Rv Acc Stud (2006) 11:159 189 DOI 10.1007/s11142-006-9012-1 Ovr-invstmnt of fr cash flow Scott Richardson Publishd onlin: 23 Jun 2006 Ó Springr Scinc+Businss Mdia, LLC 2006 Abstract This papr xamins th xtnt of firm lvl ovr-invstmnt of fr cash flow. Using an accounting-basd framwork to masur ovrinvstmnt and fr cash flow, I find vidnc that, consistnt with agncy cost xplanations, ovr-invstmnt is concntratd in firms with th highst lvls of fr cash flow. Furthr tsts xamin whthr firms govrnanc structurs ar associatd with ovr-invstmnt of fr cash flow. Th vidnc suggsts that crtain govrnanc structurs, such as th prsnc of activist sharholdrs, appar to mitigat ovr-invstmnt. Kywords Fr cash flow Æ Ovr-invstmnt Æ Agncy costs JEL Classification G3 Æ M4 This papr xamins firm invsting dcisions in th prsnc of fr cash flow. In thory, firm lvl invstmnt should not b rlatd to intrnally gnratd cash flows (Modigliani & Millr, 1958). Howvr, prior rsarch has documntd a positiv rlation btwn invstmnt xpnditur and cash flow (.g., Hubbard, 1998). Thr ar two intrprtations for this positiv rlation. First, th positiv rlation is a manifstation of an agncy problm, whr managrs in firms with fr cash flow ngag in wastful xpnditur (.g., Jnsn 1986; Stulz 1990). Whn managrs objctivs diffr from thos of sharholdrs, th prsnc of intrnally gnratd cash flow in xcss of that rquird to maintain xisting assts in plac and financ nw positiv NPV projcts crats th potntial for thos funds to b squandrd. Scond, th positiv rlation rflcts capital markt imprfctions, whr costly xtrnal S. Richardson (&) Wharton School, Univrsity of Pnnsylvania, 1314 Stinbrg Hall Ditrich Hall, Philadlphia, PA 19104-6365, USA -mail: scottric@wharton.upnn.du
160 S. Richardson financing crats th potntial for intrnally gnratd cash flows to xpand th fasibl invstmnt opportunity st (.g., Fazzari, Hubbard, & Ptrsn, 1988; Hubbard, 1998). This papr focuss on utilizing accounting information to bttr masur th constructs of fr cash flow and ovr-invstmnt, thrby allowing a mor powrful tst of th agncy-basd xplanation for why firm lvl invstmnt is rlatd to intrnally gnratd cash flows. In doing so, this papr is th first to offr larg sampl vidnc of ovr-invstmnt of fr cash flow. Prior rsarch, such as Blanchard, Lopz-di-Silans, and Vishny (1994), documnt xcssiv invstmnt and acquisition activity for lvn firms that xprinc a larg cash windfall du to a lgal sttlmnt, Harford (1999) finds using a sampl of 487 takovr bids, that cash-rich firms ar mor likly to mak acquisitions that subsquntly xprinc abnormal dclins in oprating prformanc, and Bats (2005) finds for a sampl of 400 subsidiary sals from 1990 to 1998 that firms who rtain cash tnd to invst mor, rlativ to industry prs. This papr xtnds ths small sampl findings by showing that ovr-invstmnt of fr cash flow is a systmatic phnomnon across all typs of invstmnt xpnditur. Th mpirical analysis procds in two stags. First, th papr uss an accounting-basd framwork to masur both fr cash flow and ovr-invstmnt. Fr cash flow is dfind as cash flow byond what is ncssary to maintain assts in plac and to financ xpctd nw invstmnts. Ovr-invstmnt is dfind as invstmnt xpnditur byond that rquird to maintain assts in plac and to financ xpctd nw invstmnts in positiv NPV projcts. To masur ovr-invstmnt, I dcompos total invstmnt xpnditur into two componnts: (i) rquird invstmnt xpnditur to maintain assts in plac, and (ii) nw invstmnt xpnditur. I thn dcompos nw invstmnt xpnditur into ovr-invstmnt in ngativ NPV projcts and xpctd invstmnt xpnditur, whr th lattr varis with th firm s growth opportunitis, financing constraints, industry affiliation and othr factors. Undr th agncy cost xplanation, managmnt has th potntial to squandr fr cash flow only whn fr cash flow is positiv. At th othr nd of th spctrum, firms with ngativ fr cash flow can only squandr cash if thy ar abl to rais chap capital. This is lss likly to occur bcaus ths firms nd to b abl to rais financing and thrby plac thmslvs undr th scrutiny of xtrnal markts (DAnglo, DAnglo, & Stulz, 2004; Jnsn, 1986). Consistnt with th agncy cost xplanation, I find a positiv association btwn ovr-invstmnt and fr cash flow for firms with positiv fr cash flow. 1 For a sampl of 58,053 firm-yars during th priod 1988 2002, I find that for firms with 1 Prior work in financ and conomics xamining th rlation btwn cash flow and invstmnt xpnditur has tndd to us ithr balanc sht masurs of th stock of cash and cash quivalnts (.g., Harford, 1999) or arnings basd masurs as a proxy for cash flow (.g., Lang, Stulz, & Walkling, 1991; Oplr & Titman, 1993). It is wll known that arnings and cash flows ar not quivalnt masurs (.g., Sloan, 1996). This papr sks to masur fr cash flow dirctly using information from th statmnt of cash flows as opposd to noisy combinations from th incom statmnt and balanc sht.
Ovr-invstmnt of fr cash flow 161 positiv fr cash flow th avrag firm ovr-invsts 20% of its fr cash flow. Furthrmor, I documnt that th majority of fr cash flow is rtaind in th form of financial assts. Th avrag firm in my sampl rtains 41% of its fr cash flow as ithr cash or marktabl scuritis. Thr is littl vidnc that fr cash flow is distributd to xtrnal dbt holdrs or sharholdrs. Finding an association btwn ovr-invstmnt and fr cash flow is consistnt with rcnt rsarch documnting poor futur prformanc following firm lvl invstmnt activity. For xampl, Titman, Wi, and Xi (2004) and Fairfild, Whisnant, and Yohn (2003) show that firms with xtnsiv capital invstmnt activity and growth in nt oprating assts rspctivly, xprinc infrior futur stock rturns. Furthrmor, Dchow, Richardson, and Sloan (2005) find that cash flows rtaind within th firm (ithr capitalizd through accruals or invstd in financial assts) ar associatd with lowr futur oprating prformanc and futur stock rturns. This prformanc rlation is consistnt with th ovr-invstmnt of fr cash flows documntd in this papr. Th scond st of mpirical analyss xamin whthr govrnanc structurs ar ffctiv in mitigating ovr-invstmnt. Prior rsarch has xamind th impact of a varity of govrnanc structurs on firm valuation and th quality of managrial dcision making (s Brown & Caylor, 2004; Gomprs, Ishii, & Mtrick, 2003; Larckr, Richardson, & Tuna, 2005 for dtaild summaris). Collctivly, th ability of cross-sctional variation in govrnanc structurs to xplain firm valu and/or firm dcision making is rlativly wak. Consistnt with this, I find vidnc that out of a larg st of govrnanc masurs only a fw ar rlatd to ovr-invstmnt. For xampl, firms with activist sharholdrs and crtain anti-takovr provisions ar lss likly to ovr-invst thir fr cash flow. Th nxt sction dvlops tstabl hypothss concrning th rlation btwn fr cash flow and ovr-invstmnt. Sction 2 dscribs th sampl slction and variabl masurmnt. Sction 3 discusss mpirical rsults for th ovr-invstmnt of fr cash flow. Sction 4 contains mpirical analysis xamining th link btwn corporat govrnanc and th ovr-invstmnt of fr cash flow, whil sction 5 concluds. 1. Fr cash flow and ovr-invstmnt This sction dscribs in dtail th various thoris supporting a positiv rlation btwn invstmnt xpnditur and cash flow and thn dvlops masurs of fr cash flow and ovr-invstmnt that can b usd to tst th agncy basd xplanation. 1.1. Explanations for a positiv rlation btwn invstmnt xpnditur and cash flow In a world of prfct capital markts thr would b no association btwn firm lvl invsting activitis and intrnally gnratd cash flows. If a firm ndd additional cash to financ an invstmnt activity it would simply
162 S. Richardson rais that cash from xtrnal capital markts. If th firm had xcss cash byond that ndd to fund availabl positiv NPV projcts (including options on futur invstmnt) it would distribut fr cash flow to xtrnal markts. Firms do not, howvr, oprat in such a world. Thr ar a varity of capital markt frictions that impd th ability of managmnt to rais cash from xtrnal capital markts. In addition, thr ar significant transaction costs associatd with monitoring managmnt to nsur that fr cash flow is indd distributd to xtrnal capital markts. In quilibrium, ths capital markt frictions can srv as a support for a positiv association btwn firm invsting activitis and intrnally gnratd cash flow. Th agncy cost xplanation introducd by Jnsn (1986) and Stulz (1990) suggsts that monitoring difficulty crats th potntial for managmnt to spnd intrnally gnratd cash flow on projcts that ar bnficial from a managmnt prspctiv but costly from a sharholdr prspctiv (th fr cash flow hypothsis). Svral paprs hav invstigatd th implications of th fr cash flow hypothsis on firm invstmnt activity. For xampl, Lamont (1997) and Brgr and Hann (2003) find vidnc consistnt with cash rich sgmnts cross-subsidizing mor poorly prforming sgmnts in divrsifid firms. Howvr, th vidnc in ths paprs could also b consistnt with markt frictions inhibiting th ability of th firm to rais capital xtrnally and not ncssarily an indication of ovr-invstmnt. Rlatd vidnc can also b found in Harford (1999) and Oplr, Pinkowitz, Stulz, and Williamson (1999, 2001). Harford uss a sampl of 487 takovr bids to documnt that cash rich firms ar mor likly to mak acquisitions and ths cash rich acquisitions ar followd by abnormal dclins in oprating prformanc. Oplr t al. (1999) find som vidnc that companis with xcss cash (masurd using balanc sht cash information) hav highr capital xpnditurs, and spnd mor on acquisitions, vn whn thy appar to hav poor invstmnt opportunitis (as masurd by Tobin s Q). Prhaps th most dirct vidnc on th ovr-invstmnt of fr cash flow is th analysis in Blanchard t al. (1994). Thy find that lvn firms with windfall lgal sttlmnts appar to ngag in wastful xpnditur. Collctivly, prior rsarch is suggstiv of an agncy-basd xplanation supporting th positiv rlation btwn invstmnt and intrnally gnratd cash flow. Howvr, ths paprs ar basd on rlativly small sampls and do not masur ovr-invstmnt or fr cash flow dirctly. Thus, th findings of arlir work may not b gnralizabl to largr sampls nor is it dirctly attributabl to th agncy cost xplanation. Mor gnrally, a criticism of th litratur xamining th rlation btwn invstmnt and cash flow is that finding a positiv association may mrly indicat that cash flows srv as an ffctiv proxy for invstmnt opportunitis (.g., Alti, 2003). My aim is to bttr masur th constructs of fr cash flow and ovr-invstmnt by incorporating an accounting-basd masur of growth opportunitis, and tst whthr th rlation is vidnt in a larg sampl of firms. In addition to prior mpirical work on agncy basd xplanations for th link btwn firm lvl invstmnt and intrnally gnratd fr cash flow,
Ovr-invstmnt of fr cash flow 163 thr xists a stram of rsarch ddicatd to xamining th rol of financing constraints (.g., Fazzari t al. (1988), Hoshi, Kashyap, and Scharfstin (1991), Fazzari and Ptrsn (1993), Whitd (1992) and Hubbard (1998)). Myrs and Majluf (1984) suggst that information asymmtris incras th cost of capital for firms forcd to rais xtrnal financ, thrby rducing th fasibl invstmnt. Thus, in th prsnc of intrnally gnratd cash flow, such firms will invst mor in rspons to th lowr cost of capital. Som arly work in this ara xamind th snsitivity of invstmnt to cash flow for high vrsus low dividnd paying firms (Fazzari t al., 1988), comparing diffring organizational structurs whr th ability to rais xtrnal financing was asir/hardr (Hoshi, Kashyap and Scharfstin, 1991, with Japans kirtsu firms) and dbt constraints (Whitd, 1992). Ths paprs find vidnc of gratr snsitivity of invstmnt to cash flow for sts of firms which appard to b financially constraind (.g., low dividnd paying firms, high dbt firms and firms with limitd accss to banks). Howvr, mor rcnt rsarch casts doubt on th arlir rsults. Spcifically, Kaplan and Zingals (1997, 2000), find that th snsitivity of invstmnt to cash flow prsists vn for firms who do not fac financing constraints. Thy construct a masur of x ant financing constraints for a small sampl of firms and find that th snsitivity of invstmnt to cash flow for firms is ngativly associatd with this masur, thrby casting doubt on th financing constraint hypothsis. Nonthlss th invstmnt xpctation modl dscribd in Sction 1.4 includs a varity of masurs dsignd to captur financing constraints. 1.2. Primary hypothsis As dscribd in th arlir sction, in a world of prfct capital markts (no frictions for raising xtrnal financ, no information asymmtris and associatd moral hazard problms, no taxs tc.), thr should b no association btwn firm lvl invstmnt and intrnally gnratd cash flows. Howvr, whn it is costly for xtrnal capital providrs to monitor managmnt, and it is costly for th firm to rais xtrnal financ, an association is xpctd. Spcifically, thr should b a positiv rlation btwn firm lvl invstmnt xpnditur and intrnally gnratd cash flows. This rlation, howvr, could b du to svral factors. It could rflct managmnt ngaging in additional invstmnt on slf-srving projcts rathr than distribut th cash to sharholdrs. Such dcisions can includ: (i) mpir building (s.g., Shlifr & Vishny, 1997), (ii) prquisit consumption (Jnsn & Mckling, 1976), (iii) divrsifying acquisitions (.g., Morck, Shlifr, & Vishny, 1990), and (iv) subsidizing poorly prforming divisions using th cash gnratd from succssful ons instad of rturning th cash to sharholdrs (.g., Brgr and Hann, 2003; Jnsn & Mckling, 1976; Lamont, 1997). Altrnativly, it could rflct th incrasd invstmnt opportunity st from (rlativly lss costly) intrnal financing sourcs. To focus on th agncy-basd xplanation, th nxt sction builds an invstmnt xpctation modl that capturs firm spcific growth opportunitis
164 S. Richardson and masurs of financing constraints. Firms with positiv rsiduals from this xpctation modl ar likly to b ovr invsting. Th mpirical tsts focus on this group of firms and xamin whthr ovr-invstmnt is rlatd to availabl fr cash flow at th tim thos invstmnts wr mad. Thus, th primary hypothsis (statd in altrnat form) is: H1: Firms with positiv fr cash flow ovr-invst. Th rlation is xpctd to b asymmtric (i.., concntratd in firms with positiv fr cash flow). This is bcaus whn firms hav ngativ fr cash flow thy ar forcd to find altrnativ sourcs of financing for invstmnt projcts. Th xtrnal capital markts ar xpctd to srv an additional monitoring rol in disciplining managrial us of funds (.g., Jnsn 1986). 1.3. A framwork to masur th constructs of fr cash flow and ovr-invstmnt Th mpirical analyss xamin th rlation btwn ovr-invstmnt and fr cash flow. This sction dscribs how ths two constructs will b masurd. I dfin total invstmnt, I TOTAL, as th sum of all outlays on capital xpnditur, acquisitions and rsarch and dvlopmnt lss rcipts from th sal of proprty, plant and quipmnt: I TOTAL;t ¼ CAPEX t þ Acquisitions t þ RD t SalPPE t Total invstmnt xpnditur can thn b split into two main componnts: (i) rquird invstmnt xpnditur to maintain assts in plac, I MAINTENANCE, and (ii) invstmnt xpnditur on nw projcts, I NEW (s Strong & Myr, 1990 for a similar dcomposition). My proxy for I MAINTENANCE is amortization and dprciation. Amortization and dprciation is an stimat of th portion of total invstmnt xpnditur that is ncssary to maintain plant, quipmnt and othr oprating assts. 2 Th nxt stp is to thn dcompos I NEW into xpctd invstmnt xpnditur * in nw positiv NPV projcts, I NEW, and abnormal (or unxpctd) invstmnt, I NEW. This brakdown is shown blow (and in complt dtail in Fig. 1): 2 Dprciation and amortization is likly to b a rasonabl stimat for maintnanc invstmnt (of th capital xpnditur varity) for firms whos dprciation schdul closly maps with th us of th asst. Howvr, this is not likly to b th cas for all firms. Likwis, dprciation and amortization is not likly to b a good approximation of maintnanc invstmnt for R&D. Rcognizing ths limitations, th invstmnt xpctation modl dvlopd in Sction 1.4 includs prior firm lvl invstmnt. To th xtnt that thr is a tmporally constant componnt to maintnanc invstmnt including this variabl will hlp captur such invstmnt.
Ovr-invstmnt of fr cash flow 165 I TOTAL,t = I MAINTENANCE,t + I NEW,t I * NEW,t I NEW,t Th abnormal componnt of invstmnt can b ngativ or positiv. Ngativ (positiv) valus corrspond to undr-(ovr-)invstmnt. Th focus of th mpirical analysis in this papr is on th ovr-invstmnt of fr cash flow. Hnc, th analysis will focus on firms with positiv valus for I NEW. Th Panl A: Dfinition of Invstmnt Expnditurs Acronym Data Itm Total Invstmnt Expnditur I TOTAL + Capital Expnditurs CAPEX 128 + Rsarch and Dvlopmnt Expnditur RD 46 + Acquisitions ACQ 129 - Sal of Proprty, Plant and Equipmnt SalPPE 107 Invstmnt to Maintain Existing Assts in Plac + Amortization and Dprciation I MAINTENANCE 125 Panl B: Dcomposition of Invstmnt Expnditurs Nw Invstmnts (I NEW ) Total Invstmnt Expnditur = Invstmnt to Maintain Existing Assts in Plac + Expctd Invstmnt on Nw Projcts + Ovr-invstmnt in Nw Projcts I TOTAL,t = I MAINTENANCE,t + I NEW,t I * NEW,t ε I NEW,t ˆ I NEW, t = a ε ˆ + bvp ˆ t 1 + jz t 1 + I NEW, t Panl C: Dfinition of Growth Opportunitis I * NEW,t V/P is a masur of growth opportunitis. It is calculatd as th ratio of th valu of th firm (V AIP ) to th markt valu of quity (itm 25 * itm 199). V AIP is stimatd as V AIP = (1-a r)bv + a (1+r)X a rd whr, a =( ω/(1+r- ω)) and r =12% and ω=0.62. ω is th abnormal arnings prsistnc paramtr from th Ohlson (1995) framwork, BV is th book valu of common quity (itm 60), d is annual dividnds (itm 21) and X is oprating incom aftr dprciation (itm 178). Z is a vctor of additional dtrminants of invstmnt xpnditur. This vctor includs lvrag, firm siz, firm ag, stock of cash, past stock rturns, prior firm lvl invstmnt, annual fixd ffcts and industry fixd ffcts. Fig. 1 Framwork for xamining invstmnt xpnditur and fr cash flow
166 S. Richardson Panl D: Rconciliation of th Sourcs and Uss of Fr cash flow Acronym Data Itm Totals SOURCES: Fr cash flow from Existing Assts in Plac CF AIP + Nt Cash flow from Oprating Activitis CFO 308 - Maintnanc Invstmnt Expnditur I MAINTENANCE 125 + Rsarch and Dvlopmnt Expnditur RD 46 1 Fr cash flow from Growth Opportunitis I * NEW - Expctd Invstmnt on Nw Projcts 2 Nt Sourcs of Fr cash flow FCF = CF AIP I * NEW (2) 1-2 USES: Ovr-Invstmnt I NEW 3 Nt Cash Flow to Equity Holdrs D Equity + Purchas of Common and Prfrrd Stock 115 + Cash Dividnds 127 - Sals of Common and Prfrrd Stock 108 4 Nt Cash Flow to Dbt Holdrs D Dbt + Long-trm Dbt Rduction 114 - Long-trm Dbt Issuanc 111 - Changs in Currnt Dbt 301 5 Chang in Financial Assts D Fin. Asst + Incras in Cash and Cash Equivalnts 274 - Chang in Short Trm Invstmnts 309 6 Othr Invstmnts Othr Inv. + Incras in Invstmnts 113 - Sal of Invstmnts 109 7 Miscllanous Cash Flows Othr - Othr Invsting Activitis 310 - Othr Financing Activitis 312 - Exchang Rat Effct 314 8 Nt Uss of Fr cash flow 3+4+5+6+ 7+8 Th following quality will always hold: FCF t = I NEW,t + DEquity t+ D Dbt t + DFinancial Asst t + Othr Inv. t + Othr t FCF t I NEW,t DEquity t D Dbt t DFinancialAsst t Othr Inv. t Othr t Fig. 1 continud
Ovr-invstmnt of fr cash flow 167 invstmnt xpctation modl is dscribd in mor dtail in Sction 1.4. Th * prdictd valu from this xpctation modl is I NEW and th rsidual valu from th xpctation modl is I NEW. Th rsidual valu is my stimat of ovrinvstmnt. Fr cash flow is cash flow byond what is ncssary to maintain assts in plac (including srvicing xisting dbt) and to financ xpctd (optimal) nw invstmnts. To masur fr cash flow, I nd stimats of thr componnts: 1. A masur of cash flow gnratd from assts in plac (CF AIP ). 2. A masur of invstmnt xpnditur ncssary to maintain assts in plac (I MAINTENANCE ). 3. A masur of th xpctd lvl of nw invstmnt xpnditur (I NEW ). CF AIP is stimatd dirctly from th statmnt of cash flows by adding rsarch and dvlopmnt xpnditur back to oprating cash flows. This is rquird bcaus accounting standards forc companis to xpns rsarch and dvlopmnt (RD) xpnditur. As such this amount is includd as a dduction to oprating cash flows. Financial conomists, howvr, usually considr RD as discrtionary invstmnt xpnditur. Maintnanc xpnditur (I MAINTENANCE ) is also dductd to rflct th fact that this invstmnt xpnditur is not a discrtionary us of funds. Thus, my stimat of th cash flow gnratd from assts in plac, CF AIP, is computd as follows: CF AIP ¼ CFO I MAINTENANCE þ RD Again this is dpictd in complt dtail in Fig. 1. Finally, to comput fr * cash flow (FCF ), xpctd nw invstmnt (I NEW ) is subtractd from cash flow gnratd from assts in plac (CF AIP ): FCF ¼ CF AIP I NEW Utilizing th invstmnt dcomposition dscribd abov (and in full dtail in th nxt sction) this framwork allows th simultanous stimation of fr cash flow and ovr-invstmnt. 1.4. Expctation modl for firm lvl invstmnt dcisions Thr is an xtnsiv litratur in conomics and financ that has xamind firm lvl invstmnt dcisions (.g., Hubbard 1998). I us this litratur to stimat xpctd invstmnt according to th following rgrssion spcification: I NEW;t ¼a þ b 1 V=P t 1 þ b 2 Lvrag t 1 þ b 3 Cash t 1 þ b 4 Ag t 1 þ b 5 Siz t 1 þ b 6 Stock Rturns t 1 þ b 7 I NEW;t 1 þ RYar Indicator þ RIndustry Indicator
168 S. Richardson Th fittd valu from th abov rgrssion is th stimat of th xpctd lvl of nw invstmnt, I * NEW. Th unxplaind portion (or rsidual) is th stimat of ovr-invstmnt, I NEW. 3 Expctd invstmnt xpnditur on nw projcts will b an incrasing function of growth opportunitis. Th undrlying construct of growth opportunitis rfrs to th prsnt valu of th firm s options to mak futur invstmnts (Myrs, 1977). As rsarchrs w ar at a disadvantag whn w try to masur this construct, bcaus managrs hav accss to th information prtaining to prospctiv invstmnt activity and popl outsid th firm do not. Th standard approach in th litratur has bn to us markt pric rlativ to som masur of fundamntal valu to dtrmin growth opportunitis. Tobin s Q (th ratio of th markt valu of assts to th currnt rplacmnt cost of thos assts) is th most widly usd masur of growth opportunitis. Howvr, masurs such as Q alon do not giv a complt pictur of th markt s xpctations of growth opportunitis. Prvious rsarch that uss book-to-markt of quity (BM) and arnings-pric ratios (EP) as masurs of growth opportunitis can b viwd as spcial cass of th rsidual incom valuation modl (Pnman, 1996). For BM to b a sufficint statistic for growth opportunitis it must b tru that arnings ar compltly transitory. Convrsly, for EP to b a sufficint statistic rquirs arnings to b compltly prmannt. Howvr, it is wll known that arnings display a dgr of man rvrsion in btwn ths two xtrms (.g., Dchow, Hutton, & Sloan, 1999). Thus, using ithr markt-to-book or pric-arnings or som arbitrary combination will gnrat an infficint stimat of growth opportunitis bcaus knowldg of arnings prsistnc is ignord. Using th rsidual incom framwork, it is possibl to construct a parsimonious masur of growth opportunitis, incorporating information in markt pric in conjunction with masurs of th valu of firm s assts in plac as rflctd in book valu and currnt arnings. I start with th prmis that firm valu can b dcomposd into two componnts: valu of th assts in plac, V AIP, and th valu of growth opportunitis, V GO. So firm valu, P, can b rprsntd as: P ¼ V AIP þ V GO Firm valu, P, is obsrvabl. So I nd to stimat ithr V AIP or V GO dirctly. A natural starting point is to stimat V AIP using th rsidual incom framwork. Th intuition bhind this approach is that th valu of assts in 3 I stimat th invstmnt xpctation modl across all firms which implis that th avrag ovrinvstmnt across firm-yars is qual to zro. Obviously, this analysis is subjct to th standard criticism of mis-spcification in th invstmnt xpctation modl (with rspct to both functional form and th st of includd indpndnt variabls). To addrss ths concrns, I considr diffrnt sts of indpndnt variabls in th invstmnt modl (s Sction 3) and prform analysis using raw and rankd data as wll as a portfolio approach that assums masurmnt rror is uncorrlatd across portfolios (discussd in Sction 3.2). My rsults ar robust to all of ths spcifications.
Ovr-invstmnt of fr cash flow 169 plac will manifst itslf in currnt book valus and arnings. On th othr hand growth opportunitis ar yt to b accountd for and will rprsnt th diffrnc btwn obsrvd firm valu and an stimat of th valu of assts in plac. Assuming pric is qual to discountd xpctd dividnds, accounting information articulats via th clan-surplus rlation, and abnormal arnings follow an auto-rgrssiv procss with prsistnc paramtr, x, it is possibl to xprss th valu of assts in plac, V AIP as: V AIP ¼ð1 arþbv þ að1 þ rþx ard whr BV is th book valu of common quity, X is arnings, r is th discount rat, d is dividnds, x is a fixd prsistnc paramtr rstrictd to b positiv and lss than on, and a =(x/(1+r x). 4 V AIP rflcts th valu of th firm indicatd by currnt book valus and currnt arnings. Thus, it provids an stimat of firm valu attributabl to assts in plac. It is usful to not that this spcification of firm valu introducd by Ohlson (1995) is an stimat of firm valu absnt growth opportunitis. Additional rsarch by Fltham and Ohlson (1996) allows for th prsnc of nw positiv NPV projcts. Undr thir modl, firm valu is similar to th algbraic xprssion abov xcpt for an additional trm that capturs growth opportunitis. This framwork simultanously capturs markt valu rlativ to both book valu and arnings in an accptd valuation framwork. It is asily implmntd, as th only rquird inputs ar pric, book valu, arnings, dividnds, a discount rat and an arnings prsistnc paramtr. 5 Thus, to captur growth opportunitis from accounting and markt information, V/P is masurd as th ratio of V AIP to markt valu instad of th standard Tobin s Q masur. 6 It is usful to discuss how V/P rlats to both book-to-markt and arningsto-pric ratios. V/P is a linar combination of BM and EP (th numrator of V/P is a wightd avrag of book valus and arnings). BM can b xprssd as th summation of futur abnormal rturn on quity (s.g., Fairfild, 4 In th mpirical implmntation of this modl I us a masur of oprating arnings. This is drivn by practical considrations rlating to th prdictability of futur abnormal arnings. Masurs of bottom lin arnings do not prform as wll as masurs of oprating arnings in prdicting abnormal arnings. This is largly du to th lowr prsistnc of th transitory itms that ar includd in masurs of comprhnsiv or bottom lin incom (.g., Dchow t al., 1999). 5 Spcifically, th framwork is flxibl nough to allow intr-tmporal and cross-sctional variation of ths last two paramtrs. Howvr, for my purposs I assum a constant discount rat of 12 prcnt and th prsistnc paramtr of 0.62 as rportd in Dchow t al. (1999). I hav rprformd all analyss using (i) industry spcific arnings prsistnc paramtrs, and (ii) firm spcific cost of capital stimats from th CAPM modl. Th ky infrnc that ovr-invstmnt is concntratd in firms with positiv fr cash flow is unaffctd by ths altrnativ stimation approachs. 6 Th rciprocal is prfrrd for two rasons. First, th distribution of th rciprocal is lss skwd lading to mor dsirabl proprtis for statistical tsts. Scond, th masur is continuous through zro such that firms with ngativ book valus ar rankd similar to high growth firms. Not that using th rciprocal (i.., V/P) mans that th xpctd rlation btwn invstmnt and growth opportunitis is ngativ.
