FIRM S FINANCING CONSTRAINTS AND INVESTMENT- CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS

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1 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN FIRM S FINANCING CONSTRAINTS AND INVESTMENT- CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS Ahmed Marhfor, Bouchra M Zali 2 and Jean-Claude Cosse 3 Deparmen of adminisraive sudies, Universiy of Quebec in Abiibi-Témiscamingue 2 Deparmen of Finance, ESG/UQÀM Monréal 3 HEC Monréal Absrac. In his paper, we invesigae wheher high invesmen-cash flow sensiiviy can be inerpreed as evidence ha firms are facing binding financing consrains. Using insiuional feaures and an inuiive measure of sock price informaiveness o disinguish beween mos consrained and leas consrained firms, we documen ha firms ha are supposed o be more financially consrained exhibi greaer invesmen-cash flow sensiiviy. Our findings suppor he resuls of Fazzari e al. (988) who also find ha invesmen spending of firms wih high levels of financial consrains is more sensiive o he availabiliy of cash flow. Keywords: Invesmen decisions, sock price informaiveness, invesmen-cash flow sensiiviy, financing consrains JEL Classificaions: E22; G3; G3 Inroducion Under he perfec and complee capial markes assumpions, Modigliani and Miller (958) argue ha firm s invesmen decisions are independen from he financing sources. However, many sudies appeal o problems in capial markes, especially asymmeric informaion, o sugges ha financial srucure is relevan o invesmen decisions. For example, Myers and Majluf (984), Greenwald e al. (984), and Myers (984) provide srong suppor of he fac ha exernal funds are no a perfec subsiue for inernal capial. As a resul, he cos of exernal finance may differ subsanially from inernal capial. According o his view, invesmen expendiures may depend on financial facors such as he availabiliy of inernal capial (Fazzari e al. 988); and firms are considered as financially consrained when he wedge beween inernal and exernal cos of capial increases. Considerable research relies on he associaion beween invesmen and inernal capial o es for he presence and imporance of firm s financing consrains. However, from he exising lieraure, i s no clear wheher greaer invesmen-cash flow sensiiviy can be inerpreed as evidence ha firms are facing more or less financing consrains. For insance, Fazzari e al. (988) argue ha such sensiiviy increases wih he degree of firm s financing consrains. On he oher hand, Kaplan and Zingales (997) disagree wih Fazzari e al. (988) inerpreaion. 5

2 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN According o Kaplan and Zingales (997), firms wih sronger financial posiions exhibi high invesmen-cash flow sensiiviy in comparison o firms wih weaker financial posiions. This work represens an aemp o solve he financing consrains hypohesis conroversy. I s moivaed by he fac ha many auhors (e.g. Moyen, 24 and Cleary e al. 27) consider ha he source of such conroversy lies in he disagreemen in idenifying appropriae facors o disinguish beween financially consrained and unconsrained firms. We argue ha he radiional classificaion scheme based on firm-level daa (dividend payou, size, leverage, ec.) is no wihou drawbacks. Firs, firm-level financial variables can be regarded as endogenous and ime-varian (firms idenified now as facing binding financial consrains can change heir financial saus in he fuure). Second, ess based on firm-level daa do no provide a direc evidence ha i s asymmeric informaion ha explains he cos differenial beween inernal and exernal capial. Therefore, we propose new empirical approaches o examine he invesmencash flow sensiiviy conroversy. In our ess, we use more exogenous facors and accoun for varying degrees of informaion asymmery. We make several conribuions o he lieraure. Firs, our classificaion scheme aemps o overcome he problem of endogeneiy of he sandard classificaion approach. In fac, we choose o sor firms ino financially consrained and unconsrained according o counry-level daa relaed o legal environmen. We claim ha such facors are less endogenous (our classificaion is based on measures less correlaed wih firm s inernal funds) and more sable over ime. In addiion, we use counry-level variables because here is a growing lieraure supporing he fac ha naional capial markes impac firms cos of capial, despie increasing markes inegraion. Sulz (29) considers ha firms can raise funds a lower cos in heir counry and no elsewhere if heir capial marke performs beer han capial markes of oher counries. According o Sulz (29), a major reason why naional capial markes remain an imporan facor for opimal resource allocaion and invesmen decisions is ha hey have differen securiies laws. We argue ha equiy valuaion and cos of exernal capial should differ across counries because securiies laws impac producion decisions, he cos of rading and informaion acquisiion coss. Indeed, he findings of many papers in he lieraure sugges ha srong securiies regulaion helps diminish firms cos of capial and relax financing consrains (Hail and Leuz, 26; and Qian and Srahan, 27). Given he significan body of research recognizing he imporance of legal insiuions in shaping he financial secor, we base our firs firms classificaion mehodology on legal origin (common law versus civil law counries). In 26, Lapora e al. find significan differences in capial markes developmen based on legal origin. According o hem, common law counries have more developed sock markes compared o civil law counries because common law sysems focus on marke discipline and privae liigaion. Furhermore, legal sysems wih common law origin offer beer proecion o invesors (Lapora e al. 26). In he same vein, Aggarwal e al. (28) show ha firms from common law counries are more likely o adop governance pracices ha resric he discreion of insiders. Therefore, in our ess, we consider common law firms as facing lower financing consrained and civil law firms as more consrained. Our second measure of legal environmen is he ani-direcor righs index from Djankov e al. (28) ha proxies he level of minoriy invesors proecion. We propose o pariion our sample ino wo subsamples based on ani-direcor righs scores. Firms from counries wih scores above he sample median are considered as financially unconsrained because sronger invesors proecion laws are linked o beer funcioning capial markes. For insance, Morck e al. (2) find ha capial allocaion efficiency is posiively correlaed o he level of invesors proecion. Similarly, Lapora e al. (22) show ha srong invesors 5

