Cash Flow Sensitivities With Constraints

Transcription

1 Cash Flow Sensiiviies Wih Consrains Todd Pulvino and Vefa Tarhan* *Norhwesern Universiy, Kellogg Graduae School of Managemen, and Loyola Universiy Chicago, School of Business. We hank Mahew Bille, Tim Bollerslev, Jon Garfinkel, Michael Fishman, Charles Himmelberg, Ravi Jagannahan, Rober A. Korajczyk, Iwan Meier, Tom Nohel, Arur Raviv, Paul Spind, Erns Shaumburg, Seven Todd, Toni Whied, and seminar paricipans a DePaul Universiy, he Federal Reserve Bank of Chicago, Financial Managemen Associaion, Loyola Universiy Chicago, Norhwesern Universiy, Tulane Universiy, and Universiy of Iowa for useful discussions.

2 ABSTRACT Empirical sudies of firms financing, invesmen, and payou policies ypically examine hose policies in isolaion. For example, dividend policy is ypically no considered when examining he deerminans of capial expendiures. In his paper, we examine corporae policies simulaneously, subjec o he consrain ha sources of cash mus equal uses of cash. We use his mehodology o re-examine he invesmen/cashflow lieraure. Unlike single-equaion sudies ha conclude ha firms reac o cashflow shocks by changing invesmens, we find ha firms reac by changing leverage. We conclude ha failing o employ a consrained simulaneous-equaion framework when examining corporae policies can cause omied variable bias and resul in large esimaion errors.

3 1. Inroducion In heir 1988 Brookings paper, Fazarri, Hubbard, and Peersen (hereafer FHP) documen a posiive relaionship beween inernally generaed cashflow and invesmen. They also find ha his relaionship is sronges for firms ha are mos likely o have difficuly accessing exernal capial markes. FHP inerpre heir findings as evidence of a difference beween he inernal and exernal coss of capial and conclude ha capial marke fricions may cause some firms o forego posiive NPV projecs. Because his resul, if rue, has serious implicaions regarding he efficiency wih which capial is allocaed in he economy, i provoked a number of addiional sudies examining he relaionship beween cashflow and invesmen. Many of hese sudies suppor he original FHP findings (FHP (1996, 2000), Almeida and Campello (2002), Boyle and Guhrie (2003), Calomiris and Hubbard (1989, 1990, and 1995), Hoshi, Kashyap, and Scharfsein (1991), Oliner and Rudebusch (1992), Hubbard, Kashyap, and Whied (1992), Pawlina and Renneboog (2005), Schaller (1993), Bond and Meghir (1994), Gilchres and Himmelberg (1995)). 1, 2 Ohers find compleely he opposie resul. For example, Kaplan and Zingales (1997 and 2000) conclude ha a monoonic relaion beween he degree of exernal marke consrains and cash-flow sensiiviy does no exis. 3 They find ha firms wih he easies access o capial markes display he larges 1 In addiion o cashflow/invesmen sensiiviy, here is evidence ha consrains in accessing exernal capial affec oher corporae decisions. For example, Korajczyk and Levy (2002) examine he connecion beween firms financial healh and he iming of heir financing decisions. They find ha, unlike consrained firms, unconsrained firms are able o issue securiies a economically favorable imes. 2 Minon and Schrand (1999) find ha higher cashflow volailiy increases he cos of exernal capial, and hence resuls in higher invesmen cashflow sensiiviy. In paricular hey find ha higher volailiy is correlaed wih lower capial expendiures, R&D, and adverising expenses. 3 Ohers such as Moyen (2004),and Ali (2003) find suppor for boh camps. For example, Moyen, using generaed daa, finds ha he resuls obained from her unconsrained model suppor Kaplan and Zingales. However, she also finds ha cashflow sensiiviy is higher for low dividend paying firms han i is for high dividend paying firms, supporing he resuls of FHP. 1

4 sensiiviy of invesmen o cash flow. Firms ha are financially consrained have he nex larges sensiiviy, and firms ha are parially consrained are leas sensiive. Their findings imply ha invesmen/cashflow sensiiviies are uncorrelaed wih access o capial markes. Using a larger sample of firms, Cleary (1999) confirms Kaplan and Zingales conclusion. In fac, Cleary finds ha invesmen-cash flow sensiiviies are acually inversely relaed o consrains--he mos consrained firms have he lowes sensiiviies and he leas consrained firms have he highes sensiiviies. Economeric problems associaed wih model misspecificaion may be he cause of he lack of consensus in he lieraure. The exising lieraure examines he cash flow sensiiviy of invesmen in isolaion, ha is, wihou accouning for he simulaneous effec ha cash flows have on invesmen and financing decisions. When invesmen and financing decisions are condensed ino a single capial expendiure equaion, he esimaed cashflow sensiiviy coefficien is likely o suffer from omied variable bias. Single-equaion models are also likely o produce inefficien coefficien esimaes because hey do no exploi he informaion conained in he consrain ha sources and uses of cash mus be equal. In addiion o economeric problems, single-equaion models produce coefficien esimaes ha are difficul o inerpre from an economic perspecive. For example, observing ha capial expendiures and cashflows are uncorrelaed is consisen wih he absence of financing consrains. However, i is also consisen wih he exisence of financing consrains if firms insulae capial expendiures by increasing asse sales o compensae for cashflow shorfalls. In his paper, we propose a model in which firms make heir invesmen and financing decisions joinly, subjec o he consrain ha sources and uses of funds are 2

