The Relationship Between Firm Investment and Financial Status
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This document summarizes a study that examined the relationship between firm investment and financial status using a sample of 1,317 public firms between 1987-1994. The study found that: 1) Firms classified as facing fewer financial constraints (NFC) had stronger financial ratios and investment sensitivity to cash flow compared to financially constrained (FC) firms. 2) Investment levels were more sensitive to internal cash flow for NFC firms compared to partially financially constrained and FC firms. 3) The study validated prior research finding that investment decisions of more creditworthy firms are more sensitive to internal funds availability.
The Relationship Between Firm Investment and Financial Status
- 1. COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622 Presentation on The relationship between firm investment and financial status Written by: Sean Cleary, Saint Mary’s University, Halifax Published in: Journal of Finance, Vol. LIV, No. 2, April 1999 30th March, 2011
- 2. Article Outline I. Background A. Evidence of financing hierarchy B. Conflicting views C. Motivation II. Research design A. Sample characteristics B. Classification methodology C. Regression estimation D. Determination of significance level III. Discussion of results A. Results B. Interpretation IV. Conclusions
- 3. Presentation Outline Background Motivation of the study Research Methodology Major Findings Conclusions Comments
- 4. Investment decisions and financial factors are related issues. The controversy found in the literature on the ground that the relationship is changing. Modigliani and Miller (1958) - Financial factors are irrelevant for investment decisions. Greenwald, Stiglitz, and Weiss (1984), Myers and Majluf (1984), and Myers (1984) Bernanke and Gertler (1989, 1990) and Gertler (1992) - Financial structure may be relevant to the investment decisions. Background
- 5. Fazzari, Hubbard, and Petersen (1988), Hoshi, Kashyap, and Scharfstein (1991), Oliner and Rudebusch (1992), Whited (1992), Schaller (1993), and Gilchrest and Himmelberg (1995) also are in favor for the relevance of financial status. The investment decisions in market imperfection are sensitive to the availability of internal funds . Reason: low cost over external funds. Back…..
- 6. Fazzari, Hubbard, and Petersen (1988) - Use Value Line data, 422 U.S. mfg. firms, 1970 to 1984, and found that internal funds have cost advantage. Hoshi et al. (1991) – Studied on 146 Japanese mfg. firms and revealed that the investment outlays are much more sensitive to firm liquidity. Oliner and Rudebusch (1992) - Examine 120 U.S. firms, 1977 to 1983 period and found that investment is most closely related to cash flow. Back…..
- 7. Schaller (1993) - Studied 212 Canadian firms, 1973 to 1986, and concluded that firm investment with dispersed ownership concentration is the most sensitive to cash flow. Whited (1992) & Bond and Meghir (1994) - Use an Euler equation approach, 325 U.S. mfg. firms, 1972 to 1986 period & 626 U.K. mfg. firms from 1974 to 1986 period found exogenous finance constraint to be particularly binding for the constrained groups of the firms.
- 8. Mayer (1990) - Examined the sources of industry finance of eight developed countries from 1970 to 1985 and found that: i) Retentions are the dominant source of financing in all countries ii)The average firm in any of these countries does not raise substantial amounts of financing from security markets. and, iii) The majority of external financing comes from bank loans in all countries. Objective of the study A major focus of this study is the comparison of investment-liquidity sensitivities across different groups of firms. Back…..
- 9. Research Gap The contrariety conclusion of Kaplan and Zingales’s study. Implications of the results. Limitations of Kapland and Zingles’s study: Sample (49 manufacturing firms) Value line database Too small sub-groups (22, 19 and 8) Sorting criteria Subjective and possibility of self-serving managerial statements, etc. Motivation
- 10. Approach applied = Kaplan and Zingales Approach (NFC = increase cash div., NC = large cash position., Unconstrained = financially healthy firm with low debt & high cash) Statistical tools Multiple discriminant analysis (similar to Altman’s Z factor) Bootstrap methodology (Sign. level) Correlation matrix Regression analysis Descriptive statistics Financial constraint index, etc. Sample size = 1317 firms Study period = 1987 to 1994 Methodology
- 11. Sample composition Listed company view Firms SIC code view Firms NYSE 709 Mfg. firms (SIC codes 2000–3999) 843 Nasdaq 416 Agri., mining, forestry, & Cons. (SIC codes 1–1999) 99 AMEX or US exchange 192 Retail and wholesale trade (SIC codes 5000–5999) 201 Service firms (SIC codes 7000–8999) 174 Sample size 1317 Sample size 1317 Method… Basic conditions for samples selection: a) Banks, insurance companies, other financial companies, and utility companies is avoided, and b) Required to have positive values for sales, total assets, net fixed assets, and market-to-book ratio.
