Investment Cash Flow Sensitivities Really Reflect Related Investment Decisions

Transcription

1 Invesmen Cash Flow Sensiiviies Really Reflec Relaed Invesmen Decisions Rober M. Bushman Kenan-Flagler Business School, Universiy of Norh Carolina a Chapel Hill Abbie J. Smih Booh School of Business, Universiy of Chicago X. Frank Zhang School of Managemen, Yale Universiy May 202 We appreciae he commens of Seve Fazzari, Bob Holhausen, Seve Kaplan, Anil Kashyap, Bruce Peersen, Jerry Zimmerman, and seminar paricipans a Carnegie Mellon Universiy, Chinese Universiy of Hong Kong, Emory Universiy, INSEAD, Penn Sae Universiy, Yale Universiy, and he Universiy of Torono. This paper previously circulaed under he ile Invesmen Cash Flow Sensiiviies are Really Invesmen-Invesmen Sensiiviies. Bushman hanks he Kenan-Flagler Business School, Universiy of Norh Carolina a Chapel Hill for financial suppor, and Smih appreciaes suppor from he William Ladany Research Fund a he Universiy of Chicago Booh School of Business.

2 Invesmen Cash Flow Sensiiviies Really Reflec Relaed Invesmen Decisions Absrac There exiss a longsanding, unresolved debae over wheher he sensiiviy of capial invesmen o inernally generaed cash flows reflecs he impac of binding financing consrains on firms invesmen decisions. We exploi he underlying accrual accouning srucure of he cash flow variable used in he lieraure, earnings before depreciaion (EBD), o reveal he empirical underpinning of invesmen-cash flow sensiiviy (ICFS). By decomposing EBD ino cash flow from operaions (CFO) and working capial accruals (WCACC), we provide sysemaic evidence ha ICFS primarily reflecs he fundamenal connecion beween capial invesmen and working capial invesmen as inerrelaed manifesaions of firm growh. In conras, invesmen-cfo sensiiviy is ofen negaive and ends o decrease as financing consrains increase, inconsisen wih CFO serving as a source of invesmen financing for consrained firms. Furher, we use he framework of Dechow and Dichev (2002) and show ha CFO acually represens noise in EBD ha obscures he primiive growh relaion beween capial and working capial invesmen. Our paper, by empirically revealing he inner workings of ICFS, provides a framework for reinerpreing he large body of exising ICFS evidence and for guiding a more informed and nuanced use of ICFS in he fuure.

3 Inroducion Beginning wih Fazzari, Hubbard, and Peersen (988), a large lieraure uilizes coefficiens from regressing firms capial invesmen on inernally generaed cash flow (i.e., invesmen cash flow sensiiviy, hereafer ICFS) o explore he impac of financing consrains on firms invesmen behavior. The idea is ha if financing fricions due o informaion asymmery or agency problems increase he cos of exernal sources of finance relaive o inernal funds, hen invesmen decisions of financially consrained firms will be sensiive o availabiliy of inernally generaed cash flows. This lieraure inerpres higher ICFS as evidence of greaer financing consrains, and documens ha firms classified as a priori more likely o confron binding financing consrains display greaer ICFS. 2 However, a number of papers criicize he ICFS approach and raise serious concerns over wheher higher ICFS acually represens greaer financing consrains. 3 Kaplan and Zingales (2000, p. 7) conend ha a key, open issue for fuure research is o deermine wha acually causes ICFS. In his paper, we direcly address he open issue raised by Kaplan and Zingales (2000) by providing sysemaic evidence ha ICFS primarily reflecs he fundamenal connecion beween capial invesmen and working capial invesmen as inerrelaed manifesaions of firm growh. A key conribuion of our analysis is is focus on he underlying accouning srucure of he cash The invesmen-cash flow sensiiviy approach coninues o be widely used as a ool o sudy a variey of issues in accouning and finance. For example, recen sudies examine earnings qualiy and capial invesmen (Biddle and Hilary 2006, Li and Tang 2008, Polk and Sapienza 2008), informaion asymmery and invesmen-cash flow sensiiviy (Ascioglu, Hegde, and McDermo, 2008), SOX and informaion asymmery (Chowdhury e al. 202), managemen bias (Li 200), he financial crisis and invesmen (Khramov 202), invesor proecion (McLean e al. 202), asse angibiliy and financing consrains (Almeida and Campello 2007), and U-shaped invesmen (Cleary, Povel and Raih 2007), among many ohers. 2 A ypical design pariions firms based on measures of he a priori likelihood ha hey face binding financing consrains and hen examines wheher ICFS increases as financial consrains inensify. For lieraure reviews see Schianarelli (996), Hubbard (998), and Bond and Van Reenen (2007). 3 We discuss he main argumens below. Key papers include Poerba (988), Kaplan and Zingales (997, 2000), Gilchris and Himmelberg (995), Cleary (999), Fazzari, Hubbard, and Peersen (2000), Erickson and Whied (2000), Ali (2003), Moyen (2004), and Hadlock and Pierce (200), among ohers. Hubbard (998) provides an excellen synhesis of he criicisms leveled agains he invesmen-cash flow sensiiviy approach. 2

4 flow variable. This allows us o direcly address a longsanding criicism of ICFS posiing ha if inernal cash flow embeds informaion abou invesmen opporuniies, hen ICFS may simply reflec he relaion beween capial invesmen and invesmen opporuniies raher han reflecing financing consrains. 4 While his criicism is well known, he exen o which growh informaion in cash flows is a cenral driver of ICFS has no been definiively resolved. By exploiing he underlying srucure of he cash flow variable as defined by accrual accouning, our analysis reveals new insighs ino how growh ineracs wih he cash flow variable o generae ICFS. Our poin of deparure is he fac ha prior research generally defines inernal cash flow as accouning earnings before depreciaion and amorizaion (EBD). EBD can be decomposed ino a non-cash working capial accrual componen (WCACC) which reflecs ne invesmen in non-cash working capial iems such as invenory and accouns receivable, and a cash componen, cash flow from operaions (CFO). This decomposiion clearly shows ha he cash flow variable (EBD) does indeed reflec invesmen opporuniies in ha i direcly includes an aspec of invesmen iself in he form working capial invesmen. To he exen ha an invesmen in fixed asses (i.e. capial invesmen ) represens an increase in firms scale capaciy, i is naural o expec corresponding invesmen in complemenary facors of producion such as invenory and accouns receivable capured by WCACC. This suggess ha ICFS may be driven by he direc connecion beween fixed capial and working capial invesmen as inerrelaed manifesaions of firm growh. Alernaively, since CFO represens inernally available cash, ICFS may capure he role of CFO in funding invesmens by firms consrained in heir abiliy o access ouside capial, consisen wih he radiional inerpreaion. We explore 4 Key papers here include Poerba (988), Gilchris and Himmelberg (995), Erickson and Whied (2000), and Ali (2003), among ohers. 3

