Cash Flow Uncertainty Research Articles

The interaction of debt financing, cash grants and the optimal investment policy under uncertainty

Significant progress has been made toward understanding a levered firm's optimal investment policy under uncertainty. To date, however, not much work has concentrated on the time scale trade-off and collectively held real options. We employ a game-theoretic real option model between a firm and a government to analyze the effect of uncertainty and investment stimulus in the form of cash grants on optimal investment timing, financing and investment scaling. We find that the jointly held real option between the firm and the government leads to underinvestment, regardless of whether the firm has the possibility to issue debt. Subsidies, however, reduce the level of underinvestment. Notably, the results indicate that even though levered firms receive less support, they invest more than unlevered firms. This challenges recent findings that a firm's optimal investment level is not affected by the way it finances a project. Similarly, we find that for realistic parameter constellations the levered firm's optimal investment threshold can be higher than that of its unlevered counterpart. This indicates that the availability of tax shield benefits does not necessarily serve as an incentive to invest earlier. Finally, we show that the effect of cash flow uncertainty on the equilibrium level of grants is ambiguous and triggers the switch from a subsidy to non-subsidy regime.

Do Lenders Price Tax Risk in the Debt Contract?

We investigate the relation between tax risk and the cost of private debt. Tax risk can lead to significant negative outcomes, including penalties, interest and additional tax payments, which in turn can increase the uncertainty of future cash flows and make it costlier for a firm to borrow. Consistent with our hypothesis, we find a significant, positive relation between the cost of borrowing and tax risk. In terms of economic significance, a one percent increase in our tax risk measure implies an interest rate increase of 4.04 basis points. We also find that lenders are more likely to require collateral, include more covenants, and issue smaller loans when borrowers have higher tax risk.

Hedging weather risk and coordinating supply chains

The sales of many products can be influenced by weather conditions, positively or negatively. For the manufacturers in question, one of their entrepreneurial risks is to incur lower than expected sales because of adverse weather conditions. The variability of weather conditions is expected to continue to rise because of climate change. Manufacturers can choose to do nothing and suffer the financial consequences, or transfer the weather risk partly or wholly to others. This paper presents an approach to transfer weather risks to risk takers and reduce sales volatility using weather index-based financial instruments. In our approach, the risk of adverse weather conditions is calculated on the basis of adverse conditions observed in the past. We do not use forecasts of weather conditions. We illustrate our action design with case studies of three companies: a company manufacturing automotive replacement parts, a clothing company and a company producing of sunscreen products. We demonstrate its efficiency in reducing cash-flow uncertainty and potential losses caused by adverse weather, and in influencing sales to the next tier.

Extrapolation Bias and Dynamic Liquidity Management

We consider the optimal dynamic liquidity management of a financially constrained firm when its manager is risk-neutral but ambiguity-averse with respect to the firm’s future cash flows. Managerial ambiguity-aversion generates endogenous time-varying worst-case beliefs that overweight recent cash flow realizations, thereby providing a microeconomic foundation for managerial extrapolation bias. Moreover, managerial ambiguity-aversion has different implications on firms’ liquidity management and recapitalization policies than risk. Models with risk alone imply that higher cash flow volatility increases firms’ payout and refinancing thresholds. By contrast, our model predicts that when ambiguity-averse managers face a higher long-term cash flow uncertainty, they optimally reduce firms’ payout and refinancing thresholds. Implications for investment and implied ambiguity premia are also studied.

Asset liquidity and firm innovation

In this paper, we examine the effects of asset liquidity on innovation investments. We show that firms with highly liquid assets tend to invest more in research and development (R&D) and to generate higher numbers of patents and patent citations. These findings hold even after controlling for cash holdings, stock liquidity, and firm characteristics. We hypothesize that the positive effect of asset liquidity on innovation is because this liquidity can help firms reduce the cost of capital. Consistent with this hypothesis, we find that the effect is more pronounced for firms with high cash-flow uncertainty or less capacity to access external equity capital. Overall, our findings show that asset liquidity is an important determinant of innovation.

BEHAVIORAL VALUE ADJUSTMENTS

Assets or liabilities with embedded prepayment/extension options can be subject to behavioral risk, due to the unpredictable exercise strategy followed by the option holder who does not act purely on the strength of financial convenience. When seen from the viewpoint of the option seller, such behavior results in a lower option value and an additional source of uncertainty in future cash flows. In this paper, we propose a general framework to model behavioral risk by taking advantage of a full parallel with credit portfolio modeling and by combining the features of option-based and intensity models. Our approach is micro-structural, meaning that the aggregate prepayment rate derives from the sum of individual decisions. In principle, a detailed characterization of the behavior of a pool of investors can be performed depending on available data. A particular emphasis is placed on the precise definition of behavioral risk and on the modeling of nonmarket factors, which may contribute significantly to the variance of future cash flows. Finally, we discuss the calibration of a behavioral risk premium and the pricing of contracts with embedded options by introducing the concept of behavioral risk adjustment ([Formula: see text]VA), in line with the recent development of XVA methodology.

