Corporate Finance

1. Corporate Finance Financial constraint

2. Kaplan and Zingales (1997) • This paper investigates the relationship between financing constraints and investment-cash flow sensitivities by analyzing the firms identified by Fazzari, Hubbard, and Petersen (1988) as having unusually high investment-cash flow sensitivities. • We find that firms that appear less financially constrained exhibit significantly greater sensitivities than firms that appear more financially constrained. • These results suggest that higher sensitivities cannot be interpreted as evidence that firms are more financially constrained.

3. What is financial constraint? • The most precise (but also broadest) definition classifies firms as financially constrained if they face a wedge between the internal and external costs of funds. • A firm is considered more financially constrained as the wedge between its internal and external cost of funds increases. • Fazzari, Hubbard, and Petersen (1988) was the first of many papers to consider higher investment-cash flow sensitivities as evidence of greater financing constraints.

4. Theoretical framework • Consider a firm that chooses the level of investment to maximize profits. • The return to an investment, I, is given by a production function F(I ), where F(I)’>0 and F(I)’’<0. • Investment can be financed either with internal funds (W) or with external funds (E). The opportunity cost of internal funds equals the cost of capital, R, which, for simplicity, we set equal to 1. • Because of information, agency, or risk aversion problems, we assume that the use of external funds generates a deadweight cost.

5. Theoretical framework • We represent (in reduced form) this additional cost of external funds with the function C(E,k), where E is the amount of external funds raised and k is a measure of a firm’s wedge between the internal and the external costs of funds. I=W+E where W is the availability of internal funds. • Each firm, then, chooses I to maximize • The first-order condition of problem (1), then, is given by where C1(0) represents the partial derivative of C with respect to its first argument and F1() the first derivative of F with respect to I.

6. Theoretical framework • The effects of the availability of internal finance on investments can be easily obtained by implicit differentiation of (2): • which is clearly positive (to the extent that C is convex). In other words, in an imperfect capital market world, investments are sensitive to internal funds. • Similarly, it is possible to derive the sensitivity of investment to the wedge between the cost of internal and external financing. By implicit differentiation of (2) we obtain which is negative if the marginal cost of raising external finance is increasing in k (i.e., C12 > 0).

7. Implications • For these reasons, previous papers focus on cross-sectional differences in the investment-cash-flow sensitivity across groups of firms likely to have a different wedge between internal and external funds. • From equation (3) we obtain • Given that the second term is always positive, it follows that d2I/ dW2 is negative if and only if is negative. • In sum, even in a one-period model, investment-cash flow sensitivities do not necessarily increase with the degree of financing constraints.

8. Sample • In this paper we analyze the sample of 49 low-dividend paying firms in FHP [1988]. • FHP divide all manufacturing firms in the Value Line database with uninterrupted data from 1970 to 1984 into three classes based on dividend payout policy. • Their 49 Class 1 firms (which we analyze) have a dividend payout ratio of less than 10 percent in at least ten of the fifteen years. • FHP classify 39 firms that have a dividend payout ratio between 10 percent and 20 percent as Class 2 firms. • All 334 other firms in their sample as Class 3 firms. • FHP argue that the Class 1 firms are more likely, a priori, to have been financially constrained. In their analysis they find that the Class 1 firms have an investment-cash flow sensitivity that is significantly greater than that for firms that pay higher dividends.

9. Data collection on constraint • For each firm we collected data from several sources. • First, we collected letters to shareholders, management discussions of operations and liquidity (when available), financial statements, and the notes to those statements from the annual report or 10-K for each firm-year. • We obtained Wall Street Journal Index entries over the fifteen-year sample period. We obtained standard accounting variables from COMPUSTAT except those for Coleco which we obtained from Coleco’s annual reports. • Because FHP obtained their data from Value Line not COMPUSTAT, our data are not precisely the same as theirs.

10. A comparison • In Table I we compare the basic regression results for our sample with those reported in Table 4 of FHP [1988]. These regressions regress investment on cash flow and Q, and control for fixed firm and year effects. Our results are qualitatively similar to those reported by FHP, although they differ slightly in some details.

