremental value relevance of cash flows, we also examine the effects of net external, net debt and net equity financings on idiosyncratic risk. To test whether the external financing policy of a firm is consistent with over-investment hypothesis, this study investigate the effects of net external, net debt and net equity financings on future stock returns under controlling for value relevance of earnings and cash flows. This paper further analyzes the relation between current idiosyncratic risk and future stock returns following financing activities. We find that external financing activities are positively related to value relevance of earnings but are unrelated to incremental value relevance of operating cash flows, and external financing is unrelated to value relevance of operating cash flows but is positively related to incremental value relevance of earnings. Moreover, debt financing is unrelated to value relevance of cash flows but is positively correlated to incremental value relevance of earnings, and equity financing is unrelated to value or incremental value relevance of earnings but is positively correlated to value relevance and incremental value relevance of cash flows. We also find that both value relevance of earnings and cash flows are positively correlated to idiosyncratic risk, and current idiosyncratic risk and equity financing are negatively correlated to future returns after controlling value relevance of earnings and cash flows.

The Impact of Corporate Cash Holdings and Dynamic Financial Constraints on Investment-Cash Flow Sensitivity

In this paper, we propose several factors which can explain the negative relationship between financial constraints and investment-cash flow sensitivity. First, we find that substitutability between reserved cash holdings and internal free cash flow can partially explain why financially constrained firms do not depend on cash flow as heavily as we expect. Second, we confirm that the level of net external financing can also partially explain the investment-cash flow puzzle. Lastly, by examining the relationship between bank dependency and investment-cash flow sensitivity for recession and non-recession periods, we show that investment-cash flow sensitivity can be used as a proxy for a relative measure of financial constraints.

External Financing and Cross-Sectional Returns: A Global Analysis

Net external financing predicts cross-sectional returns in a large sample of firms drawn from 38 non-U.S. countries. In contrast, the proportion of net equity issues in total net financing, often used to measure the extent of managerial market timing, does not. With a strong cross-firm association between net external financing and investment growth rates, this suggests that firms’ real investment behavior rather than their strategic switching between equity and debt financings contains information relevant to future returns. Despite its popularity in the literature, the behavioral market-timing effect is absent globally even among countries with weak investor protection, limited corporate disclosure, and less developed financial markets.

Errors in Estimating Unexpected Accruals in the Presence of Large Changes in Net External Financing

We demonstrate that managers’ “normal” operating decisions associated with large (positive or negative) net external financing activities are likely to lead to significant measurement errors in unexpected accruals. The problem occurs pervasively in samples drawn from different time periods, samples that reflect a wide variety of alleged earnings management stimuli, as well as random samples. Simulation tests show that even at modest levels of net external financing changes, rejection frequencies for the null hypothesis of no earnings management rise dramatically. These results are robust to controls for performance and firm growth. Further analysis suggests that net debt financing is more likely to induce measurement error than equity financing. We find that the use of a matched-firm approach using industry and external financing matches is generally appropriate. These findings highlight the importance of controlling for the effect of external financing on unexpected accruals measures, and also have implications for research testing earnings management and financial reporting quality.

Errors in Estimating Unexpected Accruals in the Presence of Large Changes in Net External Financing

We demonstrate that the articulation among accruals, cash flows and revenues which is typically assumed in tests of earnings management does not hold when large (positive or negative) external financing activities are present. Our study provides evidence that managers’ “normal” operating decisions associated with net external financing activities are likely to lead to economically and statistically significant measurement errors in unexpected accruals. This is a serious concern given the frequency with which the partitioning variable used to identify instances of alleged earnings management is correlated with significant movements in net external financing. Simulation tests show that even at modest levels of net external financing changes, rejection frequencies for the null hypothesis of no earnings management rise dramatically. This result underscores the importance of additional specification tests being conducted to control for estimation biases in unexpected accruals associated with external financing. We suggest the use of a matched-firm approach using industry and external financing matches. Using this method, we demonstrate that prior conclusions about the existence of earnings management around open market repurchases (Gong et al. 2008) do not appear robust when attempts are made to control for the effect on unexpected accruals of large changes in net external financing.

External Financing and Future Stock Returns

We develop a comprehensive and parsimonious measure of the extent to which a firm is raising (distributing) capital from (to) capital market participants. We show that the relation between our measure of net external financing and future stock returns is stronger than has been documented in previous research focusing on individual categories of financing transactions. Decompositions of our measure reveal additional insights. First, the weaker results of previous research are attributable to 'refinancing' transactions having no change on net external financing. Second, after controlling for refinancing transactions, there is a consistently strong and negative relation between all major categories of external financing transactions and future stock returns. Third, the negative relation between external financing and future stock returns is most consistent with a combination of over-investment and aggressive accounting.

External shocks and growth prospects: The case of Brazil, 1973–1989

This is a study of the factors underlying the current account deficits experienced by Brazil since the mid-1970s. It also explores the country’s economic prospects through 1989, with the help of a simple macro-simulations model. The current account deficit is identically equal to the excess of domestic spending over national income. Provided that net external financing is available, this excess may increase for a number of reasons. Prominent among them is an expansion of real domestic spending, associated with increases either of real consumption expenditures or of real domestic capital formation. Even if domestic absorption is invariant, the external deficit may worsen because of inadequate domestic pricing policies. These may make it impossible for local firms to compete with cheaper foreign products, thus forcing a contraction of national income and employment. A temporary reduction of GNP below its potential value may also be caused by domestic supply shocks of a climatic or other nature. However, other factors can also cause a deterioration of the current account. In this context, this study investigates the factors underlying the evolution of the external accounts of Brazil since the mid-1970s following an approach suggested in the Dell Report and elaborated by Balassa.’ The reasons for a deterioration of the current account are divided into three groups: external shocks, burden of accumulated debt, and domestic policy actions. The first group comprises terms of trade, international interest rates, and world recession. The second includes the accumulated effect of past shocks and domestic policy actions. Finally, the third group encompasses the variables supposedly under the control of local policy-makers: domestic absorption and the economy’s tradability.

The newly-industrializing developing countries after the oil crisis: A comment

order to study the balance of payments effects of external shocks and policy responses to those shocks, Balassa presented an analytical framework in a recent number of Weltwirtschaftliches Archiv*. He gives an equation which permits him to estimate the shock on the balance-ofpayments due to the 1974 oil crisis and to compare the direct effects on the terms of trade with the indirect effects of changes in foreign demand. On the response side, he wants to compare import substitution, the increases in the country's export share in world markets, the effects of lower GNP growth rate on the country's imports and additional net external financing. But it seems that the interpretations of Balassa's relationship are far less obvious than he supposes. We notice particularly that some terms are estimated in current prices whereas others are estimated in constant prices. Before entering into discussion, however, let us recall the most important features of his analytical framework. Balassa gives the following equation: