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Debt Capacity
Author(s): Maria-Teresa Marchica and Roberto Mura
Source: Financial Management, Vol. 39, No. 4 (WINTER 2010), pp. 1339-1365
Published by: Wiley on behalf of the Financial Management Association International
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Financial Flexibility,InvestmentAbility,
and FirmValue: Evidence fromFirms
with Spare Debt Capacity
Maria-Teresa Marchica and Roberto Mura*
Wedocument,
for thefirsttime,thata conservative
leveragepolicy directedat maintaining
can enhanceinvestment
financialflexibility
ability.Our analysisrevealsthatfollowinga period
and increaseabnormalinvestment.
We
of low leverage,
firmsmakelargercapitalexpenditures
arefinancedthrough
newissuesofdebt.Theimpactoffinancial
findthatthesenewinvestments
is bothstatistically
andeconomically
sizable.Further,
flexibility
significant
long-run
performance
testsrevealthatfinancially
Our results
flexible
firmsnotonlyinvestmorebutalso investbetter.
areconsistent
withtheviewthatfinancialflexibility
intheformofuntappedreservesofborrowing
poweris a crucialmissinglinkincapitalstructure
theory.
Thereis a puzzlingempiricalregularity
in thecapitalstructure
literature.
Manyfirmsappear
toborrowless thanthedominant
In
theories
his
influential
Graham
predict.
paper,
(2000) finds,
firmswithlowexpecteddistress
costsuse debtconserva"Paradoxically,
large,liquid,profitable
He also reports
thatthisconservative
behaviorappearstobe persistent.
Similarissuesare
tively."
Minton
and
Wruck
andYang(2008).
discussed,
amongothers,
by
(2001) and Strebulaev
Recentsurveyevidencehas shedsomelightonthismatter
(BancelandMittoo,2004; Brounen,
De Jong,and Koedijk,2004; Grahamand Harvey,2001; Pinegarand Wilbricht,
1989). These
studiessuggestthatitis financialflexibility
thatprimarily
driveschieffinanceofficers'leverage
choices.Respondents
is veryimportant
in enablingtheircompaniesto unsay thatflexibility
dertakeinvestment
in thefuture,
whenasymmetric
information
andcontracting
problemsmight
otherwise
forcethemto foregoprofitable
In otherwords,companiesmay
growth
opportunities.
reservesof untappedborrowing
adopta conservative
leveragepolicyto maintain"substantial
Wethank
Bill Christie(editor)and theanonymous
whosecomments
havesignificantly
thepaper.
referee
helpedtoimprove
Weare indebtedto MichaelBrennan,Harryand Linda DeAngelo,Marie Dutordoir,
Mara Faccio,AnnalisaFerrando,
AndreaGamba,Ian Garrett,
Marc Goergen,AlessandraGuariglia,JohnHutton,EvangelosKharalambakis,
Meziane
Alex Triantis,
Lasfer,WeiMinLiu, Kasper Nielsen,Aydin Ozkan,Ser-HuangPoon,NormanStrong,Alex Taylor,
and
in theFIRS 2008, FMA USA 2008, FMA
SergeyTsyplakov
for helpfuldiscussions.Wealso thankall theparticipants
Europe2008,EFA USA2007,FMA Europe2007,EFMA 2006,andFMA USA2006 "TopTenPercent"SpecialSession,
and PFN 2006 meetings
comments.
Weare also grateful
to theparticipants
in theseminarseriesat
fortheirinsightful
BusinessSchool,theNottingham
EuropeanCentralBank,Cass BusinessSchool,Manchester
Department
ofEconomics,
School,and theUniversity
KindhelpfromDavid Roodman
Sheffield
Management
of Verona
fortheirusefulsuggestions.
oftheCenter
Pic SupportTeamand
forGlobalDevelopment,
RogerWalshofBureauVanDijk,DerekRouseofHemscott
FrancescoCerliencoofReutersis also acknowledged.
Weare also grateful
to Wendy
PamLosefsky,
andAlison
Jennings,
Walters
foreditorialhelp.Theusualdisclaimerapplies.
*Maria-Teresa
Marchicais a LecturerinFinanceat theManchester
BusinessSchool,University
ManchofManchester,
ester,EnglandMl 3 9PL, UK. RobertoMurais a LecturerinFinanceat theManchester
BusinessSchool,University
of
Manchester,
Manchester,
EnglandMl 3 9PL, UK.
FinancialManagement Winter2010 pages 1339 - 1365
1340
FinancialManagement Winter201 0
intheeventof
power"(ModiglianiandMiller,1963) allowingthemto accessthecapitalmarket
shocks
to
their
investment
set.
positive
opportunity
How can we identify
However,as yet,littleis knownaboutfinancialflexibility.
financially
flexible
Does financial
theinvestment
(FF) firms?
flexibility
reallyimprove
abilityofcompanies?
is thisstrategy
forfirms?Thispaperprovidesempirical
evidenceto
Ultimately,
value-enhancing
addressthesequestions.
