The Impct of Negtive Csh Flow nd In uentil Observtions on Investment-Csh Flow Sensitivity Estimtes George Allynnis Drden Grdute School of Business, University of Virgini PO Box 6550, Chrlottesville, VA 906 (804) 94-3434, llynnisy@drden.virgini.edu Abon Mozumdr Pmplin College of Business, Virgini Tech 7054 Hycock Rod, Flls Church, VA 043 (703) 538-8414, bon@vt.edu Keywords: Finncing Constrints, Csh Flow, Investment JEL Clssi ction Code: G31, G3 Erlier versions of the pper were circulted under the title `Resolving the Investment-Csh Flow Sensitivity Puzzle: Negtive Csh Flows nd In uentil Observtions'. We would like to thnk Honghui Chen nd Siyid Islm for help with the dt, nd two nonymous referees, Ykov Amihud, Sen Clery, John Esterwood, Rob Hnsen, Kose John, Greg Kdlec, Rmn Kumr, N.R. Prbhl, Alexndros Prezs, Vijy Singl, Toni Whited, nd seminr prticipnts t Boston University, Northestern, Virgini Tech, University of Msschussetts t Amherst, the Frnk Btten conference t Willim nd Mry, EFMA 000 in Athens, nd WFA 001 in Tucson for comments nd suggestions. We lso wish to thnk respectively the Drden School Foundtion nd the Pmplin College of Business, Virgini Tech, for summer support.
Abstrct Kpln nd Zingles (1997) nd Clery (1999) diverge from the lrge literture on investment-csh ow sensitivity by showing tht investment is most sensitive to csh ow for the lest nncilly constrined rms. We exmine if this result cn be explined by the fct tht when rms re in su±ciently bd shpe (incurring csh losses), investment cnnot respond to csh ow. We nd tht while Clery's results cn be explined by such negtive csh ow observtions, the Kpln-Zingles results re driven more by few in uentil observtions in smll smple. We lso record decline in investment-csh ow sensitivity over the 1977-96 period, prticulrly for the most constrined rms.
1. Introduction The reltion between rm nncing constrints nd investment-csh ow sensitivity hs been the topic of n importnt debte in recent yers. The trditionl viewpoint, originlly put forwrd by Fzzri, Hubbrd, nd Petersen (1988) (herefter FHP) holds tht rms tht fce tighter nncing constrints, i.e., lrger cost di erentil between internl nd externl funds, hve to rely more on internl csh for mking investments. Using di erent proxies for nncing constrints, numerous empiricl studies hve found tht the estimted investment-csh ow sensitivity is indeed higher 1 for more constrined rms. However, Kpln nd Zingles (1997) (herefter KZ) chllenge this literturebypresentingopposing evidencefrom the lowdividend pyout subset ofthefhp 1970-84 smple. They show tht within this smple of low dividend pyout rms, the lest constrined rms hve the highest estimted sensitivity. The KZ result nds further support from Clery (1999), who uses more recent dt (1987-94), exmines lrge cross-section (1317 rms), nd mesures nncing constrints by discriminnt score estimted from severl nncil vribles. This pper exmines whether the KZ/Clery (1999) ndings re driven by the fct tht when rm is in su±ciently bd shpe, investment cnnot respond to csh ow. The intuition is tht when the csh shortfll is severe, the rm is pushed into nncil distress nd is ble to mke only the bsolutely essentil investments. Any further cutbck in investment in response to further declines in csh ow is impossible, so tht investment-csh ow sensitivity is very low. By de nition, the more constrined rm hs more restricted ccess to externl nncing nd reches this `miniml investment' stge more rpidly. Therefore, the less constrined rm is likely to disply greter investment-csh ow sensitivity thn the more constrined rm, when internl csh ows re prticulrly low. We rgue tht negtive csh ow is useful proxy for chrcterizing rms 1 Some of the proxies used for nncing constrints re: dividend pyout rtio (FHP), bond rtings nd ccess to debt mrkets (Clomiris, Himmelberg, nd Wchtel (1995), Gilchrist nd Himmelberg (1995)), membership in corporte groups (Hoshi, Kshyp, nd Schrfstein (1991), Clem nd Rizzo (1995), Shin nd Prk (1998)), bnking reltionships (Houston nd Jmes), nd ge nd dispersion of ownership (Schller (1993)). See Hubbrd (1998) for review of this literture. Fzzri, Hubbrd, nd Petersen (000) mke similr point in their response to KZ. Speci clly, they point out 1
tht re in such nncilly distressed situtions, nd present evidence on rm chrcteristics such s growth rtes, debt rtings, debt rtios, nd dividend chnges, con rming the vlidity of this proxy. In KZ, the bis induced by negtive csh ows is compounded by the problem of smll smple size. KZ tke the 49 rms tht FHP identify s the most constrined, nd further rnk them by thedegree of nncingconstrints. Consequently, thereis littlesystemtic cross-sectionl vrition in nncingconstrints between the di erent groups, nd we nd tht their results re sensitive to the inclusion of two rms (Coleco nd Mohwk Dt Sciences) in the constrined group, nd two rms (Digitl nd Dt Generl) in the less constrined one. Along with the negtive csh ow observtions, these observtions induce the di erence in estimted sensitivities for the two groups found by KZ. Smll smple size is not problem in Clery (1999): we nd tht the results in this study re driven lrgely by the impct of negtive csh ow observtions. Clery(1999) includes ll non- nncil, non-utility, publicly-trded US rms over the 1987-94 period, without reference to their csh ow positions. This leds to the inclusion of severl negtive csh ow observtions, which lowers the investment-csh ow sensitivity estimtes forthe groups in which they re included. Since the incidence of these negtive csh ow observtions is the highest in the high- nncing-constrints group, this e ect is the strongest, nd the estimted sensitivity the lowest for this group. Using smple nd methodology similr to Clery's, but excluding the negtive csh ow observtions, we nd tht investment-csh ow sensitivity estimtes re lmost identicl cross ll nncing constrint groups.speci clly, in line with Clery's results, the estimted sensitivities for the most nd lest constrined groups re 0.069 nd 0.14, respectively, (the di erence being sttisticlly signi cnt) when negtive csh ow observtions re included; nd 0.19 nd 0.11, respectively, tht even when rm csh ows re extremely low or negtive, gross investment cnnot be less thn zero. This my introduce censored regression bis in the estimted investment-csh ow sensitivities if the impct of such negtive csh ow observtions is not ccounted for in the estimtion procedure.
when they re excluded (the di erence being sttisticlly insigni cnt). This indictes tht the 3 Clery(1999) result is mterilly ected by the inclusion of negtive csh ow observtions. We obtin similr results in n lterntive speci ction, where insted of omitting negtive csh ow observtions, we include n dditionl interction term between the negtive csh ow dummy vrible nd the csh ow vrible toccount for the impct of negtive csh ow observtions on estimted sensitivities. The result on the uniformity of investment-csh ow sensitivity cross constrint ctegories found in the Clery smple when negtive csh ow observtions re excluded is of dditionl interest becuse it is lso di erent from the evidence in FHP nd other erlier studies tht showed positivereltion between nncing constrints nd investment-csh owsensitivity (e.g., estimted sensitivities of 0.461nd 0.30for the most constrined nd lest constrined groups, respectively, in FHP). A possible explntion is tht there hs been reduction over time in the impct of nncing constrints on rm investment. We exmine this possibility using dt for ll mnufcturing rms with continuous coverge by Compustt for the period 1977-96, nd nd evidence supporting such conclusion: fter excluding negtive csh ow observtions from the smple, the investment-csh ow sensitivity is signi cntly higher for more constrined rms thn less constrined rms (0.586 versus 0.13) over the 1977-86 period, but they re similr for the two groups (0.196 versus 0.175) nd the di erence sttisticlly insigni cnt over the 1987-96 period. The pper thus mkes two contributions to the literture. First, it reconciles the ndings of KZ nd Clery (1999) with erlier results, nd shows tht the level of internl welth s proxied by csh ow is mjor determinnt of investment, nd hs mjor in uence on the investmentcsh ow reltionship. To the extent tht nncil distress is form of nncing constrint, our results lso con rm thecentrl conclusions of KZ/Clery tht theinvestment outlys of rms with weker nncil positions re less sensitive to internl csh ows by showing tht negtive csh 3 Note tht for rm with csh losses in some yers, we do not exclude observtions for ll yers, but only for those speci c yers in which csh ow ws negtive. 3
ow observtions (our proxy for wek nncil helth), which re most prevlent mong the most 4 constrined rms, show less sensitivity of investmement to csh ow. Second, the pper documents decline in investment-csh ow sensitivities for US rms, especillyfor the nncilly constrined ctegory. Thepperisorgnized sfollows. Section presentsbriefreviewoftheliterture nd develops our hypothesis, employing KZ's theoreticl frmework. Section 3 revisits the KZ nd Clery (1999) studies nd exmines the impcts of in uentil observtions nd negtive csh ow observtions. Section 4 exmines the chnge in investment-csh ow sensitivity over time using Compustt dt on mnufcturing rms over the 1977-96 period. Section 5 exmines the operting nd nncil chrcteristics of rms cross the di erent constrint ctegories, nd for the negtive csh ow observtions. Section 6 concludes.. Literture Review nd Hypothesis Development In their seminl pper, FHP observe tht cpitl mrket imperfections led to corporte underinvestment when internl csh is not enough to invest t the rst-best level. They rgue tht this connection between csh ow nd investment should be strongest for those rms tht re most constrined in ccessing externl cpitl. Empiriclly, they nd tht rms fcing tighter nncing constrints indeed hve higher investment-csh ow sensitivities. In contrst, KZ rgue tht it is theoreticlly not necessry for this sensitivity to be strongest for the most constrined rms. 5 Therefore, their empiricl nding tht the sensitivity is strongest for the lest constrined rms should not be seen s n enigm. Rther, they rgue tht both their theoreticl nd empiricl results refute the trditionl view tht this sensitivity is mesure of nncing constrints. 4 We thnk one of the referees for pointing out this dditionl interprettion of our ndings. 5 KZ dopt the underinvestment model of Froot, Schrfstein, nd Stein (1993) which shows tht when the production function is concve nd the dditionl cost of externl nnce is convex, investment is below the rst-best level if internl csh is not su±cient. 4
In the most recent exchnge in this ongoing debte, Fzzri, Hubbrd, nd Petersen (000) contest KZ's conclusions by rguing tht the KZ smple is too smll nd homogeneous. They lso suggesttht the lowinvestment-csh ow sensitivity for themost constrined group my be due to instnces of nncil distress. In response, Kpln nd Zingles (000) rgue tht this distinction between nncing constrints nd nncil distress is unimportnt. Further, they counter the criticism bout insu±cient cross-sectionl heterogeneity in their smple by citing Clery's (1999) study, where the smple is lrge nd clerly heterogeneous. This pper seeks to brek this impsse, by exmining the impct of negtive csh ow observ- tions on the KZ nd Clery (1999) results. 6 Negtive csh ow observtions need specil scrutiny becuse they represent instnces in which investments re down to their lowest possible levels, nd cnnot be reduced ny further in response to dditionl csh ow declines. Therefore, for such rms, the estimted investment-csh ow sensitivity is low. To the extent tht one views nncil distress s n bnorml stte nd not representtive of the cpitl mrket imperfections tht the investment-csh ow sensitivity literture seeks to study (i.e., how otherwise helthy rms re forced to cut bck investments when they experience csh ow shortflls) then these observtions should be excluded from considertion. On the other hnd, however, to the extent tht nncil distress is form of nncing constrint, then the inclusion of these observtions is pproprite. 7 Consider the bsic Froot, Schrfstein, nd Stein (1993) frmework tht KZ dopt. The rm invests I in production technology with (gross) outputf(i) tht is incresing nd concve, i.e., F I > 0 nd F II < 0. The rm hs internlly generted csh W. If W is insu±cient to invest in ll vilble positive NPV projects, the rm hs to rise externl nncing E = I W. Due to cpitl mrket imperfections, externl funding E hs n dditionl cost C(E;k) over the cost of 6 Since FHP mesured nncing constrints on the bsis of dividend pyout rtio, they explicitly concentrted on rms tht hd t lest some income to distribute. Speci clly, they included rm in their smple only if it hd positive rel sles growth over the smple period (1969-84). Therefore, their smple is likely to hve excluded most negtive csh ow observtions. See Fzzri, Hubbrd, nd Petersen (1996, p. 7). 7 See Fzzri et l (000) nd Kpln nd Zingles (000) for detils on this ongoing debte. 5
internl funds (ssumed to be zero), where k mesures the degree of nncing constrints fced by the rm. C is incresing nd convex in E, nd incresing in k, i.e., C > 0;C > 0; nd C > 0. E EE k FSS nd KZ show tht when the rm hs to rely upon externl funds, it underinvests, i.e., the investment level chosen is lower thn the rst-best level. The f.o.c. for this constrined solution is nd the investment-csh ow sensitivity is KZ rgue tht it is not necessry for di dw F I = 1 +C E (1) di C = EE : () dw C F EE II to be higher for rms fcing tighter nncing constrints. If the degree of nncing constrints is mesured by the lck of internl csh W, then this condition is equivlent to But, so tht condition (3) is stis ed i d I < 0: (3) dw Ã! di F C F C III EEE = II EE (4) dw F C (C F ) 3 II EE EE II Ã! FIII CEEE < 0 (5) FII CEE which is not necessrily true. For exmple, KZ show tht when C is qudrtic function of E nd ½ F(I) = I ;0 < ½ < 1; condition (5), nd therefore condition (3) re violted. However, it is rguble whether the degreeof nncingconstrints is properly mesured by the shortfll in internl csh ow W. A low-w rm is probbly in greter nncil distress, but not necessrily fcing tighter nncing constrints (see, e.g., Fzzri, Hubbrd, nd Petersen (000)). This distinction between nncil distress nd nncil constrints is lso discussed by Lmont, Polk, nd S-Requejo (001), who use negtive rel sles growth s proxy for nncil distress. 8 8 We show in Section 5 tht negtive csh ow observtions re lso ssocited with negtive rel sles growth, indicting tht these two proxies for nncil distress re strongly correlted. 6
Finncing constrints refer to the di±culty of rising externl nncing, or the cost di erentil between internl nd externl funds, nd re represented by k in the model. A high vlue of k, rther thn low vlue of W, is more direct sign of nncing constrints, even though the two re likely to be correlted. 9 Thus, more pproprite condition describing the trditionl view of the impct of nncing constrints on investment-csh ow sensitivity is d I dkdw > 0; (6) i.e., investment-csh ow sensitivity ( di dw ) is greter for rms fcing bigger cost di erentil (k) between internl nd externl funds. But gin, it is esy to nd instnces where this condition would be violted. From (), we obtin d I C Ek(FIIC EEE FIIIC EE) CEEkFII = 3 (7) dkdw (C F ) (C F ) EE II EE II nd there re no theoreticl rguments to gurntee tht this expression is positive. 10 di di dkdw dw The fct tht therere notheoreticl restrictions on thesigns of nd unconditionlly leds KZ to conclude tht the reltion between nncing constrints nd investment-csh ow sensitivity is completely indeterminte. Further nlysis of the model, however, suggests tht in n empiricl context, wecn qulify this indetermincy result tosome extent, nd develop predictions d I dkdw bout the reltion conditionl on the csh ow reliztion. The quntity mesures the di dw d I dkdw derivtive of w.r.t. k given speci c vlue of W. We nd tht even when is negtive for some (extremely low) vlues of W, there re resons to expect it to be positive in most cses (moderte nd lrge W). 9 This correltion between nncil distress nd nncil constrints is prticulrly problemtic in empiricl work. For exmple, Kpln nd Zingles(000) rgue tht nncil distress is form of nncing constrints, nd Povel nd Rith (001) suggest tht low csh ow is component of nncing constrints. (We thnk one of the referees for pointing this out to us.) 10 di If C(E; k) is dditively seprble, i.e., C(E; k) = f(e) + g(k), then C Ek = C EEk = dkdw = 0. If C(E; k) is multiplictively seprble, i.e., C(E; k) = f (E)g(k), then C Ek = feg k > 0; C EEk = feeg k > 0; the second term on the RHS of (7) is positive, nd the rst term is negtive if F III > 0 nd/or C EEE > 0 =) condition (6) my or my not be stis ed. 7
Consider the clss of functions tht KZ use qudrtic cost function nd frctionl power ½ 11 returns function, i.e., C(E) =ke nd F(I) =I ; ½ (0; 1). Substituting these functions into eqution (7), we show tht di 1 ½ 1 ½ dkdw k k vilble upon request). For exmple, with k = 1 nd ½ = 0:5, thn, nd negtive when W is lower thn, -0.5. is positive for W > nd negtive for W < (exposition d I dkdw is positive when W is higher Figures 1 3 provide grphicl illustrtion. The intuition is clerer when the problem is viewed in terms of mrginl returns nd costs, insted of totl returns nd cost functions F(I) nd C(E;k). Accordingly, let Á(I) = F I(I) be the mrginl returns function nd Ã(E;k) = C E(E;k) be the mrginl cost function, with Á = F 0, nd à = C I II E EE 0. Figures 1 nd depict 0 the underinvestment problem. The unconstrined optiml level of investment, I, represents the 0 point t which Á = 1. But if internl csh ow W is less thn I, then this level of investment is not ttined. The constrined optiml level of investment is the point t which condition (1) is stis ed, i.e., Á = 1 +Ã. Thus, investment hs to be cut bck from its rst-best level. Figures 1 nd illustrte how it is possible for d I dkdw to hve di erent signs over di erent vlues of W. For i = 1;, let Ã(W;k ) be the (dditionl) mrginl cost of externl nncing for rm-i, i with k > k nd Ã(W;k ) > Ã(W;k );8W. When the csh ow level chnges by W, the chnge 1 1 I 1 I I 1 I i W W W W di di 1 dkdw H dkdw L in investment for rm-i is I. In Figure 1, <, while in Figure, >. In the limit s W! 0 nd k! k, > 0 t W = W (Figure 1), while < 0 t W = W (Figure ). In Figure 1, the csh ow level W is reltively lrge nd both rms hve signi cnt exibility H in choosing the level of investments. The mrginl impct of csh ow reduction on investment is stronger for the more constrined rm- thn the less constrined rm-1. In Figure, however, the csh ow level W is very low. Firm- hs lredy cut investments drsticlly, nd hs very L little room to reduce investments ny further, while rm-1 still hs some investments tht cn be cut if csh ow declines further. Thus, the sign of d I dkdw is seen to reverse s csh ow flls from 11 When both the cost nd returns functions re qudrtic (mrginl cost nd returns functions re liner), i.e., C(E) =ke nd F (I) =l +mi ni, it cn be esily shown tht d I=dkdW > 0; 8W. 8