New Product Launch and Stock Returns in the Period of Demonetization : Cross Section and Multivariate Time Series Analysis

The period of demonetization witnessed negative stock returns and earnings growth rates across various industries in India. The average weekly returns during this period on benchmark BSE Sensex was -0.42%, translating into an annualized return of -20.34 %. Using the discounted cash flow (DCF) valuation formula, under the imperfect market conditions, new product innovations can create shareholders' value by affecting one of the two variables: (a) future cash flows that are expected to be produced by the business ; and (b) capital providers' required rate of return at which those cash flows are discounted by the market. A firm can beat competition and increase its future cash flows by indulging in product innovation and launching such new products, which are able to command higher prices in the consumer market. New product innovations can also support the revival of products, which are in declining stages of their product lifecycle, and in turn can reduce uncertainty around a firm's cash flows. Reduction in cash flow uncertainty results in lower required rate of returns by capital providers. Consequently, new product launches can create shareholders' value, which can be captured by stock returns. The present paper used cross section data for listed Indian firms to study investors' response to new product launches in the period of demonetization, that is, October - December 2016. To establish a long-term effect of new product launches on stock returns, a multivariate time series analysis was also conducted for a single firm Maruti Suzuki for 26 quarters ending December 2016. The results suggested that a new product launch has a significant positive impact on quarterly EPS growth rate, and stock returns in the long run as well as in the short run. Also, in the crisis period of demonetization, where all the firms across various industries registered negative growth in EPS and hugely negative stock returns, new product launch worked as a savior for the firm.

Asset Liquidity and Firm Innovation

This paper examines the effects of asset liquidity on innovation investment. We show that firms with high liquid assets tend to invest more in research and development (R&D) and generate high number of patents and patent citations, even after controlling for stock liquidity and other firm’s characteristics. We further document that this effect is more pronounced for firms with high cash flow uncertainty or less capacity to access external equity capital. Using asset sales as a quasi-natural experiment to detect the change in firms’ asset liquidity, we show that asset sales are significantly positively related to R&D investment. Overall, our findings show that asset liquidity is an important determinant of innovation investment.

Types of investor uncertainty and the cost of equity capital

AbstractWe jointly test the effects of two types of investor uncertainty, one related to future firm performance and unrelated to accruals (cash flow uncertainty) and one directly related to accrual estimation errors (accounting quality uncertainty). Distinct from prior studies, our uncertainty estimates are based on a matched‐firm design that minimizes the mechanical relationship between the two uncertainty variables. We find a strong negative relationship between cash flow uncertainty and multiple estimates of the cost of equity capital. With respect to accounting quality uncertainty, we find a strong positive association with both expected stock returns and implied costs of equity, but only in settings that control for cash flow uncertainty. Collectively, our results suggest the need to consider different types of investor uncertainty when examining how investor uncertainty affects the cost of equity capital.

Dividend Paying Firm and Flexibility Hypothesis

Previous research suggests that firms substitute stock repurchases for dividend increases in response to higher cash flow volatility and/or higher tax rates on dividends relative to capital gains. However, when we separately examine repurchase decisions by dividend and non-dividend paying firms, we find little evidence that either cash flow uncertainty or reduced dividend tax rates after the Tax Act of 2003 induces the expected shifts in payments. Instead, we find that the two payout methods appear to have distinctly different shareholder clientele rather than being substitutes for each other.

Application of particle swarm optimization and robust net present value for BOT-type contracts

ABSTRACTMajor infrastructure construction projects contracted to private companies by governments are important for maximizing profitability. This paper extends an existing build–operate–transfer (BOT) concession model (BOTCcM) for identifying the reasonable concession period which would be profitable both to the government and to the private sector. There are some major limitations with BOTCcM – for example, the total investment cost is pre-given and the impact of uncertainty of parameters affecting the concession period were not considered. In this research, the total investment cost is assumed as variable which should be optimally determined and the uncertainty of net cash flows is considered. Further, the proposed model is implemented to calculate the robust concession period and required capital for the construction period, using the obtained values and particle swarm optimization method.