3 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS proecion laws reduce he abiliy of firm s insiders o expropriae ousiders, and hus enhance invesors confidence in firms managers. In his paper, we sress he imporance of such bonding mechanism in relaxing firms financing consrains. Therefore, if counries can be ranked by he srengh of heir legal sysem, firms originaing from counries where minoriy invesors are beer proeced should face lower binding financial consrains. I s worh menioning ha our classificaion mehodology assumes ha firms cos of capial is se in cenralized capial markes and is no dependan on firms' paricular characerisics. To overcome his limiaion, we propose, for robusness, o sor firms based on boh firm-level and insiuional characerisics. To our knowledge, our research is he firs sudy ha uses counry legal insiuions o disinguish beween financially consrained and unconsrained firms. Second, we focus on asymmeric informaion issues by using an inuiive and direc measure of sock price informaiveness. We consider ha greaer sock price informaiveness is relaed o more informaion abou fuure earnings being refleced in curren sock prices. To measure his relaion, we regress currens reurns agains boh curren and fuure earnings, in accord wih a growing lieraure (Collins e al. 994; Gelb and Zarowin, 22; Lundholm and Myers, 22; and Durnev e al. 23). Theoreically, more informaive sock prices should reflec more informaion abou fuure earnings (firm fundamenals). This reasoning leads us o choose fuure earnings response coefficiens as our proxy of he severiy of a firm s informaion problems. We argue ha firms wih sock prices reflecing more informaion abou fuure earnings should face less asymmeric informaion problems. Hence, we consider hese firms as unconsrained because many heoreical and empirical sudies imply a cos premium for exernal capial based on asymmeric informaion (Myers and Majluf, 984; Barry and Brown, 985; and Meron, 987). Should we find negaive associaions beween our proxy of price informaiveness and invesmen-cash flow sensiiviy, we can infer ha ransparen firms (wih more informaive sock prices and less financial consrains) exhibi lower invesmen-cash flow sensiiviy. Despie is common sense appeal, our approach has ye o appear in he lieraure. Finally, we es and validae our hypoheses using a large sample of firms originaing from 44 counries (developed and emerging counries) over he period Sampling sops in 27 insead of 2 because some of our variables require hree years of daa beyond any sampling year. I is worh menioning ha mos sudies in he lieraure provide eiher US evidence or limied inernaional evidence. For insance, Kadapakkam e al. (998) sudy is based on firms originaing from six developed counries and Cleary (26) provides evidence for seven developed counries. Our resuls sugges ha invesmen decisions of companies originaing from counries ha provide srong legal proecion o minoriy invesors are less sensiive o he availabiliy of cash flow. Furher, ransparen companies exhibi lower invesmen-cash flow sensiiviy in comparison o opaque companies. Finally, addiional analysis shows negaive associaions beween our proxy of sock price informaiveness and invesmen cash-flow sensiiviy. Our large sample evidence suppors he resuls of Fazzari e al. (988) who also find ha invesmen spending of firms ha are less financially consrained is less sensiive o inernal funds. The remainder of he paper is organized as follows. Secion 2 reviews he exising lieraure. In secion 3, we develop our empirical model and ouline he consrucion of some of our variables. In secion 4, we presen he main resuls including robusness ess resuls. Secion 5 concludes. 52