moderte to very low levels. Recent work by Povel nd Rith (001) reches similr conclusion using more forml theoreticl model. Note however, tht the constrined optiml level of investments is lwys lower for the more constrined rm, i.e., I (W;k ) > I (W;k );8W;k < k, while the unconstrined optiml level is 1 1 independent of k. Therefore, the investment-csh ow pro le for the more constrined rm lwys lies below tht for the less constrined rm, s shown in Figure 3. The gure lso shows tht investment sensitivity di dw is higher for the more constrined (high-k) rm for norml levels of csh ow, but is higher for the low-k rm for very low/negtive csh ows, con rming the reversl of the sign of di dkdw discussed erlier. Empiricl studies of investment-csh ow sensitivitytypiclly estimtethe stright linepproximtion of possibly nonliner csh ow-investment pro le, given certin degree of nncing constrints k fced by the rm (controlling for other fctors). 1 The usul speci ction is I K I K Wt = + Q t + + FIRMDUM + YEARDUM + ² (8) K t t 1 t 1 t t where is investment during yer t, scled by beginning-of-yer cpitl stock; is csh ow t 1 t 1 during yer t, scled similrly; Q is beginning-of-yer Tobin's Q, used s proxy for investment t W K opportunities; nd FIRMDUM nd YEARDUM re rm nd yer dummies. 13 The coe±cient does not mesure the slope of the curve for ny speci c vlue of internlly generted csh W. Rther, it mesures the verge slope over the entire observed rnge of W. Clerly, its vlue depends upon this rnge. Consider the investment-csh ow sensitivities of two rms s shown in Figure 3. The investment-csh ow pro le of the more constrined rm ( rm-) is more steeply sloped, i.e., it hs higher di dw, when csh ow W is positive. However, investment s function of csh ow ttens out, nd its investment-csh ow sensitivity becomes lower thn tht of the less constrined 1 In ctul empiricl work, it is customry to use group of rms with similr levels of k. 13 Erickson nd Whited(000) hve recently critiqued this speci ction by rguing tht reserchers do not hve true mesure of mrginl Q nd resort to using verge Q insted, leding to bis in the estimted coe±cients. They propose mesurement error-consistent estimtor tht uses the informtion in third nd higher order moments of the regression vribles to overcome this problem. 9
rm ( rm-1) when csh ow turns negtive. If observtions from the left til of the distribution di d dkdw dk (the low-csh ow or the distressed stte observtions) re excluded, then > 0) > 0, i.e., the more constrined rms hve higher investment-csh ow sensitivity. In contrst, when lrge number of observtions from the left til re included (s in KZ nd Clery(1999)), the signs di d dkdw dk of nd cnnot be determined priori. The empiricl nlysis is complicted by the fct tht W nd k re not independent. Themore constrined (high-k) rms re lso more likely to hve low reliztions of W. Therefore, when low-w observtions re included in the smple, the estimted coe±cient is reduced more for the high-k rms. Alterntively, when negtive csh ow observtions re excluded from the smple, more constrined rms should exhibit greter investment-csh ow sensitivity. 3. The Kpln-Zingles(1997) nd Clery(1999) Evidence Revisited 3.1 The Kpln-Zingles(1997) Evidence Revisited In this subsection, we exmine the role of negtive csh ow observtions on the KZ results. A second concern bout the KZ results reltes to the smll size, nd consequently, the possible lck of cross-sectionl vrition in their smple. Hubbrd (1998) rgues tht since KZ use the subset of rms tht werelredy identi ed byfhp s being most nncilly constrined, nd then further ctegorize them on the bsis of nncing constrints, there my be little cross-sectionl heterogeneity between their di erent constrint groups. In such sitution, even few in uentil outliers my mterilly lter results. Therefore, we exmine the impct of (1) negtive csh ow observtions, nd () in uentil observtions in smll smple, on the KZ results. FollowingKZ, we obtin Compustt dton the low dividends (high nncing constrint) subset of the FHP smpleoverthe 1970-84period. Firmsre ctegorized s beingfinncillyconstrined (FC), Possibly Finncilly Constrined (PFC), nd Not Finncilly Constrined (NFC) ccording 10
14 to the qulittive clssi ction reported by KZ (Appendix of their pper, p. 14-15). speci ction is given by eqution (8), with Tobin's Q mesured s in KZ. The model Results re reported in Tble 1. For ech of the three constrint groups (FC, PFC, nd NFC), we report the estimted investment-csh ow sensitivity. The rst row of estimtes reports when the group includes ll rms ssigned to tht group. Estimted investment-csh ow sensitivities re 0.344, 0.144, nd 0.66 for the FC, PFC, nd NFC groups, respectively. These estimtes re similr to those reported by KZ (0.34, 0.18, 0.70) nd support their conclusion tht the lest constrined rms disply the gretest investment-csh ow sensitivity. The NFC-FC di erence in estimted sensitivities is highly signi cnt, both economiclly nd sttisticlly. However, the subsequent rows in Tble 1 report excluding one rm in the group t time, nd show tht the results hinge criticlly on the inclusion of two rms (Coleco nd Mohwk Dt Sciences) in the FC group, nd two rms (Digitl nd Dt Generl) in the NFC group. Investmentcsh ow sensitivities re estimted using ll (positive nd negtive csh ow) observtions, s well s using positive csh ow observtions only. For the full smple, sensitivity estimtes for the FC group re tightly clustered in the rnge [0.31,0.365] when Coleco (CLO) is included in the smple, but increses to 0.438 when it is excluded, nd to 0.484 when both Coleco nd Mohwk (MDS) re excluded. For the NFC group, the estimtes lie in the rnge [0.656,0.683] when Dt Generl (DGN) nd Digitl (DEC) re included, but it declines to 0.585 when Digitl is excluded, 0.573 when Dt Generl is excluded, nd to 0.490 when both re excluded from the smple. When these rms re removed from their respective groups, investment-csh ow sensitivities re not signi cntly di erent for the most nd lest constrined rms (the t-sttistic for the di erence is 0.084 15 ). When these rms s well s negtive csh ow observtions re excluded from the 14 Dt re missing for 44 observtions, resulting in totl smple of 691 observtions. KZ's smple hd 719 observtions. The di erence in the number p of observtions is due to di erent versions of Compustt used. 15 t-sttistics re clculted s ( )= s +s 1 1. Weighting the estimted vrinces bythe number of observtions, q i.e., clculting t-sttistics s ( )= (n s +n s ) yields qulittively very similr results. 1 (n 1 1 1+n ) 11