170 S. Richardson 1994; Wilcox, 1984). Th ky drivr of BM is th xpctd lvl of abnormal futur rturn on quity for th rmaindr of th firm s oprating horizon and growth in book valus. Howvr, it is important to raliz that BM can b low du to high currnt prformanc (s.g., Fairfild, 1994; Pnman, 1991, 1996). Firms such as Coca-Cola and Krogr ar good xampls. Ths firms hav vry low BM (in bottom dcil) yt thy hav modrat lvls of V/P (around th mdian). Hnc, using BM alon will mis-classify ths firms as having high growth opportunitis. Similarly, using EP alon will lad to mis-classification. Th ky drivr of EP is th growth in futur abnormal arnings. Howvr, EP ratios alon ar difficult to intrprt in th prsnc of tmporarily dprssd currnt arnings. To discriminat btwn firms that hav low EP du to transitory arnings, as opposd to growth opportunitis, it is ncssary to look at th information in BM. Firms with low lvls of EP BM ar th firms with th gratst growth opportunitis. I includ additional control variabls that hav bn shown in prior rsarch to b dtrminants of invstmnt dcisions, including lvrag, firm siz, firm ag, th lvl of cash, past stock rturns and prior firm lvl invstmnt (.g., Barro 1990; Bats, 2005; Hubbard, 1998; Lamont, 2000). Prvious rsarch has documntd a snsitivity of firm lvl invstmnt to ths masurs. Firm lvl invstmnt is lssnd whn it is mor difficult to rais additional cash to financ th nw invstmnt as capturd by lvrag, firm siz, firm maturity and lvl of cash (.g., Fazzari t al., 1988; Hubbard, 1998). Prior stock rturns is includd as an additional variabl to captur growth opportunitis not rflctd in V/P (Barro, 1990; Lamont, 2000) and prior firm lvl invstmnt is includd to captur non-modld firm charactristics that impact invsting dcisions. I also includ indicator variabls for industry mmbrship and tmporal ffcts to captur additional variation in invstmnt xpnditur that ar not xplaind by my masurs of growth opportunitis and financing constraints. It is important to not that including ths additional variabls may rduc th powr of my tsts to captur ovrinvstmnt. For xampl, if ovr-invstmnt is concntratd in industry groups, in particular tim priods or is concntratd in crtain firms thn th modl may inappropriatly classify abnormal invstmnt as normal invstmnt, ffctivly controlling for th ffct that I am trying to documnt. To addrss this possibility, multipl invstmnt xpctation modls ar xamind in Sction 3. 1.5. Uss of fr cash flow Th focus of this papr is th ovr-invstmnt of fr cash flow. Howvr, ovr-invstmnt is but on of many altrnat uss of fr cash flow. Panl D of Fig. 1 dpicts th sourcs and uss of fr cash flow. This analysis charactrizs all possibl uss of th fr cash flow drivd in Sction 1.3. Using information obtaind from th statmnt of cash flows, I am abl to allocat fr cash flow flows into six catgoris. This is simply a r-charactrization of
Ovr-invstmnt of fr cash flow 171 th statmnt of cash flows, whr cash gnratd must qual cash usd. Th six catgoris ar: (i) ovr-invstmnt, I NEW, (ii) nt paymnts to sharholdrs, DEquity, (iii) nt principal paymnts to dbt-holdrs, DDbt, (iv) nt chang in financial assts, DFinancial Asst, (v) Othr Invstmnts and (vi) miscllanous cash flows, Othr. This is rprsntd by th following idntity: FCF t I NEW;t þ DEquity t þ DDbt t þ DFinancial Asst t þ Othr Invstmnts t þ Othr t Th final two catgoris contain miscllanous rconciling itms that ar not important mpirically (vry littl variation in th sampl). Th main concrn from th prspctiv of sharholdrs is th first catgory, ovrinvstmnt, bcaus this imposs substantial agncy costs on sharholdrs. Howvr, it is lss clar what th bst us of fr cash flow is byond avoiding ovr-invstmnt. Paymnts to sharholdrs will b affctd by th tax status of th firm s invstor bas (Alln & Michaly, 2003). In addition, paymnts to both sharholdrs and dbt-holdrs will impact th capital structur of th firm. To th xtnt that managmnt is sking an optimal capital structur, it is difficult to dtrmin what th optimal distribution of fr cash flow should b. Rtntion of fr cash flow in th form of financial assts is also an option availabl to managmnt. Th optimal lvl of fr cash flow to b rtaind will b a function of firm spcific charactristics such as variability of cash flow and ability to accss xtrnal capital markts (.g., Harford, 1999). Firms with mor volatil cash flows will want to rtain cash for futur priods whn cash flow is low, and firms who find it mor difficult to rais xtrnal capital will dsir largr cash holdings (.g., Oplr t al., 1999). My primary focus is on th xtnt of ovr-invstmnt and th rol that govrnanc structurs can play in mitigating ovr-invstmnt. I lav dtaild xamination of how firms us fr cash flow (othr than ovr-invsting) to futur rsarch. 2. Data and sampl slction Th main mpirical tsts mploy financial statmnt data from th Compustat annual databas (inclusiv of activ and inactiv scuritis). I xclud financial institutions from my analysis (SIC cods btwn 6000 and 6999) bcaus th dmarcation btwn oprating, invsting, and financing activitis is ambiguous for ths firms. Th sampl priod covrs th fiscal yars 1988 2002 with 58,053 firm-yar obsrvations. In th mpirical analysis that follows I scal all financial variabls by avrag total assts (rsults ar similar using sals as an altrnativ dflator). To minimiz th influnc of outlirs I dlt firms whr th dflatd valu of fr cash flow or any of th potntial uss of fr cash flow xcds on in absolut valu. Th masur of growth opportunitis, V/P, is winsorizd by rcoding obsrvations lss (gratr) than th 1st (99th) prcntil to th 1st (99th) prcntil. In unrportd tsts, I r-prform all analyss using rank
172 S. Richardson rgrssions according to th procdur outlind in Iman and Conovr (1979). Rsults from this analysis ar similar to thos rportd in th txt. 3. Rsults 3.1. Analysis of invstmnt xpnditur and fr cash flow Tabl 1 rports dtails on invstmnt xpnditur and th dtrmination of fr cash flow. Th avrag firm undrtaks invstmnt activity qual to 13.1% of its asst bas. Th major componnt of invstmnt is capital xpnditur, followd by rsarch and dvlopmnt xpnditur. Of th total invstmnt xpnditur, 44% is spnt maintaining xisting assts in plac and th rmaining 56% is spnt on nw invstmnts. 7 Tabl 2 rports various spcifications of th invstmnt xpctation modl. This modl facilitats th computation of ovr-invstmnt and xpctd nw invstmnt dscribd in Sction 1.3. Ovr-invstmnt is th rsidual from th * modl (I NEW ), and xpctd nw invstmnt is th fittd valu (I NEW ). Modl Tabl 1 Analysis of invstmnt xpnditur Man Std Dv P1 Q1 Mdian Q3 P99 Panl A: Dscriptiv statistics for invstmnt xpnditur I TOTAL;t ¼ CAPEX t þ Acquisitions t þ RD t SalPPE t I NEW;t ¼ I TOTAL;t I MAINTENANCE;t I TOTAL 0.131 0.135 0.024 0.043 0.094 0.180 0.647 CAPEX 0.070 0.083 0 0.023 0.047 0.087 0.406 Acquistions 0.025 0.078 0 0 0 0.005 0.411 RD 0.042 0.088 0 0 0 0.047 0.416 SalPPE 0.006 0.033 0 0 0 0.002 0.111 I MAINTENANCE 0.057 0.048 0 0.032 0.048 0.068 0.230 I NEW 0.075 0.134 0.167 0.001 0.041 0.119 0.578 This tabl xamins th proprtis of invsting cash flows as a function of growth opportunitis. Th sampl covrs 58,053 firm yars with availabl data on Compustat for th priod 1988 2002 P1 (P99) is th 1st (99th) prcntil of th rspctiv distribution Q1 (Q3) is th lowr (uppr) quartil of th rspctiv istribution I TOTAL is total invstmnt xpnditur. It is calculatd as rsarch and dvlopmnt xpnditur, RD (itm 46) plus capital xpnditur, CAPEX (itm 128) plus acquisition xpnditur, Acquisitions (itm 129) lss cash rcipts from sal of proprty, plant and quipmnt, SalPPE (itm 107) I MAINTENANCE is invstmnt xpnditur ncssary to maintain assts in plac. I proxy for this construct using rportd dprciation and amortization (itm 125) I NEW is th diffrnc btwn I TOTAL and I MAINTENANCE All invstmnt xpnditur variabls ar scald by avrag total assts (itm 6) 7 Th man firm in my sampl undrtaks invstmnt xpnditur qual to 13.1% of its asst bas. Maintnanc xpnditur for th avrag firm is qual to 5.7% of th asst bas. This constituts 44% of total invstmnt xpnditur (0.057/0.131 = 0.44).