5 hese alernaives in our empirical analysis, and furher consider he possibiliy ha WCACC and CFO joinly impac invesmen. Anoher imporan criicism of he ICFS lieraure concerns he mehods used o classify firms based on heir a priori degree of financing consrains (Kaplan and Zingales 997, Cleary 999 and Moyen 2004). The ICFS lieraure following Fazzari e al. (988) uses a range of firm specific characerisics o measure a priori financing consrains and documens ha firms classified as more consrained by hese measures display greaer ICFS. Two widely used measures are dividend payou raio and firm age, wih higher values indicaing lower financing consrains. However, in an influenial paper, Kaplan and Zingales (997) insead measure financing consrains based on quaniaive and qualiaive informaion from annual repors and show ha more financially consrained firms exhibi lower ICFS han less financially consrained firms. Cleary (999) replicaes he Kaplan and Zingales (997) finding ha ICFS is higher for less financially consrained firms using a large sample version of he Kaplan and Zingales (997) measure called Z FC, where higher values correspond o lower financing consrains. 5 In his paper, we address hese compeing lieraures by employing dividend payou raio, firm age, and Cleary s Z FC index as measures of a priori financing consrains. However, raher han focusing on differences, we insead focus on commonaliy across hese measures. The source of commonaliy we isolae is firm growh. We find ha all hree measures are highly correlaed wih firm growh, where dividend yield and firm age are negaively correlaed wih growh while Z FC exhibis a srong posiive correlaion. Based on his finding, we conjecure ha pariions based on hese hree measures fundamenally reflec 5 Kaplan and Zingales (2000) and Fazzari e al. (2000) vigorously debae he implicaions of conflicing evidence beween ICFS and measures of financing consrains, arriving a no resoluion. Kaplan and Zingales (997) develop a simple model o show ha even if firms face differing degrees of financing consrains, i is no necessarily he case ha ICFS increases monoonically wih he degree of financing consrains. This poin is also esablished in a richer model seing by Moyen (2004). 4

6 differences in firm growh, raher differences in financing consrains. We ulimaely verify his conjecure. Under his inerpreaion, ICFS is shown o monoonically increase wih firm growh, reconciling conflicing resuls in he lieraure where ICFS decreases wih dividend yield and firm age, bu increases in Z FC. To empirically esablish ha ICFS is driven by he growh connecion beween capial invesmen and working capial invesmen, we proceed by replacing EBD in he invesmen equaion firs wih WCACC and hen wih CFO, and examining how invesmen-wcacc sensiiviy and invesmen-cfo sensiiviy vary across a priori financing consrain, where we now inerpre hese pariions in erms of firm growh. 6 We find ha invesmen-wcacc sensiiviy is posiive and increasing in firm growh, reflecing co-movemen in capial and working capial invesmen as relaed manifesaions of capaciy expansion. In conras, invesmen-cfo sensiiviy is ofen negaive and ends o decrease as financing consrains increase, rejecing he hypohesis ha invesmen decisions of consrained firms are relaively more sensiive o inernally generaed cash flows han for less consrained firms. We nex invesigae underlying drivers of invesmen-wcacc sensiiviy. We recognize ha WCACC no only reflecs invesmen in working capial, bu also capures random flucuaions in working capial due o iming issues ha are independen of growh. 7 Building direcly on Dechow and Dichev (2002), we disaggregae WCACC ino a working capial invesmen componen and a random iming componen. We esablish ha he monoonically increasing relaion beween invesmen-wcacc sensiiviy and firm growh is driven solely by 6 While we refer o he esimaed coefficien on WCACC as invesmen-wcacc sensiiviy, we inerpre he coefficien as a reflecion of he co-movemen of fixed and working capial invesmen raher han he causal effec of working capial invesmen on capial invesmen. 7 A significan lieraure considers he random iming of accruals (e.g., Financial Accouning Sandards Board 978; Dechow 994; Dechow and Dichev 2002). There also is a line of research on he fundamenal invesmen of accruals (e.g., Sickney, Brown, and Wahlen (2003, Chaper 3); Fairfield e al. 2003; Zhang 2007; Wu e al. 200). 5

7 he fundamenal invesmen componen of WCACC, no he random iming componen. We also include WCACC and CFO simulaneously in he invesmen equaion. I is generally acceped ha he robus negaive correlaion beween WCACC and CFO is a manifesaion of accrual accouning s role in smoohing random iming flucuaions (e.g., Dechow 994). When boh WCACC and CFO are included in he invesmen equaion, we find ha he sensiiviy of invesmen o CFO is significan because, operaing hrough is negaive correlaion wih WCACC, i conrols for he random iming flucuaions in WCACC. I is really WCACC ne of iming flucuaions ha is he primiive driver of ICFS, while CFO basically serves o conrol for random iming flucuaions in WCACC, raher han serving as a source of invesmen financing. The analysis up o now has pariioned firms based on dividend payou raio, firm age, and Z FC, inerpreing hese pariions in erms of firm growh raher han financing consrains. We direcly verify ha ICFS is higher for high-growh firms han for low-growh firms by subsiuing growh proxies in place of he hree financing consrain variables, finding ha ICFS increases monoonically in firm growh. We furher examine he relaive power of growh proxies versus financing consrain variables, and find ha ICFS significanly increases wih growh proxies while he financing consrain measures have no incremenal explanaory power in he presence of he growh measures. Our evidence suppors he case ha ICFS primarily reflecs he fundamenal growh connecion beween capial invesmen and working capial invesmen. The evidence also suggess ha he cash flow variable EBD does no generally capure he exen of inernal financing as posied by Fazzari e al. (988), bu raher reflecs growh via he WCACC componen. Wha does his growh inerpreaion imply abou he connecion beween ICFS and financing consrains? We argue ha he naure of ICFS is condiional on he underlying caalys 6

