The Impact of Capital Market Imperfections. on Investment-Cash Flow Sensitivity * Şenay Ağca George Washington University. Abon Mozumdar Virginia Tech

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1 The Impac of Capial Marke Imperfecions on Invesmen-Cash Flow Sensiiviy * Şenay Ağca George Washingon Universiy Abon Mozumdar Virginia Tech This version: February 14, 2007 Absrac We examine he invesmen-cash flow sensiiviy of U.S. manufacuring firms in relaion o five facors associaed wih capial marke imperfecions fund flows, insiuional ownership, analys following, bond raings, and an index of aniakeover amendmens. We find a seady decline in he esimaed sensiiviy over ime. Furhermore, we find ha invesmen-cash flow sensiiviy decreases wih increasing fund flows, insiuional ownership, analys following, aniakeover amendmens and wih he exisence of a bond raing. The overall evidence suggess ha invesmen-cash flow sensiiviy decreases wih facors ha reduce capial marke imperfecions. Keywords: Invesmen-cash flow sensiiviy, capial marke imperfecions, fund flows, insiuional ownership, analys following, bond raings, corporae governance JEL Classificaion: G14, G31, G32 * Şenay Ağca, School of Business, George Washingon Universiy, 2201 G Sree, Funger Hall 505, Washingon, D.C , Tel: (202) , Fax: (202) , sagca@gwu.edu; Abon Mozumdar, Pamplin College of Business, Virginia Tech, 7054 Haycock Road, Room 352, Falls Church, VA 22043, Tel.: , Fax: , abon@v.edu. We are graeful o Andrew Merick for kindly providing us wih he corporae governance daa, and o Toni Whied for kindly making available on her web page her GAUSS programs for implemening cerain ess and esimaors. We hank Gonul Colak, David Dobofsky, Gayane Hovakimian, Florian Heider, Saiyid Islam, Chrisopher Jones, Mark Klock, Amnon Levy, Erlend Nier, Oguzhan Ozbas, Bernell Sone, and he seminar paricipans a he 2004 European Finance Associaion meeing, he 2004 Washingon Area Finance Conference, and 2005 European Financial Managemen Associaion meeing for helpful commens. Ağca acknowledges a summer research gran from he School of Business, George Washingon Universiy. Mozumdar likewise acknowledges a summer research gran from he Pamplin College of Business, Virginia Tech.

2 I. Inroducion As argued by Modigliani and Miller (1958), he invesmen decisions of firms are no affeced by heir financing decisions in perfec capial markes. Capial markes, however, are no perfec, and exising imperfecions inroduce a wedge beween he coss of exernal and inernal funds. Firms facing higher informaional imperfecions experience a wider wedge, and herefore are more financially consrained. A measure ha has been used in he lieraure o assess he degree of financial consrains experienced by firms is he sensiiviy of invesmens o he availabiliy of inernal funds, conrolling for invesmen opporuniies as measured by Tobin s Q. A number of sudies, saring wih Fazzari, Hubbard, and Peersen (1988), show ha invesmen is more sensiive o cash flow for firms ha have a high degree of financial consrains. 1 On he oher hand, Kaplan and Zingales (1997) and Cleary (1999) show ha invesmen-cash flow sensiiviy can be higher for unconsrained firms. 2 Addiionally, Gilchris and Himmelberg (1995), Erickson and Whied (2000), and Ali (2003) argue ha measuremen problems associaed wih Tobin s Q affec he esimaed sensiiviy of invesmens o he availabiliy of inernal funds. There has been lile invesigaion of he evoluion of invesmen-cash flow sensiiviies over ime. The evidence ha exiss suggess ha i has decreased over ime in he US: while earlier papers in he area (Fazzari, Hubbard, and Peersen (1988), and Kaplan and Zingales (1997)), using daa from he sevenies and early eighies, have repored sensiiviies in he (0.4, 1 See Hubbard (1998) for a deailed review of his lieraure. 2 Allayannis and Mozumdar (2004) show ha including firms wih negaive cash flows can lead o hese findings, since hese firms are financially disressed and herefore heir invesmens are no sensiive o cash flow. Rauh (2005) presens evidence ha capial expendiures decrease as inernal funds reduce due o mandaory pension conribuions. Moyen (2004) shows ha differen crieria used o differeniae beween financially consrained and unconsrained firms can lead o resuls consisen eiher wih Fazzari, Hubbard, and Peersen (1988) or wih Kaplan and Zingales (1997). According o Gomes (2001) and Ali (2003), invesmen-cash flow sensiiviy can be posiive even wihou any financial fricions. 2

3 0.7) range, sudies employing daa from he lae eighies and nineies (Cleary (1999), and Erickson and Whied (2000)) have found sensiiviies in he (0.1, 0.2) range. Therefore, in his paper, we firs examine wheher here is a decline in invesmen-cash flow sensiiviy hrough ime. Applying he Erickson-Whied esimaors o U.S. manufacuring firm daa, we find ha, consisen wih Erickson and Whied (2000), cash flow is no significan in explaining invesmen for he period from 1992 o Exending he analysis o a much longer sample period ( ), however, we find ha while he role of Q increases and ha of cash flow declines (relaive o OLS esimaes) in explaining invesmen, cash flow coninues o be a significan facor in mos of he sub-samples examined. 3 Of paricular ineres is he finding ha he declining paern of esimaed cash flow effecs is robus o he applicaion of he Erickson- Whied esimaors. If invesmen-cash flow sensiiviy is linked wih capial marke imperfecions, hen i should decrease wih facors ha reduce hese imperfecions. There is some inernaional crosssecional evidence o suppor his hypohesis. Wurgler (2000) examines cross-secional daa from 65 counries, and shows ha capial allocaion is more efficien in financially developed markes. Using cross-secional daa for several counries, Love (2003) and Islam and Mozumdar (2006) show ha he sensiiviy of invesmen o cash decreases wih financial marke developmen. We pursue his analysis furher by focusing on U.S. firms and examining he relaion beween heir invesmen-cash flow sensiiviies and five facors relaed o capial marke imperfecions aggregae fund flows, insiuional ownership, analys following, bond raings, and corporae 3 Polk and Sapienza (2004) oo find ha cash flow effecs remain significan when Erickson and Whied s (2000) esimaors are used. Also, using Erickson and Whied s (2000) sample and esimaors, Hennessy (2004) finds cash flow o be significan for firms wih junk-raed deb, and insignifican for hose wih invesmen-grade deb. 3