5 equal. The model follows James Tobin s suggesion, in his discussion of he original FHP aricle, ha he firm joinly deermines invesmen, dividend paymens, and oher ways of allocaing is cash flow. Therefore, he auhors (should) model invesmen and dividends as depending on he same se of explanaory variables. Pu differenly, a firm s invesmen, financing, and disribuion decisions are necessarily inerrelaed by he ideniy ha sources of funds equal uses of funds. 4 A firm ha experiences a one dollar increase in operaing cash flow could increase capial expendiures, say, by one dollar. 5 However, i could also use he incremenal cash flow o pay down deb, increase shareholder disribuions, or make any combinaion of invesmen and financing decisions ha resul in a ne response of one dollar. Ex-pos, his consrain holds precisely. Ex-ane, i holds in expecaion. Specifically, our model conains nine equaions describing he invesmen (capial expendiures, acquisiions, and asse sales), financing (shor-erm deb issues, long-erm deb issues, and changes in cash balances), and disribuion (equiy issues, dividends, and share repurchases) decisions ha firms make. We esimae his model using a sample ha covers Our simulaneous equaion model exends he lieraure in wo primary ways. Firs, i provides an empirical esimae of he size of he omied variable bias ha resuls from esimaing he capial expendiure/cashflow sensiiviy in isolaion. Second, raher 4 While here are no papers ha esimae a sysem of cashflow sensiiviy equaions subjec o he sources and uses of funds consrain, here are some papers ha examine cashflow sensiiviy of seleced sources/uses variables. For example Gilchris and Himmelberg (1998) use a srucural model o find he marginal cos of funds and examine how i relaes o deb, cash, and working capial. Also Fazzari and Peersen (1993), examine he cashflow sensiiviy of working capial. Addiionally, Almeida, Campello, and Weisbach (2002), develop a model of how cash holdings respond o cashflow changes (cashflow sensiiviy of cash). Our resuls do no suppor heir predicion ha more of he cashflow increases will be used o build up he cash holdings in he case of he consrained firms compared wih unconsrained firms. 3

6 han focusing solely on capial expendiures, i provides a descripion of how firms adjus leverage, disribuions, and oher invesmen decisions in response o a change in cashflow. By examining each of hese responses simulaneously, we are able o make more accurae inferences regarding effecs of poenial capial consrains on invesmen. For example, we are able o deermine wheher firms respond o negaive changes in cashflow by cuing invesmen and mainaining leverage (consisen wih an inabiliy o access exernal capial) or by mainaining invesmen and increasing leverage (consisen wih an absence of capial consrains). Our empirical analyses yield hree primary findings. Firs, conrary o previously published sudies, he cash flow sensiiviy of invesmens is small, regardless of he firm s financial healh. Esimaing our muli-equaion model using he full sample, a one dollar increase in cash flow produces a saisically insignifican $0.001 increase in capial expendiures. In conras, previously published single-equaion sudies ypically find ha a one dollar increase in cash flow resuls in an increase in capial expendiures ranging beween $0.10 and $0.25, a resul ha we are able o replicae using a singleequaion analysis. Second, we find ha a firm s primary response o a change in cashflow is o adjus financial leverage. Unlike invesmen/cashflow sensiiviies, financing/cashflow sensiiviies are large and highly significan, regardless of he firm s financial healh. Using he full sample, a one dollar increase in cashflow resuls in a $0.78 decrease in oal deb and a $0.23 increase in cash balance. Thus, our resuls show ha ne deb changes by approximaely one dollar in reacion o a one dollar change in cashflow. This 5 In fac, he firm in quesion could even increase is capial expendiures even by more han a dollar, if he increase in he cashflow increases he firms deb and/or exernal equiy capaciy by more han a dollar. 4

7 resul implies he absence of a sysemaic underinvesmen problem. If such a problem exised, we would observe firms spending a porion of he incremenal cashflow o underake new projecs, raher han reiring capial. I is no possible o obain his evidence from single-equaion invesmen models ha examine he capial expendiure/cashflow sensiiviy in isolaion. Third, when we pariion he sample on he basis of posiive and negaive cashflow changes, we observe ha boh he invesmen and financing sensiiviies are symmeric. 6 For he full sample, a one dollar cashflow decrease causes firms o borrow an addiional $0.80 whereas a one dollar cashflow increase causes firms o repay $0.76 of deb. Wha is more remarkable is ha he symmery holds even for he subsample of firms ha are classified as being financially consrained. Firms in he financially consrained subsample borrow $0.81 in response o a $1 reducion in cashflow and reduce deb by $0.75 when hey experience a posiive one dollar change in cashflow. The borrowing abiliy of firms ha are perceived o have he weakes financial healh, in an environmen when hey are experiencing negaive cashflow shocks, combined wih he small invesmen/cashflow sensiiviy, provides srong evidence ha impedimens o accessing capial markes have lile impac on firms invesmen decisions. The organizaion of he res of he paper is as follows. Secion 2 conrass our sysem of equaions model wih he single-equaion models employed in he lieraure. In Secion 3, we develop he simulaneous-equaions model ha we use in our esimaions. The daa are described in Secion 4. Secion 5 presens and discusses empirical resuls and secion 6 concludes. 6 We hank he associae edior for suggesing ha we esimae our model for boh posiive and negaive cashflow changes. 5

8 2. Single Equaion versus Sysem of Equaion Models Single-equaion models used o sudy he effec of capial consrains on invesmen ypically esimae he following equaion: CAPX K CF (1) = β 1 + β 2MB + ε K where CAPX is capial expendiures, K is fixed asses, CF is cashflow, and MB is he raio of he marke value of asses o he book value of asses. A common inerpreaion of he cashflow coefficien in equaion (1) is ha a relaively small coefficien implies ha firms can immunize capial expendiures agains adverse cashflow realizaions. Conversely, a relaively large posiive coefficien is ofen inerpreed as evidence ha firms respond o negaive cashflow realizaions by decreasing capial expendiures, a reacion ha is consisen wih cosly access o exernal capial. To deermine wheher capial consrains affec invesmen, equaion (1) is ypically esimaed using samples of firms wih differen saes of financial healh. The underlying hypohesis is ha financially unhealhy firms are more likely o face capial consrains, and should herefore have a larger invesmen/casfhlow coefficien han financially healhy firms. Prior sudies ha esimae equaion (1) consisenly find a posiive relaionship beween capial expendiures and cashflow. As shown in Table 1, coefficien esimaes beween 0.10 and 0.25 are common. Using our sample of firms o esimae equaion (1), and afer maching he sample period and selecion crierion in Cleary (1999), produces a coefficien esimae of Based on he inerpreaion ha is common in he lieraure, 7 For Table 1 only, we resric he sample o o mach he period used by Cleary (1999). 6