Ovr-invstmnt of fr cash flow 173 Tabl 2 Extndd analysis of invstmnt xpnditur Variabl Prdictd Sign Modl I II III IV I NEW;t ¼ a þ b 1 V=P t 1 þ b 2 Lvrag t 1 þ b 3 Cash t 1 þ b 4 Ag t 1 þ b 5 Siz t 1 þ b 6 Stock Rturns t 1 þb 7 I NEW;t 1 þ RYar Indicator þ RIndustry Indicator V/P 0.051 ( 39.70) 0.013 ( 26.64) Lvrag 0.052 ( 19.15) 0.049 ( 17.82) Cash + 0.124 (27.03) 0.104 (21.57) Ag 0.006 ( 9.84) 0.006 ( 11.54) Siz + 0.003 (9.16) 0.003 (10.64) Stock Rturns + 0.012 0.010 (17.75) I NEW,t 1 + 0.428 (52.24) Yar Indicators No Ys No Ys Industry Indicators No Ys No Ys Adjustd R 2 0.057 0.111 0.302 0.326 (14.88) 0.386 (45.65) This tabl dvlops a modl of invstmnt xpnditur. Th dtrminants of invstmnt includ masurs of growth opportunitis, lvrag, firm ag, firm siz, cash balanc, industry fixd ffcts and annual fixd ffcts. Th sampl covrs 58,053 firm yars with availabl data on Compustat for th priod 1988 2002 T-statistics ar rportd in parnthss undrnath cofficint stimats basd on Hubr Whit robust standard rrors I NEW is th diffrnc btwn I TOTAL and I MAINTENANCE I TOTAL is total invstmnt xpnditur. It is calculatd as rsarch and dvlopmnt xpnditur, RD (itm 46) plus capital xpnditur, CAPEX (itm 128) plus acquisition xpnditur, Acquisitions (itm 129) lss cash rcipts from sal of proprty, plant and quipmnt, SalPPE (itm 107) I MAINTENANCE is invstmnt xpnditur ncssary to maintain assts in plac. I proxy for this construct using rportd dprciation and amortization (itm 125) V/P is a masur of growth opportunitis. It is calculatd as th ratio of th valu of th firm (V AIP ) and markt valu of quity (itm 25 * itm 199). V AIP is stimatd as V AIP =(1 a r)bv+a (1+r)X a rd whr, a=(x/(1+r x)) and r=12% and x =0.62. x is th abnormal arnings prsistnc paramtr from th Ohlson (1995) framwork, BV is th book valu of common quity (itm 60), d is annual dividnds (itm 21) and X is oprating incom aftr dprciation (itm 178) Ag is th log of th numbr of yars th firm has bn listd on CRSP as of th start of th yar Siz is th log of total assts (itm 6) masurd at th start of th yar Lvrag is th sum of th book valu of short trm (itm 34) and long trm dbt (itm 9) dflatd by th sum of th book valu of total dbt and th book valu of quity (itm 60) Cash is th balanc of cash and short trm invstmnts (itm 1) dflatd by total assts masurd at th start of th yar Stock Rturns is th stock rturns for th yar prior to th invstmnt yar. It is masurd as th chang in markt valu of th firm ovr that prior yar Yar Indicators is a vctor of indicator variabls to captur annual fixd ffcts Iundustry Indicators is a vctor of indicator variabls to captur industry fixd ffcts. Thr ar 43 industry indicator variabls (using Fama-Frnch, 1997 groupings) in this rgrssion All invstmnt xpnditur variabls ar scald by avrag total assts (itm 6)
174 S. Richardson I compriss only th accounting basd masur of growth opportunitis, V/P. Th rgrssion stimats rportd in this tabl ar for th poold sampl with Hubr Whit robust standard rrors, which ar a gnralization of th Whit (1980) standard rrors that ar robust to both srial corrlation and htroskdasticity (Rogrs, 1993). Th cofficint stimat for b 1 is 0.051. To giv som conomic intrprtation to th strngth of this rlation, an intrquartil chang in V/P of 0.582 [th first (third) quartil of th V/P distribution is 0.310 (0.892)], corrsponds to an additional 0.030 (0.582 * 0.051) in nw invstmnt xpnditur. Altrnativly statd, an intr-quartil chang in growth opportunitis translats to additional invstmnt qual to thr prcnt of th asst bas of th firm. Whil this numbr appars small it is important to rmmbr that V/P capturs th xpctd bnfit from currnt and xpctd invstmnt xpnditur in all futur priods. Th point stimat from this rgrssion spcification capturs only invstmnt in th currnt priod. In unrportd analyss this spcification was stimatd by industry and industry-yar groupings (using Fama & Frnch, 1997 industry dfinitions and th Fama & Macbth, 1973 tchniqu of stimating rgrssion cofficints by group and avraging rsults across groups). Th rsults ar vry similar to thos rportd in th tabl. Across all rgrssion spcifications th cofficint on V/P is significantly ngativ. Th modl of invstmnt xpnditur in th first column of Tabl 2 includs only growth opportunitis as an xplanatory variabl. Th rmaining modls xpand th st of includd dtrminants (ach spcification rports rsults with Hubr Whit robust standard rrors). Th scond modl shows that including only industry and annual fixd ffcts xplains 11.1% of th variation in I NEW. Th control variabls lvrag, cash balanc, firm ag, firm siz, prior stock rturns and prior firm lvl invstmnt xpnditur xplain 30.2% of th variation (modl III). Including all of th variabls incrass th xplanatory powr to 32.6% (modl IV). All control variabls load as xpctd nw invstmnt xpnditur is incrasing in firm siz, prior cash holdings, prior stock rturns and prior invstmnt activity and dcrasing in firm ag and lvrag. In subsqunt analyss dcomposing I NEW into * xpctd invstmnt (I NEW ) and ovr-invstmnt (I NEW ) I us modl IV. Latr rsults xamining th rlation btwn ovr-invstmnt and fr cash flow ar similar if I instad us any of th modls in Tabl 2. Tabl 3 panl A provids dscriptiv statistics for th fr cash flow masur. Th avrag firm in my sampl has cash flow from assts in plac qual to 3.8% of its asst bas. Aftr subtracting xpctd invstmnt on nw projcts (7.5% of asst bas for th avrag firm), th avrag firm has a cash shortfall (i.., ngativ fr cash flow) qual to 3.6% of its asst bas. Approximatly 45% of sampl firms hav positiv valus of fr cash flow. Panl B of Tabl 3 contains th ky rsult that ovr-invstmnt is a function of fr cash flow. I run th following rgrssion: I NEW;t ¼ a þ d 1FCF\ 0 t þ d 2 FCF > 0 t þ
Ovr-invstmnt of fr cash flow 175 Tabl 3 Analysis of fr cash flow and ovr-invstmnt Man Std Dv P1 Q1 Mdian Q3 P99 Panl A: Dscriptiv statistics for fr cash flow * FCFt ¼ CFAIP;t I NEW;t is th fittd valu from: INEW INEW;t ¼ a þ b 1 V=Pt 1 þ b 2 Lvrag t 1 þ b 3 Casht 1 þ b 4 Ag t 1 þ b 5 Sizt 1 þ b 6 StockRturnst 1 þ b 7 INEW;t 1 þ RYar Indicator þ RIndustry Indicator CF AIP 0.038 0.145 0.445 0.019 0.042 0.106 0.414 * I NEW 0.075 0.076 0.058 0.024 0.059 0.112 0.325 I NEW 0 0.110 0.249 0.050 0.012 0.030 0.414 FCF 0.036 0.153 0.573 0.092 0.012 0.045 0.288 Panl B: Rlation btwn ovr-invstmnt (I NEW I NEW;t ¼ a þ d 1FCF\0t þ d2fcf[0t þ ) and fr cash flow (FCF) Modl a d 1 d 2 Adjustd R 2 Poold 0.002 (2.65) F-statistic for tst d 1 =d 2 : 40.87*** 0.037 Fama-MacBth (15 yars) 0.002 (1.54) T-statistic from annual cofficint stimats for tst: d1=d2: 2.35*** 0.111 (15.19) 0.115 (9.47) 0.171 (13.78) 0.172 (12.13) 0.032 Th tabl xamins th proprtis of fr cash flow and how it rlats to ovr-invstmnt. All variabls ar scald by avrag total assts. Th sampl covrs 58,053 firm yars with availabl data on Compustat for th priod 1988 2002 T-statistics ar rportd in parnthss undrnath cofficint stimats. ***indicats significant diffrnc at th 1% lvl For th poold rgrssions I rport t-valus basd on Hubr Whit robust standard rrors For th industry and industry-yar group rgrssions th paramtr stimats and ar th wightd avrag (using th squar root of th numbr of obsrvations in ach group as th wight) of individual group rgrssion paramtrs. Tst statistics ar basd on th across group variation in ths paramtrs P1 (P99) is th 1st (99th) prcntil of th rspctiv distribution Q1 (Q3) is th lowr (uppr) quartil of th rspctiv distribution
176 S. Richardson Tabl 3 continud I NEW is th diffrnc btwn I TOTAL and I MAINTENANCE I TOTAL is total invstmnt xpnditur. It is calculatd as rsarch and dvlopmnt xpnditur, RD (itm 46) plus capital xpnditur, CAPEX (itm 128) plus acquisition xpnditur, Acquisitions (itm 129) lss cash rcipts from sal of proprty, plant and quipmnt, SalPPE (itm 107) I MAINTENANCE is invstmnt xpnditur ncssary to maintain assts in plac. I proxy for this construct using rportd dprciation and amortization (itm 125) * I NEW I NEW is th fittd valu from rgrssion modl IV in Tabl 2. It is an stimat of th xpctd lvl of invstmnt is th rsidual from rgrssion modl IV in Tabl 2. It is an stimat of ovr-invstmnt CF AIP is cash flow from oprating activitis aftr maintnanc invstmnt xpnditur. It is calculatd as cash from oprations (itm 308) lss I MAINTENANCE plus rsarch and dvlopmnt xpnditur (itm 46) * FCF is CF AIP lss I NEW. FCF is cash flow byond that ncssary to maintain assts in plac (including srvicing xisting dbt obligations) and financ xpctd nw invstmnts (i.., fr cash flow) FCF <0 (FCF > 0) is qual to FCF for valus of FCF lss (gratr than) zro and zro othrwis All invstmnt and cash flow variabls ar scald by avrag total assts (itm 6)