4 governance. 4 Again, o conrol for he measuremen problems relaed o Tobin s Q, we apply he GMM esimaors of Erickson and Whied (2000) in addiion o OLS. Our evidence suggess ha he sensiiviy of invesmen o inernal funds decreases wih facors ha reduce capial marke imperfecions. 5 Specifically, we find ha invesmen-cash flow sensiiviy reduces wih increasing fund flows, insiuional ownership, analys following, aniakeover amendmens and wih he exisence of a bond raing. Therefore, he sensiiviy of invesmens o he availabiliy of inernal funds canno be explained solely as an arifac of measuremen error. The res of he paper is organized as follows. Secion 2 provides a brief summary of he basic q model of invesmens, he measuremen error problem in esimaing i, as well as he major hypoheses. Secion 3 describes he daa. Secion 4 analyzes he ime series characerisics of invesmen-cash flow sensiiviy. Secion 5 examines he relaion beween invesmen-cash flow sensiiviy and he facors associaed wih capial markes. Secion 6 concludes he paper. II. The q Model of Invesmens and Hypoheses on Invesmen-Cash Flow Sensiiviy in Relaion o Capial Marke Facors A. The q Model of Invesmens and Measuremen Error As a remedy for he measuremen error problem highlighed in heir criique, Erickson and Whied (2000) propose a class of GMM esimaors ha exploi he informaion in he higher 4 Miigaion of capial marke imperfecions may have wo effecs: firs, i may cause a reducion in he cos of inernal funds, and second, i may cause a reducion in he wedge beween he coss of exernal and inernal funds. I is he second effec ha is of ineres from an invesmen-cash flow sensiiviy viewpoin. The mechanism by which his effec may occur is also wo-fold. Firs, reduced capial marke imperfecions could induce a liquidiy effec of greaer supply of funds o primary capial markes ha increases he oal pool of exernal funds available o firms. Second, here could be a narrowing of he informaion gap beween firm insiders and ousiders due o superior informaion producion. The capial marke facors ha we consider seek o capure one or boh of hese mechanisms. 5 Our findings, however, do no allow he inference ha invesmen-cash flow sensiiviies in he U.S. have declined because capial marke imperfecions have decreased over ime. While such an inference may appear plausible, i may only be reliably made on he basis of an explici analysis of he emporal evoluion of he relaion beween he wo. 4

5 order momens of he regression variables. Using hese esimaors and a sample of U.S. manufacuring firms over he period , hey find ha he explanaory power of Q improves dramaically relaive o radiional OLS esimaes, while cash flow loses significance as a deerminan of invesmen. Naurally hen, he firs quesion ha needs o be seled is wheher he invesmen-cash flow sensiiviy esimaes represen anyhing meaningful, or wheher hey are purely arifacual. Consider he simplified version of he sandard q invesmen model presened by Erickson and Whied (2000). The firm chooses an invesmen policy o maximize he expeced discouned value of cash flow subjec o he law of moion for capial. Le I denoe gross invesmen; K -1 beginning-of-period capial sock, and q he marginal cos of capial In perfec markes, invesmens are deermined solely by he shadow price of capial, or marginal q. In paricular, consideraions of he availabiliy of inernal funds should play no role in he process. On he oher hand, significan deviaions from he perfec marke paradigm would resul in such consideraions playing an imporan role. In empirical work, marginal q (q ) is ypically approximaed by Tobin s average Q (Q ), while he mos commonly used measure of inernal funds is cash flow. Erickson and Whied (2000) lis he several layers of approximaion ha lie beween he marginal q of heory and he various versions of Tobin s q used in pracice. Le Q be he mismeasured empirical proxy of he rue marginal q, i.e., Q a 0 q v, wih 2 v ~ i. i. d.(0, ). Then, he invesmen equaion in a regression framework is as follows: v I K 1 a a Q Q z 1 B z B ( u v ) 1 (1) where z represens some measure(s) of inernal funds. 5

6 Erickson and Whied (2000) show ha he biases induced by measuremen error in q in he above equaion may be subsanial and may be responsible for he esimaed coefficiens on Q being low and hose on cash flow being high, as repored in earlier papers. They propose a class of measuremen error-consisen GMM esimaors ha uilize he informaion in he higher order momens of he daa. We use heir GMM esimaors in addiion o OLS esimaors o address problems relaed o measuremen error. In addiion o he usual assumpion of independence beween he errors (u,v) and he (rue) regressors (z, q), Erickson and Whied s (2000) approach also requires wo echnical condiions o be saisfied for he model o be idenified. 6 B. Hypoheses on he Relaion of Invesmen-Cash Flow Sensiiviy o Cerain Capial Marke Facors If invesmen-cash flow sensiiviy is no simply an arifac of measuremen error bu raher linked o capial marke imperfecions, hen i should decrease wih facors ha reduce hese imperfecions. We explore his hypohesis by examining he relaion beween invesmencash flow sensiiviy and five facors relaed o capial marke imperfecions aggregae fund flows, insiuional ownership, analys following, bond raings, and corporae governance. Over he las fify years, here has been a seady increase in invesmens hrough insiuions such as muual funds and pension funds. This increase in fund flows can be seen as a proxy for he increase in overall marke liquidiy. As documened by Chordia, Roll and Subrahmanyam (2000), Hasbrouck and Seppi (2001), and Huberman and Halka (2001), here is 6 The wo idenificaion condiions require ha E( 1 ) and E( 3 ) be significanly differen from 0, where is he residual from a linear projecion of q on z. These wo idenificaion condiions are nooriously difficul o saisfy in he daa (Erickson and Whied (2000), Hennessy (2004), Polk and Sapienza (2004), Almeida and Campello (2006)). We encouner he problem in some of our ess as well; we repor GMM resuls only for hose sub-samples for which he condiions are me. However, he GMM overidenifying resricions (Hansen (1982)) do no hold for a number of idenified samples. We repor hese resuls also wih he corresponding J-saisics. 6