FF firmsbyfocusing
on firmswithsparedebtcapacity(SDC).1 Weestimate
First,we identify
a leverageequationfromwhichwe calculatethepredicted
levelof debt.Sincethedemandfor
itendsupintheresidualoftheestimated
financial
is anunobservable
factor,
model,and
flexibility
a systematic
deviationbetweenobservedand estimated
leverage.Forthisreason,we
generates
from
indirectly,
usingnegativedeviations
proposeto capturethedemandforfinancialflexibility
estimated
targetleverage.We classifya firmas FF ifithas sparedebtcapacityfora minimum
ofconsecutive
number
years.
has anyimpacton
whether
thisdegreeoffinancialflexibility
Second,we testeconometrically
firmsthatanticipate
Theprediction
is thatinthepresenceofmarket
investment
frictions,
ability.
valuablegrowthoptionsin thefuture
mayrespondbypursuinga policyof low leveragefora
numberof years.In thisway,FF firmshaveenoughspareborrowing
powerto be able to raise
financialpolicy.To
theconservative
externalfundsand to investmorein theyearsfollowing
we specifya q-modelof investment
testthishypothesis,
plus an
by ourFF dummy,
augmented
shouldhave
theFF dummy
toourflexibility
termwithcashflow.According
interaction
argument,
In addition,
to theextentthatFF firms
a positiveandsignificant
impacton capitalexpenditures.
external
fundsto financetheir
raise
more
can,aftera periodof conservative
easily
borrowing,
As a consequence,
funds.
on
internal
be
less
should
their
investment
dependent
ability
projects,
to cashflow.
ofinvestment
we wouldexpecta lowersensitivity
We provideevidencethata conservative
leveragepolicycan help firmsattaina degreeof
OurresultsindicatethatFF companiesexhibitenhancedinvestment
financialflexibility.
ability.
a sparedebtcapacitypolicyforthree
Ourtestsrevealthatan averagecompanythatmaintains
ourtestsrevealthat
by around37%. Further,
years(FF 3) can increaseitscapitalexpenditures
thelongertheperiodof low leverage,thelowertheeconomicimpactof FF statuson thefirm's
investment
ability.For instance,a companythatmaintainssparedebtcapacityforat leastsix
increasesitscapitalexpenditures
byaround28%. Thismaybe becausetheability
yearstypically
intothefuture
decreasesthefurther
future
ofmanagersto anticipate
they
opportunities
growth
FF
firms.
to
we
follow
method
to
the
results
are
robust
These
classify
go.
bymeansofpositivenetdebtissues.
Also,we findthatcompaniesfinancenewinvestments
sacrifice
that
evidence
Thisprovidesstrong
todayto enhancetheirability
borrowing
companies
This resultis also robustwhenwe takeinto
in thefuture.
to seize bettergrowthopportunities
suchas a cashpolicy.For
thatmayachievefinancialflexibility,
accountotherfinancing
strategies
in
investment
the
cash
of
the
for
when
we
account
decisions,orwhen
instance,
presence (excess)
we considerleveragenetofcash,as inBates,Kahle,andStulz(2009),we stillfindan economic
impactsimilarto ourmainresults.
ofpaperssuggestthat
A number
ofthisstrategy.
effect
we testthelong-run
Third,
performance
human
undiversified
their
to
risk
and
reduce
low
to
ratios
debt
to
protect
managersprefer keep
howhigher
Denis and Sibilkov(2010) demonstrate
in otherways.Forinstance,
'Firmsmayachievefinancialflexibility
firmsto investinvalue-enhancing
cashholdinghelpsconstrained
projects.We do addressthisissuelaterinthetextand
funds.PowersandTsyplakov
ofinternal
(2008) stress
showthatourresultsarerobustevenwhenwe controlfortheeffect
theirdebtearly.Jagannathan,
ofretiring
thatallowfirmsto havetheflexibility
call provisions
theroleof make-whole
how stockrepurchases
(as opposedto cash dividends)allow firmsa higher
Stephens,and Weisbach(2000) underline
degreeoffinancialflexibility.
InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,
1341
thatcomeswithinterest
commitments
payment
capital(Fama,1980),orto alleviatethepressure
1
choose
to
in
increasedebtlevels a manner
thatallows
(Jensen,986). Alternatively,
managers
may
themto pursueempirebuilding(Zwiebel,1996) and to minimizetakeoverrisk(Berger,Ofek,
andYermak,1997).In otherwords,conservative
leverageandhighinvestment
maybe symptoms
ofgreater
agencycosts.
To distinguish
thesevariouspotential
influences
andto investigate
whether
a financing
policy
is valueenhancing,
aimedat financialflexibility
thelaststepoftheanalysisexaminesitsimpact
onbothlong-run
andpostinvestment
First,weuseboththecapitalasset
performance
profitability.
modelto investigate
the
pricingmodel(CAPM) and theFama and French(1993) three-factor
behaviorofJensen's
status
(1986) alphaforFF firmsinthelongrun,aftertheyacquireflexibility
aftertheymakeabnormalinvestments.
If ourflexibility
is correct,
or,alternatively,
hypothesis
we expectthispolicytobe valueenhancing.
of
If,on theotherhand,thispolicyis an expression
we shouldfinda negative
effect
onfirmperformance.
Then,we compare
greater
agencyconflicts,
thecompany's
beforeandaftertheFF statusis acquired,andbeforeand
operating
performance
afterFF companiesmakeabnormalinvestments.
Ourfindings
indicatethatcompaniesthatacquirefinancialflexibility
strongly
through
spare
debtcapacityarenotonlyabletoinvestmorebutalso seemtoinvestbetter.
Long-run
performance
returns
resultsforJensen's
analysisconsistently
positiveandstatistically
significant
(1986) alpha
theCAPM ortheFamaandFrench( 1993) three-factor
modelupto60 months
after
the
usingeither
FF statusidentification,
ofthemethodemployed
toclassifyFF firms.Economically,
irrespective
theimpactonthereturns
ofanFF firmalso seemssizable.According
tothefigures
obtainedfrom
theFamaandFrench(1993) three-factor
themarket
model,FF companiesoutperform
byalmost
30 basis pointspermonth,whichcorresponds
to about7.1% in thefirsttwoyears.Similarly,
we findthatourFF firmsoutperform
themarket
whenwe measuretheirlong-run
performance
aftertheyhavemadeabnormalinvestments.