9 his implies ha a one dollar decrease in cashflow resuls in a $0.16 decrease in capial expendiures. The problem wih his inerpreaion is ha i requires an implici assumpion ha firms do no sysemaically adjus o cashflow revelaions by alering oher sources and uses of cash. Insead, alernae responses such as raising deb or equiy, or selling asses, are subsumed in he error erm. This can be problemaic if he omied variables are correlaed wih cash flows, in which case he cashflow coefficien may be biased. For example, he direc effec of a negaive cashflow shock may be a reducion in capial expendiures. However, an indirec effec may be an increase in deb financing and a commensurae increase in capial expendiures. To deermine he oal effec on capial expendiures of a negaive cashflow shock, boh he direc and indirec effecs mus be considered simulaneously. In addiion o inducing a bias, failing o simulaneously accoun for he direc and indirec effecs can lead o incorrec conclusions regarding firms abiliies o finance heir projecs by raising exernal capial. For example, consider wo firms, one of which is financially unconsrained and he oher financially consrained. Each firm faces a one dollar decrease o cashflow. The unconsrained firm reacs by cuing capial expendiures by $0.20 and by issuing deb worh $0.80. The consrained firm is unable o access exernal capial and insead responds by cuing capial expendiures by $0.20 and by selling $0.80 worh of asses. In his example, a single-equaion model would show idenical invesmen/cashflow sensiiviies even hough one firm is unconsrained and he oher is consrained. The presence of financial consrains is eviden no in he invesmen/cashflow sensiiviy, bu in he deb/cashflow sensiiviy. 7

10 A second example shows ha inerpreing a posiive invesmen/cashflow sensiiviy relaion as evidence of financial consrains can also be problemaic. Consider a firm ha responds o a one dollar decrease in cashflow by alering is sraegy from one of organic growh o one of deb-financed acquisiions. Because organic growh is reduced, capial expendiures will decrease leading o a posiive invesmen/cashflow sensiiviy. However, in his example, he firm is no financially consrained as i was able o access he deb markes o obain financing for acquisiions. I is possible o consruc oher examples ha sugges ha inferences regarding access o capial markes canno be made solely on he basis of invesmen/cashflow sensiiviies as is ypical in single-equaion sudies. However, i is difficul o sysemaically quanify he sign and magniude of he resuling bias induced by ignoring he firm s oher decision variables, especially when he full array of decision variables available o he firm are considered. Therefore, raher han aemping o quanify he bias analyically, we measure he bias empirically by esimaing he simulaneousequaion model described in he following secion. 3. Model The manager s ask is o selec opimal values for invesmen and financing decision variables, given he expeced values for exogenous and predeermined variables. Table 2 describes he variables ha ener he opimizaion problem. In solving his problem, he manager faces he consrain ha ex-pos, sources of funds mus equal uses of funds: Δ Cash + RP + DIV + CAPX + ACQUIS ΔLTD ΔSTD EQUISS ASALES CF + OTHER (2) 8

11 In equaion (2), decision variables have been colleced on he lef-hand side of he ideniy for convenience. OTHER is he difference beween he source and use variables used and capures miscellaneous source and use iems ha are no explicily included in he model. Our measure of cash flow (CF) is defined in equaion (3): CF = EBITDA INTEXP TAX ΔNWC (3) where EBITDA is earnings before ineres, axes, and depreciaion. Because EBITDA is joinly deermined by he firm s pas invesmens and by consumers curren behavior, i is assumed o be exogenous o he firm in he curren period. INTEXP is ineres expense and TAX is cash axes. Boh of hese variables are assumed o be deermined by financing and invesmen decisions in prior years and are herefore aken as exogenous in he curren period. Similarly, ΔNWC which equals change in ne working capial from - 1 o, is assumed o depend on pas invesmen decisions and curren sales projecions. Thus, CF is assumed o be exogenous and represens inernally generaed funds ha are available for underaking invesmens or for making paymens o shareholders and principal paymens o debholders. Because, as a simple maer of accouning, he sources/uses ideniy specified by equaion (2) is always saisfied for ex-pos quaniies, i conveys lile economic conen. Wha is imporan from an economic sandpoin is ha he consrain also holds for exane values, condiional on forecass of end-of-period exogenous variables. This ex-ane budge consrain is expressed as: ~ ~ ~ ~ ~ ~ ~ ~ Δ Ca ~ sh + RP + DIV + CAPX + ACQUIS ΔLTD ΔSTD EQUISS ASALES = CF ˆ + OTHˆ ER (4) 9