7 commonaliy in liquidiy across asses, and he liquidiy of an asse is posiively relaed o marke liquidiy. In his respec, increasing fund flows (a proxy for increasing marke liquidiy) should increase liquidiy across all asses. Addiionally, insiuions have beer informaion processing skills, and herefore, reduce informaional asymmeries. Thus, increased fund flows should reduce he exernal financing coss for all firms. Buler, Grullon and Weson (2005) presen evidence supporing his hypohesis by examining seasoned equiy offerings. They show ha securiies issuance coss are lower for firms wih socks ha are more liquid, which reduces heir cos wedge beween exernal and inernal funds. If his reducion is refleced in he sensiiviy of invesmens o he availabiliy of inernal funds, hen increasing fund flows should reduce his sensiiviy. Therefore our firs hypohesis is H1: Invesmen cash flow sensiiviy decreases wih increasing fund flows. An overall increase in fund flows reduces he liquidiy-relaed imperfecions for all firms by increasing overall marke liquidiy. However, he impac should be greaer for firms wih larger insiuional shareholdings. Moreover, as documened by Benne, Sias and Sarks (2003), insiuions ac on informaion. Therefore, firms wih insiuional ownership should have more informaion refleced ino prices, which reduces he informaion asymmery beween ousiders and insiders and herefore he cos wedge beween exernal and inernal funds. If his reducion in he cos wedge is refleced in he sensiiviy of invesmens o he availabiliy of inernal funds, one should observe a decrease in hese sensiiviies. Thus, our second hypohesis is H2: Invesmen-cash flow sensiiviy decreases wih insiuional holdings. Analys coverage is anoher imporan facor relaed o capial marke imperfecions. There is an exensive body of lieraure linking analys coverage wih he flow of informaion o prices (see Chang, Dasgupa and Hillary (2006) for a review). The incomplee informaion 7

8 heory of Meron (1987) suggess ha firms ha are covered by a large number of analyss should have lower coss of exernal capial. Consisen wih his hypohesis, Leary and Robers (2006) find ha firms wih more analys coverage rely more on exernal funds due o reduced informaion asymmeries. If his lower premium for exernal funds ranslaes ino invesmencash flow sensiiviies, hen we should observe a decrease in hese sensiiviies wih increased analys following. Hence our hird hypohesis saes ha H3: Invesmen-cash flow sensiiviy decreases as analys following increases. Bond raings also have an impac on he cos wedge beween exernal and inernal funds. When a firm obains a deb raing, i undergoes an independen evaluaion ha produces addiional public informaion and hus miigaes is asymmeric informaion problem. Moreover, access o public bond markes exends he se of exernal financing choices available o he firm. Addiionally, he junk bond marke, which sared in he early 1980s, has creaed an opporuniy for firms wihou invesmen grade bond raings o raise capial hrough bond markes. The exisence of a bond raing reduces he cos of exernal financing and hus eases he firm s reliance on inernal cash for making invesmens. Consequenly, our fourh hypohesis is H4: Invesmen cash flow sensiiviy decreases wih he exisence of bond raings. The final facor we examine is corporae governance. An imporan exernal conrol mechanism is he akeover marke. 7 The corporae governance index developed by Gompers, Ishii and Merick (2003) (GIM, henceforh), provides us a composie measure of corporae governance. The GIM index is formed by adding one poin for each akeover defense provision 8 ha increases managerial power. Therefore, a high value for his index corresponds o srong managerial righs (low akeover vulnerabiliy). While GIM find ha operaing performance is 7 See Shleifer and Vishny (1997) and Denis and McConnell (2003) for surveys on corporae governance.. 8 The provisions used in he index of Gompers, Ishii and Merick (2003) are from Corporae Takeover Defenses (Rosenbaum(1990, 1993, 1995,1998)). 8

9 beer for firms wih srong shareholder righs, hey fail o find a significan relaion beween he governance index and reurns on equiy. Klock, Mansi and Maxwell (2005) analyze he impac of corporae governance on he cos of deb financing using he same index. They find ha high managerial righs reduce he cos of deb financing. 9 The firms wih available GIM index daa are generally large firms. Deb is he major source of exernal funds for hese firms. Therefore, we would expec o find changes in invesmen-cash flow sensiiviy o be in he same direcion as he cos of deb financing. Thus, our final hypohesis is H5: Invesmen-cash flow sensiiviy decreases as akeover vulnerabiliy decreases for firms ha depend more on deb financing. III. Daa and Sample Descripion Our daa come from six sources: COMPUSTAT, CRSP, he Federal Reserve s Flow of Funds Accoun of he Unied Saes, I/B/E/S, CDA/Specrum, and he Invesors Research Responsibiliy Cener. We use annual COMPUSTAT indusrial files covering he years 1970 hrough 2001 as our primary source for U.S. manufacuring firm daa. We measure invesmen, cash flow, Tobin s Q, and capial in he same manner as Kaplan and Zingales (1997). As in Kaplan and Zingales (1997), we deflae cash flow and invesmen by capial sock a he beginning of each year. Aggregae fund flow daa are aken from he Flow of Funds Accouns of he Unied Saes, which is published by he Federal Reserve Board. The publicaion conains quarerly daa on secor holdings for each major asse class, saring wih For he years 1970 hrough 9 Several poenial explanaions for his finding are available in he lieraure: akeover relaed wealh changes of bond holders and wealh ransfer from bondholders o shareholders (Warga and Welch (1993), and Bille, King and Mauer (2004)), managers having he opporuniy o engage in longer erm projecs when shielded from akeover risks (DeAngelo and Rice (1983) and Sein (1988)), reducion in firm risk due o reduced job proecion aciviies of managers when here are akeover defenses (Jensen and Ruback (1983))). 9

