Academic journal article Financial Management

The Cash Flow/investment Relationship: Evidence from U.S. Manufacturing Firms

Academic journal article Financial Management

The Cash Flow/investment Relationship: Evidence from U.S. Manufacturing Firms

Article excerpt

Substantial empirical evidence documents the strong influence of cash flow on some firms' investment spending.(1) This well-documented relationship between cash flow and investment spending (after controlling for the cost of capital) is inconsistent with both the Modigliani and Miller (1958) irrelevance theorem and the so-called static trade-off theories of financial behavior.(2)

Two recent explanations focus on imperfect information. The pecking order (PO) hypothesis of Myers and Majluf (1984) identifies the adverse selection problem that arises when firm insiders (owners and managers) have better information than the capital markets about the value of their firm. An important implication of adverse selection is that firms with positive-net-present-value (NPV) investment opportunities will forgo profitable projects to avoid the excessive cost of external financing. This implication has been explored in detail by Fazzari, Hubbard, and Petersen (1988) for capital spending (i.e., fixed plant and equipment) and by Himmelberg and Petersen (1994) for research and development spending. These authors show formally that the excess cost of external finance causes some firms to be liquidity-constrained, so that cash flow becomes an important determinant of investment spending.

The second explanation, the free cash flow (FCF) hypothesis (Jensen (1986)), focuses on the agency issue. Jensen argues that managers can increase their wealth at the expense of shareholders by investing a firm's free cash flow in unprofitable investment opportunities rather than paying out those funds in the form of dividends, debt-financed share repurchases, and the like. Carpenter (1993), Devereux and Schiantarelli (1990), Oliner and Rudebusch (1992), and Strong and Meyer (1990) study the role that agency problems play in the cash flow/investment relationship. Their findings are contradictory regarding the importance of free cash flow. Oliner and Rudebusch find little evidence that ownership structure affects the cash flow/investment relationship. Strong and Meyer find that stock prices of firms undertaking investment spending with discretionary cash flow experience negative performance.

The aim of this research is to examine whether the importance of cash flow in the firm's investment decision is because firms waste free cash flow, or because they face excessive costs of external financing created by asymmetric information. First I develop the theoretical implications of both the FCF and PO explanations for the equilibrium level of Tobin's Q. If the free cash flow theory explains the cash flow/investment relationship, firms with low Q values should rely heavily on cash flow to finance investment. Alternatively, if the PO hypothesis explains the relationship, firms with high Q values will depend more heavily on cash flow. A model of firm investment spending using cross-sectional time-series data with fixed time and firm effects is then used to test the relative importance of the FCF and PO hypotheses for both plant and equipment spending and research and development spending.

The firm's dividend decision also has implications for both theories. In the FCF theory, dividends are one means of eliminating free cash flow (Lang and Litzenberger (1989)). The model developed here shows that firms with the opportunity to exploit free cash flow will follow low-dividend-payout policies and have a low value of Q, and cash flow will have a strong influence on investment spending. Conversely, if firms are constrained from obtaining external finance because of adverse selection problems (as in the PO theory), those firms with profitable investment opportunities will maintain low-dividend-payout policies in order to conserve on cash flow. In this case, the model is consistent with Fazzari, Hubbard, and Petersen (1988); it predicts that low-payout firms should be associated with high values of Q and a strong cash flow/investment relationship.

Finally, I perform additional tests using asset size as a proxy for both asymmetric information and free cash flow problems. …

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