11. KZ measure- source of data • In 1977 the SEC strengthened the reporting requirements by adopting Regulation S-K, which requires firms to discuss explicitly their liquidity, capital resources, and results of operations. This section is usually titled management’s discussion of operations. Item 303 of Regulation S-K states: • Liquidity • Capital Resources • Describe any known material trends, favorable or unfavorable in the registrant’s capital resources. • The term “liquidity” . . . refers to the ability of an enterprise to generate adequate amounts of cash to meet the enterprise’s needs for cash. . . . Liquidity shall generally be discussed on both a long-term and short-term basis

12. KZ measure- classification • The first group contains firms that we deem definitely not financially constrained in that year. We refer to these firm-years as not financially constrained (NFC). • The second group includes firm-years that we label likely not to be financially constrained (LNFC). In LNFC firm-years the firms are healthy financially and do not give any indication of being liquidity constrained. • The third group includes firm-years we found difficult to classify either as financially constrained or as unconstrained. We call these firm-years possibly financially constrained (PFC). • The fourth group contains all firm-years in which firms are likely to be financially constrained (LFC). This group includes firms that mention having difficulties in obtaining financing. • The last group includes all firm-years in which firms are undoubtedly financially constrained (FC). In these firm-years, these companies are in violation of debt covenants, have been cut out of their usual source of credit, are renegotiating debt payments, or declare that they are forced to reduce investments because of liquidity problems.

13. Ordered logit model • KZ Index = -1.001909 Cash Flows / K + 0.2826389 Q + 3.139193 Debt / Total Capital -39.3678 Dividends / K -1.314759 Cash / K • By Lamont, Polk, and Saa-Requejo (2001)

14. Investment-cash flow sensitivity in subsamples • Higher sensitivities cannot be interpreted as evidence that firms are more financially constrained

15. Whited and Wu (2006) • We construct an index of firms’ external finance constraints via generalized method of moments (GMM) estimation of an investment Euler equation. • Unlike the commonly used KZ index, ours is consistent with firm characteristics associated with external finance constraints. Constrained firms’ returns move together, suggesting the existence of a financial constraints factor.

16. WW index • The time t value of our index of financial constraints can therefore be read • from the fourth column of Table 1: • WWit=0.091CFit – 0.062DIVPOSit + 0:021TLTDit - 0.044LNTAit + 0:102ISGit - 0:035SGit

17. Constraint index and firm characteristics

18. Portfolio characteristics and returns

19. Almeida, Campello and Weisbach (2004) • This paper models a firm’s demand for liquidity to develop a new test of the effect of financial constraints on corporate policies. The effect of financial constraints is captured by the firm’s propensity to save cash out of cash flows (the cash flow sensitivity of cash). • They hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms’ cash savings should not be systematically related to cash flows. • They empirically estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971 to 2000 period and find robust support for our theory.

20. A Model of Liquidity Demand- Assumptions • The model has three dates, 0, 1, and 2. At time 0, the firm is an ongoing concern whose cash flow from current operations is c0. • The firm has the option to invest in a long-term project that requires I0today and pays off F(I0) at time 2. • The firm expects to have access to another investment opportunity at time 1. If the firm invests I1at time 1, the technology produces G(I1) at time 2. • F(.) and G(.) are increasing, concave, and continuously differentiable. • The firm has existing assets that produce a cash flow equal to c1at time 1.With probability p, the time 1 cash flow is high, equal tocH1, and with probability (1 − p), equal to cL1 < cH1.

21. A Model of Liquidity Demand- Assumptions • Everyone is risk neutral, and the cost of investment goods at dates 0 and 1 is equal to 1. • The investments I0and I1can be liquidated at the final date, generating a payoff equal to q(I0 + I1), where q ≤ 1 and I0, I1 > 0. • Define total cash flows from investments as f (I0) ≡ F(I0) + qI0, and g(I1) ≡ G(I1) + qI1. • The liquidation value of assets that can be captured by creditors is given by (1 − τ )qI. The parameter τ ∈ (0, 1) is a function of factors such as the tangibility of a firm’s assets and of the legal environment that dictates relations between debtors and creditors. • There are no new investment opportunities to fund at time 2. • C is the amount of cash the firm chooses to carry from time 0 until time 1. • They also assume that the firm can fully hedge future earnings at a fair cost.

22. A Model of Liquidity Demand- Assumptions • Dividend is nonnegative. • B0 and B1 are the borrowing amounts, which have to be lower than the collateral value generated by the new investments. • Hedging payments in states H and L are denoted by hHandhL, respectively. The hedging strategies we focus on typically give hH < 0andhL > 0. If the firm uses futures contracts, for example, cS1+ hS is the futures payoff in state S.

23. Analysis • Objection function is to • Where hHis a function of hLso that

24. First-Best Solution • The firm is financially unconstrained if it is able to invest at the first-best levels at times 0 and 1, which are defined as • Since the productivity of investment does not vary across states, we have IFB,H1=IFB,L1≡ IFB1 . • More explicitly, the condition for the firm to be unconstrained is that there exists a financial policy (B0, BS1, C, hH) such that • B0 and BS1 are less than or equal to the collateral value created by the first-best investments. There should be no systematic relationship between changes in cash holdings and current cash flows.