smple, the estimted sensitivities re lmost identicl for the FC nd NFC groups (0.61 nd 0.618, respectively) nd the di erence is sttisticlly insigni cnt (t-sttistic of -0.033). Results for the 1970-77 nd 1978-84 sub-smples re similr. 16 The t sttistics mentioned bove nd described in footnote 15 my be inpproprite becuse of the heteroscedsticity inherent in pnel dt. However, most erlier ppers, including FHP nd KZ, use similr t tests nd we report these t sttistics for redy comprison with such erlier ndings. Clery(1999) uses empiricl p vlues to overcome this potentil problem. Another wy to del with it is to pool observtions from two groups, nd use group dummy vrible s well s n interction vrible (csh ow intercted with group dummy). A t test of the interction term coe±cient then yields the sttisticl signi cnce of the di erence in the estimted sensitivities for the two groups. We cll this sttistic t, nd report it long with the usul t sttistics. All our results re robust to this djustment fort sttistics. Thet sttistics for the KZ smple re 0.08 when the four rms re excluded, nd -0.1 when negtive csh ows re excluded s well. 17 These results indicte the sensitivity of the KZ ndings to the in uence of two rms in ech constrint group Coleco nd Mohwk in the constrined group, nd Digitl nd Dt Generl in the not-constrined one. The di erence in the estimted investment-csh ow sensitivities of constrined nd unconstrined groups is ctully the sensitivity di erence of these few rms only. When these rms re removed from the smple, the estimted investment-csh ow sensitivities 16 In 1970-77, for the FC group the estimted sensitivity lies in the rnge [0.378,0.501] when negtive csh ow observtions re included, nd is not prticulrly sensitive to the exclusion of ny one rm. For the NFC group, however, the estimte is in the rnge [0.686,0.733] when Digitl nd Dt Generl re included, but reduces to 0.583 when Digitl is excluded, 0.578 when Dt Generl is excluded, nd 0.443 when both re excluded. When Digitl nd Dt Generl re excluded, the t sttistic for the di erence in the estimted sensitivities of the FC nd NFC groups is 0.147. When negtive csh ow observtions re lso excluded, the estimted sensitivities re 0.613 for the FC group, 0.504 for the NFC group, nd the t sttistic for the di erence is -0.775. In 1978-84, the estimted sensitivity for the NFC group lies in the rnge [0.481,0.66], when negtive csh ow observtions re included. For the FC group, it lies in the rnge [0.11,0.173] when either Coleco or Mohwk Dt Sciences (MDS), or both re included, but increses to 0.435 when both re excluded. When negtive csh ow observtions s well s s these rms re excluded, the investment-csh ow sensitivity estimte for the FC group is 0.688 while tht for the NFC group is 0.746, nd the di erence is sttisticlly insigni cnt (t sttistic of 0.317). Complete results re vilble from the uthors upon request. 17 We thnk one of the referees for suggesting this correction. 1
re not signi cntly di erentfor thefc nd NFC groups, nd re similr to the estimtes reported by FHP for their constrined group (i.e., the universe of KZ's smple). 3. The Clery(1999) Evidence Revisited We next exmine the impct of negtive csh ow observtions on Clery's(1999) results. Speci clly, following Clery(1999), we obtin dt on ll non- nncil, non-utility rms trded on U.S. 18 stock exchnges over the period 1987-1994 from Disclosure Worldscope, Jnury 1995. As in Clery(1999), we perform discriminnt nlysis of the decision to increse or decrese dividends. The discriminnt score Z is used s the mesure of (the inverse of) nncing constrints. 19 FC In ech yer, the top one-third rms with the highest Z FC scores re ssigned to the Not Finn- cilly Constrined (NFC)group, thenext one-third tothe Prtilly FinncillyConstrined (PFC) group, nd the lowest one-third to the Finncilly Constrined (FC) group. Combining dt for the seven yers, we obtin three groups of 660 rm-yers ech. These re now used to estimte the investment-csh ow sensitivity model. While it hs been customry in the literture to use Tobin's Q to control for growth opportunities (see model speci ction (8)), Clery(1999) uses the simpler substitute of equity mrket-to-book rtio. Accordingly, we estimte model (8) using equity mrket-to-book ( M t 1 B t 1 ) insted of Tobin's Q for ech of the three nncing constrints groups. The results re very similr to those reported in Clery(1999). To conserve spce, we hve not reported detiled results. (Detiled results will be provided to interested reders upon request.) The estimted investment-csh ow sensitivities re 0.069, 0.1, nd 0.14 for the FC, PFC, nd NFC groups, respectively, which closely mtch those reported by Clery(1999) (0.064 for FC, 0.09 for PFC, nd 0.153 for NFC). The t sttistics for the di erence in estimted sensitivities between PFC nd FC, NFC nd PFC, nd NFC nd FC re.658,.97, nd 6.6, respectively, supporting 18 While our recreted smple is qulittively similr to the originl, there is di erence in the number of rms (1140 versus 1317) tht is due to di erence in the versions of Disclosure Worldscope used. Also, s the nlysis requires severl beginning-of-yer dt items, our rst yer of nlysis is 1988. 19 See Clery(1999) for exct descriptions nd mesurement detils of the discriminnt vribles. 13