The economicimpactimpliedby Jensen's(1986)
anabnormal
ofapproximately
13.24%inthefirst
twoyears.
alphasuggests
long-run
performance
firmsexperiencean increaseof morethan18% in operating
within
two
Further,
performance
of
the
of
FF
the
status
and
a
increase
of
in
38%
their
years
acquisition
staggering
profitability
within
twoyearsafteran abnormalinvestment.
Thisenhancesthestrength
ofourconclusions
and
allowsus toruleoutthepossibility
thatmanagerial
entrenchment
driveslowleverageandhigher
investments.
Ourstudycontributes
totheliterature
ina number
ofways.Weprovidedirectevidence,forthe
firsttime,of thevalue of financialflexibility
to companiesby studying
theimpactthispolicy
has on investment
and
These
are
resultswithin
ability
long-run
performance.
veryimportant
recentdevelopments
in thecapitalstructure
literature.
to
and
According DeAngelo
DeAngelo
is thecriticalmissinglinkforan empirically
viabletheory
(2007),"financial
flexibility
[ofcapital
Weprovideverysoundevidencethatcomplements
thishypothesis.
A largefraction
of
structure]."
observedleverageis leftunexplained
theoriesofcapitalstructure.
Ourinability
byconventional
to "measure"theFF factorex antecauses a systematic
spreadbetweenobservedandpredicted
smthattallieswith
leverage.In thisway,ourworkalso providesa rationalefordebtconservativi
thetheoretical
predictions
recently
proposedbyAlmeida,Campello,and Weisbach(2009) and
oftheso-calledlow
DeAngelo,DeAngelo,andWhited(2010), andmayprovidean explanation
leveragepuzzle.
The remainder
of thepaperis organizedas follows.In SectionI, we describethedata and
the
main
In SectionII, we present
theempirical
resultsandall therobustness
present
hypotheses.
testsperformed,
whilein SectionIII, we discussourconclusions.
FinancialManagement Winter2010
1342
and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,
1343
thatmaybe correlated
withtheexplanatory
oftheregressors
andforfixedeffects
theendogeneity
variables(Blundelland Bond,1998; Lemmonet al., 2008). Inclusionof thelaggeddependent
behavior.3
Thebaselinemodelweestimate
is thefollowing:
variableallowsforthefirm's
targeting
LEVit = ot'LEVit-'+ 'Industry
Leverage+ iMtbv+ ^Size + ^Tangibility
+ 6Expected
Inflation+ rji+ r)t+uit.
(1)
Wethencomparethefitted
valuesfromtheregression
analysiswiththeactualvaluesanddefine
as SDC thosefirmsthatexhibita negativedeviationbetweenactualandpredicted
leverage.As
discussedabove,we expectthe systematic
of
these
deviations
to
be
due to the
component
offinancialflexibility
intheleveragemodel.To minimize
unobserved
effect
theimpactofnoise,
we requirethedeviation
tobe largerthan10%. Weperform
a number
ofrobustness
testsinwhich
we requirea minimum
deviationof either5% or 25%. Alternatively,
we followHarford(1999)
andrequireobservedleveragetobe 1.5 standard
deviations
lowerthanthepredicted
value.
to
firm
it
a
as
we
to
have
SDC
for
a
minimum
number
of
consecutive
FF, require
Finally, classify
a policy,notjusta transitory
shocktothecapital
periods.Thisensuresthatweareindeedobserving
structure
ofthefirm.As a baselinespecification,
we use FF 3, whichis theFF dummy
thattakes
a valueofonewhenwe observeat leastthreeconsecutive
in
firm
which
the
is
classified
periods
as SDC. Thereis no theoretical
rationaleforchoosinga specifictimelength.Therefore,
to
assesswhether
theresultsaresensitive
tothechoiceoftimehorizon,
we use a number
ofdifferent
oftwotoa maximum
ofsixconsecutive
proxies,froma minimum
yearsofleverageconservatism.
Thisapproachis notfreeofdrawbacks.
The mostseriousis thatthechoiceofleveragemodel
mayaffecttheestimatedtargetand thedeviationfromit. This,in turn,wouldinfluencethe
of firmsand thesubsequentinvestment
classification
results.To minimizethepossibility
that
theresultsare drivenbythechoiceof a specificleveragemodel,we taketwoimportant
steps.
numerous
robustness
testsusingdifferent
we
First,we perform
leveragemodels.In particular,
thatmayallowfirmsto attaina degreeoffinancialflexibility,
the
tryto controlforotherfactors
mostimportant
of whichis financialslack.Second,we followan alternative
approachsimilar
to Mintonand Wruck(2001) and classifyfirmsas low leveragewhentheirdebtratiois in the
bottom20% ofthedistribution.4
Werefertothisas thepercentile
methodology.
C. Financial Flexibilityand InvestmentAbility
In theirseminalpaper,Modiglianiand Miller(1963) notethatdespitetheexistenceof some
tax advantagesfordebtfinancing,
firmstendnot "to use themaximumpossibleamountof
debtin theircapitalstructure"
due to limitations
bylendersleadingto "theneedforpreserving
In themodifiedversionofthepeckingordertheory(Myers,1984),firmshavetwo
flexibility."
mainreasonsto restrain
themselves
fromissuingdebt:1) to avoidthecostsoffinancialdistress
and2) to maintain
financialslack.Takingtheseideas as a starting
point,we testthehypothesis
thatinthepresenceofmarket
firmsthatanticipate
valuablegrowth
frictions,
optionsinthefuture
mayrespondbypursuinga policyof low leveragefora numberof years.As in Myers(1984),
reservesof borrowing
powerenableFF firmsto raiseexternalfundsand to investmorein the
conservative
financialpolicy.
yearsfollowing
3Numerous
theidea thatfirmshave a targetcapitalstructure.