10 2001, annual ne fund flows are obained by adding up he corresponding quarerly daa on he ne equiy purchased by insurance companies, pension funds, muual funds and closed-end funds. Ne fund flow values for each year are convered o 2001 values using he CPI index of he Bureau of Labor Saisics. The daa on analys following are obained from I/B/E/S for he period To ge annual figures for he number of analyss following a firm, he las available quarerly daa a or before ha firm s fiscal year end are used. If no daa exis for a firm, he number of analyss following ha firm is aken o be zero. Insiuional ownership daa for 1980 hrough 2001 are from he CDA/Specrum daabase. This daabase provides quarerly repors on insiuional holdings derived from he SEC s 13(f) filings. Specrum classifies each insiuion as one of five ypes: bank, insurance company, invesmen company, independen invesmen advisor or oher. The insiuional holdings of hese insiuions are added up in order o deermine he insiuional ownership of each sock. If a sock has no repored insiuional ownership, we assume he insiuional holdings of he sock o be zero. Bond raings daa from 1985 o 2001 are aken from he annual COMPUSTAT indusrial files. On he basis of bond raings daa, firms are divided ino wo caegories firms wih raing and wih no raing. Dummies are assigned accordingly. 10 Annual daa on akeover defenses for he period are aken from he Invesors Research Responsibiliy Cener. GIM creaed an annual corporae governance index for U.S. firms based on five governance rules ha consis of a oal of weny-four akeover defense provisions We consider hese weny-four provisions o form he index as in GIM. The value of 10 We carry ou he analyses using all junk bonds as well as by removing hose ha have a below-ccc raing. The laer is carried ou o remove he impac of financial disress. The resuls are comparable o hose repored. 10

11 he index varies beween 2 and 18. A high governance index value corresponds o srong managerial righs (or low akeover vulnerabiliy) and weak shareholder righs. The annual index values are used as a measure of corporae governance. If he governance index of a firm is missing for a year, he index value of he previous year is used. Since all he daa are no available for he overall sample period , we repor he resuls for he and periods. 11 We also examine he ime series paern of invesmen-cash flow sensiiviy by running en year rolling regressions of invesmen on cash flow and Tobin s Q from 1970 o Addiionally, we look a he period from 1992 o 1995, since his is he sample analyzed in Erickson and Whied (2000). We omi firm-years wih negaive cash flows on accoun of heir poenial disorionary impac on invesmen-cash flow sensiiviy esimaes. 12 Addiionally, in order o reduce he effecs of exreme observaions, for each sub-period, he op and boom one percenile of he daa wih respec o invesmen, cash flow, and Tobin s Q are removed. We require a firm o have a leas hree years of daa o be in he sample. 13 Since invesmen and cash flow are deflaed by capial sock, and Tobin s Q is a raio, we conver all variables o raios. Wih respec o fund flows, he ne fund flow value for 1970 serves as a base and is assigned a value of one. The fund flow values for subsequen years are calculaed relaive o his base. We divide he number of analyss following a firm each year by he mean number of analyss following socks for ha year. This raio gives us a relaive figure for analys following of a firm compared o oher firms in ha year. This allows us o disinguish reduced informaion asymmeries due o analys following across firms in a given 11 We also examine he periods and wih available variables for hese periods. The resuls are comparable o hose repored for he available variables. 12 See Allayannis and Mozumdar (2004) and Bhaga, Moyen, and Suh (2005). 13 We require hree years of daa o calculae beginning-of-year Q and capial sock as well as o examine firs difference regressions. Firs difference regressions are no repored since he resuls are comparable o hose repored. 11

12 year. For similar reasons, for each year, he insiuional ownership of a firm is divided by he oal insiuional holdings for ha year, depending on he fiscal year end of he firm. The firs quarerly repor on insiuional holdings a or afer he firm s fiscal year end is used o calculae he raio. Again, o ge a relaive figure for corporae governance index for each firm in a year, each firm s annual governance index value is divided by he mean governance index for ha year. Table 1 repors descripive saisics for hese variables. As can be observed in Table 1, invesmen, cash flow, analys following, insiuional ownership and percenage of firms wih bond raings are fairly sable hroughou he and periods. Firm size and fund flows, on he oher hand, are higher for he period compared o period. The governance index values are similar o hose repored in GIM. Also, as expeced, when we require firms o have governance index values, he sample size is reduced. The proporion of large firms wih bond raings, large insiuional ownership and number of analyss following increases for his sample. Table 1 IV. The Time Series Paern of Invesmen-Cash Flow Sensiiviy Using daa from he lae eighies and early nineies, Cleary (1999) and Erickson and Whied (2000) repor invesmen-cash flow sensiiviies ha are much lower han hose esimaed by Fazzari, Hubbard, and Peersen (1988) and Kaplan and Zingales (1997), who used daa from he period. To examine if a decline is observed in our sample, we run rolling regressions from 1970 o 2001 for overlapping periods of en years. This allows us o analyze he ime series paern of invesmen-cash flow sensiiviy. Our firs regression is for he period 12