Ovr-invstmnt of fr cash flow 177 FCF <0(FCF > 0) is qual to FCF for valus of FCF lss (gratr than) zro and zro othrwis. This allows th rlation btwn ovr-invstmnt and fr cash flow to b asymmtric. In particular, allowing th slop cofficint to vary basd on th sign of fr cash flow rvals that ovr-invstmnt is concntratd in firms with positiv fr cash flow (th stimat of d 1 is 0.111 and th stimat of d 2 is 0.171, significantly diffrnt at th 1% lvl). Panl B rports both poold rgrssion stimats (using robust standard rrors) as wll as avrag stimats from annual rgrssions. Out of th fiftn annual rgrssions, th stimat for d 2 is statistically gratr than th stimat for d 1 in lvn yars. Whn firms hav do not hav fr cash flow, (i.., FCF < 0) th possibility of ovr-invstmnt is mitigatd as th firm is forcd to accss xtrnal markts to rais funds ncssary for any additional invstmnt. Capital markts srv an additional monitoring rol in disciplining managrial us of funds. Th rgrssion rsults in Tabl 3 support H1 by showing that firms with positiv fr cash flow ar mor likly to ovr-invst on avrag and thn for ach additional dollar of fr cash flow thy ovr-invst mor. It is important to not th rlativly low xplanatory powr from this rgrssion spcification. Th modl dscribing fr cash flow as th dtrminant of ovrinvstmnt only xplains 3.2% of th variation. Howvr, this xplanatory powr is incrmntal to th st of othr dtrminants of firm lvl invstmnt xpnditur (which was 32.6% for modl IV). So, th combind framwork is abl to xplain a significant portion of th cross-sctional variation in invstmnt xpnditur and find a statistically significant rlation btwn ovrinvstmnt and fr cash flow. Whil not th focus of my papr, th rgrssion rsults in Tabl 3 also rlat to undr-invstmnt. Th positiv cofficint on d 1 indicats that firms with ngativ fr cash flow xprinc lss ovr-invstmnt (or quivalntly statd mor undr-invstmnt as th man valu of ovr-invstmnt for this sub-sampl of firms is ngativ). This rlation is consistnt with th notion that firms subjct to cash short falls from oprating activitis scal back on invstmnt activity. But it is important to not that th strngth of th rlation btwn abnormal invstmnt and fr cash flow is mutd for firms with ngativ fr cash flow (i.., d 1 is much smallr than d 2 ) bcaus ths firms ar abl to rais additional cash from xtrnal financial markts. Panl A of Tabl 4 rports th distributional proprtis of th fr cash flow masur and th various uss of fr cash flow. Thr is littl variation in th othr invstmnts and miscllanous othr catgory I ignor ths uss in subsqunt discussion. Th brakdown of ach additional dollar of fr cash flow is shown in panl B of Tabl 4. I xamin firm-yar obsrvations with positiv fr cash flow sparatly from ngativ fr cash flow obsrvations. For ach sampl, I avrag th diffrnt uss of fr cash flow and xprss ach us as a prcntag of availabl fr cash flow. This partition on th sampl mphasizs how th us of fr cash flow varis basd on th sign of fr cash flow. For firms with positiv fr cash flow (44.6% of th sampl) th avrag us of a dollar of fr cash flow is as follows: 20% is ovr-invstd, 13% is paid out
178 S. Richardson Tabl 4 Analysis of altrnativ uss of fr cash flow. Th sampl covrs 58,053 firm yars with availabl data on Compustat for th priod 1988 2002 Man Std Dv P1 Q1 Mdian Q3 P99 Panl A: Dscriptiv statistics for how fr cash flow is usd FCF 0.036 0.153 0.573 0.092 0.012 0.045 0.288 I NEW 0 0.110 0.249 0.050 0.012 0.030 0.414 DEquity 0.021 0.132 0.665 0.008 0 0.017 0.196 DDbt 0.017 0.115 0.461 0.041 0 0.025 0.251 D FinancialAsst 0.001 0.127 0.409 0.025 0.000 0.027 0.441 Othr Inv. 0.002 0.058 0.160 0 0 0 0.182 Othr 0.002 0.075 0.293 0.003 0 0.008 0.189 Panl B: How fr cash flow is usd Sourcs and Uss FCF > 0 Firm-yars (n = 25,897) FCF < 0 Firm-yars (n = 32,156) Avrag Prcnt (%) Avrag Prcnt (%) Sourcs FCF 0.075 100 0.126 100 Uss I NEW 0.015 20 0.012 10 DEquity 0.009 13 0.046 37 DDbt 0.011 15 0.039 31 DFinancialAsst 0.031 41 0.022 18 Othr Inv. 0.004 6 0.000 0 Othr 0.004 5 0.006 5 P1 (P99) is th 1st (99th) prcntil of th rspctiv distribution Q1 (Q3) is th lowr (uppr) quartil of th rspctiv distribution DEquity is th nt cash rturnd to sharholdrs for th priod. It is calculatd as th sum of rpurchass, (itm 115) and dividnds (itm 127) lss cash raisd from stock issuanc (itm 108) DDbt is th nt cash rturnd to dbtholdrs for th priod. It is calculatd as long trm dbt rduction (itm 114) lss long trm dbt issuanc (itm 111) lss changs in currnt dbt (itm 301) DFinancial Assts is th chang in cash holdings. It is calculatd as chang in cash (itm274) lss chang in short trm invstmnts (itm 309) Othr Invstmnts is othr invstmnts mad. It is calculatd as incras in invstmnts (itm113) lss sal of invstmnts (itm 109) Othr includs all othr catgoris on th statmnt of cash flows not includd in DEquity, DDbt, DFinancial Assts, I NEW and Othr Invstmnts. It is calculatd as th ngativ of th sum of xchang rat ffcts (itm 314), othr invsting activitis (itm 310) and othr financing activitis (itm 312) * FCF is CF AIP lss I NEW. FCFs cash flow byond that ncssary to maintain assts in plac (including srvicing xisting dbt obligations) and financ xpctd nw invstmnts CF AIP is cash flow from oprating activitis aftr maintnanc invstmnt xpnditur. It is calculatd as cash from oprations (itm 308) lss I MAINTENANCE plus rsarch and dvlopmnt xpnditur (itm 46) I NEW is th diffrnc btwn I TOTAL and I MAINTENANCE. I NEW rprsnts invstmnt xpnditur aftr maintnanc of xisting assts in plac. I TOTAL is total invstmnt xpnditur. It is calculatd as rsarch and dvlopmnt xpnditur, RD (itm 46) plus capital xpnditur, CAPEX (itm 128) plus acquisition xpnditur, Acquisitions (itm 129) lss cash rcipts from sal of proprty, plant and quipmnt, SalPPE (itm 107). I MAINTENANCE is invstmnt xpnditur ncssary to maintain assts in plac. I proxy for this construct using rportd dprciation and amortization (itm 125)
Ovr-invstmnt of fr cash flow 179 Tabl 4 continud * I NEW is th fittd valu from rgrssion modl IV in Tabl 2. It is an stimat of th xpctd lvl of invstmnt I NEW is th rsidual from rgrssion modl IV in tabl 2. It is an stimat of ovr-invstmnt All cash flow and invstmnt variabls ar scald by avrag total assts to sharholdrs, 15% is paid out to dbt-holdrs, 41% is rtaind in financial assts, and th rmaining 11% is sprad across th othr catgoris. For firms with ngativ fr cash flow, th brakdown is quit diffrnt. Th fr cash flow shortfall is financd as follows: 10% is undr-invstd, 37% is rcivd from sharholdrs, 31% is rcivd from to dbt-holdrs, 18% is financd from xisting financial assts, and th rmaining 5% is sprad across th othr catgoris. It is clar that firms with cash shortfalls rais additional funds through quity and dbt offrings and also by running down xisting cash balancs. For firms with positiv fr cash flow, th two main uss ar rtntion in th form of financial assts and ovr-invstmnt. Consistnt with th rgrssion rsults in Tabl 3 and th agncy cost xplanation, th positiv rlation btwn ovr-invstmnt and fr cash flow is concntratd in thos obsrvations whr fr cash flow is positiv. 3.2. Robustnss tsts and limitations for th primary hypothsis To addrss concrns about th robustnss of th primary finding of a positiv rlation btwn ovr-invstmnt and fr cash flow I prform svral additional tsts (all unrportd). Th finding that ovr-invstmnt is concntratd in firms with positiv fr cash flow is supportd by all of ths additional tsts. 3.2.1. Altrnativ masurs of growth opportunitis I xamin th strngth of th rlation btwn ovr-invstmnt and fr cash flow for altrnativ masurs of growth opportunitis. Altrnat masurs for growth opportunitis includ book-to-markt of quity, arnings-to-pric ratios and Tobin s Q. I xamin ths variabls (along with a factor scor combination of th variabls) instad of V/P and continu to find a strong positiv rlation btwn ovr-invstmnt and fr cash flow with ths altrnat pric-basd masurs of growth opportunitis. Thr is also th possibility that markt pric has alrady incorporatd th liklihood of ovr-invstmnt and th strngth of govrnanc mchanisms. This will impact th us of pric-basd masurs to idntify ovrinvstmnt. Th bias that this introducs into my mpirical analysis is not immdiatly clar. Howvr, I hav rplicatd my analysis of ovr-invstmnt and fr cash flow using only a pric-fr stimat of growth opportunitis (using th industry mdian lvl of invstmnt as a bnchmark). I compar I NEW for ach firm to th industry mdian lvl of I NEW, dnotd as I IND NEW. My masur of ovr-invstmnt (I NEW ) is thn th
180 S. Richardson diffrnc btwn I NEW and I IND NEW and my stimat of xpctd invstmnt * (I NEW ) is qual to I IND NEW. Using this pric-fr stimation I still find ovr-invstmnt concntratd in firms with positiv valus of fr cash flow. R-stimating th rgrssion quation in panl B of Tabl 3, I find that d 2 is statistically gratr than d 1 in fourtn out of th 15 yars (i.., th rlation btwn ovr-invstmnt and fr cash flow continus to b concntratd in firms with positiv fr cash flow consistnt with th agncy cost xplanation). Th algbraic rprsntation of V AIP prsntd in Sction 1.4 is qual to th valu of th firm with unbiasd accounting and no positiv NPV projcts. In practic, accounting is systmatically biasd and firms fac positiv NPV projct choics. Thus, my stimat of growth opportunitis will captur not only th positiv NPV projcts but also th impact of consrvativ accounting practics. This could b a problm as I includ rsarch and dvlopmnt xpnditur (RD) as part of invstmnts. To mitigat th problm of consrvativ accounting on my mpirical analysis, I hav prformd all analyss xcluding firm yar obsrvations whr th markt-to-book ratio xcds 5 or RD xcds 25% of sals. Ths xclusions do not impact th ky infrnc that ovr-invstmnt is concntratd in firms with positiv fr cash flow. 3.2.2. Masurmnt rror in ovr-invstmnt and fr cash flow Th rducd form invstmnt modl that I xamin can also b criticizd for masurmnt rror. To mitigat this concrn, I utiliz a portfolio approach to r-stimat th rlation btwn ovr-invstmnt and fr cash flow. I randomly sort firms into 200 portfolios and thn calculat th man valu for ovr-invstmnt and fr cash for ach portfolio. Nxt, I prform a rgrssion of man ovr-invstmnt on man fr cash flow for ths 200 portfolios. Th rsulting rgrssion has an adjustd R 2 of 0.045 and a cofficint of 0.195 on fr cash flow. Similar rsults ar obtaind using mdian valus. To th xtnt that masurmnt rror is uncorrlatd across ths avragd random portfolios th positiv rlation btwn ovr-invstmnt and fr cash flow is not attributabl to masurmnt rror. 8 In unrportd tsts I also includ a masur of th volatility of past cash flows as an additional control variabl. I do not includ th cash flow volatility variabl in th main tsts as it gratly rducs th sampl siz (to 34,112 firm-yar obsrvations) bcaus I rquir a sufficint tim sris for ach firm to b abl to stimat oprating cash flow volatility. As xpctd, this variabl is ngativly 8 It is not critical for my analysis that my invstmnt modl is fr from rror. I only nd to b abl to idntify a masur of unxpctd (undr/ovr) invstmnt that is corrlatd with tru unxpctd (undr/ovr) invstmnt. This is likly to b achivd givn that my modl of xpctd invstmnt xpnditur is drawn from prior rsarch. Th thortical foundation for th rducd form modl, th robustnss of th rlation (btwn ovr-invstmnt and fr cash flow) to altrnativ spcifications, th concntration of th rlation in firms with positiv fr cash flow and cross-sctional variation in th rlation basd on th strngth of govrnanc structurs (s Sction 4) allspaks to an conomic rsult and not mrly a spurious corrlation.