Grahamand Harvey(2001)
surveystudiescorroborate
that37% ofUS firmshavea flexibletarget
debtratio,whilea further
35% havea stricter
BancelandMittoo
report
target.
De Jong,andKoedijk(2004) reportsimilarfiguresfortheUnitedKingdom.
(2004) andBrounen,
4Mikkelson
and Partch(2003) classifyas "highcash" thosecompaniesthatholdmorethan25% oftheirassetsin cash
andequivalents.
See also lona,Leonida,andOzkan(2004) forUK firms.
FinancialManagement Winter2010
1344
(2)
Rf,t
(3a)
5
we assumethereplacement
Forthefirst
method.
observation,
inventory
usingtheperpetual
Capitalstock(K) is measured
we applya
Forthefollowing
observations,
costoftotalnetfixedassets,adjustedforinflation.
costequals thehistoric
assumedto
methodas follows:Kit= ^_i(l - 8) + Iit,where8 is therateof depreciation
standard
perpetualinventory
be 0.08 (Bondetal., 2003).
+ hpFFHMLt
+ spFFj,
RpFFj Rf,t= aPFF+ bpFF(Rm,tRf,t)+ spFFSMBt
1345
(3b)
whereRpFFjdenotesthemontht return
of an equallyweighted
of all firmsidentified
portfolio
as financially
flexible(pFF) in thepreceding
24 (36 or 60) months,
Rftis theUK three-month
to a monthly
rateof return,
Rmtis thereturnon the FTSE All
Treasurybill rateconverted
ShareIndexin montht,SMBt(HMLt)is thereturn
difference
betweena portfolio
of smalland
firms.If FF firmsare outperforming
themarket,
thenthe
large(highand low book-to-market)
and
in
the
time-series
should
be
than
intercepts
zero,
regressions
significantly
greater
apFF
apFF
thata FF policyis valueenhancing.
suggesting
As a further
test,we followDenis and Denis (1993) and we analyzetrendsin operating
theprofitability
beforeandaftertheFF statushasbeenacquired,and
performance
bycomparing
beforeandafterabnormalinvestments
havebeenmade.Thisallowsus totestwhether
thispolicy
is also valueenhancing
on theoperating
side.
FinancialManagement Winter201 0
1346
Baseline
Extended
0.626
(0,000)
0.421
(0.000)
-0.005
(0.004)
0.002
(0.007)
0.025
(0.077)
-0.009
(0.000)
0.81
(0.001)
0611
(0.000)
0.469
(0.000)
-0.049
(0.000)
0.005
(0.000)
0.070
(0.017)
-0.002
(0.000)
0.61
(0.008)
-0.075
(0.000)
0.025
(0.000)
-0.416
(0.001)
0.007
(0.000)
-0.142
(0.000)
47,553
4,290
Yes
Yes
47,553
4,290
Yes
Yes
Maturity
Dividends
Tax
Ndts
(%)
ManagerialOwnership
(%)
Blockholding
BoardComposition
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects
aIndicates
information.
wehandcollected
forwhich
offirms
a subsample
ownership
InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,
1347
BookLev
MarketLev
Mtbv
Size
Tangibility
Profitability
Cash
DebtMaturity
Dividends
EarningsVolatility
Risk(Z-Score)
Bankruptcy
Risk(Quiscoref
Bankruptcy
DebtRating*
ManagerialOwnership
(%)a
Blockholding
(%)a
BoardComposition*
Totalfirms
FF
NFF
AFF
0.09
0.08
1.40
12.42
0.35
0.10
0.07
0.45
0.025
0.09
5.00
67.11
78.12
9.71
31.11
0.46
1,178
0.26
0.23
1.32
12.24
0.32
0.04
0.05
0.51
0.016
0.14
2.26
61.43
70
10.85
36.45
0.42
966
0.04
0.04
1.57
10.87
0.36
0.02
0.09
0.44
0.027
0.10
34.75
70.90
85.61
8.40
22.73
0.42
397
(0.000)
(0.000)
(0.001)
(0.855)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.023)
(0.108)
(0.000)
(0.000)
""Indicates
a subsample
offirms
forwhich
wehand-collected
information.
ownership
1348
FinancialManagement Winter2010
in Strebulaev
andYang(2008). The vastmajority
ofthese
zeroleveragefirmsto thosereported
AFF
to
our
cluster
of
firms.
belong
As expected,FF firmsborrowless thanNFF firms,althoughthe subgroupof AFF firms
FF firmsseem
thelowestlevelsofborrowing
sincetheyarealwaysunderleveraged.
demonstrates
NFF
inmeans
in
terms
of
over
firms
as
the
test
of
difference
tohavea smalledge
growth
options
NFF
assetsthanthe
whilelittle
revealsa/7-value
ofzero.FF firmsalso seemtohavemoretangible
size.Inlinewiththeleverageregression
difference
results,
appearstoemergeintermsofcompany
orcashholdingtendto
thatcompanieswithgreater
thedescriptive
profitability
analysisindicates
debtthanNFF firms.This
oflong-term
borrowless.FF firmsalso appeartohavea lowerfraction
theattempt
debtmayreflect
oflowerleverageandhighershort-term
combination
byFF firmsto
andRaman,2005;
minimizeunderinvestment
2003; Datta,Iskandar-Datta,
problems(Johnson,
Marchica,2007). However,FF firmstendto pay higherdividendsthanNFF firms.This is in
linewiththeevidenceprovidedby Grahamand Harvey(2001) whoreportfinancialflexibility
difference
is detectedin the
to be moreimportant
to dividend-paying
companies.An important
valuefinancial
Itmightbe arguedthatfirmswithmoreuncertain
ofearnings.
earnings
volatility
forthisconjecture
as FF firmshavemorestable
no support
more,butourresultsoffer
flexibility
ofa positivelink
withtheexpectation
consistent
thanNFF firms.