13 , he second for he period , and so forh. We esimae he following regression: I / K, (2) 1 1Q 1 2CF / K 1 where I, and CF represen invesmen and cash flow during period, respecively; K -1 is he amoun of fixed capial a he beginning of period ; and Q is Tobin s Q, calculaed a he beginning of period. 2 measures invesmen-cash flow sensiiviy for he period. The daa are ransformed ino heir mean deviaion form by aking he differences beween he raw daa and he firm-level means. This allows us o eliminae fixed firm effecs. We include year dummies o conrol for year effecs. Heeroscedasiciy correcion is used for esimaing sandard errors. We repor he resuls based on OLS esimaion as well as he measuremen errorconsisen GMM esimaion of Erickson and Whied (2000). GMM esimaes based on produc momens up o hird and fourh orders (GMM3 and GMM4, respecively) are repored for he idenified models. Table 2 and Figure 1 presen he resuls of he above regressions for he overall sample. In Table 2, Panel A repors he resuls of en year rolling regressions from 1970 o 2001, and Panel B repors he resuls of he regression for he sample period from 1992 o 1995 for comparison wih Erickson and Whied (2000). In line wih he resuls of Erickson and Whied (2000), he applicaion of GMM esimaors resuls in he coefficien on Tobin s Q being more han hree imes higher and he coefficien on cash flow being lower han hose obained wih OLS esimaion. For he period from 1992 o 1995, as in Erickson and Whied (2000), cash flow is no significan when GMM esimaors are used. Over mos of he oher years, however, he esimaed invesmen-cash flow sensiiviy, 2, is posiive and significan, indicaing ha he Erickson and Whied (2000) sample period was somewha special in his respec. Only hose 13

14 resuls for which boh he idenificaion and he over-idenificaion crieria are saisfied, as well as he coefficien is significanly differen from 0, are repored in bold. 14 Furher, here is a clear and seady decrease in he esimaed sensiiviy, 2, over ime for mos of he sub-samples examined. Ineresingly, he decrease in invesmen-cash flow sensiiviy 2 is no associaed wih any corresponding paern in 1, he sensiiviy o Tobin s Q. A possible alernaive explanaion for he decline in 2 is ha Tobin s q became a less noisy proxy for marginal q over ime, such ha he incorrecly inflaed role of cash flow also reduced. However, since he measuremenerror consisen esimaors also yield a declining paern for 2, and he paern for 1 remains sable, he decline in 2 canno be explained by a reducion in measuremen error alone. Furhermore, since he sample period spans several business cycles, and almos every en year sub-sample covers a leas one recession and one expansion, hese resuls canno be explained by business cycle flucuaions. 15 Thus, he evidence lends suppor o he hypohesis ha he esimaed sensiiviy 2 is decreasing hrough ime and is significan mos of he ime even afer conrolling for measuremen errors. Table 2 and Figure 1 V. Invesmen-Cash Flow Sensiiviy in Relaion o Capial Marke Facors Since he sensiiviy of invesmen o he availabiliy of inernal funds is significan (alhough decreasing) hrough differen ime periods, i is no merely an arifac of measuremen errors, bu is linked o capial marke imperfecions. Therefore i should decrease wih facors 14 Noe ha his means ha he idenificaion es rejecs, he over-idenificaion es fails o rejec, and he coefficien -es rejecs. 15 Business cycle expansions and recessions are as repored by he NBER a is web sie, hp:// only en year period considered in our rolling regressions ha does no cover boh an expansion and a recession is March 1991 o March 2001, which is a 120 monh expansionary period. 14

15 ha reduce hese imperfecions. We consider facors ha prior research has idenified as being relaed o capial marke imperfecions, and examine he impac of hese facors on invesmencash flow sensiiviy. Our regression model is as follows: I / K 1 1Q 1 2CF / K 1 i( CF / K 1 Facori ). (3) The facors considered in he regression are fund flows, analys following, insiuional ownership, bond raings, and he corporae governance index. The daa are ransformed ino heir mean deviaion form by aking he differences beween he raw daa and he firm-level means o eliminae fixed firm effecs. We include year dummies o conrol for year effecs. Heeroscedasiciy correcion is used for esimaing sandard errors. We analyze he ineracion of cash flow wih hese facors, and repor he resuls for he and periods. 16 When he ineracion of cash flow wih he corporae governance index is considered in period, he sample size is reduced due o unavailabiliy of he index value for many small firms. We include he ineracion of cash flow wih he naural logarihm of size (book value of oal asses) as an addiional conrol variable. 17 The resuls are given in Table 3. OLS esimaes as well as he GMM esimaes based on Erickson and Whied (2000) are repored. Table 3 In Table 3, we observe a negaive and significan coefficien on he ineracion of cash flow wih fund flows for all periods. Consisen wih hypohesis saed in Secion 2, hese resuls sugges ha he sensiiviy of invesmens o he availabiliy of inernal funds decreases wih facors ha reduce capial marke imperfecions. The coefficien on he ineracion of cash flow 16 We also examine , and periods. The resuls are comparable o hose repored for he and periods. 17 We conrol for firm size since Gilchris and Himmelberg (1995), Kadapakkam, Kumar and Riddick (1998), Erickson and Whied (2000), and Allayannis and Mozumdar (2004) find a significan relaion beween firm size and financing consrains. 15