12 where ildes represen decision variables and has represen exogenous variables ha mus be forecased. Equaion (4) saes ha a he beginning of period, when firms make heir invesmen and financing decisions, he planned values of decision variables are seleced such ha he expeced end-of-period sources/uses consrain is saisfied. This implies ha a firm canno plan o allocae funds in excess or defici of he amoun i expecs o generae, eiher hrough operaions or financing, during he curren period. For choice variables, ex-ane quaniies are planned values, deermined based on beginning-of-period known quaniies. While he firm has precise conrol over ex-ane (planned) levels, ex-pos quaniies depar sochasically from heir ex-ane counerpars as follows: CAPX ACQUIS M ΔLTD ΔCASH = CAPX ~ ~ ACQUIS M + ~ ΔLTD ~ ΔCASH e e e e CAPX, ACQUIS, M ΔLTD, ΔCASH, (5) e CAPX,,... e CASH, are error erms associaed wih he nine financing and invesmen decision variables, and represen deviaions of acual quaniies from planned quaniies. Similarly, ex-pos exogenous source variables (CF and OTHER) equal forecass of hese variables made a he beginning of he period plus forecas errors: CF OTHER = CF ˆ e (6) CF, + OTHER ˆ eother, Taken ogeher, equaions (4), (5), and (6) imply ha he error erms are relaed in he following manner: 10

13 e Δ e e = e + e (7) Cash + e RP + e DIV + e CAPX + e ACQUIS e ΔLTD e ΔSTD EQUISS ASALES CF OTHER We assume ha when making invesmen and financing decisions, firms aemp o achieve long-run opimal levels subjec o available invesmen opporuniies. The proxy variable used for invesmen opporuniies is he raio of marke value of equiy o book value of equiy (MB). In addiion, firm size is included as an exogenous variable o conrol for he possibiliy ha invesmen opporuniies and access o exernal capial depend on firm size. Firm size (SIZE) is measured as he naural logarihm of he book value of asses. * CAPX ACQUIS M * ΔLTD ΔCASH * * = MB ˆ M SIZE ˆ + CF ˆ L OTHER ˆ (8) Our model assumes ha firms aemp o minimize a penaly funcion ha depends on deviaions from opimal levels and on he speed of adjusmen owards opimal levels. If he penaly funcion is quadraic in hese wo coss, hen minimizing he penaly funcion subjec o he consrain ha sources of funds mus equal uses of funds produces he linear equaions ha we esimae in he empirical secion of he paper. If he rue cos funcion has a more complicaed form, he equaions ha we esimae should be inerpreed as being reduced form. By making invesmen and financing decisions o minimize he cos of being a subopimal levels, subjec o he consrain specified by equaion (4), he following sysem of nine equaions is obained: 11

14 Δ Δ = Δ Δ OTHER CF L SIZE MB M CASH LTD ACQUIS CAPX K CASH LTD ACQUIS CAPX ˆ ˆ ˆ ˆ ~ ~ ~ ~ M M (9) Where, K, M, and L are marices of response coefficiens of size 9X9, 9X2, and 9X2 respecively. Subsiuing equaion (9) ino equaion (5) gives he sysem of equaions o be esimaed: Δ Δ = Δ Δ Δ Δ CASH LTD ACQUIS CAPX e e e e OTHER CF L SIZE MB M CASH LTD ACQUIS CAPX K CASH LTD ACQUIS CAPX,,,, ˆ ˆ ˆ ˆ M M M (10) The sources and uses consrain requires ha he parameer marices saisfy: [ ] [ ] [ ] ' ' 0'; ' 0'; ' i L i M i K i = = = (11) Where i' is a uni vecor of appropriae order. The inerpreaion of equaion (11) is ha when here is a one dollar shock in a source or use variable, he oal response of he invesmen and financing variables is opposie in sign o he shock and adds up o one dollar. For example, if he source variable, CF, increases by one dollar, oher source variables mus decline by a dollar, use variables mus increase by one dollar, or some combinaion of he response of source and use variables mus add up o one dollar. If, insead of cashflow, he shock originaes from a variable ha represens neiher a source nor a use of funds in he curren period, he oal response across he sysem of equaions mus sum o zero. These non-source/non-use variables are he lagged dependen

15 variables and he exogenous variables, MB and SIZE. For example, consider he case where he esimaed coefficien for he SIZE variable in he capial expendiures equaion is 0.30, implying ha capial expendiures go up by 30 cens when he naural log of book asses increases by one. Since capial expendiures is a use variable, and because sources of funds mus equal uses of funds, eiher oher use variables mus decrease by 30 cens, ne source variables mus increase by 30 cens, or some combinaion of hese responses mus sum o 30 cens. As a resul, he coefficiens on SIZE will sum o zero. Similar consrains hold for MB and lagged dependen variables. 4. Daa The annual daa we use covers Compusa firms from 1950 o 2003, excluding financial insiuions and uiliies. Because he model conains lagged variables, he nine equaion sysem specified in equaion (10) is esimaed over he period Table 2 describes he variables used in he model in erms of heir sources/uses characerisics, and also in erms of wheher hey ac as endogenous or exogenous variables in he model. Table 3 describes how he variables used in he model are consruced from Compusa definiions. 8 Means and sandard deviaions for each of he variables as a percenage of oal asses (excep for SIZE and MB) are presened in Table 4. In addiion o he full sample, summary saisics are provided for hree subsamples of firm-years segmened based on Shumway (2001) bankrupcy probabiliies which are used o proxy for financial consrains. Firm-years wih prediced bankrupcy probabiliies below he 25h percenile consiue he unconsrained subsample, firm-years wih 13