Thisresultis,however,
earnings
andMittoo,2009).
ofearnings(Bancel,Bhattacharyya,
betweendividendpayoutandstability
riskthefirmis exposedto,
thatmayrevealthebankruptcy
We also inspectsome features
intheirleverage
to behave(more)conservatively
an incentive
andthatcouldtherefore
generate,
FF
firms
are indeedless
find
that
we
Altman
z-score
calculate
the
When
we
(1968),
policy.
at any
NFF
firms
is
from
the
difference
file
for
and
to
significant
statistically
bankruptcy,
likely
robustness
level.As a further
conventional
test,we collectthevariableQuiscore,a measureof
riskprovidedbytheFAME-BureauvanDijk Database.The scorerangesfrom0 to
bankruptcy
risk.Again,FF firmshave
lowerbankruptcy
where
like
thez-score,largerfigures
100,
represent
As a finalstep,we
is statistically
andthedifference
a highervaluethanNFF firms,
significant.
forthe
andPetersen
information.
SimilartowhatFaulkender
collectdebtrating
(2006) document
thatthe
document
thefigures
UnitedStates,veryfewUK companieshavea debtrating.
However,
is againstatistically
averageratingforFF firmsis 78.12 versus70 forNFF firms.Thedifference
notmoreexposed
FF
firms
are
that
tests
These
the
1%
level.6
at
preliminary suggest
significant
andgovernance
turn
to
when
we
than
other
tomarket
ownership
companies.Also,
imperfections
affected
firms
seems
of
no
cluster
find
that
we
by "entrenched
characteristics,
particularly
for
all
10%
is
around
board
which,
accordingto the
groups,
ownership
managers."Average
area.Similar
the
falls
inside
of
UK
the
Mura
on
firms,
alignment
(2007)
performance
studyby
andaverageblockholding.
canbe drawnfromthefigureson boardcomposition
conclusions
level.Wefollow
attheindustry
Wealsoinspectthedatatosee ifthereis anyparticular
clustering
of
A largeproportion
concentration.
and analyzeindustry
SIC code classification
thetwo-digit
is
The
service
Codes
sector
the
to
FF firms,
industry
20-39).
41%, belongs
manufacturing (SIC
17%
find
we
also
while
Codes
18%
at
approximately
70-89),
represented approximately (SIC
services,
and 12% inthetradeandthetransportation,
electric,
communications,
gas,andsanitary
about
for
account
construction
and
and
Codes
50-59
40-49). Finally,mining
(SIC
respectively
1%.
less
than
has
and
12% ofFF firms(SIC Codes 10-17),whileagriculture,
forestry, fishing
InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,
1349
(4)
FinancialManagement Winter2010
1350
^^^^^
0.1 T-
- 0.090.08 -
| 0.07
S 0.06 -
*r~~^
1
t-2
t-1
0.05 -I
1-
-,
t+1 t+2
Investment
Panel B. Industry-Adjusted
% 0.027 H
1 0.022% 0.017 I
0.012 '
^*
1
y*r^*~~*
1
Panel C. AbnormalInvestment
^^^^^^^^^
g 0.03 -,
0.028
|
| 0.026
| 0.024| 0.022
0.02 -I
+^
1
,
t-2 t-1
*-.
1
1
1
t t+1 t+2
~~~~
{(Continued)
Thistrendis inlinewith
sharerepurchases.
FF firmsseemtoundertake
newinvestments.
Rather,
and
Oswald
theUK market
recentevidenceregarding
Young(2004).
by
In PanelH, we observea sharpdropin theircash positionbetweent - 1 and t + 1, where
t is themomenttheyare classifiedas FF. Cash dropsby about16%, from7.40% in t - 1 to
1351
and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,
Panel D. Leverage
U.I O
-j
0.11 |* 0.09
0.07
4f
j^
*V^/
0.05 J
1 1 1
1 1 .
t-2 t-1 t t+1 t+2
'
U 1
Q)
^ -0.01-0.02
|
I -0.03-
"O-04-0.05 -I
r^^*
I 0.003
/
5
/
~0-002'
t-2 J t t+1 t+2
1
1
J ____
_0
007
|
U.U
T~-
0.055 0.05 -I
"*"
- "
011"
"
O-007
|
s
0.005 J
^V.
^^^^>
.
, .