8 of firm growh. For example, a firm s raional response o a decrease in he cos of capial may be o increase invesmen in fixed capial and complemenary working capial iems. However, a cenral ene of he ICFS lieraure is ha cos of capial is comprised of wo pars, he opporuniy cos of inernal capial and he premium required o access exernal capial. If he decrease in he cos of capial is wholly due o a decrease in he exernal financing premium, he wedge beween inernal and exernal coss of capial ges smaller. Therefore, ICFS will reflec he raional invesmen response o his reducion in financing consrains. In his case, conrary o Fazzari e al. (988), higher ICFS is associaed wih a greaer reducion in he exernal financing premium, no wih higher financing consrains! If however, capaciy expansion is driven by macro shifs in he opporuniy cos of firms inernal funds, exogenous shocks in invesmen opporuniies, execuive s empire building behavior, or managerial irraionaliy, ICFS does no reflec financing fricions bu raher reflecs he naural consequence of capaciy expansion on he co-movemen of fixed and working capial invesmen. Our paper makes hree conribuions o he longsanding debae over ICFS. Firs, we provide a novel answer o he research challenge posed by Kaplan and Zingales (2000, p. 7) o deermine wha acually causes ICFS. We presen sysemaic evidence ha ICFS is caused by firm growh and reflecs he direc growh connecion beween fixed capial and working capial as complemenary producion facors. This growh inerpreaion in urn implies ha he naure of ICFS is condiional on he underlying caalys of firm growh. Second, our accrual decomposiion of cash flow conribues direcly o he lieraure posiing ha ICFS reflecs he relaion beween capial invesmen and informaion abou invesmen opporuniies in cash flows (e.g., Poerba 988, Ali 2003). Consisen wih his idea, we show ha IFCS is indeed driven by he fac ha cash flow reflecs invesmen opporuniies in he sense ha a componen 7

9 of EBD is working capial invesmen which is a response o real or perceived invesmen opporuniies. Third, our reinerpreaion of a priori measures of financing consrains in erms of growh resolves conflicing resuls in he lieraure where ICFS decreases wih dividend yield and firm age, bu increases in Z FC. Our paper also makes significan conribuion o he accouning lieraure. A variey of accouning papers use ICFS o examine earnings qualiy, informaion asymmery, managemen bias, and oher issues (e.g., Biddle and Hilary 2006, Li and Tang 2008, Li 200). The evidence in our paper calls ino quesions he inferences of hese sudies. In addiion, we conribue direcly o he accouning lieraure on he naure of accruals. We provide a novel dissecion of he relaion beween accruals and capial invesmen by exploiing he framework of Dechow and Dichev (2002) o decompose WCACC ino a random iming componen and a fundamenal invesmen componen. We show ha including wo growh variables increases he adjused R 2 from he accrual model from 34% in Dechow and Dichev (2002) o 55%, highlighing he imporance of conrolling for fundamenal invesmen when examining earnings qualiy in accruals.. The res of he paper is organized as follows. Secion 2 lays discusses he concepual foundaion of ICFS and he accrual decomposiion of cash flow. Secion 3 describes he sample and provides preliminary evidence on he growh-icfs connecion. In secion 4, we presen our main empirical analysis of he drivers of ICFS. In secion 5 we analyze he implicaions of growh for he connecion beween ICFS and financing consrains. Secion 6 presens addiional resuls and robusness analysis, and secion 7 concludes. 2. Concepual foundaion of ICFS and he accrual decomposiion of cash flow 8

10 In secion 2. we inuiively develop he concepual foundaion of he Fazzari e al. (988) empirical specificaion for esimaing ICFS. Building on his concepual foundaion, in secion 2.2 we discuss he cash flow variable which is cenral o he esimaion of ICFS. In paricular, we deail he main issues concerning he naure of he cash flow variable and ICFS, describe our decomposiion of cash flow ino WCACC and CFO componens, and develop he implicaions of his decomposiion for undersanding ICFS. 2. Concepual foundaion of ICFS To develop he concepual foundaion of ICFS, we combine he model from Kaplan and Zingales (997) wih he graphical analysis from Hubbard (998) and Fazzari e al. (2000). The Kaplan and Zingales (997) model consiss of a reurn on invesmen F(I), where I is capial invesmen, inernal financing W wih consan opporuniy cos r, exernal financing EF, and he cos of raising exernal funds C(EF,k) in he presence of financing fricions, where k measures he severiy of informaion asymmeries or agency problems driving he cos wedge beween inernal and exernal funds. 8 Assume firs an economy wih perfec markes and hus no financing fricions. Tha is inernal and exernal funds have he same cos r. The firm chooses I o solve: Max F(I) I*r I. () The firs-order condiion yields he following characerizaion of opimal invesmen: F ( I ) r. (2) Figure graphically characerizes he soluion o equaion (2) designaed as I *. F represens invesmen opporuniies, and because markes are perfec, he marginal cos of capial is consan and he firm raises EF=I* - W of exernal capial o supplemen inernal funds. The 8 The model assumes ha F 0, F 0, C 0, and C 0. In he graphical analysis of figure, we assume for simpliciy ha boh F and C = 0. 9