16 wih firm size is posiive whenever i is significan, alhough i is largely insignifican wih GMM esimaes. The finding ha he coefficien is largely insignifican wih he GMM esimaes bu no wih he OLS esimaes may be indicaive of size capuring some unobserved facors relaed o Tobin s Q ha are no capured by OLS esimaes due o measuremen error. Alhough fund flows have an impac on he overall marke, we would expec he larges effec o be on firms wih higher levels of insiuional ownership. These firms should be able o raise exernal funds more easily, since increased liquidiy as well as reduced informaional asymmeries hrough informaion flow o prices should reduce he cos wedge beween exernal and inernal funding. In Table 3, we find ha he coefficien on he ineracion of cash flow wih insiuional ownership is negaive and significan. Sock analyss produce research ha adds o he publicly available informaion abou he firm and hus reduces he informaion asymmery beween insiders and ousiders. Thus analys following should reduce he wedge beween inernal and exernal financing coss. Consisen wih his hypohesis, in Table 3, GMM esimaes of he coefficien on he ineracion of cash flow wih he number of analyss following are negaive and significan. Deb markes play a major role in he exernal financing of corporaions. The credi raing process generaes addiional public informaion abou he firm as well as making public bond markes accessible o i. In Table 3, we observe ha he ineracion of cash flow and he bond raing dummy is always negaive and significan. These resuls are supporive of an associaion beween a decreasing invesmen-cash flow sensiiviy and a decreasing cos wedge beween inernal and exernal funds due o access o bond markes. Klock, Mansi and Maxwell (2005) find ha he cos of deb financing decreases wih an increase in he GIM index. Using insiuional ownership as a proxy for shareholder conrol, 16

17 Cremers, Nair and Wei (2006) show ha aniakeover amendmens lead o a decrease in he cos of deb financing when here is srong shareholder conrol. We examine he relaion beween invesmen-cash flow sensiiviy and he GIM index for he sample period Mos of he firms in his sample are large firms (Table 1). Deb financing is he major source of exernal financing for large firms. Thus he cos of deb financing should have a larger impac on he cos wedge beween inernal and exernal funds for he firms in our sample. We repor OLS esimaes in Table 3. GMM esimaes are no repored since he corresponding GMM models are no idenified. The coefficien on he corporae governance index is negaive and significan. The evidence hus indicaes a negaive relaion beween invesmen-cash flow sensiiviy and he number of aniakeover amendmens. However, since OLS esimaes may no be reliable due o measuremen error problems relaed o Tobin s Q, his evidence can a bes be seen as weak suppor for he hypohesized negaive relaion beween invesmen-cash flow sensiiviy and he GIM index. VI. Conclusion This paper examines he sensiiviy of invesmens o he availabiliy of inernal funds using U.S. manufacuring firm daa. The paper firs shows ha here has been a seady decrease in invesmen-cash flow sensiiviy over ime, and ha his decline canno be explained on he basis of measuremen error alone. Nex, invesmen-cash flow sensiiviy is examined in relaion o five capial marke-relaed facors: fund flows, insiuional ownership, analys following, bond raings, and aniakeover amendmens. By analyzing he relaion of invesmen-cash flow sensiiviy o hese five capial-marke relaed facors, we explore wheher his sensiiviy reduces wih facors ha decrease capial marke imperfecions. 17

18 Our findings indicae ha invesmen-cash flow sensiiviy decreases when here is a reducion in capial marke imperfecions hrough increased fund flows, insiuional ownership, analys following, aniakeover amendmens and wih he exisence of a bond raing. Thus capial marke facors ha decrease marke imperfecions and as a resul reduce he cos wedge beween exernal and inernal funds, lead o lower invesmen-cash flow sensiiviies. I is possible ha he decline in invesmen-cash flow sensiiviy has been due o reducion in capial marke imperfecions over ime. However, such an inference canno be made caegorically wihou a direc ime-series analysis of he relaion beween he wo. We leave ha exercise for fuure research. 18

19 References Allayannis, George, and Abon Mozumdar, 2004, The Invesmen-cash flow sensiiviy puzzle: Can negaive cash flow observaions explain i? Journal of Banking and Finance, 28, Almeida, Heior, and Murillo Campello, 2006, Financial Consrains, Asse Tangibiliy, and Corporae Invesmen, Review of Financial Sudies, forhcoming. Ali, Aydogan, 2003, How Sensiive Is Invesmen o Cash Flow When Financing Is Fricionless? Journal of Finance, 58, Benne, James A., Richard W. Sias, and Laura T. Sarks, 2003, Greener pasures and he impac of dynamic insiuional preferences, Review of Financial Sudies, 16, Bhaga, Sanjai, Nahalie Moyen, and Inchul Suh, 2005, Invesmen and inernal funds of disressed firms, Journal of Corporae Finance 11, Bille, Mahew T., Dolly King, and David C. Mauer, 2004, Bondholders Wealh Effecs in Mergers and Acquisiions: New Evidence from he 1980s and 1990s, Journal of Finance 59, Buler, Alex, Gusavo Grullon, and James Weson, 2005, Sock Marke Liquidiy and he Cos of Issuing Equiy, Journal of Financial and Quaniaive Analysis, 40, Chang, Xin, Sudipo Dasgupa, and Gilles Hilary, 2006, Analys Coverage and Financing Decisions, Journal of Finance 61, Chordia, Tarun, Richard Roll, and Avanidhar Subrahmanyam, 2000, Commonaliy in liquidiy, Journal of Financial Economics 56, Cleary, Sean, 1999, he relaionship beween firm invesmen and financial saus, Journal of Finance 54, Cremers, Marijn, Vinay Nair, and Chenyang Wei, 2006, Governance Mechanisms and Bond Prices, forhcoming in he Review of Financial Sudies. DeAngelo, Harry, and Edward Rice, 1983, Aniakeover Charer Amendmens and Sockholder Wealh, Journal of Financial Economics 11, Denis, Diane K., and John J. McConnell, 2003, Inernaional corporae governance, Journal of Financial and Quaniaive Analysis 38, Erickson, Timohy, and Toni M. Whied, 2000, Measuremen error and he relaionship beween invesmen and q, Journal of Poliical Economy 108,