Ovr-invstmnt of fr cash flow 181 rlatd to invstmnt xpnditur. Mor importantly, including this variabl dos not affct th positiv rlation btwn ovr-invstmnt and fr cash flow. 3.2.3. Is th rlation btwn fr cash flow and ovr-invstmnt mchanical? Thr is a concrn of a potntial mchanical rlation btwn fr cash flow and ovr-invstmnt as stimatd from this framwork. This concrn ariss bcaus th masur of fr cash flow can b r-writtn as (CF AIP I NEW + I NEW ). Thus, any association with ovr-invstmnt might b mchanical. Whil this is a valid concrn, th rsults suggst that th rlation is non-linar and is concntratd in firms with positiv fr cash flow. If th rlation was purly mchanical, thr is no rason to xpct this to apply to only a subst of th data. Nonthlss, I conduct additional mpirical analyss to addrss this concrn. Th simplst way to rmov th potntial mchanical rlation is to xamin th association btwn I NEW (i.., all nw invstmnt xpnditur and not th stimatd normal lvl of nw invstmnt) and th masur of cash flows gnratd from assts in plac including masurs of growth opportunitis. In this spcification, thr is no longr th potntial for a pur mchanical rlation as I do not subtract th sam variabl (I* NEW ) from both sids. Th following rgrssion spcification was prformd: I NEW;t ¼ a þ d A CF AIP \0 þ d B CF AIP > 0 þ b 1 V=P t 1 þ rror CF AIP <0 (CF AIP >0) is qual to CF AIP for valus of CF AIP lss (gratr than) zro and zro othrwis. As with th rgrssion analysis in Tabl 3, this allows th rlation btwn nw invstmnt xpnditur and cash flows from assts in plac to b asymmtric. Th rsults from this analysis ar consistnt with th rportd rsults. Spcifically, cofficint stimats for d A and d B ar 0.131 and 0.319, rspctivly (statistically diffrnt at convntional lvls). 3.2.4. Altrnativ tratmnt of maintnanc invstmnt Th invstmnt dcomposition has assumd maintnanc invstmnt is a valu addd activity. Dprciation and amortization is likly to b a rasonabl stimat for maintnanc invstmnt (of th capital xpnditur varity) for firms whos dprciation schdul closly maps with th us of th asst. Howvr, this is not likly to b th cas for all firms. Likwis, dprciation and amortization is not likly to b a good approximation of maintnanc invstmnt for R&D. An altrnat viw of th firm is that all invstmnt (including maintaining assts in plac) is discrtionary. Undr such a viw, th firm should only rplac/rpair xisting assts to th xtnt that this is a positiv NPV projct. To addrss this issu th ntir analysis was rpatd rmoving I MAINTENANCE from th invstmnt calculation. Thus, I TOTAL, rathr than I NEW, is dcomposd. Rsults from this analysis yild similar rsults to thos rportd in Sction 3.1, namly that ovr-invstmnt is concntratd in firms with positiv fr cash flow.
182 S. Richardson 3.2.5. Gnral limitations Finally, a criticism of any rsarch mthodology using an xpctations modl is th quality of that modl. Spcifically, th infrncs I can draw ar contingnt on th quality of th invstmnt xpctation modl. I hav basd my xpctations modl on xisting rsarch, but nonthlss it is still subjct to th criticism that non-linaritis and corrlatd omittd variabls outsid my modl may driv th positiv rlation btwn my masurs of ovrinvstmnt and fr cash flow. Howvr, in th absnc of thory, thr is littl guidanc as to altrnativ functional forms for th invstmnt modl. 4. Govrnanc hypothss In this sction, I xamin whthr govrnanc structurs mitigat th agncy costs associatd with ovr-invstmnt. Givn th arlir rsults of an on avrag ovr-invstmnt problm, th analysis in this sction is xploratory in natur to idntify which, if any, of a larg st of govrnanc mchanisms mitigats th ovr-invstmnt of fr cash flow. 4.1. Masuring govrnanc and sampl slction Thr ar many mchanisms that stakholdrs mploy to chck th activitis of managmnt. Rcnt acadmic paprs hav startd to xamin xtnsiv sts of govrnanc variabls (.g., Dy, 2005; Larckr t al., 2005). Furthrmor, govrnanc rating agncis (such as Institutional Sharholdr Srvics and Govrnanc Mtrics Intrnational) produc summary rating statistics that ar basd on hundrds of inputs. For th analysis in this sction, I us 13 of th 14 govrnanc factors dvlopd in Larckr t al. (2005) for a sampl of 1,417 firms for th 2002 fiscal yar. Th dbt govrnanc factor is xcludd as lvrag is part of th invstmnt xpctation modl. Th govrnanc masurs fall into six gnral catgoris: charactristics of th board of dirctors, stock ownrship by xcutivs and board mmbrs, stock ownrship by institutions, stock ownrship by activist holdrs, compnsation mix variabls and anti-takovr dvics. Th govrnanc data usd to construct ths factors ar obtaind primarily from Equilar Inc. and TruCours Inc. Nots to Tabl 5 summariz th 37 componnt variabls that ar usd to construct th 13 factors (a full dscription can b found in Larckr t al., 2005). 4.2. Standard linar rgrssion analysis To xamin th impact of th 13 govrnanc factors on th rlation btwn ovr-invstmnt and fr cash flow, I stimat th following rgrssion: INEW ¼a þ d 1FCFþ R/Govrnanc Factors þ RwGovrnanc Factors FCF þ
Ovr-invstmnt of fr cash flow 183 Tabl 5 Rlation btwn govrnanc structurs, ovr-invstmnt and fr cash flow Indpndnt variabl Prdictd sign Cofficint stimat (T-statistic) INEW ¼ a þ d 1FCF þ R/Govrnanc Factors þ RwGovrnanc Factors FCF þ Intrcpt 0.001 (0.15) FCF + 0.167 (3.06)*** Activ 0.268 ( 3.11)*** BLOCK 0.083 ( 1.37) Affiliatd + 0.025 ( 0.29) Insidr appointd + 0.075 (1.13) Compnsation mix 0.045 ( 0.74) Mtings 0.013 ( 0.17) Anti-takovr I + 0.139 (1.83)* Old dirctors + 0.037 ( 0.37) Insidr powr + 0.023 ( 0.28) Board siz + 0.094 (1.09) Lad dirctor 0.046 ( 0.61) Anti-takovr II + 0.133 ( 1.82)* Busy dirctors + 0.107 (1.10) Main ffcts ar includd but not rportd for sak of brvity Adjustd R 2 full modl 0.018 Adjustd R 2 govrnanc factors only 0.005 Th sampl covrs 815 firms with positiv fr cash flow for th 2002 fiscal yar for which data is availabl from Equilar Inc. and TruCours Inc. to comput rlvant govrnanc masurs *, **, ***indicats significanc at th 10%, 5%, 1% lvl rspctivly S arlir tabls for dfinition of FCF Th 14 govrnanc factors includd in th rgrssion ar basd on a principal componnts analysis of 39 structural masurs of govrnanc as outlind in Larckr t al. (2005). I rtain all factors with an ignvalu gratr than unity. This rsults in 14 factors that rtain 61.7% of th total varianc in th original data. This rducd solution is thn rotatd using an obliqu rotation that allows th rtaind factors to b corrlatd in ordr to nhanc intrprtability of th PCA solution. Ths 14 factors rprsnt th undrlying dimnsions of corporat govrnanc. For full dtails of th loadings across componnt masurs s Larckr t al. (2005). Th factors ar standardizd combinations of th following variabls (Dbt is xcludd as lvrag is includd in th invstmnt xpctation modl) Activ compriss th numbr of activist sharholdrs (as dfind in Crmrs and Nair, 2003), prcntag hld by activist sharholdrs and th fraction of outstanding shars hld by th avrag outsid dirctor
184 S. Richardson Tabl 5 continud BLOCK compriss th fraction of outstanding shars ownd by block-holdrs (a block-holdr is dfind as a sharholdr who holds mor than 5% of outstanding shars), th numbr of blockholdrs and th sharholding of th largst institution Affiliatd compriss th fraction of th audit and compnsation committs that ar comprisd of affiliatd (gry) dirctors and whthr th chair of ths committs is affiliatd. Any outsid dirctor who is a formr xcutiv or who is mntiond in th crtain transactions sction of th proxy statmnt is classifid as affiliatd Insidr Appointd capturs th fraction of affiliatd and outsid dirctors that wr appointd by xisting insidrs Compnsation Mix compriss th dtails of annual CEO compnsation (th portion that is tid to prformanc plans, stock options, rstrictd stock grants and annual bonuss) Mtings compriss th numbr of mtings of th board and th compnsation and audit committs Lad Dirctor capturs whthr th firm has a lad dirctor or an insidr chair-prson Anti-Takovr I capturs whthr th firm has a staggrd board, has adoptd a poison pill and th fraction of outstanding shars hld by th avrag affiliatd dirctor Old Dirctors compriss th fraction of insidr, affiliatd and outsid dirctors that ar oldr than 70 Insidr Powr compriss th fraction of board who ar insidr (xcutiv) dirctors, th fraction of outstanding shars hld by th avrag xcutiv dirctor (xcluding th holdings of th top xcutiv), th fraction of outstanding shars hld by th top xcutiv, and whthr th firm has dual class shars Board Siz compriss th siz of th board, compnsation and audit committs Anti-Takovr II compriss suprmajority provision for takovrs and stat of incorporation Busy Dirctors compriss th fraction of outsid and affiliatd dirctors who srv on 4 or mor othr boards and th fraction of insid dirctors who srv on 2 or mor othr boards I xpct a significantly positiv cofficint for d 1 and ngativ cofficints for ach of th intractd govrnanc factors (i.., th w cofficints) that ar incrasing in good govrnanc (Activ, BLOCK, Compnsation Mix, Mtings, and Lad Dirctor) and positiv cofficints for thos that ar incrasing in bad govrnanc (Affiliatd, Insidr Appointd, Anti-Takovr I, Old Dirctors, Insidr Powr, Board Siz, Anti-Takovr II, and Busy Dirctors). Givn th arlir rsults documntd a concntration of ovrinvstmnt in firms with positiv fr cash flow, I limit th analysis of govrnanc structurs to this subst of firms. Th rgrssion rsults ar prsntd in Tabl 5. Consistnt with th arlir analysis, thr is a strong positiv rlation btwn ovr-invstmnt and fr cash flow (th cofficint d 1 is 0.167 and is significantly diffrnt from zro). Of th 13 govrnanc factors only thr, Activ, Anti-Takovr I and Anti- Takovr II ar statistically associatd with ovr-invstmnt. Activ and Anti- Takovr I ar significant in th xpctd dirction. As xpctd, firms with mor activist sharholdrs xprinc lowr lvls of ovr-invstmnt of fr cash fiow, and firms with staggrd boards and poison pills in plac (componnts of Anti-Takovr I) xprinc highr lvls of ovr-invstmnt of fr cash flow. Howvr, firms with suprmajority voting provisions and thos firms incorporatd in managmnt frindly stats xprinc lss