11 perfec marke seing has been exensively examined empirically using a specificaion derived formally from he q-heory of invesmen (Tobin 969, Hayashi 982). The q-heory analogue of equaion (2) posis ha in perfec markes wihou financing fricions, invesmen is compleely deermined by invesmen opporuniies and adjusmen coss as I / K q e, (3) where I is capial invesmen in period, K - is capial sock a he beginning of period, q - capures invesmen opporuniies (i.e., marginal q), and adjusmen coss are capured by (see Hayashi 982 or Hubbard 998 for a formal derivaion of (3)). We reurn o he Kaplan and Zingales (997) model, and drop he perfec markes assumpion. Thus, if he firm invess beyond inernal funds W, i mus raise exernal financing EF a cos C(EF,k). The firm now chooses I o solve yielding firs order condiion Max F(I) C(EF,k ) I, such ha I = W + EF, (4) F ( I ) C ( I W, k). (5) When here is risk of opporunisic behavior by firms, suppliers of exernal funds require compensaion as capured by C in (5). In figure, he upward sloping porion of C implies ha he marginal cos of funds is increasing afer he poin ha inernal funds W are exhaused. The slope of C capures he exen of financing fricions, wih higher slopes indicaive of greaer financing fricions. Figure illusraes ha financing fricions lead o a significan reducion in invesmen from he firs bes of I* o I 0. 0

12 Wih he basics in place, we urn o he concepual foundaion of he Fazzari e al. (988) empirical specificaion for esimaing ICFS. We presen he argumen graphically in figure. 9 Consider he implicaions of an exogenous increase in inernal funding from W o W, holding invesmen opporuniies F consan. The key idea, as seen in figure, is ha he increase in inernal funds of W=W W generaes an increase in invesmen from I 0 o I. Tha is, invesmen is sensiive o inernal cash flows! Wih perfecs markes, he level of invesmen is insensiive o inernal cash flows and he firm invess I * regardless of W. To empirically examine he implicaions of his model, Fazzari e al. (988) exend he perfec markes version of he q-heory model in equaion (3) o include inernal cash flows. The exended specificaion is I / K e, (6) q 2CashFlow / K where he cash flow variable is generally operaionalized as earnings before exraordinary iems plus depreciaion and amorizaion expense. The coefficien 2 in (6) capures sensiiviy of capial invesmen o inernally generaed cash flows, or ICFS. We urn nex o a discussion of equaion (6) ha focuses on he underlying srucure of he cash flow variable and wha his srucure implies abou he naure of ICFS. 2.2 The accrual decomposiion of cash flow and ICFS The characerizaion of he sensiiviy of invesmen o cash flows in secion 2. and figure requires holding invesmen opporuniies consan. I is hus imporan o conrol for invesmen opporuniies in he empirical esimaion of ICFS. Beginning wih Poerba (988), a number of papers quesion he inerpreaion of ICFS esimaed from (6). These papers argue ha if q imperfecly conrols for invesmen opporuniies, and if cash flows conain informaion 9 The ineresed reader is direced o Kaplan and Zingales (997, 2000) and Fazzari (2000) for more formal developmen of he model.

13 abou invesmen opporuniies no refleced in q, hen ICFS may simply reflec he relaion beween invesmen and invesmen opporuniies, no financing consrains. In an imporan paper, Ali (2003) posis a seing where measuremen error in q is higher for young, high growh firms wih low dividend payou policies, and where cash flow conains informaion abou invesmen opporuniies ha may no be refleced in q. 0 Under hese assumpions, Ali (2003) shows ha ICFS is higher for low dividend payou firms (relaive o high payou firms) because q has more measuremen error for hese firms which is compensaed for by he informaion in cash flows. While his criicism of Ali (2003) and ohers is well known, he exen o which growh informaion in cash flows is a cenral driver of ICFS has no been definiively resolved. In his paper we exploi he underlying accouning srucure of he cash flow variable o provide evidence ha IFCS is driven by he fac ha cash flow is comprised of a working capial invesmen componen which represens a direc response o real or perceived invesmen opporuniies. However, unlike Ali (2003), our explanaion does no require ha measuremen error in q vary sysemaically across growh pariions. We argue insead ha he exen o which working capial invesmen is refleced in cash flows varies wih growh. We develop his furher in secion 3.2. As discussed earlier, he primary cash flow measure used in he lieraure is earnings before exraordinary iems plus depreciaion and amorizaion expense (EBD). As oupu from a firm s accrual accouning sysem, EBD can be disaggregaed as EBD E DEPEXP ( CFO ACCRUALS ) DEPEXP ( CFO WCACC DEPEXP) DEPEXP CFO WCACC, (7) 0 Oher key papers include Erickson and Whied (2000) and Gilchris and Himmelberg (995). 2

14 where E is earnings before exraordinary iems, ACCRUALS is oal accruals (he difference beween accouning ne income and cash flow from operaions), WCACC is working capial accruals, CFO is cash flow from operaions, and DEPEXP is depreciaion and amorizaion expense. The WCACC componen of EBD primarily reflecs ne invesmen in non-cash working capial iems such as invenory and accouns receivable. Accrual accouning sysems recognize economic evens in firms financial saemens independenly of he iming of cash flows associaed wih hese evens. In (7), he relaion EBD= CFO + WCACC reflecs he fac ha accrual accouning ransforms CFO ino EBD via a series of adjusmens capured by WCACC. The WCACC componen of EBD can be concepualized as consising of wo aspecs: () random flucuaions in working capial due o iming issues ha are largely independen of growh, and (2) invesmens in non-cash working capial which are a direc manifesaion of firm growh. The firs aspec of WCACC derives from accrual accouning s shor erm role in smoohing ou random iming flucuaions in cash flows (e.g., Dechow (994)). For example, consider a firm in seady sae wih consan scale of operaions over ime. An increase in accouns receivable due o a cusomer delaying paymens unexpecedly would simulaneously reduce CFO and increase WCACC by he same amoun. Similarly, if a firm auomaically replenishes invenory o upper hreshold S when invenory level his lower hreshold s, an unexpeced change in he iming of sales o cusomers would generae random flucuaions in WCACC unrelaed o firm growh as invenory levels bounce beween s and S. The random Wih few excepions exising sudies define cash flow as earnings before depreciaion (Compusa daa iem 8 plus daa iem 4). Examples using his definiion include Fazzari e al. (988), Whied (992), Fazzari and Peersen (993), Kaplan and Zingales (997), Erickson and Whied (2000), Biddle and Hilary (2006), Almeida and Campello (2007), Cleary e al. (2007), Polk and Sapienza (2008), Li and Kang (2008), Hadlock and Pierce (200), Li (200), and McLean e al. (202). While Cleary (999) in addiion adds back changes in deferred axes, his cash flow measure follows he res of lieraure by embedding changes in non-cash working capial iems. In able 4 below we replicae he main resuls in Cleary (999) wih he sandard EBD measure. 3