16 prediced bankrupcy probabiliies above he 75h percenile consiue he consrained subsample, and firm-years ha fall beween he above wo perceniles consiue he parially consrained subsample. Spliing he sample in his way resuls in an uneven number of firms in each subsample he parially consrained subsample conains approximaely wo imes he number of firm-years as do he consrained and unconsrained subsamples. The benefi of his mehod of segmenaion over a simple rifurcaion of he sample is ha he idenificaion of consrained and unconsrained firmyears is more accurae. Table 4 shows ha mean cashflow (as a percen of oal asses) increases monoonically wih financial healh. The mean cashflow for he financially unconsrained subsample is wice as large as he mean cashflow for he parially consrained subsample. Furhermore, mean cashflow is negaive for he financially consrained subsample. There is a similarly monoonic relaionship beween dividends and financial healh. Unconsrained firms pay larger dividends (as a percen of oal asses) han consrained firms. Addiionally, reliance on shor-erm deb increases monoonically, as financial healh deerioraes. Marke-o-book raio is used in he regressions as a proxy for invesmen opporuniies. Based on his proxy, unconsrained firms have he riches invesmen opporuniies, while financially consrained firms have he poores invesmen opporuniies. Financially unconsrained firms, which have high marke-o-book raios also appear o be less acquisiive, which is consisen wih hese firms having healhy inernal growh opporuniies. Finally, like he marke-o-book raio, firm size exhibis a 8 To avoid dropping observaions wih missing Compusa variables, we replace missing daa wih zero. We also esimaed he model afer dropping observaions wih missing daa. Resuls are no significanly 14

17 monoonic relaionship wih financial healh unconsrained firms end o be larger whereas financially consrained firms end o be smaller. 5. Empirical Resuls The sysem specified in equaion (10) is esimaed using wo mehods for forecasing he endogenous variables. The firs forecas model, which we refer o as he perfec foresigh model, assumes ha planned values of he decision variables equal end-ofperiod (ex-pos) realizaions of hese variables. The second forecas model uses I/B/E/S analyss' forecass o consruc esimaes of inernally generaed cash flow (CF). 9 Because boh approaches generae similar esimaes, resuls only from he perfec foresigh model are repored. The model is firs esimaed for he full sample using levels (no firs differences) wihou firm and year fixed effecs. Following his, resuls are presened using firs differences for subsamples of daa based on firms financial healh Model Esimaion Resuls from esimaing equaion (10) subjec o he resricion specified by equaion (11) are shown in Tables 5A and 5B. The esimaion uses he full sample, consising of affeced by how missing daa is reaed. 9 Forecased cashflow is measured using he following equaion: ~ CF = CF + ( IBFIMD)( CSHO) NI [ ] XIDO where IBFIMD is he median earnings per share esimae for he curren fiscal year provided by I/B/E/S, CSHO is common shares ousanding, NI is ne income, and XIDO is exraordinary iems and disconinued operaions (all Compusa annual mnemonics.) The firs erm in he above equaion is he realized cashflow. The second erm adjuss realized cashflow o reflec differences beween expeced and acual ne income. Finally, exraordinary iems are subraced o reflec he fac ha had hey been expeced, hey would be unlikely o be exraordinary. 15

18 244,081 firm-years. The regressions are esimaed wih robus sandard errors ha accoun for wihin-firm clusering (18,849 clusers.) Esimaed responses of each of he endogenous financing and invesmen variables o changes in cash flow, he residual sources/uses variable (OTHER), marke-o-book raio, and firm size are repored in Table 5A. Column 1 displays he casfhlow coefficiens. As expeced, a one dollar increase in casfhlow resuls in an increase in use variables and a decrease in source variables. In he case of use variables, he coefficiens in he firs column of Table 5A show ha a one dollar increase in cashflow causes a $0.03 increase in capial expendiures (saisically insignifican), a $0.01 increase each in dividends and share repurchases, and a $0.24 increase in cash balances (all saisically significan). The firs column of Table 5A also shows ha posiive cashflow innovaions cause oher source variables o decline. Firms reac o a $1 cashflow shock by reiring $0.15 of long-erm, and $0.58 of shor-erm deb. Boh of he esimaed deb coefficiens are saisically differen from zero a he 1% level. Asse sales and equiy issues remain unchanged while acquisiions decline (significan a he 10 percen level.) In all, 7 of he 8 coefficiens in he esimaed sysem have he expeced sign, and he shareholder disribuion and leverage variables are significan a he 1% level. Because of he consrain specified in equaion (11), a one dollar increase in cashflow mus resul in a one dollar decrease in oher sources of funds, a one dollar increase in uses of funds, or some combinaion of a reducion in sources or increase in uses o exacly offse he one dollar cashflow increase. The coefficiens repored in he firs column of Table 5A show ha his indeed is he case use variables increase by $0.27, while source variables decrease by $0.73. While he sign of boh oal uses and 16

19 oal sources are as expeced, he primary conclusion ha emerges from hese resuls is ha financing/cashflow sensiiviies dominae invesmen/cashflow sensiiviies. Ne deb (long-erm deb plus shor-erm deb minus cash balance) decreases by $0.97 and ne invesmens increase by a meager $0.02 (capial expendiures increase by $0.03.) The variable OTHER in Table 5A is defined o be he difference beween miscellaneous source and use variables no explicily accouned for in he model. For example, a decrease in oher asses represens a source of funds as does an increase in oher liabiliies. Neiher one of hese balance shee accouns is explicily modeled since hey do no represen economically imporan decisions. Thus, he effecs of all miscellaneous sources and uses are subsumed in OTHER. Because of he way in which OTHER is defined, i has an inerpreaion ha is similar o he cash flow variable. A one dollar shock in OTHER mus be offse by a one dollar increase in uses, a one dollar decrease in oher sources, or some combinaion of he wo. As is he case for cashflow shocks, resuls displayed in he second column of Table 5A show ha long-erm and shor-erm deb are he primary buffers o changes in oher asses and liabiliies. The final variables in Table 5A are marke-o-book raio (MB) and firm size (SIZE). Since hese variables represen neiher sources nor uses of funds, he response of he sysem o innovaions in hese variables sums o zero. Resuls shown in he fourh column of Table 5A sugges ha firms wih higher marke-o-book raios are more likely o issue equiy. When disribuing cash o shareholders, high marke-o-book raio firms rely more on share repurchases and less on dividends. High marke-o-book raio firms are also likely o reduce boh shor and long-erm deb compared o low marke-o-book raio firms. Overall, hese resuls are consisen wih wha one would expec of firms 17