Tournament-Based Incentives, Corporate Cash Holdings, and the Value of Cash

This research examines the relations between tournament-based incentives and corporate cash holdings and the value of cash. We find robust evidence that tournament-based incentives are positively related to cash holdings and the value of cash. Moreover, the effect of tournament-based incentives on the value of cash is stronger for financially constrained firms. Our evidence indicates that as tournament-based incentives motivate riskier corporate policy choices that lead to not only larger expected shareholder value but also greater cash-flow uncertainty, firms increase cash holdings to cushion potential liquidity shortfalls that may cause underinvestment.

The use of fuzzy real option valuation method to rank Giga Investment Projects on Iran's natural gas reserves

Giga investments are exposed to numerous syste­matic and unsystematic (or specific) risks that significantly influence their feasibility and value. In addition to the conventional issues and complexities in evaluating investment projects, factors such as long construction time, high amount of capital required and irreversibility of investment, increase uncertainty of cash flows in these types of projects. As a consequence, decision makers are usually not satisfied with the results of the most popular va­luation methodology – discounted cash flow analysis – in valuation of Giga investments. The most promising methodology of valuing flexibility in such investment projects is the real options valuation which quantifies the value of embedded flexibilities through option pricing techniques. In this paper, fuzzy real options valuation techniques are used to rank Giga project proposals faced in Iran's gas industry. To this end, different scenarios of project payoff and future uncertainties are quantified, using fuzzy numbers based on findings from earlier real option valuation methods.

Investment decisions and bank loan contracting

PurposeThe purpose of this paper is to examine how a firm’s investment behavior relates to its subsequent bank loan contracting.Design/methodology/approachUsing a sample of US firms during the period 1992-2011, the authors examine the association between overinvestment (underinvestment) and three characteristics of bank loan contracts: loan spread, collateral requirement, and loan maturity.FindingsThe authors find that overinvesting firms obtain loans with higher loan spreads. Additional tests show that the effect of overinvestment on loan spreads is generally more pronounced in firms with lower reputation, weaker shareholder rights, and lower institutional ownership. The effect of overinvestment on collateral requirement is mixed, and investment efficiency has no significant relation to loan maturity.Research limitations/implicationsThe results are subject to the following caveats. First, while the study provides empirical evidence that investment efficiency affects bank loan contracting terms, especially the cost of bank loans, the underlying theory is not well-developed. The authors leave it up to future research to provide a theoretical framework to clearly distinguish the cash flow and credit risk effects of past investment behavior from those of existing agency conflicts. Second, due to data limitation, the sample size is small, especially when the authors control for corporate governance measured by G-index and institutional ownership.Practical implicationsThe finding that overinvestment is costly to corporations suggests that managers should consider the potential trade-offs from such investment decisions carefully. The evidence also alerts shareholders and board members to the importance of monitoring management investment decisions. In addition, the authors find that corporate governance moderates the relationship between investment decisions and cost of bank loans, suggesting that it would be beneficial to design effective governance mechanisms to prevent management from empire building and motivate managers to pursue efficient investment strategies.Originality/valueFirst, the findings enhance understanding of the potential economic consequences of overinvestment decisions in the context of a firm’s private debt contracting. The evidence suggests that lenders perceive higher credit risk from overinvestment than from underinvestment, likely because firms squander cash in the current period by investing in (negative net present value) projects that are likely to result in future cash flow problems. Second, the study contributes to the literature on the determinants of bank loans by identifying an observable empirical proxy for uncertainty in future cash flows that increases credit risk.

Stochastic internal rate of return on investments in sustainable assets generating carbon credits

Internal rate of return (IRR) is a widely used tool in ranking capital budgeting projects and eventual accept or reject decisions. In this paper, we consider an investment decision involving a sustainable, energy efficient, greenhouse gases (GHG) reducing asset and incorporate the value of carbon emission allowances for the investing company. These allowances create cash flows that may be characterized by significant volatility and uncertainty. The methodology developed in this paper allows decision makers to integrate their knowledge of carbon trading markets and the cash flows that result from sale of emissions credits. The novel methodology utilizes a Bayesian model for IRR that uses Gibbs sampler. Analysis of the results shows that IRR is influenced by volatility and uncertainty of carbon credit cash flows. Ignoring those uncertainty characteristics and simply using the expected values of cash flows can result in significantly inaccurate investment rate of returns. When compared to deterministic IRR calculations, the results show that the occurrence of very high and very low cash flows affects IRR positively, whereas higher variability of cash flow distribution affects IRR of GHG-reducing asset negatively. In other words, frequent large or small cash flows are preferred over fluctuating cash flows. The results may also provide a rationale for the existence of an anomalous consumer behavior known as the energy efficiency gap.