15 iming componen of WCACC bears no concepual relaion o capial invesmen and we do no expec his componen o impac esimaed invesmen-ebd sensiiviy. We laer verify his by direcly esimaing he random iming componen of WCACC and showing ha i is unrelaed o fixed invesmen regardless of firms financing consrains or growh characerisics. The second aspec of WCACC derives from accrual accouning s role in long-erm smoohing over firms business and life cycles. Accrual accouning acs o smooh earnings by recognizing higher (lower) earnings han cash flows during periods of growh (decline), implying ha he difference beween earnings and cash flows is sensiive o firms business rajecory. During expansions, firms increase levels of fixed asses, employees, producion oupu, and sales o cusomers. Invesmen in fixed asses for growing firms is naurally accompanied by invesmen in working capial iems like invenory and accouns receivable o suppor he increasing scale of operaions, where his growh in working capial impacs WCACC and CFO. For example, if a growing firm invess in higher invenory levels by spending cash, CFO decreases bu WCACC increases o reflec he fac ha his invenory growh represens an invesmen asse raher han an expense of he period. The fac ha WCACC direcly embeds an elemen of invesmen in he form of working capial invesmen is he foundaion of our analysis. To he exen ha capial invesmen represens growh in firms scale capaciy, i is naural o expec corresponding invesmen in complemenary facors of producion such as invenory and accouns receivable capured by WCACC. 2 This suggess ha ICFS may be driven by he direc connecion beween fixed capial 2 Consisen wih his sory, Wu e al. (200) use a q-heory model o show analyically ha fixed capial and working capial accruals co-move in response o changes in he discoun rae. Their heory implies ha when he discoun rae falls, more invesmen projecs become profiable, increasing boh fixed invesmen and working capial accruals, and fuure reurns decrease on average because he lower discoun rae means lower expeced reurns going forward. They provide empirical evidence consisen wih his opimal invesmen hypohesis (see also Zhang 2007 and Dechow, Richardson, and Sloan 2008, p. 564). 4

16 and working capial invesmen as inerrelaed manifesaions of firm growh. We explore his possibiliy nex in our empirical analysis of ICFS. 3. Sample and preliminary evidence on he growh-icfs connecion In secion 3. we describe our sample and presen descripive saisics. Then, we presen a preliminary analysis ha provides wo imporan pieces of he ICFS puzzle. Our main objecive in his paper is o provide evidence ha ICFS reflecs co-movemen beween capial invesmen and working capial invesmen as relaed elemens of growh. To esablish his, we need o show how our growh explanaion squares wih he exan lieraure showing ha ICFS varies sysemaically wih a priori measures of financing consrains. In secion 3.2, we firs clarify why co-movemen beween capial invesmen and working capial invesmen is higher for higher growh firms and provide evidence consisen wih our explanaion. In secion 3.3, we demonsrae ha hree of he mos widely used a priori measures of financing consrains used in he lieraure can be re-inerpreed as measures of firm growh. 3. Sample and descripive saisics Our sample selecion procedure follows ha of Gilchris and Himmelberg (995), Almeida e al. (2004), and Almeida and Campello (2007). We consider he universe of manufacuring firms (2000<=SIC<=3999) spanning he period 97 o We delee: () Firm-years wih beginning PP&E less han $5 million (in 982 dollars) in order o avoid he small denominaor problem. (2) Firm-years wih asse growh exceeding 00% in order o avoid large M&A ransacions and seasoned equiy offers. (3) Firms-years wih negaive q or wih q in excess of 0 o reduce measuremen error. 5

17 Addiionally, following Bond and Meghir (994) and Almeida and Campello (2007), we do no require ha firms have no-missing observaions hroughou he sample period. Insead, we only require ha firms have a leas five consecuive years of daa in he sample period in order o address survivorship bias. Following he lieraure, invesmen (I) is measured as capial expendiures. Tobin s q is measured as he marke value of asses divided by he book value of asses. 3 EBD is earnings before exraordinary iems plus depreciaion. Working capial accruals (WCACC) are defined as changes in curren asses excluding he cash balance, minus changes in curren liabiliies excluding deb and axes payable. Cash flow from operaions (CFO) equals earnings plus depreciaion expense minus working capial accruals. 4 Beginning capial (K - ) is beginning ne propery, plan, and equipmen. Table provides descripive saisics and describes precisely how all variables are measured. Panel A shows ha sample firms on average inves 23.6% of beginning capial. All variables exhibi significan variaion, where he variables EBD, CFO, and WCACC, all scaled by K -, range from large posiive o large negaive values. Table, panel B repors a correlaion marix. Focusing on Pearson correlaions (resuls from Spearman correlaions are qualiaively similar), he invesmen variable, I /K -, exhibis correlaions of.26 or higher wih all variables excep for CFO ( =.06). All variables are correlaed wih q a greaer han.7 excep for CFO ( =.06). Also noe ha CFO and WCACC are negaively correlaed a This large negaive correlaion is well documened in he lieraure (see e.g., Dechow (994) and Dechow, Kohari and Was (998)). Despie he large 3 In secion 5, we ry alernaive measures of invesmen opporuniies and implemen a variey of oher robusness checks. 4 We measure WCACC using he balance shee mehod. A more direc mehod uses he cash flow saemen, bu his daa is available only from 989 forward. In secion 5, we verify ha our resuls are no an arifac of using he balance shee mehod. 6