20 wih significan growh opporuniies. Size is also relaed o firms invesmen, financing, and disribuion decisions. In general, larger firms appear o be more acive paricipans in financial markes, having higher levels of acquisiions, equiy issues, dividend paymens, share repurchases, and boh long and shor-erm deb issues. Coefficiens for he lagged endogenous variables (esimaes for marix K in equaion (10)) are displayed in Table 5B. The esimaed coefficiens of he marix describe how curren invesmen and financing variables depend on lagged invesmen and financing variables. Diagonal elemens of K can be loosely inerpreed as own adjusmen raes; he smaller in absolue value is he jh diagonal coefficien, he less ineria is displayed in he adjusmen of he jh variable. Dividends, capial expendiures, and asse sales display he mos ineria, wih lagged coefficiens of 0.92, 0.87, and 0.84, respecively. These coefficiens reflec he sicky naure of dividends, and he muli-year naure of capial expendiure programs. Conversely, leverage variables (long and shorerm deb issues, and change in cash balances) show very lile ineria, indicaing ha hese variables adjus quickly o shocks. In addiion, deb variables respond srongly in he curren period o lagged capial expendiures (boh in erms of magniude and saisical significance) reflecing he use of deb o finance capial expendiure programs. Off-diagonal elemens provide evidence ha changes in cash balances and boh long and shor-erm deb issues ac as shock absorbers in he sysem. In general, he larges off diagonal elemens (in absolue value) are found in he rows associaed wih hese hree leverage variables, implying ha curren-period cash holdings and deb issues respond srongly o prior changes in oher sysem variables. Conversely, columns associaed wih leverage variables have by far he smalles off-diagonal coefficiens 18

21 indicaing ha lagged changes in hese variables do no influence he res of he sysem in he curren period. In sum, he relaive sizes (in absolue value) of he off-diagonal rows and columns, along wih small diagonal coefficiens, sugges ha deb absorbs, bu does no ransmi, shocks o he res of he sysem Model Esimaion Using Firs Differences Because of he cross-secional naure of he analysis described in he preceding secion, regression coefficiens reflec differences in capial expendiures across firms raher han wihin firms. Therefore, hey provide only an indirec esimaion of how individual firms aler invesmen and financing variables in response o cashflow shocks. To provide a more direc esimae, we firs ransform all variables from levels o firs differences and use ime dummies o accoun for fixed firm and year effecs. The model in firs differences mus saisfy he consrain ha changes in sources of funds equal changes in uses of funds. 10 Resuls from esimaing he firs-difference version of he model are presened in Table 6. For breviy, only cashflow coefficiens and adjused R 2 for each of he nine equaions are presened. To faciliae comparison, cashflow coefficiens repored in Table 5A using levels raher han firs differences are replicaed in Table 6. Table 6 shows ha using firs differences provides even sronger evidence ha firms respond o cashflow shocks by alering financing raher han invesmen variables. The cashflow coefficien from he capial expendiures equaion is using firs differences versus 10 Cleary (1999) does no use firs differences, bu insead ransforms variables by subracing firm and year means. In our analysis, ransforming variables in his way makes i difficul o inerpre he sources/uses consrain. Neverheless, we also performed he analysis using his ransformaion. Resuls (unrepored) are nearly idenical o hose obained using firs differences. 19

22 0.031 using levels. This implies ha a one dollar cashflow change affecs capial expendiures by less han one penny. The firs difference analysis confirms ha firms reac o cashflow changes primarily by alering deb and cash balances. A one dollar decrease in cashflow causes long-erm deb o increase by $0.14, shor-erm deb o increase by $0.63, and cash balances o decrease by $0.23. In addiion, here is an economically small bu saisically significan decrease in share repurchases. Overall, resuls presened in Table 6 indicae ha firms do no cu capial expendiures in response o negaive cashflow shocks bu insead reac by increasing ne deb Effecs of Capial Consrains Prior invesmen/cashflow sudies focus on wheher consrains in accessing exernal capial affec firms invesmen levels. Based on resuls presened in Tables 5 and 6, here is lile evidence ha financing consrains aler invesmen levels for he broad sample. However, he effec could be absen for he majoriy of firms, bu migh sill exis for financially unhealhy firms. The approach aken in prior sudies is o segmen he sample based on some measure of financial healh and hen deermine wheher here is a relaionship beween financial healh and invesmen/cashflow sensiiviy. In heir original paper, FHP (1988) segmened firms according o dividend payou raios. Firms ha paid no dividends were deemed o be financially consrained, firms ha paid small dividends relaive o ne income were deemed o be parially financially consrained, and firms ha paid moderae-o-large dividends relaive o ne income were deemed o be unconsrained. Subsequen papers quesioned he legiimacy of simply using dividend levels as a deerminan of financial healh and insead used a 20

23 range of financial variables o classify firms financial healh. For example, Cleary (1999) uses muliple discriminan analysis, similar o ha used by Alman o generae Z scores for bankrupcy predicion. To conduc he discriminan analysis, Cleary generaes hree groups of firms. Firms ha decrease heir dividends in a given period are placed in Group 1, firms ha increase heir dividend are placed in Group 2, and firms ha leave heir dividends unchanged are placed in Group 3. Using financial variables ha are likely o reflec a firms classificaion ino Group 1 or Group 2, Cleary calculaes Z FC, a pseudo Z-Score ha reflecs a firm s degree of financial consrain. In his paper, we follow a similar approach. However, because firms aler dividend policies for many reasons unrelaed o financial consrains, we segmen firms by bankrupcy probabiliy raher han change in dividend policy. 11 There are a number of ways o calculae bankrupcy probabiliy. Perhaps he bes approach would be o use a Meron-ype model ha accouns for he volailiy of he firm s asses as well as he firm s capial srucure (Meron 1974.) Ye because of problems in esimaing asse volailiy and in gahering deailed capial srucure daa for individual firms, his approach is cumbersome o implemen over a large sample. An alernaive approach is o use bankrupcy probabiliies calculaed using reduced-form models such as he Alman Z-Score model or he Shumway (2001) hazard model. Boh of hese models are easy o implemen and provide reasonably accurae rankings of financial healh. Shumway s hazard model in paricular has been shown o produce resuls ha are similar o hose produced using he Meron asse-based model (Bharah 11 In addiion o segmening he daa using he Shumway (2001) bankrupcy probabiliy model, we also formed subsamples by using Alman s Z-Scores, and by replicaing Cleary s (1999) discriminan analysis wih boosrapped sandard errors (able available upon reques.) All hree approaches produce similar resuls indicaing ha he analysis is robus o subsample formaion and sandard error esimaion. 21

