Academic journal article Journal of Money, Credit & Banking

Corporate Investment with Financial Constraints: Sensitivity of Investment to Funds from Voluntary Asset Sales

Academic journal article Journal of Money, Credit & Banking

Corporate Investment with Financial Constraints: Sensitivity of Investment to Funds from Voluntary Asset Sales

Article excerpt

THERE IS A large body of literature that suggests that because of information asymmetries and capital market imperfections, corporate investment expenditures are strongly influenced by a firm's ability to internally generate cash. In an influential study, Fazzari, Hubbard, and Petersen (1988) show that firms that pay no dividends demonstrate higher sensitivity of investment to cash flow and suggest that investment-cash flow sensitivity reflects the tighter liquidity constraints faced by these firms. There has been subsequent empirical evidence supporting this finding, particularly for firms that are young, small, pay no dividends, and have no bond rating. In another prominent study, Hoshi, Kashyap, and Scharfstein (1991) show that investment is much more sensitive to internal funds for independent Japanese firms compared to those that have close ties with banks and are therefore less likely to be financially constrained. In general, a strong positive effect of internal funds on investment has been interpreted as evidence reflecting the difference in the costs of external versus internal financing. (1)

There is also a growing parallel literature that addresses some of methodological problems that were originally outlined in Poterba's (1988) discussion of the Fazzari, Hubbard, and Petersen (1988) paper. The first strand of this literature questions how firms are classified into financially more or less constrained groups. For example, Kaplan and Zingales (1997), applying an alternative approach to classifying firms into financially more or less constrained, report that the sensitivity of investment to cash flows is not monotonic with respect to financial constraints. In particular, it is the lowest for firms that they classify as being the most likely to be financially constrained. (2) The second strand of the literature addresses issues relating to measurement error in Tobin's Q. Specifically, if investment opportunities are not measured properly, then cash flows, in addition to conveying information about internal liquidity, may also reflect information about future investment opportunities that are not captured by proxies for Q. Since the measurement of Q incorporates firm market value, this effect is likely to be more severe for firms suffering from problems of information asymmetry, which are also the firms that are most likely to be financially constrained. As a result, we might expect higher estimated coefficients of cash flow in investment regressions for firms a priori classified as financially constrained.

Using alternative approaches that mitigate the problems with measuring Q, recent literature casts doubt on the notion that investment-cash flow sensitivity is a reliable indicator of financial constraints. Some studies find insignificant investment-cash flow sensitivities for unconstrained as well as constrained firms. (3) Other studies argue that investment-cash flow sensitivities could be obtained even in the absence of financing constraints. (4)

This study, which examines the relationship between funds obtained from voluntary asset sales and firm investment expenditures, addresses both strands of the literature. Specifically, to address the issue raised by the exogenous classification of firms in the prior literature, we estimate a switching regression model with endogenous sample separation. This method avoids the necessity of a priori knowledge of whether or not a firm is financially constrained. Rather, the likelihood of a firm demonstrating investment behavior, consistent with financial constraints, is endogenously determined by multiple firm characteristics. In addition, as we explain below, asset sales are not likely to be positively related to investment opportunities, implying that the estimated sensitivity of investment expenditures to asset sales is likely to be less affected by measurement error in our proxy for investment opportunities.

The prior literature provides two motivations for why financially healthy firms undertake voluntary asset sell-offs. …

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