18 negaive correlaion beween WCACC and CFO, WCACC is highly correlaed wih capial invesmen (( =.26) while CFO is only correlaed wih invesmen a a level of.06. This fac will prove imporan o our analysis. 3.2 Firm growh and co-movemen beween fixed capial and working capial invesmen Why is co-movemen beween capial invesmen and working capial invesmen higher for higher growh firms relaive o low growh firms? Consider firs ha he naure of capial invesmen differs for high growh firms relaive o low growh firms. Specifically, capial invesmen of high growh firms will generally be higher in magniude and reflec a higher proporion of capaciy expanding invesmen relaive o ha of low growh firms where invesmen will be dominaed by replacemen of depreciaed capial. Furher, growh in working capial invesmen will be relaed o capaciy expanding invesmen, no replacemen invesmen. Because he connecion beween capial and working capial invesmen is driven by capaciy expanding invesmen, he higher proporion of capaciy expanding versus replacemen invesmen for high growh relaive o low growh firms implies ha he correlaion beween capial invesmen and working capial invesmen will be higher for high growh relaive o low growh firms. Consider nex ha higher capaciy expanding versus replacemen invesmen suggess ha he volailiy of invesmen will be higher for high relaive o low growh firms. When invesmen approximaes replacemen capial (i.e., depreciaion) i will end o be small in magniude and fairly seady over ime. In conras, capaciy expanding invesmen will end o be large in magniude and reflec significan volailiy given he general lumpiness of manufacuring invesmen (e.g., Doms and Dunne 998). Higher invesmen volailiy in urn increases he volailiy of he working capial invesmen componen of WCACC relaive o random iming 7

19 flucuaions, driving a higher correlaion beween WCACC and capial invesmens for high growh firms. For slow growh or seady sae firms, random flucuaions dominan he working capial invesmen aspec of WCACC, resuling in a lower correlaion beween capial invesmen and WCACC for hese firms. To clarify hese argumens consider he following simple model. Assume ha. Capial Invesmen is given by I. The proporion of I represening capaciy expanding invesmen (as opposed o replacemen of depreciaed capial) is given by he fracion G. G is sricly increasing in firm growh. 5 2 Le VAR( I) I ; 2. Working capial invesmen is WCI = a ( G I ). Tha is, working capial invesmen is proporional o he growh componen of capial invesmen, G I ; and 3. Working capial accruals, WCACC = WCI + = a GI, where is independenly 2 disribued random flucuaion in WCACC due o iming issues and VAR ). ( I is sraighforward o show ha he correlaion beween I and WCACC is given by a ( I, WCACC). (8) 2 / 2 a G I ( I, WCACC) Using (8), we esablish sufficien condiions under which 0. From (8) we see growh 2 ( I, WCACC) ha ( I, WCACC ) is increasing in G I. I is hen clear ha 0 growh if, holding dg consan, 0 dgrowh d and I 0. Noe ha we rea he underlying caalys of growh dgrowh as being ouside he model. Tha is, he model is indifferen as o wheher growh is spurred by a decrease in he cos of capial, an increase in invesmen opporuniies, empire building, or 5 G can be concepualized as he expeced value of he raio growh invesmen. ( growh invesmen replacemen invesmen) This implies ha he growh componen of capial invesmen is equal o G I. 8

20 managerial irraionaliy. However, as we argue laer, while ICFS is driven by growh from any source, he inerpreaion of ICFS depends direcly on he specific underlying caalys of growh. To esablish he plausibiliy of his growh explanaion, in able 2 we provide empirical dg evidence ha 0 dgrowh d and I 0. We measure G as he fracion of oal invesmen dgrowh represening capaciy expanding invesmen (i.e., growh invesmen/ (growh invesmen + replacemen invesmen)), where replacemen invesmen is se equal o depreciaion expense and growh invesmen is he remaining porion (i.e., invesmen depreciaion expense). Table 2, panels A and B show ha G and he sandard deviaion of capial invesmen increase wih dg growh (i.e. 0 dgrowh d and I 0 dgrowh ). 6 Finally, we acknowledge ha he random accrual iming noise may increase wih growh, requiring furher ha as firm growh increases, G I mus increase faser han he. While we do no hink i is likely ha random iming noise would in general increase faser han changes in fundamenals, his is an empirical quesion. In secions 4.2. and we deal wih composiion of WCACC head on by empirically decomposing WCACC ino working capial invesmen and random flucuaion componens and showing ha he random iming componen is basically unrelaed o capial invesmen. 3.3 Re-inerpreing a priori financing consrain pariions in erms of firm growh The ICFS lieraure following Fazzari e al. (988) uses a range of firm specific characerisics o measure a priori financing consrains and documens ha firms classified as 6 In panel A we compue sandard deviaion of invesmen ( Sd(I /K - )) and average proporion of growh invesmen (G) across quariles of growh measures using pooled firm years, while in panel B we compue firm specific Sd(I /K - ) and firm average G, and hen pariion all firms ino four growh quariles based on a firm s average growh characerisics. 9

21 more consrained by hese measures display greaer ICFS. Two of he mos widely used measures in his lieraure are dividend payou raio and firm age, wih higher values indicaing lower financing consrains. In conras, Kaplan and Zingales (997) use a measure based on quaniaive and qualiaive informaion from annual repors and show ha more financially consrained firms exhibi lower ICFS han less financially consrained firms. Cleary (999) replicaes he Kaplan and Zingales (997) finding ha ICFS is higher for less financially consrained firms using a large sample version of he Kaplan and Zingales (997) measure called Z FC (higher values correspond o lower financing consrains). 7 The premise of Z FC is ha firms who cu dividends are more likely o be financially consrained. Following Cleary (999), we use discriminan analysis, classifying firms ino dividend cu, no change, and dividend increase groups based on he following beginning-of-period variables: curren raio (Curren), deb raio (Deb), fixed charge coverage (FCCov), ne income margin (NI%), sales growh (SalesGrowh), and slack/ne fixed asses (SLACK/K). Z FC is esimaed using he following model (see Cleary (999) for more deail) 8 : Z FC Curren 2FCCov 3SLACK / K 4NI% SalesGrowh Deb 5 6 (9) In his paper, we span he compeing lieraures by employing dividend payou raio, firm age, and Cleary s Z FC index as measures of a priori financing consrains. However, raher han focusing on differences, we insead focus on commonaliy across hese measures. The source of commonaliy we isolae is firm growh. In able 3, Panel A we documen ha all hree 7 Kaplan and Zingales (2000) and Fazzari e al. (2000) vigorously debae he implicaions his documened nonmonooniciy beween ICFS and measures of financing consrains, arriving a no resoluion. Kaplan and Zingales (997) develop a simple model o show ha even if firms face differing degrees of financing consrains, i is no necessarily he case ha ICFS increases monoonically wih he degree of financing consrains. This poin is also esablished in a richer model seing by Moyen (2004). 8 Noe ha Slack is defined as balance shee cash + shor erm invesmens + (0.50 x invenory) + (0.70 x accouns receivable) - shor erm loans. 20