1 .
t_2 t_-| t t+1 t+2
Panel I. Profitability
^^^
1
1
t-2 t-1
0.013 i
Panel H. Cash
0.075 -
Panel G. NetEquityIssues
0.008
'
r~~^^
/
Panel F. NetDebtIssues
0.013 -j
'
1
1
1
t t+1 t+2
U. I *t
~j
"
"
.fe 0.12
* 0-06
0.04 -I
"
^__^
1
1
t-2 t-1
1
1
1
t t+1 t+2
FinancialManagement Winter2010
1352
Investment
Abnormal
Investment
f- 2
f+ 1
% Change
0.070
0.016
0.087
0.020
24.29
22.60
Investment
Investment
Abnormal
0.069
0.022
0.090
0.028
29.69
27.10
(0.000)
(0.000)
FF{25%)
Investment
Investment
Abnormal
0.071
0.017
0.090
0.021
26.76
23.11
(0.000)
(0.000)
FF{L5SD)
0.070
Investment
Abnormal
Investment 0.016
0.085
0.019
21.42
15.99
(0.000)
(0.000)
betweent - 2 and
and 23% in AbnormalInvestment
increaseof about30% in Investment
of 21 yearsand plottheir
In a further
test,we isolateFF firmsthatsurvivefora minimum
t
is now thetimewhenwe
where
t
10
and
between
H-10,
deviationfromtargetleverage
behavior
more
us
to
observe
This
allows
investment.
observean abnormal
closelytherebalancing
investment
the
new
finance
to
has
borrowed
after
the
of leverage
opportunity.
large
company
overshoot
is made,companiesmomentarily
Figure2 reportsthatafterthe largeinvestment
in
the
one
is
the
to
t
The
observation
theirtargetleverage.
positivequadrant
only
corresponding
we also observe
fromtarget
a positivedeviation
However,
leverage(i.e.,overshooting).
indicating
It seemsto
its
estimated
below
firm
back
the
takes
that
trend
andopposite
an immediate
target.
to
the
back
and
least
firm
to
the
for
3-4
takeapproximately years
prejump
partly) go
adjust(at
to the
in t + 6, theobserveddeviation(-0.00743) is of similarmagnitude
levels.Forinstance,
at
if
look
we
hold
results
Similar
t
6
value
longerperiods.The
(-0.0071).
corresponding
value for
the
whereas
is
about
in
t
10
observed
deviation
-0.0104,
corresponding
average
finance
to
in
debt
increase
this
that
view
the
corroborates
This
10
is
-0.0101.
t+
large
strongly
InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,
1353
0.015
0.01
l'
0.005
I '
%
s>
'
'
n^ * Jo A
I
I
<b 3
K>
-0.005
-0.015
K JMiV 3
>
<b A
<b q> o
'
^*
-0.02
thenewinvestment
a temporary
deviationfromthelong-term
low leveragetargetto
represents
whichthecompanyreverts.
This is consistent
withtheargument
of DeAngelo,DeAngelo,and
Whited(2010) who maintainthatthetargetis made of two components,
a permanent
and a
one. The former
is thelong-run
to
transitory
targetcompaniesareat beforethejumpandrevert
afterthelargeinvestments
are made.The temporary
deviationfromthislong-run
targetis the
transitory
component
allowingfirmsto actuallycarryouttheseabnormalinvestments.
The resultwe reportis in linewithGraham(2000) whoreports
thatcompaniesthatpreserve
debt
to
boost
future
investments
tend
to
substantial
eveninthe
spare
capacity
preserve
flexibility
havebeenmade.
periodsaftertheinvestments
Theseareall verysignificant
ourinitialhypothesis
thatat
piecesofevidenceandtheyconfirm
leastsomecompaniessacrificecurrent
and
use
this
borrowing
sparedebtcapacityto be able to
afford
tomorrow.
This lendsstrongempiricalsupportto
larger(and possiblybetter)investment
thesurveyevidenceregarding
A
structure.
financial
capital
flexibility
strategy
appearstoimprove
FinancialManagement Winter2010
1354
1355
FF2
FF3
FF4
FF5
FF6
0.169
(0.000)
0.112
(0.000)
0.003
(0.012)
0.031
(0.000)
-0.033
(0.000)
26,626
2,541
Yes
Yes
32.37
0.176
(0.000)
0.119
(0.000)
0.003
(0.007)
0.034
(0.000)
-0.028
(0.000)
26,626
2,541
Yes
Yes
37.25
0.179
(0.000)
0.100
(0.000)
0.003
(0.010)
0.031
(0.000)
-0.035
(0.001)
26,626
2,541
Yes
Yes
31.95
0.176
(0.000)
0.099
(0.001)
0.003
(0.005)
0.026
(0.000)
-0.022
(0.006)
26,626
2,541
Yes
Yes
28.36
0.175
(0.000)
0.096
(0.000)
0.003
(0.006)
0.033
(0.014)
-0.066
(0.045)
26,626
2,541
Yes
Yes
27.90
FF3{5%)
0.194
(0.000)
0.118
(0.000)
0.003
(0.000)
0.037
(0.000)
-0.078
(0.035)
26,626
2,541
Yes
Yes
30.43
FF3(25%)
0.181
(0.000)
0.081
(0.000)
0.003
(0.000)
0.035
(0.000)
-0.022
(0.000)
26,626
2,541
Yes
Yes
39.79
FF3(1.5SD)
0.195
(0.000)
0.096
(0.000)
0.003
(0.000)
0.033
(0.000)
-0.023
(0.000)
26,626
2,541
Yes
Yes
37.04
FinancialManagement Winter2010
1356
dueto thefactthatverysmalldeviations
aresimplyaffected
impactofFF3. Thisis probably
by
in
which
turn
waters
down
the
result.10
noise,
E. The Role of InternalFunds
A number
ofcashholdinginobtaining
financial
ofstudiesemphasizetheimportance
flexibility
Faulkender
and
find
thatthemarginal
and reducingunderinvestment
Wang(2006)
problems.