24 and Shumway (2004)). Shumway calculaes bankrupcy probabiliies using he following model: 12 [ NI/A (L/A) 0.467ln(RelaiveSize) 1.809(Re -1 Re Marke 1 ) (Sigma)] Pr = e (13) where NI/A is ne income divided by oal asses; L/A is oal liabiliies divided by oal asses; Relaive Size is he naural log of firm marke capializaion divided by he oal marke capializaion of he NYSE and AMEX; Re -1 Re Marke -1 is he firm s equiy reurn over he prior year minus he marke reurn over he prior year; Sigma is he sandard deviaion of he residual from a regression of firm reurns on marke reurns over he prior year. To classify firms according o bankrupcy probabiliy, we calculae he 25 h and 75 h perceniles of he prediced bankrupcy probabiliy across he enire sample. Firmyears wih probabiliies below he 25 h percenile are classified as financially unconsrained (FUC), firm-years wih bankrupcy probabiliies above he 75 h percenile are classified as financially consrained (FC), and all oher firm-years are classified as parially financially consrained (PFC). Because of he ordinal naure of his caegorizaion scheme, he precise level of bankrupcy probabiliy produced by Shumway s model is no imporan for our purposes. To deermine if firms invesmen/cashflow sensiiviies depend on wheher or no hey are consrained from accessing exernal capial, we esimae he sysem specified by equaion (10), subjec o he consrain in equaion (11) for each of he hree groups (FC, FUC, and PFC). Equaion (10) is esimaed using firs differences and year dummies. 12 Shumway (2001), Table 6B, p

25 Raher han presening coefficien esimaes for all variables, we focus on he sensiiviies of each of he invesmen and financing variables o changes in cashflow. Panel A of Table 7 presens resuls for each of he subsamples. In addiion, resuls for he full sample from Table 6 are repeaed for ease of comparison. Resuls displayed in Panel A of Table 7 show ha over he full sample and he hree subsamples, 29 of he 36 coefficiens have he expeced sign (i.e. use variables increase and source variables decrease in response o posiive cashflow changes) and 19 of he 29 are saisically significan. Only one of he significan coefficiens has he wrong sign (he acquisiions coefficien in he parially consrained sample, which is significan a he 10% level.) Consisen wih he full sample resuls, firms reac o a one dollar change in cashflow by alering financial leverage, regardless of financial healh. For all of he subsamples, he sensiiviy of leverage o changes in cashflow overwhelms he sensiiviies of boh invesmens and shareholder disribuions. In fac, he capial expendiures coefficien is less han 0.01 in all of he subsamples. Thus, he approximaely 0.10 o 0.25 invesmen/cashflow sensiiviy documened in previous single-equaion sudies disappears when he simulaneous equaion model is esimaed. While deb/cashflow sensiiviies are similar across subsamples, he changes in shor-erm versus long-erm deb differ monoonically across he subsamples. The shorerm deb sensiiviy for he unconsrained subsample is 0.38 suggesing ha firms in his sample reac o a one dollar decrease in cashflow by borrowing $0.38 of shor-erm deb. Conversely, sensiiviies for parially consrained and consrained firms are 0.58 and 0.70, respecively. Since change in cash balance and changes in overall leverage are similar across subsamples, he mirror image of shor-erm deb sensiiviy holds rue for long- 23

26 erm deb sensiiviy. Long-erm deb/cashflow sensiiviies are 0.35, 0.17, and 0.07, for he unconsrained, parially consrained, and consrained samples, respecively. These resuls imply a greaer reliance by financially unhealhy firms on shor-erm deb. Diamond (1991), using a model where borrowers have privae informaion abou heir fuure credi raing, finds ha borrowers wih lower credi raing can issue only shorerm deb, in spie of he fac ha hey prefer long-erm deb. The resuls of Table 7 and Table 8 (which will be discussed in he nex secion) provide evidence in suppor of his hypohesis. In deermining wheher capial marke consrains induce underinvesmen, we argue ha he relaive magniudes of invesmen/cashflow and financing/cashflow sensiiviies, raher han jus he magniude of he invesmen/cashflow sensiiviy, should be considered. Resuls in Panel A of Table 7 show ha financing/cashflow sensiiviies dominae invesmen/cashflow sensiiviies for firms in all caegories. Thus, here is lile evidence ha firms are forced o forgo posiive NPV projecs because hey are unable o access exernal capial. If firms were prevened from invesing in valuable projecs due o capial marke fricions, we would expec a more dramaic change in invesmens and a much less dramaic change in financial leverage in response o cashflow changes. Panel B of Table 7 examines differences beween coefficiens for he subsamples of daa presened in Panel A. The resuls in Panel B show a srong similariy beween firms in all subsamples. Of he 27 differences considered, only 9 are saisically differen from zero. The significan pair-wise differences relae o shareholder disribuions and shor versus long-erm deb. There is no evidence ha invesmen/cashflow sensiiviies vary across subsamples. 24