4 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN Previous Research Work In he lieraure, he invesmen-cash flow sensiiviy has been exensively used as a measure of firm s financial consrains. This sensiiviy is measured by regressing invesmen on cash flow, conrolling for invesmen opporuniies. According o Fazzari e al. (988), firm s inernal cash flow may impac invesmen because of a financing hierarchy (Pecking Order Theory) in which inernal capial have a cos advanage over exernal capial. Following his argumen, a value maximizing firm will issue new deb or shares only afer i exhauss inernal capial (Fazzari e al. 988). In fac, more financially consrained firms will increase invesmen when hey have enough cash flow o do so. Therefore, we should expec high invesmen-cash flow sensiiviy for consrained firms. In conras, unconsrained firms have he possibiliy o increase heir invesmen expendiures even when hey do no have enough cash flow because he cos differenial beween inernal and exernal capial is small. Hence, unconsrained firms should exhibi low invesmen-cash flow sensiiviy. A relaed argumen is ha he premium on exernal capial is also linked o he collaeral represened by he ne worh of he firm. Gilchris and Himmelberg (995) argue ha an increase in cash flow signals an increase in firm s ne worh. Hence, as ne worh rises, he cos of exernal capial should decrease, and invesmen spending should respond more o cash-flow innovaion. On he oher hand, in periods when cash-flows are low, he cos of capial is high, and firms inves less (Gilchris and Himmelberg, 995). A large number of empirical sudies have provided srong suppor for he financing hierarchy hypohesis. The sandard approach of his research is o caegorize firms according o a variey of firm-level financial variables (dividend payou, size, Leverage, ec.) before measuring he invesmen-cash flow sensiiviy. The main resuls of hese papers sugges ha invesmen is more sensiive o cash flow for firms wih high levels of financial consrains. For insance, Fazzari e al. (988) consider firms wih high dividend payou raios as unconsrained and firms wih low raios as financially consrained. They show ha invesmen is less sensiive o inernal funds for firms wih high dividend payou raios. Oher papers sor companies according o firm size and age. Smaller and young firms are considered o be more financially consrained because hey face high informaion asymmery problems. In 992, Oliner and Rudebusch use proxies of informaion asymmery based on firm age, exchange lising and firm s paerns of insider rading. Their resuls show greaer invesmen-cash flow sensiiviy for socks raded over-he-couner, firms ha end o be young, and ha exhibi paerns of insider rading behaviour. Scaller (993) shows ha invesmen decisions of young firms are more influenced by inernal funds in comparison o maure firms. In addiion, Scaller findings sugges ha firms wih unspecialized asses, which can serve as collaeral, have lower invesmen-cash flow sensiiviy. As for Gilchris and Himmelberg (995), hey show ha invesmen spending of firms wih limied access o public deb markes appear o be highly sensiive o flucuaions in cash flow. On he oher hand, oher conribuions challenge he conclusions summarized above. In 997, Kaplan and Zingales have reached opposie conclusions suggesing ha corporae invesmen is less sensiive o flucuaions in cash flow for financially consrained firms. In addiion, Kadapakkam e al. (998) provide inernaional evidence supporing Kaplan and Zingales (997) resuls. They find ha invesmen-cash flow sensiiviy is higher for large firms and lower for small firms. In 999, Cleary shows ha corporae invesmen is more sensiive o cash flow for firms wih high credi worhiness. In addiion, Cleary (26) uses an inernaional daa se o furher examine he invesmen-cash flow conroversy. His resuls sugges ha companies wih sronger financial 53

5 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS posiions are more invesmen-cash flow sensiive han companies wih weaker financial posiions. As for us, we fashion our own way o provide a valuable seing ha clarifies he role of cash flow in invesmen equaions. In fac, we propose o sor firms according o various insiuional facors raher han firm-level facors. Empirical Mehodology The major focus of our mehodology is o compare invesmen-cash flow sensiiviy across wo differen groups of firms (consrained versus unconsrained firms). Our firs conribuion o he lieraure consiss of differeniaing companies according o a variey of counry-level variables relaed o legal environmen. The second conribuion is o examine he relaion beween our cash flow coefficiens and an inuiive measure of sock price informaiveness. We conjecure ha a counry s legal sysem can affec firm s financing consrains for many reasons. For insance, Sulz (29) considers ha securiies laws remain an imporan deerminan for equiy valuaion because srong naional regulaions help reduce agency coss. In addiion, we argue ha legal insiuions are also ied o firms disclosure qualiy. In counries where disclosure laws are more exensive and more sricly enforced, we should expec firms o provide high levels of disclosure. The laer should reduce informaion asymmeries beween marke paricipans and ulimaely lower firms cos of capial (Diamond and Verrecchia, 99; Leuz and Verrecchia, 2; and Verrecchia, 2). A relaed argumen is ha increased levels of disclosure broaden firm s invesors base because invesors are more confiden ha sock ransacions occur a fair prices (Bailey e al. 26). As a consequence, risk is more widely shared, which should reduce firm s cos of capial (Meron, 987). The lieraure also suggess ha he enhanced ransparency linked o sricer disclosure rules and poenial legal exposure may influence negaively cos of capial hrough cash flow effecs. In fac, he hrea of shareholder liigaion makes i harder and more cosly for firm s insiders o expropriae ouside shareholders. Such bonding (Coffee, 999 and Sulz, 999) should increase invesors expecaion abou fuure cash-flows and improve firm s abiliy o raise capial. Finally, legal insiuions may also impac corrupion. We argue ha lower corrupion engenders lower risks for invesors because i makes firms crediors and shareholders beer able o monior poenial violaions in financial conracs. The esimaion of invesmen-cash flow sensiiviy across our wo differen groups (consrained and unconsrained firms) is based on he following equaion: () ( ε I / K) = β + β( CF / K) + β2( M / B) + β3( Size) + Where I represens invesmen in plan and equipmen for firm i during period ; K denoes he beginning-of-period value of oal asses; CF is he sum of income before exraordinary iems and depreciaion ne of cash dividends (for robusness, we also measure CF as : ne income + depreciaion and/or amorizaion + changes in deferred axes); M/B denoes he marke o book raio, and Size denoes he naural logarihm of firm size. The marke o book raio is a proxy for invesmen opporuniies and growh, while size variable conrols for poenial marke imperfecions relaed o firm size. Our main ineres in equaion () ceners on β. This coefficien represens he invesmen-cash flow sensiiviy (cash flow coefficien). If our resuls sugges ha corporae invesmen is less sensiive o inernal funds for companies originaing from counries 54

