American cash flow association

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. Larger firms with more diverse ownership structures are more likely to suffer agency problems. Consequently, the cash flow/investment relationship should be stronger in large firms with low Q values. Alternatively, asymmetric information-induced liquidity constraints are more likely to be found in smaller firms. Thus, the cash flow/investment relationship should be stronger for small firms with high Q values.

In the case of capital spending, the empirical results tend to support the free cash flow description of the cash flow/investment relationship. Behavior that supports the PO hypothesis, however, is found in small firms paying low dividends. In the case of research and development spending, results are more consistent with the pecking order hypothesis. These results together suggest that the effect that cash flow-financed investment has on firm value depends on asset size, dividend behavior, and the type of investment spending.

I. Background on the Cash Flow/Investment Relationship

Considerable empirical evidence indicates that internally generated funds are the primary way firms finance investment expenditures. In an in-depth study of 25 large firms, Gordon Donaldson (1961, p. 67) concludes that: "Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable 'bulges' in the need for new funds." A more recent survey of 176 corporate managers by Pinegar and Wilbricht (1989) also finds that managers prefer cash flow over external sources to finance new investment; 84.3% of sample respondents indicate a preference for financing investment with cash flow.

Researchers have also discovered the impact of cash flow on investment spending in Q models of investment. Fazzari, Hubbard, and Petersen (1988) find that cash flow has a strong effect on investment spending in firms with low-dividend-payout policies.(3) They argue that this result is consistent with the notion that low-payout firms are cash flow-constrained because of asymmetric information costs associated with external financing. One reason these firms keep dividends to a minimum is to conserve on cash flow from which they can finance profitable investment expenditures. More recently, Fazzari and Petersen (1993) find that this same group of low-payout firms smooths fluctuations in cash flow with working capital to maintain desired investment levels. This result is consistent with the Myers and Majluf (1984) finding that liquid financial assets (slack) can mitigate the underinvestment problem arising from asymmetric information.

Whited (1992) extends the Fazzari, Hubbard, and Petersen (1988) results in a study of firms facing debt financing constraints because of financial distress. She finds evidence of a strong relationship between cash flow and investment spending for firms with a high debt ratio or a high interest coverage ratio, or without rated debt.

Finally, Himmelberg and Petersen (1994) in a study of small research and development firms find that cash flow strongly influences both capital and R & D expenditures. They argue that the asymmetric information effects associated with such firms make external financing prohibitively expensive, forcing them to fund expenditures internally.(4)

An alternative explanation for the strong cash flow/investment relationship is that managers divert free cash flow to unprofitable investment spending. One study assessing the relative importance of such an agency problem is by Oliner and Rudebusch (1992), who analyze several firm attributes that may influence the cash flow/investment relationship. They find that insider share holdings and ownership structure (variables that proxy for agency problems) do little to explain the influence that cash flow has on finn investment spending; firm age, exchange listing, and insider stock trading patterns exhibit a moderately stronger influence. They conclude that weak support exists for the asymmetric information explanation. Data limitations, however, may restrict the generality of these conclusions about ownership structure.

Carpenter (1993) focuses on the relationships among debt financing, debt structure, and investment spending to test the free cash flow theory. He finds that finns that restructure by replacing large amounts of external equity with debt increase their investment spending compared to non-restructured firms. He sees these results as inconsistent with free cash flow behavior, because cash flow committed to debt maintenance should be associated with reductions in subsequent investment spending.