20 Erickson, Timohy, and Toni M. Whied, 2002, Two-Sep GMM esimaion of he errors-invariables model using high-order momens, Economeric Theory 18, Fazzari, Seven M., R. Glenn Hubbard, and Bruce P. Peersen, 1988, Financing consrains and corporae invesmen, Brookings Papers on Economic Aciviy, Gilchris, Simon, and Charles P. Himmelberg, 1995, Evidence on he role of cash flow for invesmen, Journal of Moneary Economics 36, Gomes, Joao, 2001, Financing Invesmen, American Economic Review 91, Gompers, Paul A., Joy L. Ishii, and Andrew Merick, 2003, Corporae governance and equiy prices, Quarerly Journal of Economics 118, Hansen, Lars, 1982, Large sample properies of generalized mehod of momens esimaors, Economerica 50, Hasbrouck, Joel, and Duane Seppi, 2001, Common facors in prices, order flows, and liquidiy, Journal of Financial Economics 59, Hennessy, Chrisopher A., 2004, Tobin s Q, deb overhang, and invesmen, Journal of Finance 59, Hubbard, Glenn R., 1998, Capial marke imperfecions and invesmen, Journal of Economic Lieraure 36, Huberman, Gur, and Dominic Halka, 2001, Sysemic liquidiy, Journal of Financial Research 24, Islam, Saiyid S., and Abon Mozumdar, 2006, Financial developmen and he imporance of inernal cash: Evidence from inernaional daa, Journal of Banking and Finance, forhcoming. Jensen, Michael C., and Richard S. Ruback, 1983, The Marke for Corporae Conrol: The Scienific Evidence, Journal of Financial Economics 11, Kadapakkam, Palani-Rajan, P. C. Kumar, and Leigh A. Riddick, 1998, The impac of cash flows and firm size on invesmen: The inernaional evidence, Journal of Banking and Finance 22, Kaplan, Seven N., and Luigi Zingales, 1997, Do invesmen-cash flow sensiiviies provide useful measures of financing consrains?, Quarerly Journal of Economics, Klock, Mark, Saar A. Mansi, and William F. Maxwell, 2005, Does corporae governance maer o bondholders? Journal of Financial and Quaniaive Analysis, 40,

21 Leary, Mark T. and Michael R. Robers, 2006, The Pecking Order, Deb Capaciy, and Informaion Asymmery, Working Paper, Universiy of Pennsylvania. Love, Inessa, 2003, Financial developmen and Financing Consrains: Inernaional Evidence from he Srucural Invesmen Model, Review of Financial Sudies, 16, Modigliani, Franco, and Meron Howard Miller, 1958, The Cos of Capial Corporaion Finance, and he Theory of Invesmen, American Economic Review, 48, Moyen, Nahalie, 2004, Invesmen-cash Flow Sensiiviies: Consrained versus Unconsrained Firms. Journal of Finance, 59, Meron, Rober, 1987, A simple model of capial marke equilibrium wih incomplee informaion, Journal of Finance 42, Polk, Chrisopher K., and Paola Sapienza, 2004, Real Effecs of Invesor Senimen, Working Paper, Norhwesern Universiy. Rauh, Joshua, 2006, Invesmen and Financing Consrains: Evidence from he Funding of Corporae Pension Plans, Journal of Finance, 61, Rosenbaum, Virginia, 1990, 1993, 1995, 1998, Corporae Takeover Defenses, Invesor Responsibiliy Research Cener, Washingon, D.C. Shleifer, Andrei, and Rober W. Vishny, 1997, A survey of corporae governance, Journal of Finance 52, Sein, Jeremy C., 1988, Takeover hreas and managerial myopia, Journal of Poliical Economy 96, Warga, Arhur, and Ivo Welch, 1993, Bondholder Losses in Leveraged Buyous, Review of Financial Sudies 6, Wurgler, Jeffrey, 2000, Financial Markes and he Allocaion of Capial, Journal of Financial Economics, 58,

22 Table 1 Descripive Saisics This able repors he mean and median values of he variables for he and sample periods. The Obs column shows he sample size for each period. For he period , here are wo samples. When we require a firm o have a corporae governance index, he sample size reduces o he one repored a he boom of he able. I, CF, and Q represen invesmen, cash flow, and Tobin s Q, respecively, calculaed as in Kaplan and Zingales (1997). Fund flows are calculaed using he 1970 values as he base. Fund flows are convered o 2001 values using he CPI index of he Bureau of Labor Saisics. The analyss column shows he analys following for he sample firms. The number of analyss following a firm is divided by he mean number of analyss following for each year. The IO column repors he proporion of he insiuional ownership of he sample firms relaive o he insiuional ownership of all firms wih fiscal year ends corresponding o he same quarer. The Bond column repors he proporion of firms ha have bond raings. The Govn column repors he corporae governance index, and is aken from GIM. The corporae governance index value of each firm is divided by he mean corporae governance index for ha year. For each variable excep bond raings, he firs row repors he mean values and he second row he median values. Obs Toal Asses I CF Q Fund flows Analyss IO Bond Governance Index ** ** Sample size is reduced due o he exclusion of firms ha do no have corporae governance index daa available.