The real options to shutdown, startup, and abandon: U.S. electricity industry evidence

The purpose of this paper is to examine empirically the partially irreversible decisions to shutdown, startup, and abandon existing production assets under cash flow uncertainty and regulatory uncertainty. We use detailed information for 1121 individual electric power generators located in the U.S. for the period 2001–2009 and find strong evidence of real options effects. We find that both profitability uncertainty and regulatory uncertainty decrease the probability of shutdown. Regulatory uncertainty also decreases the probability of startup, but we find that cash flow uncertainty increases the probability of startup, especially for large generators.

Behavioral Value Adjustments

Assets or liabilities with embedded prepayment/extension options can be subject to behavioral risk, due to the unpredictable exercise strategy followed by the option holder who does not act purely on the strength of financial convenience. When seen from the viewpoint of the option seller, such behavior results in a lower option value and an additional source of uncertainty in future cash flows. In this paper we propose a general framework to model behavioral risk by taking advantage of a full parallel with credit portfolio modeling and by combining the features of option-based and intensity models. Our approach is micro-structural, meaning that the aggregate prepayment rate derives from the sum of individual decisions. In principle, a detailed characterization of the behavior of a pool of investors can be performed depending on available data. A particular emphasis is placed on the precise definition of behavioral risk and on the modeling of non-market factors, which may contribute significantly to the variance of future cash flows. Finally, we discuss the calibration of a behavioral risk premium and the pricing of contracts with embedded options by introducing the concept of behavioral risk adjustment (bVA), in line with the recent development of XVA methodology.

Does Capital Tax Uncertainty Delay Irreversible Risky Investment?

Tax uncertainty is often claimed to be harmful for investments. Capital taxes, such as property and wealth taxes, are particularly exposed to tax uncertainty. Capital tax uncertainty emerges from expected tax reforms, the unclear outcome of future tax audits, and simplified estimates of capital tax bases in investment models. Uncertain returns on investment as well as stochastic taxation contribute to overall uncertainty and may significantly affect investment decisions. Hitherto, it is unknown how capital tax uncertainty affects investment timing. However, it is well known that both uncertainty and capital tax may be harmful for investment and decelerate investment activities. We are the first to study the investment timing effects of stochastic capital taxes in a real options setting with risky investment opportunities. Our results indicate that even risk neutral investors are sensitive with respect to capital tax risk and may react in a surprising manner to a newly introduced stochastic capital tax. As an apparently paradoxical investment effect, we find that increased capital tax uncertainty can accelerate risky investment if such uncertainty is sufficiently low compared to cash flow uncertainty. In contrast, high capital tax risk delays high-risk innovative investment projects. To reduce unintended consequences of uncertain tax policy, tax legislators and tax authorities should avoid high levels of capital tax uncertainty. Broadening the capital tax base or increasing the capital tax rate induces ambiguous timing effects. Furthermore, high-growth investments are likely to be postponed if they experience a capital tax cut. Since investment reactions upon tax reforms are well-known to affect income and wealth distribution, reliable estimations of the impact of taxes on economic decisions are necessary.

Solar photovoltaic projects in China: High investment risks and the need for institutional response

The Chinese government identifies the renewable energy sector as a core strategic industry. Since 2009, China is the country with the highest annual investment into renewable energy, predominantly wind and solar photovoltaic projects. Due to rapid cost decline, industrial transformation, and policy support, the relative share of solar project investment is growing at a disproportionate rate. However, there is no systematic analysis of how efficiently these investments are allocated; or the underlying risk and return characteristics. Based on structured interviews with 69 market participants, this paper identifies severe cash-flow uncertainty, unreliable supply chains and a weak regulatory environment as most prominent risk factors that currently inhibit sustainable and demand-driven market development. Expanding on the interview results, this study discusses the origins of risk in China and how the institutional response to investment risk currently fails to address the core problems.

Risk Management and Real Options with Operating Hedging Contracts

We analyze the optimal capacity investment (or operating leverage) and financial leverage policies with irreversible investment in the presence of financial distress and capacity expansion costs. In a loan market equilibrium with endogenous default, financial and operating leverage may either be substitutes or complements depending on the magnitude of expansion costs and whether the marginal tax rate exceeds marginal distress costs. Consequently, the relation of financial leverage and cash-flow uncertainty can be complex, consistent with empirical evidence. We generate novel predictions on the effects of financial and technological parameters on the cross-sectional variation in financial and operating leverage, and book-to-market.