6 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN wih srong securiies laws; we will conclude ha unconsrained firms exhibi lower invesmencash flow sensiiviy. Such resuls will be consisen wih Fazzari e al. (988) findings. To furher examine he impac of firm s financing consrains on he invesmen-cash flow sensiiviy, we also propose o sor our sample according o an inuiive measure of sock price informaiveness before comparing he invesmen-cash flow sensiiviy across our wo differen groups. We consider firms wih more informaive sock prices as unconsrained because high sock price informaiveness can lower he informaion risk borne by invesors, and in urn, reduce firm s cos of capial. Furher, informaive sock prices should help providers of exernal capial o beer assess firm s invesmen opporuniies. Following his argumen, firms wih informaive sock prices should exhibi low coss of capial because such coss are funcion of he esimaion risk (Barry and Brown, 985). The proxy of sock price informaiveness we propose is based on Collins e al. (994). I measures how much curren sock prices conain informaion abou fuure earnings (informaive prices should reflec more informaion abou fuure earnings). Therefore, in his research, we regress curren reurns agains boh curren and fuure earnings o esimae price informaiveness: R (2) = β + βuce + β2 jδe ( fe + j ) + ε Where j= R curren sock reurn (period ) uce unexpeced curren earnings (period ) Δ E (fe +j ) change in expecaions abou fuure earnings ε error erm The explanaory variables in regression (2) being unobservable, similar proxies are used in he lieraure. For insance, Lundholm and Myers (22), and Durnev e al. (23) use earnings a periods () and (-) o proxy for he unexpeced curren earnings in period. Lundholm and Myers (22) consider ha including pas year earnings (e - ) in equaion (2) allows he regression o dicae he bes represenaion of he prior expecaion for curren earnings. According o Lundholm and Myers (22): if earnings are reaed by he marke as a random walk process, hen he coefficien on e - and e are of similar magniude bu opposie signs. In conras, if he coefficien on e - is approximaely zero hen earnings are reaed as a whie noise process. Furhermore, o proxy for he changes in he expeced fuure earnings, we follow he sandard pracice in he lieraure and use he realized fuure earnings (e +j ) and fuure reurns (R +j ) as proxies. Noe ha Beaver e al. (98) and Warfield and Wild (992) proxy for ΔE (fe +j ) by using only realized fuure earnings. However, Collins e al. (994) recommend including fuure sock reurns as an addiional conrol variable because he omission of his variable inroduces an error in variables (realized fuure earnings have expeced and unexpeced 55

7 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS componens). In order o conrol for he unexpeced componen, an insrumen (fuure reurns) is needed ha correlaes wih he measuremen error bu no wih he dependen variable. The underlying inuiion being ha an unexpeced shock o fuure earnings (+j) should have an impac on fuure reurns (R +j ). Hence, he regression we esimae o proxy for sock price informaiveness goes as follows: R 3 = b + be + b2e + ( b3 je + j + b4 jr + j j= ) + ε (3) We use only hree years of fuure earnings (e +, e +2 and e +3 ) and corresponding reurns (R +, R +2 and R +3 ) because prior research has shown ha amouns furher ou in ime add lile explanaory power (Collins e al. 994). The aggregaed coefficiens on he fuure earnings (Sum of b 3j ) measure he associaion beween curren reurn and realized fuure earnings. The more curren reurn, R, conains informaion abou fuure earnings, he higher he coefficiens are expeced o be. I is worh menioning ha when we measure he Pearson correlaions beween curren earnings, fuure earnings and fuure reurns, mulicollineariy is no an issue in equaion (3). We also use he variance inflaion facor and find no evidence of mulicollinariy. R are he buy-and-hold reurns for he 2 monhs period saring a he fiscal-year-end. Earnings e equaes wih income before ineres, axes, depreciaion and amorizaion (EBITDA), recorded a he end of fiscal year () divided by he iniial marke value of equiy recorded a (-). Durnev e al. (23) argue ha depreciaion and amorizaion are quie sensiive o differences in discreionary accouning rules. Therefore, knowing ha such differences in accouning pracices are counry-or indusry-specific, he advanage of relying on EBITDA is increasing wih ransindusry and ransnaional sampling. Furhermore, he counry or he indusry fixed effecs in our regressions models are likely o pick up any poenial differences in accouning rules (see, Hail and Leuz, 26, 29 for a discussion). In our ess, we consider he sum of he coefficiens on fuure earnings as he variable ha measures sock price informaiveness: 3 (4) PI = b j= This variable cumulaes he sensiiviies of curren prices o fuure earnings. Thus, ransparen firms should have higher measures of PI because informaive sock prices conain more informaion abou fuure earnings. We obain he esimaes of PI for eiher a firm or a group of firms on an indusry level. For he firm-by-firm approach, we pool many years of daa for each firm (from 995 o 27) o esimae is PI based on equaion (4). Then, we calculae he PI sample median. We consider firms wih PI esimaes above he sample median as unconsrained because such firms face low asymmeric informaion problems. On he oher hand, pooling years of daa o calculae PI for each firm may be problemaic for wo main reasons. Firs, we use few observaions for our esimaion purpose (maximum 3 observaions for each firm). The resul could be unreliable measures for PI. Second, as sressed by Durnev e al. (23), changes in macroeconomic environmen, indusry condiions, accouning 3 j The fiscal-year-end adjused share price, plus he adjused dividends, all divided by he adjused price a he end of he previous fiscal year (-). The adjusmen facor reflecs socks splis ha occurred during he fiscal year. 56