22 pariioning variables are significanly correlaed wih firm growh. We see ha he dividend payou raio and firm age are negaively relaed o employee growh, sales growh and earnings growh, while Cleary s Z FC is significanly posiively relaed o all hree growh measures. In able 3, Panel B we deail how all hree measures of growh, employee growh, sales growh and earnings growh, vary across quariles of dividend payou raio, firm age and Z FC. Table 3, panel B clearly shows ha dividend payou raio and firm age are negaively relaed o growh, while Z FC is posiively relaed growh. Based on his finding, we conjecure ha hese hree financing consrain measures can be re-inerpreed in erms of firm growh. Under his inerpreaion, ICFS will be shown nex o monoonically increase wih firm growh, reconciling conflicing resuls in he lieraure where ICFS decreases wih dividend yield and firm age, bu increases in Z FC. 4. Main empirical analysis of ICFS In his secion, we presen direc evidence ha ICFS reflecs he fundamenal connecion beween capial invesmen and working capial invesmen as inerrelaed manifesaions of firm growh. In secion 4. we separaely analyze invesmen-wcacc and invesmen-cfo sensiiviy and show ha ICFS are driven by WCACC, no by CFO. In secion 4.2, we examine direc implicaions of growh for ICFS and provide evidence consisen wih a growh inerpreaion of ICFS. 4. Separae analysis of invesmen-wcacc and invesmen-cfo sensiiviy We begin our analysis of ICFS in able 4, where we examine he relaion beween invesmen and EBD, CFO, and WCACC, afer conrolling for q bu before considering any a priori pariioning of firms. Table 4, column documens he well-known posiive and significan ICFS, wih a coefficien on EBD of.22 and a -saisic of In conras, column 2

23 2 subsiues CFO for EBD and documens a negaive relaion beween fixed invesmen and CFO ( = -3.09), while column 3 reveals a srong, posiive relaion beween invesmen and WCACC ( = 20.23). Table 5 consiss of hree panels, one for each of he financing consrain variables dividend payou raio, firm age, and Z FC. Throughou our discussion of able 5, we will emphasize our inerpreaion of hese financing consrain pariions in erms of growh. Afer pariioning firms ino quariles, we run panel regressions of invesmen on a cash flow consruc and q for firms in each quarile, ieraively using one of hree differen cash flow measures, EBD, WCACC, and CFO. For parsimony, we only repor he coefficiens and -saisics for he cash flow measures and he differences beween he coefficiens for he boom and op quariles of each pariioning variable. All regression models include firm and year fixed effecs wih sandard errors clusered a he firm level (see able 5 for deails). In able 5, he column labeled EBD/K replicaes he classic ICFS formulaion from Fazzari, e al. (988). For all hree financing consrain measures, we see ha ICFS varies sysemaically across financing consrain pariions. For dividend payou pariions, he sensiiviy coefficien decreases.32 in he boom quarile (high financing consrains, high growh) o.6 in he op quarile (low financing consrains, low growh). The sensiiviy coefficien difference beween he boom and op quariles is posiive and significan a he 5% level. For firm age, he boom quarile has a sensiiviy of.93, while he second hrough op quariles have roughly he same sensiiviy (.085,.083 and.084 respecively). However, in his case he difference is no significan a convenional levels ( =.54). The posiive difference in 22

24 he sensiiviy for he boom and op dividend payou and firm age quariles is consisen wih ICFS increasing in financing consrains (or growh). 9 In conras, for he Z FC measure, we see ha he ordering of ICFS across financing consrains reverses, replicaing Cleary (999). Table 5 shows ha ICFS is lower for firms classified as more consrained by he Z FC measure. ICFS increases monoonically from.039 in he boom quarile (high consrains, low growh) o.8 in he op quarile (low consrains, high growh). This difference is negaive and highly significan (=-5.8). The remaining wo columns of Table 5 replace EBD in he invesmen equaion wih CFO and WCACC. We see ha for pariions based on boh dividend payou raio and firm age, CFO-invesmen sensiiviy is significanly higher for less financially consrained (Q4) han for more consrained firms (Q). Furher, CFO sensiiviies are ofen negaive or saisically insignifican. For example, he mos financially consrained firms under he dividend payou raio and firm age pariions show a negaive relaion beween invesmen and CFO. Wih respec o Z FC, invesmen-cfo sensiiviies are higher for less financially consrained firms, and are negaive for he more financially consrained firms. These resuls are inconsisen wih a sory ha invesmen decisions of consrained firms are more sensiive o inernally generaed cash flows han for less consrained firms. Finally, able 5 shows ha invesmen-wcacc sensiiviy varies monoonically across pariions based on all hree financial consrain variables. 20 For dividend payou raio and firm age pariions (inversely relaed o growh), invesmen-wcacc sensiiviy decreases monoonically from he boom quarile o he op quarile, while for Z FC pariions (posiively 9 While he resul of firm age is a lile anemic in his pariioning analysis, in able 8, panel B, we replicae Fazzari e al. (988) using a regression approach wih ineracions, documening ha IFCS is significanly decreasing in boh dividend payou and firm age. 20 Adding boh WCACC and CFO in he same regression does no change he coefficien paern presened in Table 5. 23