27 5.4. Posiive and Negaive Cashflow Shocks A poenial problem wih resuls presened in Table 7 is ha hey assume symmery: he way in which a firm reacs o a cashflow increase is assumed o be equal and opposie of he reacion o a cashflow decrease. However, he effec of capial consrains on invesmen is really abou being able o raise exernal funds when faced wih negaive innovaions in cashflow, no reiring capial in response o posiive innovaions. Therefore, in his secion we examine he symmery of invesmen/casfhlow and financing/cashflow sensiiviies. Towards his end, we esimae equaion (10) where he righ hand side variables include an ineracion variable equal o change in cashflow muliplied by a dummy variable ha akes he value of one when change in cashflow is posiive and zero when change in cashflow is negaive. Firms reacions o posiive and negaive cashflow shocks are displayed in Table 8. For example, for he full sample (Panel A), in he shor-erm deb equaion, he esimaed coefficiens for he cashflow variable and he ineracion erm are and 0.059, respecively. This implies ha when here is a negaive one dollar change in cashflow, firms borrow an addiional $0.67 of shor-erm deb. Conversely, when here is a posiive one dollar change in cashflow, firms pay down $0.61 of shor-erm deb. The saisic on he ineracion erm indicaes ha he difference beween he negaive and posiive shor-erm-deb/cashflow sensiiviies is no saisically significan. Of he nine variables sudied, here is saisical evidence of asymmery in wo variables, capial expendiures and dividends. Regarding capial expendiures, he coefficiens indicae ha firms increase capial expendiures by $0.008 when cashflow 25

28 increases by one dollar and also increase capial expendiures by $0.007 when cashflow decreases by one dollar. Thus, while here is a saisically significan difference beween invesmen cashflow coefficiens depending on wheher he cashflow change is posiive or negaive (-saisic equal o 2.22), he economic implicaion is ha capial expendiures are almos compleely insulaed from shor-erm cashflows. The significan asymmery regarding dividends suggess ha firms, on average, increase dividends bu are more likely o do so following cashflow increases. Resuls for subsamples of firms segmened based on financial healh (panels B, C, and D of Table 8) confirm ha, in general, firms respond symmerically o negaive and posiive changes in cashflow. Overall, only six ou of he 36 ess of symmery indicae an asymmeric response. Regarding capial marke access, here is virually no evidence ha firms reac differenly o posiive versus negaive changes in cashflow. Of he 12 coefficiens ha represen firms equiy issues, changes in long-erm deb, and changes in shor-erm deb, none display asymmery a he 5 percen level of saisical significance. If anyhing, he evidence presened in Table 8 suggess ha firms borrow more in response o a $1 cashflow decrease han hey pay back in response o a $1 cashflow increase. For example, for he financially consrained subsample (Panel D of Table 8), shor-erm deb increases by $0.76 in response o a $1 cashflow decrease, and decreases by $0.66 in response o a $1 cashflow increase. The $0.10 difference is significan a he 10% level. A similar effec is eviden wih respec o oal deb. This, combined wih he economically small sensiiviy of capial expendiures o cashflows, provides lile suppor for he noion ha capial marke consrains cause firms o forgo posiive NPV projecs. 26

29 6. Conclusion Typically, corporae invesmen, disribuion, and financing polices are evaluaed in isolaion using a single-equaion OLS mehodology. As illusraed in his paper, he single-equaion approach can be problemaic because i ignores ineracions beween corporae policies. As a resul, coefficien esimaes can suffer from omied variable bias and can lead o incorrec inferences regarding deerminans of corporae policies. To demonsrae he problem ha arises in single-equaion sudies, we examine he sensiiviy of invesmen o cashflow. The invesmen/cashflow lieraure is welldeveloped and has generally produced conflicing resuls. While virually all sudies agree ha for he ypical firm, he invesmen/cashflow sensiiviy is saisically posiive, here is broad disagreemen over he effecs of financial consrains on invesmen/cashflow sensiiviies. Some sudies conclude ha financially consrained firms exhibi larger invesmen/cashflow sensiiviies han financially unconsrained firms, whereas oher sudies find he opposie resul. Invesmen/cashflow sensiiviies from prior sudies range beween 0.10 and 0.25, suggesing ha firms increase invesmen when cashflow rises and decrease invesmen when cashflow falls. Using he single-equaion mehodology followed in prior sudies, we obain similar resuls (invesmen/cashflow sensiiviy equal o 0.16.) However, when we examine he invesmen/cashflow relaionship in a larger conex by simulaneously considering oher corporae policies, we find ha he posiive relaionship beween invesmen and cashflow disappears. Regardless of he firm s degree of financial consrains, here is, on average, no relaionship beween invesmen and cashflow. 27

30 Raher, firms insulae capial expendiures from cashflow flucuaions by changing ne deb. When cashflows are low, firms increase deb and reduce cash balances. When cashflows are high, firms reduce deb and increase cash balances. Our resuls, while considerably differen from prior sudies, are inuiive. Capial expendiures ypically reflec long-erm invesmen programs and, absen severe financial marke fricions, are unlikely o be affeced by shor-erm cashflow flucuaions. Financing decisions are much less cosly o change and herefore provide a superior alernaive o accommodae cashflow flucuaions. The invesmen/cashflow and financing/cashflow sensiiviies documened in his paper provide srong suppor for his inuiion. Overall, we find no evidence ha cosly access o exernal financial markes causes firms o underinves. While our resuls have implicaions for he invesmen/cashflow lieraure, he more imporan poin demonsraed in his paper is ha examining corporae policies (i.e. invesmen, disribuion, financing) in isolaion can generae misleading resuls. Raher han modeling policies independenly, hey should be modeled simulaneously, subjec o he consrain faced by every firm a all imes sources and uses of cash mus be equal. 28

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