the hypothesis tht the less constrined rms exhibit greter investment-csh ow sensitivities. We next exmine the extent to which these estimtes re ected by the inclusion of negtive csh ow observtions in the smple. We nd signi cnt chnge in the results when we exclude the negtive csh ow observtions from the smple (results re reported in Tble ). Pnel A reports results for the regression speci ction (8), using the discriminnt score s the mesure of nncing constrints, nd excluding negtive csh ow observtions. Estimted investment-csh ow sensitivities re similr for ll three nncing constrints groups: 0.19, 0.194, nd 0.11 for the FC, PFC, nd NFC groups, respectively. The t-sttistics for the di erences in investment-csh ow sensitivities between PFC nd FC, NFC nd PFC, nd NFC nd FC groups re 0.46, 1.00, nd 1.9, respectively, none of which denotes signi cnce t conventionl levels. t sttistics s described in Section 3.1 re lso ll insigni cnt. Pnels B, C, nd D present results from severl robustness checks. Pnel B reports estimtes from the lterntive speci ction I X X M X t t 1 Wt = if CDUM it + i F CDUM it + i FCDU Mit Kt 1 Bt 1 K i i i t 1 +FIRMDUM + YEARDUM +² t; iffc;pfc;nfcg (9) where FCDUM ;iffc;pfc;nfcg, re dummy vribles for the nncing constrint groups. i Thisspeci ction hs thetwin dvntge of gretere±ciencynd of constriningthe rm nd yer xed e ects to be uniform cross the three groups. The investment-csh ow sensitivity estimtes re 0.05, 0.186, nd 0.04 for the FC, PFC, nd NFC groups, respectively, nd the t-sttistics for the estimte di erences re -1.578, 1.495, nd 0.088, con rming tht the sensitivities re not signi cntly di erent cross the constrints groups. Pnel C reports results for the speci ction It X X Mt 1 X Wt = ifcdum it + i FCDUM it + i FCDUMit Kt 1 Bt 1 K i i i t 1 14
X W t + i FCDUM itnegdum +FIRMDUM +Y EARDUM +² t; K i t 1 iffc;pfc;nfcg (10) where insted of omitting negtive csh ow observtions, we include n dditionl interction term between thenegtive csh ow dummyvriblenegdum nd csh owtocontrol fortheimpct of such observtions on investment-csh ow sensitivity estimtes. This pproch overcomes the censored regression bis problem induced by the negtive csh ow observtions without hving to drop these observtions (Greene 000, p. 3-35). Once gin, estimted sensitivities (0.195, 0.183, 0.08) re very close for the three constrint groups. While the NFC-PFC di erence in the estimted sensitivities is sttisticlly signi cnt, the economic signi cnce is smll, nd the PFC- FC nd NFC-FC di erences re sttisticlly insigni cnt s well. Note lso tht the coe±cient on theinterction term is negtivend sttisticlly signi cnt, con rmingourintuition thtdistressed rms s proxied by negtive csh ow observtions hve lower investment-csh ow sensitivities thn non-distressed rms in ech of the nncing constrints groups. One importnt distinction between the pproch of FHP nd those of KZ nd Clery(1999) lies in the mesurement of nncing constrints. While FHP use pyout rtio s the mesure of (the lck of) nncing constrints, KZ nd Clery(1999) mesure nncing constrints on the bsis of severl rm-level vribles; KZ combine the informtion in these vribles qulittively, while Clery(1999) uses the discriminnt nlysis pproch described bove. We nd however, tht forming nncing constrints groups bsed on theesily clculted pyout rtioinsted of the more dt- nd computtion-intensive discriminnt score mkes little qulittive di erence to the results. Pnel D reportsresults from estimtingmodel (9) using nncing constrints groupsbsed on pyout rtio. The estimted investment-csh ow sensitivities re 0.199 for FC, 0.19 for PFC, nd 0.8for NFC. Thet sttistics for the di erence in investment-csh ow sensitivities between the PFC nd FC, NFC nd PFC, nd NFC nd FC re -0.619,.647, nd.13, respectively. The lterntive t sttistics lso convey similr picture. While the estimted investment-csh ow 15
sensitivity for the lest constrined group is signi cntly higher thn the other two, the economic signi cnces of the di erences re smll, nd the reltionship between nncing constrints nd investment-csh ow sensitivity is not monotonic, but U-shped, which is in line with Povel nd Rith's (001) theoreticl prediction. Overll, the evidence in Pnels A-D suggests tht the erlier result of the sensitivity being higher for the less constrined rms is primrily due to the inclusion of negtive csh ow observtions. An interesting feture of the dt reltes to the number of negtive csh ow observtions in ech nncing constrints group. When nncing constrints re mesured by the discriminnt score (pyout rtio), the number of negtive csh ow observtions is 437 (443) for the FC group, 148 (139) for the PFC group, nd 80 (83) for the NFC group. This highlights the e ectiveness of Clery's (1999) pproch in identifying rms with wek nncil sttus. It lso provides empiricl support toour erlier intuitivergument thtthe more nncilly constrined rms re morelikely toencounter nncil distress nd low csh ows. Thelow investment-csh ow sensitivityof rms with very low internl csh ows reduces the estimted sensitivity of the group in which they re included. Since the incidence of negtive csh ow is higher for the more constrined rms, the estimted investment-csh ow sensitivity is lower for more constrined groups when negtive csh ow observtions re included in the estimtion, even when the sensitivity in norml, i.e., non-distressed sttes is similr cross nncing constrints groups. 4. Chnging Ptterns of Investment-Csh Flow Sensitivity over 1977-1996 The evidence presented in subsection 3. is interesting for two resons. First, it shows tht Clery's(1999) result tht more constrined rms hve lower investment-csh ow sensitivity over the 1988-94 period is sensitive to the inclusion of negtive csh ow observtions, nd t the sme time consistent with his conclusion tht the investment outlys of rms with weker nncil positions re less sensitive to internl csh ow. Second, the nding tht investment-csh ow 16