25 relaed o growh) he ordering is reversed. The differences in WCACC sensiiviy for Q-Q4 are significanly posiive in all hree panels. Tha is, invesmen-wcacc sensiiviy increases monoonically wih growh, reconciling he conradicory findings beween Fazzari, Hubbard, and Peersen (988) and Cleary (999) (also Kaplan and Zingales 997) where ICFS increases in financing consrains as defined by dividend yield and firm age, bu decreases in financing consrains defined by Cleary s Z FC. 4.2 Direc implicaions of a growh sory for invesmen-cash flow sensiiviy In secion 4.2. we separae he random iming componen of WCACC from working capial invesmen componen, and show ha he paern in invesmen-wcacc sensiiviy is driven by he fundamenal invesmen componen of WCACC. In secion 4.2.2, we include WCACC and CFO simulaneously in he invesmen equaion, providing evidence ha WCACC ne of iming flucuaions is he primiive driver of ICFS, while CFO basically serves o conrol for random iming flucuaions in WCACC, raher han serving as a source of invesmen financing. And in secion 4.2.3, we show ha ICFS increases significanly wih measures of firm growh, Furher, ICFS is no sensiive o financial consrains (as measured by dividend payou, firm age, and Z FC ) once we conrol for growh Decomposing WCACC ino fundamenal invesmen and random iming componens To disinguish fundamenal invesmen and random iming componens of WCACC, we adap he Dechow and Dichev (2002) framework by including wo growh proxies as follows WCACC / K 0 CFO / K 2CFO / K 3CFO / K SGR EMPGR e. (0) 4 5 In (0), SGR is sales growh from year - o (in percenage), and EMPGR is he growh in he number of employees (in percenage). The fied value of he hree cash flow variables from (0) is used o capure he random iming componen of accruals (WCACC_RT). Tha is 24

26 WCACC _ RT CFO / K CFO / K CFO / K. () 2 3 From Dechow and Dichev (2002), we expec > 0, 2 < 0, and 3 > 0. We use sales growh and employee growh o proxy for change in a firm s scale. These proxies for growh (SGR and EMPGR) are no exhausive. The fied value of he wo growh variables is posied o capure he fundamenal invesmen componen of accruals (WCACC_FI). Tha is EMPGR. (2) WCACC_ FI 4SGR 5 As fundamenal invesmen in working capial should be posiively correlaed wih growh, we expec 4 > 0 and 5 > 0. We noe ha he original Dechow-Dichev model is designed o capure accruals shorerm role in smoohing ou random iming flucuaions in cash flows. As Dechow and Dichev (2002) acknowledge, heir model ignores accruals long-erm role in smoohing earnings over firms business and life cycles. Panel A of Table 6 shows ha he adjused R 2 increases on average across models esimaed for each 2-digi SIC code by.9 o.55 from adding he wo growh variables o capure accruals long-erm smoohing role. The residual likely capures random iming and invesmen informaion as well as accrual qualiy due o incomplee conrols of accrual shor-erm and long-erm roles in he model. Hence, we do no include he residual in eiher he esimaed random componen or he fundamenal invesmen componen of accruals. Raher, we conduc our ess based on he relaively clean proxies from he fied variables on cash flows or growh. 2 2 On accrual qualiy, Richardson e al. (2005) rae changes in invenory and accouns receivable as low reliabiliy and changes in accouns payable ( AP ) as high reliabiliy accruals. In unabulaed analyses, we find ha he behavior of invesmen- AP sensiiviy is consisen wih he behavior of invesmen- INV and invesmen- AR sensiiviies. 25

27 Panel A of able 6 shows ha he coefficien esimaes are consisen wih our predicion in every indusry ( > 0, 2 < 0, 3 > 0, 4 > 0, and 5 > 0). Addiionally, he coefficiens are similar o hose in Dechow and Dichev (2002), despie differen samples and our inclusion of wo growh proxies. Using he WCACC decomposiion from () and (2), we examine relaions beween capial invesmen and he wo componens of WCACC. We expec capial invesmen o be posiively associaed wih he invesmen componen (WCACC_FI) and unrelaed wih he random iming componen (WCACC_RT). We esimae I / K q 2WCACC _ RT / K 3WCACC _ FI / K FIRMDUMMIES YEARDUMMIES e. (3) Panel B of able 6 shows ha he coefficien on WCACC_RT is and insignificanly differen from zero (=.32), while he coefficien on WCACC_FI is 0.309, wih a -saisic of In panel C, we esimae equaion (3) for each financing consrain pariion, finding ha WCACC_FI is he main driver of he invesmen-wcacc sensiiviy paerns across dividend payou, firm age and Z FC pariions Including WCACC and CFO simulaneously in he invesmen regression The previous analyses consider invesmen-wcacc and invesmen-cfo sensiiviy separaely. However, given ha EBD = WCACC+CFO, i is imporan ha we consider WCACC and CFO simulaneously, leading o he model I / K 0 q 2WCACC / K 3CFO / K e, (4) where β 0 represens firm and year dummies. Wha are he implicaions of he growh inerpreaion of ICFS for equaion (4)? If ICFS reflecs he growh connecion beween capial invesmen and working capial invesmen, 26

28 we argue ha when WCACC and CFO are boh included, CFO will proxy for he random iming componen of WCACC and essenially serve o conrol for random iming noise in WCACC ha obscures he fundamenal invesmen componen. Tha is, CFO will imperfecly play he same role as he join effec of he hree cash flow variables in equaion (0) above. To examine his proposiion consider he regression WCACC CFO v. (5) 0 I well esablished ha WCACC and CFO are negaively correlaed (e.g., Dechow 994), and so we predic ha <0. 22 Analogous o he Dechow and Dichev decomposiion of WCACC in secion 4.3., we inerpre he fied value from (5) as an esimae of he random iming componen, and he residual ( ) as he fundamenal invesmen componen of WCACC. This suggess he following model: I / K q 0 0 ( WCACC ( * ) q 0 q 2 v e / K 2 ( CFO WCACC / K 0 / K )) e ( * ) CFO 2 / K e. (6) The final equaion in (6) shows ha he role of CFO, via is negaive correlaion wih WCACC, is o conrol ou random noise in WCACC. This is refleced in he coefficien on CFO, * 2 > 0, where he inequaliy follows from our predicions ha 2 0 and < We do no believe ha muli-collineariy from including boh WCACC and CFO in he same regression is a problem for our purposes. Mulicollineariy ends o inflae he sandard errors and o render one or boh coefficiens saisically insignifican, whereas we sill find highly significan coefficiens on boh WCACC and CFO. 23 The absolue value of should be less han one. If WCACC and CFO are perfecly mached on he iming issue, he coefficien on CFO would equal o -. Thus, any noise or mismach, such as he mismach due o pas or beween - and 0. Thus, fuure cash flows, drives he coefficien on CFO owards zero, suggesing a value of we expec he coefficien on CFO o be less han he coefficien on WCACC ( 2 * < 2 ). 27