8 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN rules and financial regulaions can cause ineremporal changes in our fuure earnings coefficiens. To avoid hese limiaions, we follow Durnev e al. (23) and use a cross-secion of similar firms (indusry level approach). This approach requires pooling firms in wo-digi SIC indusries before running regression (3). Hence, o invesigae wheher greaer sock price informaiveness is linked o higher or lower invesmen-cash flow sensiiviy, based on our indusry-level mehod, we run he following regression: CFC (5) = α + αpi + α 2( conrols ) + ε Noe ha in equaion (5), i indexes wo-digi SIC indusries and indexes years (in equaion, i indexes firms and indexes years). The wo-digi SIC indusry approach consiss of pooling firms in a wo-digi code indusry before calculaing he corresponding variables. Therefore, in equaion (5), we regress our indusry cash flow coefficiens on indusry price informaiveness esimaes and indusry average esimaes of our conrol variables (leverage and lagged values of cash). Adding leverage in equaion (5) allows us o consider he riskiness of deb. We argue ha i s imporan o conrol for poenial differences in CFC beween high and low leverage firms because higher degrees of leverage are associaed wih risky deb (binding financing consrains). Leverage is he raio of long erm deb o oal asses. In addiion, lagged values of cash may have explanaory power for firm s financing consrains because some firms end o accumulae and use liquidiy as a buffer agains hese consrains (Cleary and Booh, 28). Cash is cash and markeable securiies. Finally, o conrol furher for differences among indusries in equaion (5), we use a one-digi indusry-fixed effecs model (we do no use wo-digi indusry dummies o conserve degrees of freedom). If α is negaive and significan, we can infer ha firms wih more informaive sock prices (unconsrained firms) exhibi lower invesmen-cash flow coefficiens. Empirical Resuls We compile our counry-level daa and firms characerisics from a variey of sources. A descripion of counry-level daa is given in Appendix A. Common law or civil law describes he legal origin sysem and ani-direcor righs scores are obained from Djankov e al. (28). In his paper, we use inernaional daa from 44 counries over he period. Informaion on firm-level daa is drawn from Daasream and Worldscope. To be consisen wih prior research, commercial banks, insurance companies, diversified financial services and brokerage houses were deleed from he sample. In addiion, o avoid drawing spurious inferences from exreme values, regression resuls are robus o ouliers (observaions are winsorised a %). 57

9 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS Primary resuls Table presens he primary empirical resuls of equaion () for consrained and unconsrained firms. The equaions were esimaed wih fixed counry, indusry and year effecs (for robusness, we also esimae our regressions using fixed firm and year effecs)2. Furher, in all specificaions, sandard errors are adjused for heeroskedasiciy and clusering a he firm level. Independen variables Legal origin approach Invesors proecion approach Price informaiveness approach Common law firms Civil law firms Firms wih high scores Firms wih low scores Firms wih high PI Firms wih low PI Inercep (.) *** (.22) (.225) (.983) (.) *** (.552) Cash flow (.) *** (.) *** (.) *** (.) *** (.) *** (.) *** Marke-o-Book (.567) (.839) (.965) (.936) (.6) (.957) Size (.) *** (.) *** (.4) *** (.4) *** (.) *** (.69) Counry dummies Indusry dummies Year dummies R Inroducing fixed firm effecs esimaion should miigae concerns abou correlaed omied variables and selecion bias based on unobservable ime-invarian firm characerisics. Furher, fixed ime effecs are included o capure aggregae business-cycle influences. Firm fixed effecs esimaes are obained by demeaning he observaions wih respec o he firm average for each variable. Year dummies are included in our analysis. Our conclusions are no affeced when we esimae our regressions based on fixed firm and year effecs insead of fixed counry, indusry and year effecs. 58

