The Impact of Capital Market Imperfections on Investment-Cash Flow Sensitivity

School of Business, George Washington University, 2201 G Street, Funger Hall 505, Washington, DC 20052, United States
Journal of Banking & Finance (Impact Factor: 1.29). 02/2008; 32(2):207-216. DOI: 10.2139/ssrn.686812
Source: RePEc


We examine the investment-cash flow sensitivity of US manufacturing firms in relation to five factors associated with capital market imperfections - fund flows, institutional ownership, analyst following, bond ratings, and an index of antitakeover amendments. We find a steady decline in the estimated sensitivity over time. Furthermore, we find that investment-cash flow sensitivity decreases with increasing fund flows, institutional ownership, analyst following, antitakeover amendments and with the existence of a bond rating. The overall evidence suggests that investment-cash flow sensitivity decreases with factors that reduce capital market imperfections.

52 Reads
  • Source
    • "We examine the sensitivity of expenditure in year t to cash flow in year t within a framework similar to that in Malmendier and Tate (2005). This type of investment-cash-flow sensitivity model has been widely studied in the literature (see e.g., Agca and Mozumdar (2008); Almeida et al. (2004); Brown and Petersen (2009); Fazzari et al. (1988, 2000); Hovakimian "
    [Show abstract] [Hide abstract]
    ABSTRACT: Prior literature posits that while some CEO overconfidence may benefit shareholders, high levels of overconfidence do not. We investigate whether improvements in governance can help to mitigate the adverse effects of overconfidence while harnessing its positive aspects. We use the passage of the Sarbanes-Oxley (SOX) Act as a natural experiment to examine whether improvements in regulation and governance help to mitigate investment distortions and moderate risk-taking tendencies of the more overconfident CEOs. We conduct tests using options and press based proxies for CEO overconfidence. The results indicate that, after SOX, overconfident CEOs reduced investment, improved performance and market value, reduced their risk-exposure, increased dividends and substantially improved long-term performance following acquisitions. We also find that these SOX-related benefits are concentrated in the firms that were SOX non-compliant prior to its passage. While the beneficial aspects of SOX in harnessing overconfident CEOs may have been an unintended consequence, the message of our paper is simple: CEO over-confidence can be monitored and regulated -- just like any other CEO attribute.
  • Source
    • "Moreover, using an instrumental-variable (IV) approach would not be much of a help, since the instruments (which should ideally be correlated with the cash-flow variable to ensure relevance) are also correlated with the error term ߦ ௜௧ . Finally, excluding the structuralheterogeneity component in the error term (߭ ௜௧ ܹ ௜௧ * ) reduces the investment equation to a model including interaction terms between cash flow and observables only (e.g., Broussard et al., 2004; Pawlina and Renneboog, 2005; Almeida and Campello, 2007; Ağca and Mozumdar, 2008), and further setting π = 0 would return the basic investment model in equation (1). "
    [Show abstract] [Hide abstract]
    ABSTRACT: The relationship between investment and cash flow has been a subject of considerable empirical debate. In this paper, our aim is to shed a new light on this relationship. It is argued that a firm’s observed investment and financing decisions are endogenous, in an ex-post behavioral sense, and that, therefore, investment-cash flow sensitivity (when estimated in a reduced-form, linear investment equation) is likely to be an ambiguous, and possibly misleading, measure of (current and expected future) financial constraints. Empirical evidence is provided in support of our case, based on a two-stage estimation strategy. In the first stage, allowance is made for unobserved firm heterogeneity as related to cash flow; we generalize the Q-investment equation and estimate individual, firm-specific investment-cash flow sensitivities by applying an entropy-based fixed-effect estimator. In the second stage, we look inside the black box and investigate how and to what extent these sensitivities are “driven” by important underlying factors. A number of striking ceteris-paribus results emerge: a) investment-cash flow sensitivity is monotonically decreasing in the level of cash flow; b) cutting back on investment, hoarding more cash, taking less on debt, building up debt capacity, and paying low or zero dividends (actions that are typically associated with the presence of tighter financial constraints) tend to produce a smaller value of investment-cash flow sensitivity; c) investment-cash flow sensitivity is negatively related to cash-flow volatility and positively related to investment volatility; and d) firm size and asset tangibility do not contribute to explaining the variation in investment-cash flow sensitivities across firms. From these results, it follows that the relation between the investment-cash flow sensitivity’s magnitude and the degree of financial constraints is indeterminate a priori. While such results call into question conventional wisdom, they help to explain the many contradictory findings encountered in the literature.
    SSRN Electronic Journal 04/2010; DOI:10.2139/ssrn.1597061
  • Source
    • "As for ICFS, a number of recent empirical studies confirm the performance of the ICFSmetric in measuring financing constraints (Carpenter and Guariglia, 2008; Islam and Mozumdar, 2007; Ağca and Mozumdar, 2008), whereas other studies remain skeptical on the usefulness of the metric (Erickson and Whited, 2000; Lyandres, 2007; Wei and Zhang, 2008). Also on the more recently proposed CCFS-metric, opinions differ among researchers. "
    [Show abstract] [Hide abstract]
    ABSTRACT: We employ a Bayesian estimation technique to construct firm-varying investment-cash flow sensitivities (ICFS) for a sample of 90 Spanish listed firms over a 10-year period (1999-2008). Then we analyze which variables are associated with the firm-level ICFS-estimates both univariately and multivariately. The results indicate that firms with high ICFS are capital-intensive firms with high-growth rates that have exhausted much of their debt-capacity. Furthermore, high ICFS-firms have lower liquidity-measures, lower profitability-measures and lower stock-market valuation than their counterparts. These results provide strong evidence that high ICFS-firms have higher financing needs while faced with fewer available financing sources. Our analysis suggests that, at least for Spanish listed firms over the observed sample-period, the ICFS is an adequate proxy to measure the firm’s exposure to financing constraints.
    SSRN Electronic Journal 04/2010; DOI:10.2139/ssrn.1585172
Show more

Similar Publications


52 Reads
Available from