23 Table 2 Time Series Paern of Invesmen-Cash Flow and -Tobin s Q Sensiiviies This able presens he sensiiviy of invesmen o inernal funds and Tobin s Q. We run rolling regressions from 1970 o 2001 for overlapping periods of en years according o he following regression model: I / K 1 1Q 2CF / K 1, where I, and CF represen invesmen and cash flow during period, respecively; K -1 is he amoun of capial a he beginning of period ; and Q is Tobin s Q, calculaed a he beginning period as in Kaplan and Zingales (1997). Panel A repors he rolling en year regressions from 1970 o The firs regression is from 1970 o 1979, and is repored below as The second is from 1971 o 1980, and is repored as 1980, and so forh. Panel B repors he regression for he period from 1992 o In he regressions, he daa are ransformed ino heir mean deviaion form by aking he differences beween he raw daa and he firm-level means so as o eliminae he fixed-firm effecs. We keep he year dummies o conrol for he year effecs. OLS and GMM resuls are repored. In he columns below, Obs represens he number of observaions. Heeroscedasiciy adjused sandard errors are in parenheses. Panel A: 1979 o 2001 Rolling Regressions OLS GMM3 GMM4 Obs R 2 CF Q R 2 CF Q R 2 CF Q J-sa (0.013) (0.005) (0.03) (0.113) (0.015) (0.032) (0.508) (0.011) (0.004) (0.024) (0.083) (0.015) (0.036) (0.791) (0.011) (0.004) (0.02) (0.072) (0.015) (0.04) (0.973) (0.01) (0.005) (0.024) (0.107) (0.015) (0.05) (0.657) (0.01) (0.006) (0.021) (0.098) (0.014) (0.049) (0.198) (0.01) (0.006) (0.047) (0.13) (0.018) (0.068) (0.014) (0.01) (0.006) (0.056) (0.145) (0.017) (0.054) (0.03) (0.01) (0.007) (0.054) (0.128) (0.017) (0.052) (0.001) (0.011) (0.007) (0.058) (0.102) (0.019) (0.054) (0.001) (0.01) (0.006) (0.049) (0.098) (0.017) (0.044) (0.00) (0.01) (0.006) (0.038) (0.101) (0.015) (0.036) (0.00) (0.009) (0.006) (0.034) (0.102) (0.014) (0.033) (0.003)

24 Table 2 - Coninued OLS GMM3 GMM4 R 2 Obs CF Q R 2 CF Q R 2 CF Q J-sa (0.009) (0.005) (0.032) (0.097) (0.014) (0.034) (0.01) (0.008) (0.005) (0.028) (0.087) (0.014) (0.035) (0.008) (0.008) (0.005) (0.031) (0.101) (0.016) (0.042) (0.042) (0.007) (0.005) (0.022) (0.122) (0.015) (0.041) (0.016) (0.006) (0.005) (0.028) (0.129) (0.013) (0.037) (0.036) (0.006) (0.004) (0.026) (0.124) (0.013) (0.037) (0.044) (0.006) (0.004) (0.024) (0.083) (0.012) (0.038) (0.278) (0.005) (0.004) (0.033) (0.12) (0.013) (0.039) (0.05) (0.005) (0.004) (0.022) (0.11) (0.013) (0.038) (0.04) (0.005) (0.004) (0.026) (0.084) (0.014) (0.038) (0.165) (0.005) (0.003) (0.022) (0.07) (0.014) (0.041) (0.149) Panel B: 1992 o 1995 Regression OLS GMM3 GMM4 Obs R 2 CF Q R 2 CF Q R 2 CF Q J-sa (0.01) (0.007) (0.066) (0.022) (0.022) (0.055) (0.056)

25 Table 3 Capial Marke Imperfecions and Invesmen Cash Flow Sensiiviy This able shows he impac of capial marke imperfecions on invesmen-cash flow sensiiviy, conrolling for firm size, over wo sample periods. The periods are , and Daa are available for fund flows for all subperiods, analys following only afer 1976, insiuional ownership only afer 1980, bond raings only afer 1985, and he corporae governance index only afer We run he following regression: I / K 1 1Q 2CF / K 1 i( CF Facori ), where I, and CF represen invesmen and cash flow during period, respecively; K -1 is he amoun of capial a he beginning of period ; and Q is Tobin s Q, calculaed a he beginning period in he same manner as in Kaplan and Zingales (1997). We conrol for size by ineracing cash flow wih he naural logarihm of size (CF*Size). CF *Facor are he ineracions of cash flow wih he facors relaed o capial marke imperfecions. The facors considered are: fund flows (CF*Fund), analys following (CF*Analys), insiuional ownership (CF*IO), he proporion of firms wih bond raings (CF*Bond), and he corporae governance index (CF*Govn). In he regressions, he daa are ransformed ino heir mean deviaion form by aking he differences beween he raw daa and he firm-level means so as o eliminae he fixed-firm effecs. We keep he year dummies o conrol for he year effecs. OLS and GMM resuls are repored. Heeroscedasiciy adjused sandard errors are in parenheses. Obs J-sa R 2 CF Q OLS (0.005) (0.003) CF* Size CF* Fund CF* Analys CF*IO CF* Bond (0.012) (0.003) (0.003) (0.001) (0.005) (0.037) (0.016) GMM (0.015) (0.048) (0.016) (0.049) (0.003) (0.001) (0.012) (0.119) (0.016) GMM (0.083) (0.008) (0.023) (0.26) (0.015) (0.024) (0.004) (0.001) (0.008) (0.086) (0.017) CF* Govn

26 Obs J-sa R 2 CF Q OLS Table 3 Coninued (0.005) (0.003) CF* Size CF* Fund CF* Analys CF*IO CF* Bond (0.016) (0.004) (0.004) (0.001) (0.005) (0.038) (0.016) GMM (0.018) (0.08) CF* Govn (0.016) (0.05) (0.004) (0.001) (0.012) (0.121) (0.011) GMM (0.149) (0.011) (0.032) (0.36) (0.015) (0.029) (0.004) (0.001) (0.008) (0.087) (0.011) * 5848 OLS (0.01) (0.004) (0.009) (0.002) (0.007) (0.032) (0.011) (0.024) * Sample size is reduced from 14,935 o 5,848 due o firms ha do no have GIM index daa available

27 Figure 1A Regression Coefficiens on Cash Flow (CF) CF_OLS CF_GMM Figure 1B Regression Coefficiens on Tobin's Q (Q) Q_OLS Q_GMM Figure 1. Regression Coefficiens on Cash Flow (CF) and Tobin s Q. Invesmen is regressed on CF and Q over en year periods from 1970 o 1992, i.e , , and so forh. In he above figure, years correspond o he las years in he rolling regression. For example, he period is shown as Boh OLS (CF_OLS and Q_OLS) and GMM3 (CF_GMM and Q_GMM) esimaes are shown.