10 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN Independen variables Legal origin approach Invesors proecion approach Price informaiveness approach Common law firms Civil law firms Firms wih high scores Firms wih low scores Firms wih high PI Firms wih low PI N Table : The impac of firm s financing consrains on invesmen-cash flow sensiiviy: Primary resuls Where i indexes firms and indexes years. In our firs approach, we classify firms according o legal origin before esimaing invesmen cash-flow sensiiviy. In he second approach, we sor firms based on scores of he anidirecor righs index. Finally, in he hird approach, we classify firms according o an inuiive measure of sock price informaiveness before esimaing invesmen cash-flow sensiiviy. Financial firms were deleed from our sample. Counry, indusry and year dummies are included bu no repored. P-values for wo-ailed ess are in parenheses. One, wo or hree aserisks denoe significance a he, 5 and % levels, respecively. Our findings sugges ha he coefficiens for cash flow are all posiive and significan, which is consisen wih he exisence of a financial hierarchy. More imporan, he cash flow coefficien is greaer for civil law firms (.73) in comparison o common law firms (.452). We also perform ess for he difference beween our wo regressions coefficiens and find ha his difference ( ) is significan a % level. Table also repors resuls for he groups formed according o invesors proecion scores. As suggesed earlier, we assume ha firms wih high scores (above he median) face lower binding financing consrains. We find ha such companies exhibi low invesmen-cash flow sensiiviy (.59) compared o companies wih scores below he median (.8). We also compued he saisical difference beween he wo coefficiens and find ha i s significan a % level. So far, our evidence suggess ha financially consrained firms are more invesmen-cash flow sensiive han unconsrained firms. Our hird measure of financial consrains is based on sock price informaiveness. In Table, we consider firms wih PI coefficiens above he median sample as unconsrained (ransparen firms), and firms wih PI coefficiens below he median as consrained (opaque firms). PI is esimaed using a firm-by-firm approach. The laer is conduced by pooling many years of daa for each firm o esimae is PI. Then, he median we use o disinguish beween our wo firms classes is calculaed as he median across all firms. Again, our findings (PI approach in Table ) show large esimaed cash flow coefficiens for consrained firms (opaque firms wih low PI). Furher, he difference in esimaed coefficiens ( ) across he wo classes remains saisically significan a very high confidence levels. We now urn o invesigae he relaion beween our proxy of sock price informaiveness and he cash flow coefficiens according o equaion (5). In his regression, PI is esimaed using wo digi code cross-indusry approach. 59

11 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS Independen variables Inercep Coefficien.55 p-value. *** Price informaiveness * Leverage Lagged cash.7.56 * Indusry dummies Year dummies R 2.63 N 266 Table 2: Sock price informaiveness and cash flow coefficiens Where i indexes wo-digi SIC indusries and indexes years. The wo-digi SIC indusry approach consiss of pooling all firms in a wo-digi code indusry and calculae he corresponding variables. Indusry and year dummy variables are included bu no repored. One, wo or hree aserisks denoe significance a he, 5 and % levels, respecively. Table 2 shows ha he PI coefficien is negaive (-.24) and significan (a % level), suggesing ha greaer sock price informaiveness is linked o lower cash flow coefficiens. This addiional resul provides furher suppor for he fac ha unconsrained firms are less cash flow sensiive, which is consisen wih Fazzari e al. (988) findings. Robusness checks In his secion, we conduc exensive robusness ess o validae our primary findings. Firs, we run pooled regressions (unconsrained and consrained firms ogeher) and use a dummy variable o disinguish beween he wo groups. Second, we drop firms wih US exchange cross-lisings from our sample because relaxaion of firm s financial consrains can be an imporan oucome 6

12 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN of he US cross-lising decision (Errunza and Miller, 2; Lins e al. 25; and Hail and Leuz, 29). This addiional es will allow us o isolae he effec of companies ha cross-lis on US exchanges in order o improve heir corporae governance pracices and overcome heir weak domesic markes laws. Finally, we propose o classify firms according o boh firm-level and insiuional feaures, before esimaing invesmen-cash flow sensiiviy. Join analysis: Insead of classifying firms ino wo groups, we conduc a join analysis by using he enire daa se in one regression and adding a dummy variable o disinguish beween unconsrained and consrained firms. The following model is used: ( I / K) β + ε = + β( CF / K) + β2( M / B) + β3( Size) + θdi, + θdi, ( CF / K) (6) Where D is a dummy variable ha akes he value if he firm is unconsrained and oherwise. In fac, we will esimae hree differen models based on equaion (6). In he firs model, D is equal o for common law firms and oherwise. In he second model, D akes he value of for firms wih high invesors proecion scores and oherwise. Finally, in he hird model, D akes he value of for firms wih greaer sock price informaiveness and oherwise. The ineracion erm D (CF/K) proxies for he ineracion effec beween being an unconsrained firm and he cash flow coefficien. Given ha β represens he cash flow coefficien for consrained firms, he cash flow coefficien for unconsrained firms becomes β +θ. If θ is negaive and significan, invesmen decisions of unconsrained firms can be considered as less liquidiy sensiive. On he oher hand, if θ is posiive and significan, we can infer ha unconsrained firms are more invesmen-cash flow sensiive. The findings (no abulaed) show ha unconsrained firms exhibi lower invesmen cash flow sensiiviy (θ is negaive and significan in all models). In addiional checks, we also calculae our esimaes of CFC (cross-indusry mehod) wihou using Marke-o-Book and size as conrols variables in equaion (). Insead, we propose o add hese variables in equaion (5). We confirm again our primary resuls suggesing he presence of a negaive and significan (% level) associaion beween our proxy of price informaiveness and cash flow coefficiens. Addiional Robusness checks: In oher ess, firms wih US exchange cross-lisings are dropped from our sample before esimaing equaion (). In fac, if cross-lising in he US alleviaes firm s financing consrains as sressed in many papers in he lieraure (Errunza and Miller, 2; Lins e al. 25; and Hail and Leuz, 29), i s possible ha any differences in he esimaed cash flow coefficiens may be driven by US cross-lised firms. On he oher hand, i s worh menioning ha we find US cross-lised companies across all firms classes (consrained and unconsrained companies). This addiional es yields similar resuls (no abulaed) o hose found in our primary analysis. Finally, we propose o sor firms based on boh firm-level and insiuional characerisics before esimaing he cash flow sensiiviy. In his case, firms are caegorized, firs, according o he level of invesors proecion and, second, based on heir dividend payou raios (dividends/ebit). For insance, we will choose among a group of firms wih high invesors proecion scores only hose wih high dividend payou raios. This subsample will be considered as facing lower financing consrains. On he oher hand, firms wih lower invesors proecion scores and low dividend payou raios are considered as financially consrained. Model () and (2) in Table 3 repor resuls of esimaions based on our combined classificaion scheme. Consisen wih Fazzari e al. (988), we find ha invesmen-cash flow 6