25. First-Best Solution • Two questions raised from the first-best solution: • Suppose the firm increases its cash holdings by a small amount, C. Would that policy entail any costs? • The answer is no. The firm can compensate for C by paying a smaller dividend today (or by borrowing more). • Are therebenefits to the increase in cash holdings? • The answer is also no. The firm is already investing at the first-best level at time 1, and an increase in cash is a zero NPV project, since the firm foregoes paying a dividend today for a dividend tomorrow that is discounted at the market rate of return.

26. Constrained Solution • Unconstrained firms are thus either those that have low τ (high capacity for external finance) or those that have sufficient internal funds (high c0and c1) relative to the size of IFB0and IFB1. • The firm is financially constrained if its investment policy is distorted from thefirst-best level- i.e., (I∗0, I∗1) < (IFB0, IFB1 )- because of capital market frictions. • Financial constraints lead to an optimal cash policy C∗ • Notice that since foregoing a dividend payment or borrowing an additionalunit is a zero NPV project, it will not be optimal for a constrained firm to pay anydividends at times 0 and 1; in addition, borrowing capacity will be exhaustedin both periods and in both states at time 1. Using these facts, we can write thefirm’s problem as • To economize on notation, define λ ≡ 1 − q + τq.

27. Constrained Solution • This implies that the optimal amount of hedging is given by hL = p(cH1− cL1),leading to equal cash flows in both states (equal to E0[c1]).Given optimalhedging, the optimal cash policy C∗is determined by • The left-hand side of above equation is the marginal cost of increasing cash holdings.When the firm holds incremental cash, it sacrifices valuable (positiveNPV) current investment opportunities. The right-hand side of equation isthe marginal benefit of holding cash under financial constraints. By holdingmore cash the firm is able to relax the constraints on its ability to invest in thefuture.

28. Constrained Solution • The cash flow sensitivity of cash is which is positive. • This indicates that if a financially constrained firm gets a positive cash flow innovation this period, it will optimally allocate the extra cash across time, saving a fraction of those resources to fund future investments.

29. Data • They consider the sample of all manufacturing firms (SICs 2000 to 3999) over the 1971 to 2000 period with data available from COMPUSTAT. They eliminate firm-years for which cash holdings exceeded the value of total assets, those for which market capitalization was less than $10 million (in 1971 dollars), and those displaying asset or sales growth exceeding 100%. • The final sample consists of 29,954 firm-years. • Cash Holdings is the ratio of holdings of cash and marketable securities to total assets • Cash Flow as the ratio of earnings before extraordinary items and depreciation (minus dividends) to total assets

30. Cash Flow Sensitivity of Cash • The baseline empirical model can be written as • An augment model is • The theory’s predictions concern the change in cash holdings in response to a shock to cash flows, captured by α1.

31. Financial Constraints Criteria • Payout ratio, which is the ratio of total distributions (dividends plus stock repurchases) to operating income. • Asset size • A firms’ bond ratings. • Firms that never had their public debt rated during the sample period are regarded as financially constrained • A firms’ commercial paper ratings • KZ index

32. Cross-classification of Constraint Types

33. Cash flow Sensitivity of Cash • What do you observe?

34. Cash flow Sensitivity of Cash

35. Chen and Chen (2012) • Investment-cash flow sensitivity cannot be a good measure of financial constraints: Evidence from the time series • Investment-cash flow sensitivity has declined and disappeared, even during the 2007– 2009 credit crunch. If one believes that financial constraints have not disappeared, then investment-cash flow sensitivity cannot be a good measure of financial constraints. The decline and disappearance are robust to considerations of R&D and across groups of firms.

36. Financial constraints

37. Financial constraints (Cont’d) • As a firm’s capital supply curve is not readily observable to the econometrician, measuring financial constraints is empirically challenging. This is why the literature instead attempts to infer the elasticity of the capital supply curve indirectly, by looking either at what managers say in their 10-Ks (e.g., KZ index, WW index, SA index) or at a particular action they take (e.g., pay a dividend, obtain a credit rating). • Another way is investment-cash flow sensitivity. • Fazzari, Hubbard, and Petersen(1988) suggest investment-cash flow sensitivity as a measure of financial constraints. They argue that when there are financial constraints, external financing in the form of new debtand equity is not always available. Consequently, the investments of a financially constrained firm depend heavily on the availability of internal funds.

38. Investment-cash flow sensitivity in time series • Following Fazzari, Hubbard, and Petersen (1988), we estimate investment-cash flow sensitivity as follows • Beta2 is investment-cash flow sensitivity.

39. Investment-cash flow sensitivity in time series

40. Investment-cash flow sensitivity in the 2007–2009 credit crunch.

41. R&D-cash flow sensitivity in the 2007–2009 credit crunch • They use the quarterly CompustatXpressfeed data from 2005 to 2009. In each quarter from 2007 to 2009, R&D-cash flow sensitivity is negative and mostly statistically significant.