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Investment-Cash Flow Sensitivity: Fact or Fiction?
Abstract
We examine whether internal funds matter for investment when measurement errors in q are addressed. Through a detailed analysis of the studies that tackle measurement errors in q, we show that cash flow cannot be dismissed as an artifact of these errors. We also find that an analyst forecast based q measure is not superior to a stock market based one. Our findings indicate that while investment-cash flow sensitivities decline through time, they do not disappear during the recent financial crisis. We also propose a methodology that uses two alternative proxies of q as instruments in addressing these measurement errors.
... There is a considerable amount of study which reveals that liquidity or cash flow affects firms' investment, at least dividend payments and financial constraints. Fazzari et al. (1988) and Agca and Mozumdar (2017), respectively, are two of the most prominent and the latest instances of relevant literature. Cash-rich firms can make more investment expenditures than cash-poor ones. ...
... Cash-rich firms can make more investment expenditures than cash-poor ones. Thus, β 1.2 must be positive as supported by Fazzari et al. (1988), Moyen (2004), Hirth and Viswanatha (2011) and Agca and Mozumdar (2017) like many others in the existing literature. Finally, due to the endogeneity problem, lagged values of the variable are used in the model. ...
... Fazzari et al.'s (1988) view of I-CF sensitivity as a measure of financial constraints has been challenged by, among others, Kaplan and Zingales (1997), Cleary (1999), Moyen (2004), Alti (2003), and Gomes (2001). Also, Whited (2000) (2002) point out that the observed empirical I-CF sensitivity can be spurious as average Tobin's q is a not a valid proxy for investment opportunities, due to measurement error (see also, among many others, Bond and Cummins (2001), Cummins, Hassett, and Oliner (2006), and Agca and Mozumdar (2017)). Inasmuch as empirical q fails to adequately capture investment opportunities, part of the information content about capital productivity is captured by cash flow (see, e.g., Chen, Goldstein, and Jiang (2007), and Gilchrist and Himmelberg (1995)). ...
... Chen and Chen (2012) conclude that financial constraints cannot explain the declining pattern of I-CF sensitivity as there is no indication of financial constraints becoming more relaxed over time. They also document that the declining pattern of I-CF sensitivity still exists with measurement error-corrected estimates (Lewellen and Lewellen (2016) and Agca and Mozumdar (2017) provide evidence consistent with that result). Although , Moshirian, Nanda, Vadilyev, and Zhang (2017) and Wang and Zhang (2021) conjecture that the declining I-CF sensitivity is due to the shift of importance or productivity from physical capital to intangible assets, Chen and Chen (2012) show that it is also R&D-cash flow sensitivity that disappears by late 2000s. 1 Finally, although market power is another factor that can influence I-CF sensitivity (e.g., Cooper and Ejarque (2003)), the fact that many U.S. industries are becoming more concentrated over time (De Loecker, Eeckhout, and Unger (2020) and Grullon, Larkin, and Michaely (2019)) should lead, if anything, to an upward (rather than the observed downward) trend. ...
It is well documented that since at least the 1970s investment-cash flow (I-CF) sensitivity has been decreasing over time to disappear almost completely by the late 2000s. Based on a neoclassical investment model with costly external financing, we show that this pattern can be explained by the gradual increase of capital adjustment costs, attributable to the accumulation of knowledge capital. The result is robust to a variety of approaches, including Euler equation estimation and the simulated method of moments. More generally, our findings demonstrate that I-CF sensitivity should only be interpreted as a joint measure of financial and real frictions.
... The work of Fazzari et al. (1988) provides evidence to document, without doubt, that financing frictions can affect companies' investment behaviour. Subsequent studies provide evidence that there are costs related to raising external capital and that the presence of internal financing resources or cash flows can affect investment decisions (see Lamont, 1997;Shin and Stulz, 1998;Hoshi et al., 1991;Bond and Soderbom, 2013;Allayanis and Mozumdar, 2004;Lewellen and Lewellen, 2016;Aǧca and Mozumdar, 2017). ...
The thesis explores the determinants of corporate social responsibility (CSR) adoption and its implications on company financial performance (CFP) and investment in China. In doing so, we aim to answer two primary research questions: (1) how a company’s dynamic capabilities—its ability to respond to the changing environment—can influence the company at incorporating CSR into its operations; and (2) how corporate social performance (CSP) is associated with a company’s financial accounting and investment performance. The study is divided into three empirical research papers as outlined below.
The purpose of paper one is to investigate the determinants that influence a company to incorporate CSR into its operations, which is to adopt strategic CSR (SCSR). The paper primarily examines how a company’s dynamic capability can affect the adoption of SCSR. This study draws on the stakeholder, dynamic capability, and neo-institutional theories. Data were collected from 134 Chinese companies listed on the Shenzhen stock exchange (SZSE) and Shanghai stock exchange (SHSE) over the period 2017 to 2019 to examine the role of dynamic capability on SCSR adoption. The findings suggest that a higher level of dynamic capability than the average industrial level negatively affects SCSR adoption. The findings also reveal that dynamic capability, stakeholder pressures, and regional culture are important predictors of the adoption of SCSR. The empirical findings provide valuable insights into how CSR can affect company performance if used strategically. The use of dynamic capability theory in the study explains SCSR adoption from the perspectives of dynamic capabilities. The study partially supports DCT by focusing on the impacts of dynamic capability on SCSR adoption within companies operating in a developing country, China.