thanforunconstrained
firms.Theyalso
value of cash is substantially
higherforconstrained
In
a
recent
for
firms
with
that
this
result
is
paper,Denisand
highgrowth
options.
report
stronger
firms
to undertake
levels
of
financial
slack
allow
constrained
Sibilkov(2010) report
thathigher
with
Faulkender
and
Wang(2006) in thatcash
projects.Theirresultsalso tally
value-increasing
In a similarvein,
firms.
thanforunconstrained
holdingsare morevaluableforconstrained
in
thenegative
model whichfirmscanmitigate
GambaandTriantis
(2008) proposea theoretical
effectof financialconstraints
liquiditypolicy,althoughtheirmodel
throughan appropriate
Harford(1999) findsthatcash richcompanies
expressly
neglectsagencycosts.Alternatively,
are moreexposedto theoverinvestment
problemand thattheytendto makevalue-decreasing
acquisitions.
Wetrytotacklethisissueintwoways.First,we includecashanda proxyforexcesscashinto
modeltocontrolforthepotential
ourinvestment
impactoffinancialslack.In thefirstcolumnof
cashflowwithcash.In thesecondcolumn,we includethemboth
PanelA, TableV, we substitute
In thethirdandfourth
intheregression.
columns,we repeatthesameexercise,butwe includea
cashregression
thanthelevelofcash.To do that,we runan auxiliary
proxyforexcesscashrather
cashandclassifyfirmswithpositivedeviations
similarto Opleretal. (1999) to obtainpredicted
is adoptedinHarford
as cashrich.A similarprocedure
fromtarget
(1999) andDenisandSibilkov
modelto controlforthefact
(2010). We thenuse thisproxyforcashrichnessin theinvestment
to invest.
thanleverageto attainfinancialflexibility
thatsomefirmsmayuse excesscashrather
our origThe resultsfromthesetestsare in line withthepreviousevidencecorroborating
that(at least) the firmswe defineas FF are using spare debt capacityas
inal hypothesis
and enhancetheirinvestment
theirmain vehicleto attainfinancialflexibility
ability.Both
but across
the
with
and
cash and excess cash are statistically
sign,
expected
significant
the economicimpactof the FF statusremainssimilarto the previous
all specifications,
estimates.
way.By construction,
Second,we tryto testfortherole of internalfundsin an alternative
whenpredictedleverageis calculatedin our baselinemodeland low leverageand FF firms
foras it is notamongthe
controlled
thecash positionof thefirmis notdirectly
are classified,
of
determinant
variablesin thebaselinemodel.If cash (or excesscash) wereto be an important
would
this
of
financial
need
in
firms
for
those
decisions
flexibility),
stronger
(especially
leverage
FF dummywouldalready"contain"
end up in theresidualof themodel.Thus,theestimated
betweenthe
test
and
the
the
cash
information
previous maynotdiscriminate
position
regarding
roleplayedby theinternalfundsand thatof sparedebtcapacityas theyare bothembedded
of ourresults,we estimatea target
testtherobustness
to further
in theFF dummy.
Therefore,
that
other
factors
of
a
model
mayhelpfirmsachievefinancial
by variety
augmented
leverage
ofitsdebtanditsdividend
the
with
firm's
cash
the
We
include
maturity
along
holding,
flexibility.
"cleaned"ofthispotential
now
model
is
the
of
residual
The
Table
leverage
I).
payout(Column2,
medianto
iromindustry
10Inan unreported
leveragein difference
test,we replicatetheaboveanalysisbytransforming
in determining
effects
bettercontrolforpotential
sparedebtcapacity.The resultsare similarto thosereported
industry
above.
1357
Investmentt-X
Tobins q
FF3
OwA,_i
FF3* Casht-i
CashFlowt-X
Cash
Cash Plus
Cash Flow
0.193
(0.000)
0.003
(0.000)
0.031
(0.000)
0.035
(0.001)
-0.030
(0.087)
0.190
(0.000)
0.002
(0.003)
0.041
(0.000)
0.041
(0.020)
FF3*CashFlowt_]
ExcessCasht^i
0.127
(0.000)
-0.068
(0.026)
FF3*ExcessCasht_x
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects
Economicimpact(mean)
26,626
2,541
Yes
Yes
32.36
26,626
2,541
Yes
Yes
37.64
Excess
Cash
0.181
(0.000)
0.003
(0.000)
0.031
(0.000)
0.024
(0.057)
-0.017
(0.009)
26,626
2,541
Yes
Yes
39.38
0.112
(0.000)
-0.050
(0.030)
0.009
(0.094)
26,626
2,541
Yes
Yes
35.01
{Continued)
FinancialManagement Winter2010
1358
Excess Cash
Net Debt
Cf Volat
Percentile
FF3*CashFlowt.{
0.176
(0.000)
0.119
(0.000)
0.003
(0.007)
0.033
(0.000)
-0.028
0.165
(0.000)
0.129
(0.000)
0.004
(0.015)
0.034
(0.000)
-0.050
0.162
(0.000)
0.136
(0.000)
0.005
(0.008)
0.037
(0.000)
-0.069
0.135
(0.000)
0.151
(0.000)
0.007
(0.002)
0.040
(0.000)
-0.087
0.190
(0.000)
0.074
(0.001)
0.003
(0.000)
0.049
(0.000)
-0.121
Observations
Number
offirms
Firmfixedeffects
Yearfixedeffects
Economic
(mean)
impact
26,626
2,541
Yes
Yes
35.98
Investment^
CashFlowt-i
Tobins q
FF3
(0.000)
(0.014)
26,626
2,541
Yes
Yes
32.57
(0.002)
26,626
2,541
Yes
Yes
32.35
(0.008)
26,626
2,541
Yes
Yes
32.33
(0.005)
26,626
2,541
Yes
Yes
36.41
and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,
1359
FinancialManagement Winter201 0
1360
~~
Rf,t= apFF + pFF(Rm,t Rf,t)+ GpFF,t
~
RpFF,t Rf,t= ClpFF+ bpFF (Rm,t Rf,t) + SpFFSMBt + hpFFHMLt + 6pFFj.