sensitivity is similr cross nncing constrints groups is lso di erent from the FHP ndingtht over the 1970-84 period, the most constrined rms displyed the highest investment-csh ow sensitivity. Does this represent temporl chnge in the pttern of cross-sectionl vrition of investment-csh ow sensitivity from theseventies tothe nineties? In this section, we exminethis question using dt for mnufcturing rms over the period 1977-96. 0 We collect dt from nnul industril Compustt for ll mnufcturing rms (primry fourdigit SIC codes in the rnge 000-3999). We form two dtsets: the rst consists of rms hving continuous dt from 1977 to 1986 (54 rms), nd the second from 1987 to 1996 (708 rms). 1 As before, we sort rms in ech set by nncing constrints (mesured by pyout rtio), nd group them into three ctegories of equl size nncilly constrined (FC), prtilly nncilly constrined (PFC), nd not nncilly constrined (NFC). Investment-csh owsensitivity models (8) nd (9) re estimted for ech dt set, using Tobin's Q s proxy for growth opportunities. Results re presented in Tble 3, Pnels A nd B. Pnel A reports results for speci ctions (8) nd (9) for 1977-86, nd Pnel B for 1987-96, respectively. For the 1977-86 smple, the estimted investment-csh ow sensitivities for the groupwise regressions (8) re 0.434, 0.417, nd 0.091 for the FC, PFC, nd NFC groups respectively, nd the t sttistics for thedi erences in investment-csh ow sensitivities between the PFC nd FC, NFC nd PFC, nd NFC nd FC groups re -0.471, -10.879, nd -1.567, respectively. Results re similr for the pooled regression. The most constrined group (FC) displys higher investment-csh ow sensitivity thn the lest constrined (NFC), under both speci ctions. For the 1987-96 smple, the estimted coe±cients for the groupwise regressions re 0.045, 0.91, nd 0.133 for FC, PFC, nd NFC groups, respectively, nd the corresponding t sttistics re 15.56, -8.874, nd 6.47 for the PFC-FC, NFC-PFC, nd NFC-FC di erences, respectively. Agin, we obtin similr results 0 We focus on mnufcturing rms in order to keep our smple size mngeble, nd lso becuse these re the rms tht hve cler nd unmbiguous need for stedy investments in physicl plnt nd equipment. 1 Pyout rtio is mesured s the sum of csh dividends nd stock repurchses divided by the sum of net income nd deprecition nd mortiztion. 17
for the pooled regressions. While there is some indiction of hump-shped pttern in this period, the more noticeble nding clerly is the low estimted sensitivity for the most constrined rms. As shown in the previous sections, however, these estimtes re likely to be ected by the in uence of negtive csh ow observtions. To obtin the non-distressed investment-csh ow sensitivities, we reestimte models (8) nd (9) fter excludingnegtive csh ow observtions from the smple. Results re presented in Pnels C nd D of Tble 3. Investment-csh ow sensitivity estimtes re higher for ll ctegories, which con rms the previous section's nding tht negtive csh ow observtions induce downwrd bis in estimted sensitivities. For the 1977-86 smple, the investment-csh ow sensitivities estimted from the groupwise regressions re 0.586, 0.417, nd 0.13 for the FC, PFC, nd NFC groups, respectively. The t sttistics for the di erences in investment-csh ow sensitivities between the PFC nd FC, NFC nd PFC, nd NFC nd FC groups re -4.187, -5.964, nd -10.186, respectively. Similr results re lso obtined in the pooled regressions. These results show cler nd monotonic pttern of the more constrined rms exhibitinggreter investment-csh owsensitivity, completelyin linewith the results of FHP. For the 1987-96 smple, s in subsection 3., ll evidence of ny systemtic reltion between nncing constrints nd investment-csh ow sensitivity disppers when negtive csh ow observtions re excluded. The estimted coe±cients from the groupwise nd pooled regressions re (0.196, 0.91, 0.175) nd (0.194, 0.14, 0.07) for the FC, PFC, nd NFC groups, respectively, nd the corresponding t sttistics re (4.166, -6.07,-0.946) nd (1.9, -0.411, 0.735) for the PFC-FC, NFC-PFC, nd NFC-FC di erences, respectively. The t -sttistics clculted s described in Section 3.1 present similr picture s well. Overll, the evidence suggests tht investment-csh ow sensitivity is independent of the degree of nncing constrints in the 1987-96 smple. Thus, there hs been n interesting trend in the evolution of investment-csh ow sensitivities For both the 1977-86 nd 1987-96 smples, investment-csh ow sensitivity estimtes re lmost identicl to those reported when insted of deleting the negtive csh ow observtions, we include negtive csh ow dummy interction term in the speci ction, s in eqution (10). 18
over time from 1977 to 1996. Estimted sensitivities in the 1987-96 period re lower cross ll nncing constrint groups thn in the 1977-86 period. Moreover, the decline in investment-csh ow sensitivity hs been the shrpest for the most constrined group. Consequently, while the most constrined group displyed much higher investment-csh ow sensitivity thn the lest constrined group in the erlier period, the sensitivities were similr in the lter period. 3 5. Chrcteristics of Finncing Constrints Ctegories The evidence thus fr highlights the impct of negtive csh ow observtions on investment-csh ow sensitivity estimtes. We hve rgued tht these observtions re likely proxying for rms in distress whose investment cnnot respond to csh ow. In this section we exmine if negtive csh ow observtions re indeed ssocited with nncil distress, by nlyzing the operting nd nncil chrcteristics of these observtions. We lso present evidence on the chrcteristics of the rms in ech constrint group. Tble 4 reports summry sttistics for severl vribles describing rms in ech of the three nncing constrints groups (FC, PFC, NFC) nd for the negtive csh ow observtions, for the 1977-1996 smple of mnufcturing rms described in Section 4. Pnel A reports estimtes for 1977-86, nd Pnel B for 1987-96. In both sub-periods, nd for ll mesures of size (sles, totl ssets, nd xed ssets) FC rms re smller thn NFC nd PFC rms. FC rms re lso 4 younger thn PFC nd NFC rms in both sub-periods, nd record higher rel sles growth, both in the yer of observtion, nd verged over ten yers. This is in line with intuition nd erlier ndings (FHP, Clery(1999)) tht older nd lrger rms nd it esier to rise externl nncing thn younger, smller, high-growth rms. The reltive smllness nd higher growth rtes of FC rms re prticulrly pronounced in the lter sub-period, indicting tht the proportion of smll, 3 Estimting investment-csh ow sensitivities on yer-by-yer bsis for the di erent constrint groups lso shows tht sensitivities for the constrined nd unconstrined groups hve converged over the 1977-96 period (results not reported). 4 Age is clculted s the number of yers since listing, s reported in CRSP. 19