Ovr-invstmnt of fr cash flow 185 ovr-invstmnt of fr cash flow. Collctivly, th rsults in Tabl 5 suggst that crtain govrnanc structurs ar ffctiv in mitigating th ovrinvstmnt of fr cash flow. Howvr, it is important to not th vry low xplanatory powr of this rgrssion (only 2 prcnt of th cross-sctional variation in ovr-invstmnt is xplaind jointly by fr cash flow and th 13 govrnanc factors, and only 0.5% is xplaind solly by th govrnanc factors). 4.3. Additional govrnanc analyss Th mpirical analysis of govrnanc structurs and ovr-invstmnt dscribd in th last sction was x post in natur. In unrportd tsts, I hav also xamind th link btwn govrnanc structurs and ovr-invstmnt from an x ant prspctiv. Of cours, finding vidnc of x post ovrinvstmnt of fr cash flow (as in Sction 3.2) suggsts that govrnanc structurs ar not dsignd x ant optimally. Thrfor, tsting whthr thr is cross-sctional variation in govrnanc structurs as a function of th lvl of fr cash flow, a masur of th propnsity for ovr-invstmnt, may not b a crdibl null hypothsis. Nonthlss, it is instructiv to xamin whthr th dsign of govrnanc mchanisms incorporats prcivd agncy costs (as masurd by th propnsity of a firm to ovr-invst). To xamin whthr govrnanc structurs ar dsignd in rspons to fr cash flow rlatd agncy costs, I avrag annual masurs of fr cash flow for firms with availabl Compustat data for th priod 1997 2002 and govrnanc data for th 2002 fiscal yar. This lavs a sampl of 1,496 firms (ach firm appars only onc in this analysis). Firms ar sortd into portfolios basd on th magnitud of avrag fr cash flow ovr th 1997 2002 priod. Tsts of diffrncs in govrnanc structurs across ths groups ar thn prformd. Thr is som vidnc of diffrnt govrnanc structurs for firms with diffrnt lvls of fr cash flow from arlir fiscal priods. For xampl, firms with highr lvls of fr cash flow ar mor likly to hav a gratr concntration of activist sharholdings, largr boards, hav mor incntiv basd compnsation for top xcutivs, b incorporatd in sharholdr frindly rgims, and hav suprmajority voting provisions (all pattrns ar statistically significant at convntional lvls). Convrsly, firms with highr lvls of fr cash flow ar lss likly to hav affiliatd dirctors on th board and ky committs, and lss likly to hav staggrd boards and poison pills (again all pattrns ar statistically significant at convntional lvls). Ths rlations, howvr, ar not particularly strong. For xampl, th xplanatory powr (adjustd R 2 ) of avrag fr cash flow from 1997 to 2002 for th 13 govrnanc factors (masurd as at th nd of fiscal 2002) rangd from 0.06% for Mtings to 15.8% for Activ. Only Activ, Board Siz and Anti-Takovr II had an adjustd R 2 gratr than 2% (Adjustd R 2 wr 15.8, 6.0 and 2.3%, rspctivly). Givn ths rlativ wak associations, car nds to b takn in intrprting that govrnanc structurs ar dsignd in rspons to fr cash flow rlatd agncy costs. Furthrmor, th data xamind is
186 S. Richardson masurd as at th nd of fiscal 2002. Idally, on would xamin changs in govrnanc structurs through tim and xamin how ths structurs adjust in rspons to changs in th nvironmnt in which th firm oprats (.g., Goodman, 2005). Th absnc of a rlation btwn fr cash flow and contmporanous govrnanc structurs may not b surprising givn that govrnanc structurs do not chang frquntly, spcially if fr cash flow is not vry prsistnt. To addrss this issu, an altrnat rsarch dsign is to xamin whthr govrnanc structurs vary basd on th lvl of cash (industry-adjustd) rportd on th balanc sht. Evn with this altrnat approach, thr is littl vidnc of any systmatic rlation btwn govrnanc structurs and th lvl of cash hld by th firm. 5. Conclusion This papr prsnts vidnc on firm lvl ovr-invstmnt of fr cash flow. Th mpirical analysis utilizs an accounting basd framwork to masur th constructs of fr cash flow and ovr-invstmnt. A comparativ advantag of th accounting rsarchr is in masuring critical constructs from th financial conomics litratur. Th analysis of ovr-invstmnt and fr cash flow is but on xampl of how accounting information can b bttr utilizd in acadmic rsarch. Th vidnc in this papr suggsts that ovr-invstmnt is a common problm for publicly tradd US firms. For non-financial firms during th priod 1988 2002, th avrag firm ovr-invsts 20 prcnt of its availabl fr cash flow. Furthrmor, th majority of fr cash flow is rtaind in th form of financial assts. For ach additional dollar of fr cash flow th avrag firm in th sampl rtains 41 cnts as ithr cash or marktabl scuritis. Thr is littl vidnc that fr cash flow is distributd to xtrnal stakholdrs, thrby crating th potntial for rtaind fr cash flow to b ovr-invstd in th futur. Supplmntal analysis found only wak vidnc that govrnanc structurs ar ffctiv in mitigating th xtnt of ovr-invstmnt. Ths findings corroborat rcnt work that has found significant ngativ futur stock rturns from capital invstmnt and significant growth in nt oprating assts (.g., Fairfild t al., 2003; Titman t al., 2004). Indd, Li (2004) finds that futur oprating prformanc is lowr for firms ngaging in invstmnt xpnditur and that this ngativ rlation is incrasing in contmporanous fr cash flow. A natural xplanation for this poor futur prformanc is fr cash flow rlatd agncy costs. Th framwork dvlopd in th papr to masur ovr-invstmnt and fr cash flow can asily b xtndd to considr abnormal invstmnt mor gnrally. Indd, som rcnt rsarch has startd to us this framwork to xamin th impact of accounting information systms on invstmnt dcisions and th fficint allocation of capital (.g., Bushman, Piotroski, & Smith, 2005; Goodman, 2005; Wang, 2003).
Ovr-invstmnt of fr cash flow 187 Acknowldgmnts This papr is basd on my dissrtation at th Univrsity of Michigan. I would lik to thank mmbrs of my dissrtation committ: Richard Sloan (Chair), Jrry Davis, Patricia Dchow, Doug Skinnr and Matthw Shapiro. I apprciat hlpful commnts from workshop participants at Boston Collg, Univrsity of California, Brkly, Univrsity of Chicago, Columbia Univrsity, Harvard Univrsity, MIT, Nw York Univrsity, Northwstrn Univrsity, Univrsity of Pnnsylvania, Univrsity of Rochstr and Stanford Univrsity, Mark Bradshaw, Dan Collins, John Cor, Juli Cottr, Ilia Dichv, Jf Doyl, Hulya Eraslan, Ray Fisman, Td Goodman, Raffi Indjjikian, Irn Kim, David Larckr, Charls L (ditor), Russll Lundholm, Andrw Mtrick, David Musto, Vnky Nagar, Stphn Pnman, Abbi Smith, Gary Solon, Stv Taylor, Irm Tuna, Ross Watts, Ptr Wysocki, Stphn Young, an anonymous rfr and confrnc participants at th 2005 Rviw of Accounting Studis Confrnc, spcially thos of Danil Brgstrssr. I would lik to rcogniz financial support from th Paton Scholarship Fund, th Dloitt & Touch Foundation, th Arthur Andrsn Foundation and th Michal J. Barrtt Dissrtation Award from th Institut of Intrnal Auditors. Rfrncs Alln, F., & Michaly, R. (2003) Payout policy. In North-Holland handbook of conomics ditd by Gorg Constantinids, Milton Harris, and Rn Stulz. Alti, A. (2003). How snsitiv is invstmnt xpnditur to cash flow whn financing is frictionlss? Journal of Financ, 53, 707 722. Barro, R. (1990). Th stock markt and invstmnt. Rviw of Financial Studis, 3, 115 131. Bats, T. W. (2005). Asst sals, invstmnt opportunitis, and th us of procds. Journal of Financ, 60, 105 135. Brgr, P. G., & Hann, R. (2003). Th impact of SFAS 131 on Information and Monitoring. Journal of Accounting Rsarch, 41, 163 223. Blanchard, O. J., Lopz-d-Silans, F., & Shlifr, A. (1994). What do firms do with cash windfalls? Journal of Financial Economics, 36, 337 360. Brown, L., & Caylor, M. (2004). Corporat Govrnanc and Firm Prformanc. Working papr, Gorgia Stat Univrsity. Bushman, R. M., Piotroski, J. D., & Smith, A. J. (2005). Capital allocation and timly rcognition of conomic losss: Intrnational vidnc. Working papr, Univrsity of Chicago. DAnglo, H., DAnglo, L., & Stulz, R. (2004). Dividnd Policy, Agncy Costs and Earnd Equity. Working papr, Univrsity of Southrn California. Dchow, P. M., Hutton, A. P., & Sloan, R. G. (1999). An mpirical assssmnt of th rsidual incom valuation modl. Journal of Accounting and Economics, 26, 1 34. Dchow, P. M., Richardson, S. A., & Sloan, R. G. (2005). Th Prsistnc and Pricing of th Cash Componnt of Earnings. Working papr, Univrsity of Michigan and Univrsity of Pnnsylvania. Dy, A. (2005). Corporat govrnanc and financial rporting crdibility. Working papr, Northwstrn Univrsity. Fairfild, P. M. (1994). P/E, P/B and th prsnt valu of futur dividnds. Financial Analysis Journal, July Aug, 23 31 Fairfild, P. M., Whisnant, J. S., & Yohn, T. L. (2003). Accrud arnings and growth: Implications for futur profitability and markt mispricing. Accounting Rviw, 78, 353 371. Fama, E. F., & Frnch, K. R. (1997). Industry costs of quity. Journal of Financial Economics, 43, 153 194 Fama, E. F., & Macbth, J. D. (1973). Risk, rturn and quilibrium mpirical tsts. Th Journal of Political Economy, 81, 607 636 Fazzari, S. M., Hubbard, R. G., & Ptrsn, B. C. (1988). Financing constraints on corporat invstmnt. Brookings Paprs on Economic Activity, 141 195. Fazzari, S. M., & Ptrsn, B. C. (1993). Working capital and fixd invstmnt: Nw vidnc on financing constraints. RAND Journal of Economics, 24, 328 342. Fltham, G. A., & Ohlson, J. A. (1996). Uncrtainty rsolution and th thory of dprciation masurmnt. Journal of Accounting Rsarch, 34, 209 234.
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