of all firmsidentified
as financially
of theequallyweightedportfolio
RpFFj denotesthemontht return
24 (36 or60) months;
billrateconverted
flexible
Treasury
Rftis theUK three-month
(pFF) inthepreceding
to a monthly
rateof return;
thereturnon theFTSE All ShareIndexin montht; SMBt
Rm,trepresents
ofsmallandlarge(highandlowbook-to-market)
difference
betweena portfolio
firms,
(HMLt)is thereturn
whichareproxiedbytheFTSE SmallCap and FTSE 100 Indexes(FTSE GlobalValueandFTSE Global
flexiblefirms.It is a dummyequal to one if a companyhas a
GrowthIndexes).FF refersto financially
firmsforthreeconsecutive
negativedeviationfromitstargetlargerthanat least10% ofall undershooting
investment
data.
ofthreeyearsof industry-adjusted
is definedovera pattern
Investment
years.Abnormal
is calculatedintheextreme
Theaveragevalueofinvestments
years(i.e.,(AdjIt-' + AdjIt+')/2).Thus,there
valuein thecentralyearis at leasttwicetheaverageofthe
is a spikeinthispattern
onlyiftheinvestment
areinparentheses.
extremes.
Thejp-values
Targeting Method
Window
CAPM ot'
Percentile Method
CAPM a
StatusIs Acquired
FinancialFlexibility
PanelA. Long-Run
After
Performance
+24 months
+36 months
+60 months
0.00323
(0.015)
0.00287
(0.025)
0.00245
(0.043)
0.00297
(0.000)
0.00246
(0.003)
0.00168
(0.030)
0.00364
(0.011)
0.00346
(0.014)
0.00307
(0.021)
0.00335
(0.007)
0.00315
(0.006)
0.00217
(0.020)
Investments
Abnormal
PanelB. Long-Run
After
Performance
+24 months
+36 months
+60 months
0.00380
(0.008)
0.00353
(0.011)
0.00344
(0.010)
0.00552
(0.025)
0.00438
(0.046)
0.00232
(0.044)
0.00405
(0.008)
0.00389
(0.008)
0.00373
(0.007)
0.00240
(0.048)
0.00208
(0.045)
0.00185
(0.038)
in thiscase. FF firmsseemto
The economicimpactis even stronger
to classifyFF firms.14
13.24%.
themarket
byapproximately
outperform
theacquisitionof the
following
Third,in TableVII we examinethechangesin profitability
investment
thecreationof abnormal
FF status(Panel A) and following
(Panel B). The results
intheirprofitability
increase
an
ourpreviousevidence.Companiesappeartoexperience
confirm
more
ofmorethan18% aftertheFF statushas beenacquiredbut,
theyare able to
importantly,
two
within
boostof about38% in operating
yearsfromthe
performance
generatea remarkable
timeoftheirabnormalinvestment.
wherethisis
ofabnormalinvestment
definition
robustness
14For
purposes,we repeatedtheanalysisusingan alternative
median.The resultsarelargelyunaltered.
aboveindustry
definedas investments
1361
% Change
between
f - 1 and
t+ 1
Test of Difference
in Means t - 1
versus t + 2
(p-value)
PanelA. Profitability
aroundtheFinancialFlexibility
StatusAcquisition
Profitability
Targeting
Method
Profitability
Percentile
Method
0.094
13.81%
(0.000)
18.32%
(0.000)
0.110
4.71%
(0.000)
10.51%
(0.000)
PanelB. Profitability
aroundtheAbnormal
Investments
Profitability
Targeting
Method
Profitability
Percentile
Method
0.092
18.10%
(0.000)
38.32%
(0.000)
0.118
7.71%
(0.000)
29.78%
(0.000)
III. Conclusion
In thispaper,we studytheinteraction
betweenfinancialflexibility
andinvestment
Our
ability.
based
on
the
ideas
of
that
argument,
ModiglianiandMiller(1963) andMyers(1984), maintains
inthepresenceoffinancialconstraints,
firmsthatanticipate
valuablegrowth
optionsinthefuture
reservesofborrowing
respondbyaccumulating
power.Througha conservative
leveragepolicy,
maintain
a
thatallowsthemto havebetteraccess to
companies
degreeof financialflexibility
theexternal
market
whenfacedwithpositiveshocksto theirinvestment
set.Recent
opportunity
studies
thedeterminants
ofcapitalstructure
to thisviewin
survey
regarding
givestrongsupport
thatfinancialflexibility
is systematically
as themostimportant
factoron whichCFOs
reported
base theirleveragedecision.
Ourintertemporal
offirmbehaviorcorroborates
thesehypotheses.
Aftera period
investigation
ofleverageconservatism,
FF firmssignificantly
increasetheircapitalexpenditures
withrespect
topreviousyears.Mostnotably,
we identify
a sharpincreaseintheirabnormalinvestments.
Our
resultsindicatethatfirmsfinancethisinvestment
withpositivenetdebtissues.
1362
FinancialManagement Winter2010
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