13 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS coefficien is greaes for consrained firms (.8) while unconsrained firms exhibi a lower cash flow coefficien (.344). Independen variables Insiuional and firm-level classificaion Model () Unconsrained firms Model (2) Consrained firms Inercep Cash flow Marke-o-Book Size (.25) **.344 (.) *** -.8 (.53).46 (.) ***.46 (.98).8 (.) *** -. (.96).5 (.724) Counry dummies Indusry dummies Year dummies R N Table 3: The impac of firm s financing consrains on invesmen-cash flow sensiiviy: Combinaion of counrylevel and firm-level daa for firms classificaion Where i indexes firms and indexes years. In able 3, we classify firms according o boh firm-level and insiuional characerisics. Firms wih high invesors proecion scores and dividend payou raios are considered as financially 62

14 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN unconsrained. On he oher hand, firms wih lower invesors proecion scores and low dividend payou raios are considered as financially consrained. Financial firms were deleed from our sample. Counry, indusry and year dummies are included bu no repored. P-values for wo-ailed ess are in parenheses. One, wo or hree aserisks denoe significance a he, 5 and % levels, respecively. Conclusion In his paper, he invesmen-cash flow sensiiviy conroversy is examined using a sample of 44 counries. Invesmen decisions of consrained firms are shown o be highly sensiive o he availabiliy of inernal funds. This large sample evidence is based on a differen soring approach ha classifies firms according o a variey of counry-level variables insead of firm-level variables. We argue ha relying on insiuional feaures for firms classificaion will miigae some concerns abou he poenial endogeneiy of firm-level classificaion mehodology. In addiion, we also propose an inuiive measure of sock price informaiveness and examine is relaion wih he invesmen-cash flow coefficiens. Our findings suppor he resuls of Fazzari e al. (988) who argue ha higher invesmen-cash flow sensiiviy can be inerpreed as evidence ha firms are more financially consrained. References Aggarwal, R., Erel, I., Sulz, R., & Williamson, R. (28). Differences in governance pracices beween US and foreign firms: measuremen, causes, and consequences. Review of Financial Sudies 22, Bailey, W., Karoly A., & Salva, C. (26). The economic consequences of increased disclosure: evidence from inernaional cross-lisings. Journal of Financial Economics 8, Barry, C., & Brown, S. (985). Differenial informaion and securiy marke equilibrium. Journal of Financial and Quaniaive Analysis 2, Beaver, W., Lamber, R., & Morse, D. (98). The informaion conen of securiy prices. Journal of Accouning and Economics 2, Cleary, S. (999). The relaionship beween firm invesmen and financial saus. Journal of Finance 54, Cleary, S. (26). Inernaional corporae invesmen and he relaionships beween financial consrain measures. Journal of Banking and Finance 3, Cleary, S., & Booh, L. (28). Cash flow volailiy, financial slack and invesmen decisions. China Finance Review 2, Cleary, S., Povel, P., & Raih, M. (27). The U-shaped invesmen curve: heory and evidence. Journal of Financial and Quaniaive Analysis 42, -39 Coffee, J. C. (999). The fuure as hisory: he prospecs for global convergence in corporae governance and is implicaion. Norhwesern Universiy Law Review 93, Collins, D. W., & Khoar S.P. (989). An analysis of ineremporal and cross-secional deerminans of earnings response coefficiens. Journal of Accouning and Economics, Diamond, D., & Verrecchia, R. (99). Disclosure, liquidiy, and he cos of capial. Journal of Finance 56, Djankov, S., La Pora, R., Lopez-de-Silanes, F., & Shleifer, A. (28). The law and economics of self-dealing. Journal of Financial Economics 88, Durnev, A., Morck, R., Yeung, B., & Zarowin, P. (23). Does greaer firm-specific reurn variaion mean more or less informed sock pricing? Journal of Accouning Research 4, Errunza, V., & Miller, D. (2). Marke segmenaion and he cos of capial in inernaional equiy markes. Journal of Financial and Quaniaive Analysis 35, Fazzar S., Hubbard R.G., & Peersen B. (988). Financing consrains and corporae invesmen, Brookings papers on Economic Aciviy 9,