Paper two aims to investigate how CSP relates to CFP across the company life cycle (CLC) stages, including the introduction, growth, maturity, and decline/shake-out stages. This paper also examines how the focus of CSP, in terms of stakeholder dimensions, shifts across the CLC stages. To examine the two research objectives, we used quantitative data collected from 1,628 large, listed Chinese pharmaceutical companies from 2010 to 2018. Drawing on the resource-based view (RBV), stakeholder theory and CLC theory, the study finds supporting evidence that CFP is improved with better CSP across the CLC stages. It also finds, on the basis of different stakeholder groups and across the CLC stages, that the effects of CSP are different. Investors, employees, suppliers, and the government are the most influential stakeholder groups influencing CFP. The study results suggest that CFP is directly linked to CSP and CLC and that the link is associated with stakeholder dimensions of CSR. Overall, the findings highlight the important role of CLC and CSP, which are often cited as important factors for enhancing CFP. This study provides valuable insights into the influence of CLC on CSP, which in turn may shed light on management practices to allocate resources and improve CFP.
Paper three explores the association between CSP and company performance through capital market effects and the role of cash flow volatility (CFV). This paper uses investment–cash flow sensitivity (ICFS) to capture the capital market effects. Drawing on the RBV and stakeholder theory, the association between CSP and ICFS was tested in this paper. To investigate the research objective, this paper used quantitative data collected from 4,082 companies listed on the SZSE and SHSE in China over the period 2010 to 2020. The study finds that companies with better CSP tend to have a greater and significant ICFS in a developing economy such as China. It also finds that the positive association between CSR and ICFS is weaker for companies with a more volatile current CFV and stronger for companies with a more volatile expected CFV. This demonstrates that CFV partially mediates or moderates the relationship between CSP and ICFS. The role of CFV on the association between CSP and ICFS highlights the need for regular management attention and evaluation on the investments and performance in non-financial engagements. This management attention should also be paid when making decisions relating to resource allocation and investment policies. In addition, managers should consider the company's cash flow stability and uncertainty sides in the competitive market environment. These findings suggest that the emphasis on the role of CFV is important in evaluating the performance effect of CSR through the capital market’s response. This study contributes to the CSR, financial accounting and investment literature by responding to the call for research in ICFS in the context of developing countries in general and research on the role of CFV on CSP–ICFS association in particular.
... 4 3 However, Kaplan and Zingales (1997) reach the opposite conclusion by looking just at the firms classified as constrained by Fazzari et al. (1988) and they also criticise the assumption that sensitivity of investment to cash flows should increase monotonically as firms become more constrained. See also, for example, Bond and Meghir (1994), Almeida and Campello (2007), Agca and Mozumdar (2017). 4 This is a common problem of linking aggregate elasticity with individual one in the presence of heterogeneity that generates a compositional effect due to the different constraints firms (or households in the case of the Euler equation for consumption) are facing. ...
The Euler equation model for investment with adjustment costs and variable capital utilization is estimated using aggregate US post-war data with econometric methods that are robust to weak instruments and exploit information in possible structural changes. Various alternative identification assumptions are considered, including external instruments, and instruments obtained from Dynamic Stochastic General Equilibrium models. Results show that the elasticity of capital utilization and investment adjustment cost parameters are very weakly identified. This is because investment appears to be unresponsive to changes in capital utilization and the real interest rate.
... and financial constraint (e.g. Agca and Mozumdar, 2017;Ek and Wu, 2018;Fazzari, Hubbard and Peterson, 1988;Hoshi, Kashyap and Scharfstein, 1991). Note that financially constrained firms may have higher information asymmetry (Boubaker, Derouiche and Lasfer, 2015) and therefore are expected to have lower investment levels (Ascioglu, Hegde and McDermott, 2008). ...
We investigate the influence of national culture on corporate investment–cash flow sensitivity. We conjecture that national culture shapes managerial perceptions of information asymmetry and agency problems, thus impacting the investment–cash flow relationship. We document empirical evidence in support of our claim. By linking the investment–cash flow sensitivity to cultural differences, our findings show that, while collectivism has an attenuating influence, uncertainty avoidance, power distance and masculinity have a reinforcing effect on the relationship between cash flow and investment. Our results hold for a sample of 205,268 firm‐years across 24 OECD countries between 1990 and 2017, and are robust after accounting for alternative statistical approaches, sample compositions and measures of cultural dimensions, along with controls for institutional and governmental factors. In addition, by decomposing cash flow into uses and sources of funds in a dynamic multi‐equation model, where firms make financing and investment decisions jointly subject to the constraint that sources must equal uses of cash, we find that national culture shapes how firms react to changes in cash flow.
We demonstrate that the severity of financial constraints has declined over time for two reasons: (i) improved access to external funds as evidenced by a decreased reliance on internal cash flows, and (ii) an inward shifting investment frontier with reduced investment opportunities. The decline in financial constraints coincides with the documented diminishing sensitivity of investment to cash flows, yet we show that cash flows remain a determining factor in helping constrained firms overcome restricted access to external capital. There is a flight‐to‐quality during economic shocks, where the adverse effects following periods of tightened credit are particularly pronounced for smaller firms, with larger firms appearing largely unaffected.
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Regression models relating investment demand with firms' Tobin's q and cash flow are fraught with measurement errors which, in turn, cause endogeneity bias. We propose a solution to this problem based on modelling the interaction between the endogenous Tobin's q and the error term in the investment equation as a function of lagged values of Tobin's q. We then study the identification conditions and asymptotic properties of the resulting estimator. Our analysis of a panel of U.S. firms reveals a larger effect of Tobin's q on firms' investment demand than that obtained using available estimators in the literature. Moreover, the estimates highlight the importance of cash flow. We find mixed evidence on the relationship between investment demand and firms' cash flow with respect to different measures of financial constraints. Nevertheless, this evidence is more supportive of the view that firms' cash
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