high-growth rms in the FC ctegory hs incresed over time. FC rms re lso less pro tble (s mesured by net income mrgin), nd hve higher debtto-sset rtios. They hve lower debt service coverge rtios, nd lower credit rtings medin rting of BBB in 1977-86 nd BB in 1987-96, compred to A for NFC rms in both sub-periods. All of theseindicte lower nncil exibility forfc rms, compred to PFCnd NFCones. However, the evidence on liquidity mesures is mixed. While there is some evidence tht current rtio, csh blnce 5, nd nncil slck6 re lower for FC rms over 1977-86, indicting lower exibility for these rms during this period, there is no cler pttern in the 1987-96 sub-period. This nding is in line with KZ, who show tht liquidity reserves re not necessrily low for mny rms included in FHP's nncilly constrined ctegory. Turning to the negtive csh ow observtions, we nd tht these observtions re ssocited 7 with smll size, low pro tbility, negtive rel sles growth, high leverge, low debt service coverge, nd poor credit rtings (medin rting of B+ in both sub-periods). There is lso pttern of rtings downgrdes in the yer of the csh loss rtings fell by n verge of lmost 8 four grdes in the 1977-86 sub-smple, nd by lmost one in the 1987-96 sub-smple. Firms lso cut dividends in these yers men chnge in dividends per shre ws -19. cents in 1977-86 nd -5.9 cents in 1987-96. Overll, the evidence indictes tht csh losses re indeed ssocited with nncil distress. In terms of the time pttern of negtive csh ow observtions, we nd tht s expected, cross ll nncingconstrintgroups, such observtions re mostfrequent duringtherecessionry periods of 198-83 nd 1990-9. Recessionry periods re s de ned by theu.s. Deprtment of Commerce, 5 Normlized by totl ssets less csh, s in Opler, Pinkowitz, Stulz, nd Willimson(1999). Normlizing by totl ssets, s in Lie(000), yields similr results. 6 Mesured s in Clery(1999). 7 Negtive rel sles growth hs recently been used s proxy for identifying nd excluding instnces of nncil distress by Lmont, Polk, nd S-Requejo (001). 8 This estimte should be treted with cution, s it is bsed on only 1 observtions. 0
Business Cycle Indictors, Series 910. For our reconstruction of the Clery (1991) smple s well, csh loss observtions re the most frequent during the 1990-9 period. The lst four rows in ech pnel of Tble 4 describe sources/uses of csh other thn operting csh ow. For FC rms, csh blnces increse by n verge of.14% nd.53% over 1977-86 nd 1987-96, respectively, while the corresponding numbers for NFC rms re 0.47% nd -0.77%. Similrly, nncil slck increses by 1.86%(1977-86) nd 16.3%(1987-96) for FC rms, nd by 1.67% nd -1.9% for NFC rms. For the negtive csh ow observtions, consistent with our erlier ndings, csh blnces decline by n estimted 0.13% nd 1.14% over 1977-86 nd 1987-96, respectively, while slck declines by n estimted 7.57% nd 9.99%, suggesting gin n ssocition with nncil distress. The evidence thus indictes tht FC rms ggressively build up liquidity reserves when operting csh ow is positive, in nticiption of hving to drw them down if nd when csh ow turns negtive. This supports Fzzri, Hubbrd, nd Petersen's(000) `liquidity bu er' explntion for KZ's nding tht mny FC rms hve moderte to lrge csh blnces nd nncil slck. This is lso in line with Opler, Pinkowitz, Stulz, nd Willimson's(1999) nding tht lrge declines in excess csh re typiclly ssocited with lrge negtive opertingcsh ows. Further, with respect to issuing new securities, the evidence suggests tht FC rms nd negtive csh ow rms hve to rely more on equity, while NFC rms rely more on debt. 9 One importnt distinction between the two sub-periods reltes to the verge ge of rms hving negtive csh ows. Men ge ssocited with such observtions is 9.46 yers, which is comprble to the lrger nd older rms in the erlier sub-smple, while it is.17 yers, which is similr to the younger rms in the lter sub-smple. Similrly, while the medin ge for ll three constrints ctegories incresed by 4 yers from 1977-86 to 1987-96, it declined by 1 yer for the negtive csh ow observtions. Further, the observtion-yer nd ten-yer-verge rel sles growth rtes incresed from -1453% to -5.8% nd from -5.6% to.84%, respectively. The 9 In fct, the estimted men net new equity for NFC rms is negtive in both sub-periods, indicting tht mny of these rms were buying bck outstnding equity. 1
evidence thus suggests tht the importnce of young growing rms within the universe of negtive csh ow observtions hs incresed over time. This inference nds further support from n ge- nd industry-wise brekdown of rms. Tble 5 presents the frction of observtions in di erent ge nd primry -digit SIC code ctegories for ech constrint group, nd for the negtive csh ow observtions. Pnel A shows tht while over 1977-86, only 1.6% of the negtive csh ow observtions were ssocited with 0-10 yers old rms, the frction incresed to 6.34% over 1987-96. Conversely, the frction of csh loss observtions in the oldest rms ctegory fell from 6.44% over 1977-86 to 7.78% over 1987-96. Within the industry ctegories too, the shrpest declines in the proportion of negtive csh ow observtions from 1977-86 to 1987-96 were in the mture industries primry metls (19.90% to 8.31%) nd trnsporttion equipment (10.19% to6.70%), whilethe increses were in thehigh-tech, growth industries of electricl equipment (8.5% to 16.17%) nd computers (17.48% to 0.09%). The incresed importnce of smll, growing rms in the FC nd negtive csh ow ctegories re ects the growth in their overll numbers, s recorded by Fm nd French(001). The improved bilityofthese rms toccesspublic nncingindictesgreter informtionl e±ciency of nncil mrkets, nd suggests possible explntion for the previous section's nding tht investmentcsh ow sensitivities hvedeclined over time. As informtion gtheringnd processing bilities of cpitl mrkets hve improved, informtion symmetries between rm insiders nd outsiders hve nrrowed, resulting in improved ccess to externl funds nd reduced sensitivity of investments to internl csh ow. The reduction in informtion symmetry hs been the most bene cil to those rms for which such problems were the most severe before, i.e., the most constrined group, resulting in this group experiencing the shrpest decline in investment-csh ow sensitivity. Moreover, s the supply of funds into primry mrkets hs experienced rpid growth over the lst two decdes, lrgely through mutul funds, pension funds, nd hedge funds, fund mngers hve been forced to look beyond the lrge, stble, well-cpitlized rms tht dominted their portfolios in the pst.