15 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS Freeman, R. (987). The associaion beween accouning earnings and securiy reurns for large and small firms. Journal of Accouning and Economics 9, Gelb, D., & Zarowin, P. (22). Corporae disclosure policy and he informaiveness of sock prices. Review of Accouning Sudies 7, Gilchris, S., & Himmelberg, C. (995). Evidence for he role of cash flow in invesmen, Journal of Moneary Economics 36, Greenwald, B., Sigliz, J., & Weiss, A. (984). Informaion imperfecions and macroeconomic flucuaions. American Economic Review 74, Hail, L., & Leuz, C. (26). Inernaional differences in he cos of equiy capial: do legal insiuions and securiies regulaion maer? Journal of Accouning Research 44, Hail, L., & Leuz, C. (29). Cos of capial effecs and changes in growh expecaions around U.S cross-lisings. Journal of Financial Economics 93, Kadapakkam, P.R., Kumar, P.C., & Riddick, L.A. (998). The impac of cash flow and firm size on invesmen: he inernaional evidence, Journal of Banking and Finance 22, Kaplan, S.N., & Zingales, L. (997). Do financing consrains explain why invesmen is correlaed wih cash flow? Quarerly Journal of Economics 2, La Pora, R., Lopez-de-Silanes, F., & Shleifer, A. (26). Wha works in securiies laws? Journal of Finance 6, - 32 La Pora, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. (22). Invesor proecion and corporae valuaion. Journal of Finance 57, Leuz, C., & Verrecchia, R. (2). The economic consequences of increased disclosure. Journal of Accouning Research 38, Lins, K.V., Srickland, D., & Zenner, M. (25). Do non-u.s. firms issue equiy on U.S sock exchanges o relax capial consrains? Journal of Financial and Quaniaive Analysis 4, Lundholm, R., & Myers, L.A. (22). Bringing he fuure forward: The effec of disclosure on he reurns-earnings relaion. Journal of Accouning Research 4, Meron, R. (987). A simple model of capial marke equilibrium wih incomplee informaion. Journal of Finance 42, Modiglian F., & Miller, M.H.(958). The cos of capial, corporaion finance, and he heory of invesmen, American Economic Review 48, Morck, R., Yeung, B., & Yu, W. (2). The informaion conen of sock markes: why do emerging markes have synchronous sock price movemens? Journal of Financial Economics 58, Moyen, N. (24). Invesmen-cash flow sensiiviies: consrained versus unconsrained firms. Journal of Finance 59, Myers, S.C. (984). The capial srucure puzzle, Journal of Finance 39, Myers, S.C., & Majluf, N.S. (984). Corporae financing and invesmen decisions when firms have informaion ha invesors do no have. Journal of Financial Economics 3, Oliner, S.D., & Rudebusch, G.D. (992). Sources of he financing hierarchy for business invesmen. Review of Economics and Saisics 74, Qian, J., & Srahan, P. (27). How laws and insiuions shape financial conracs: he case of bank loans. Journal of Finance 62, Scaller, H. (993). Asymmeric informaion, liquidiy, and Canadian invesmen. Canadian Journal of Economics 26, Sulz, R.M. (999), Globalizaion, corporae finance and he cos of capial. Journal of Applied Corporae Finance 2, Sulz, R.M. (29), Securiies laws, disclosure, and naional capial markes in he age of financial globalizaion. Journal of Accouning Research 47, Verrecchia, R. (2). Essays on disclosure. Journal of Accouning and Economics 32, 98-8 Warfield, T.D., & Wild, J.J. (992). Accouning recogniion and he relevance of earnings as an explanaory variable for reurns. Accouning Review 67,

16 ACRN Journal of Finance and Risk Perspecives Vol., Issue, p. 5-66, Oc. 22 ISSN Appendix A Counry-level variables descripion This able summarizes variables for legal origin and shareholder proecion. The common law variable represens a dummy se equal o for counries falling ino he common law legal sysem and for civil law counries. The Anidirecor righs variable is aken for Djankov e al. (28). I represens an index ha measures he level of proecion for minoriy invesors. Common law Ani-direcor righs dummy Panel A : Developed markes Ausralia Ausria Belgium Canada Denmark Finland France Germany Hong Kong Ireland Ialy Japan Neherlands New Zealand Norway Porugal Singapore Spain Sweden Swizerland UK

17 FIRM S FINANCING CONSTRAINTS AND INVESTMENT-CASH FLOW SENSITIVITY: EVIDENCE FROM COUNTRY LEGAL INSTITUTIONS Panel B : Emerging markes Argenina Brazil Chile China Colombia Czech Republic Greece Hungary India Indonesia Israel Korea (Souh) Malaysia Mexico Pakisan Peru Philippines Poland Russia Souh Africa Taiwan Thailand Turkey