- 12. i) Standardized discriminant function (ZFC ) ZFC = b1Current + b2FCCov + b3SLACK/K 1 b4 NI% + b5 Sales Growth + b6 Debt. Z score help to classify the entire sample in to 3 groups (Group I – Increase DPS, II – Decrease DPS and III – No change in DPS) ii) regression model is also used. I/Kit = bM/B(M/B)it + bCF/K(CF/K)it + uit iii) A bootstrapping procedure is used to calculate empirical p-values Method…
- 13. Total Sample Group 1 Increase DPS Group 2 Decrease DPS Group 3 No change in DPS Net fixed assets $650m $1076m $913m $630 Current ratio 2.57 2.40 2.36 2.71 Debt ratio 0.22 0.20 0.26 0.23 Fixed charge coverage 12.1 16.8 7.4 9.9 Net income margin(%) 3.0 6.8 1.0 1.0 Market to Book ratio 2.18 2.64 1.62 1.97 Sales growth(%) 10.1 11.4 1.6 10.3 Slack/K 1.71 1.42 1.45 1.92 Cash flow/K 0.47 0.58 0.27 0.42 Investment/K 0.26 0.26 0.19 0.24 Discriminant score (Z) -0.31 0.17 -0.87 -0.61 Table I - Sample Summary Statistics (1988-1994) Panel A: Selected Financial Ratio Means Finding: Firms with reducing dividends appear to be more financially constrained. (Low where as high is desire)
- 14. Dividend Group Total Sample 1988 1989 1990 1991 1992 1993 1994 1. increased DPS 3241 35.1% 547 41.5% 543 41.2% 478 36.4% 408 31.0% 411 31.2% 420 31.9% 434 33.0% 2. increased DPS 636 6.9% 58 4.0% 68 5.2% 94 7.2% 127 9.6% 110 8.4% 91 6.9% 91 6.9% 3. no change in DPS 5344 58.0% 717 54.5% 706 53.6% 745 56.6% 782 59.4% 796 60.4% 806 61.2% 792 60.1% Panel B: Number of Firms per Dividend Group Finding: Largest number of firms 547 occurred in 1988 in first group and 127 firms in second group for the year 1991. This evidence supports the notion that firms face changing levels of financial constraints every year.
- 15. CF/FA CR DR FCC INV/FA M – B R NIM SG Slack/FA D Score CF/FA 1 CR .11 1 DR -.18 -.33 1 FCC .21 .19 -.43 1 I/FA .37 .17 -.23 .18 1 M to BR .21 .02 -.12 .21 .24 1 NIM .34 .08 -.14 .24 .13 .10 1 SG .19 .02 -.01 .11 .24 .20 .21 1 Slack/FA .38 .47 -.33 .13 .40 .08 .02 .05 1 D Score .32 -.07 -.29 .32 .18 .19 .80 .55 -.08 1 Table II - Correlation among variables Measure liquidity ratio but it is surprising (-ve) High correlation between D. Score and NIM followed by SG Finding: 26% of the cases are misclassified in predicting whether firms will cut or increase their dividend.
- 16. Table III - Selected Financial Ratio Means for Financially constrained Groups (1988-1994) Predicted Group 1 Predicted Group 2 FC Firms PFC Firms NFC Firms Net fixed assets $803m $591m $507m $787m $656m Current ratio 2.37 2.51 2.74 2.37 2.62 Debt ratio .18 .28 .31 .22 .14 Fixed charged coverage 18.3 4.8 3.0 8.8 24.6 Net income margin(%) 7.2 -1.2 -4.8 4.2 9.6 Market to Book ratio 2.58 1.50 1.65 1.91 2.99 Sales growth(%) 15.1 -.6 -2.3 9.0 23.5 Slack/K 1.30 1.30 1.93 1.46 1.75 Cash flow/K .52 .24 .23 .42 .75 Investment/K .27 .19 .21 .24 .33 Discriminant score(Z) .51 -1.45 -1.77 -.21 1.05
- 17. Findings: Financial ratios are superior for the NFC group, inferior for the FC group and the PFC in between. The observed average turnover rates are 40.9, 52.3, and 37.3 percent per year. Firms are classified at least one year is 75, 83 and 74 percent for the NFC, PFC, and FC respectively. Only 17 firms are classified as PFC for all 7 years, and only 49 and 80 are classified as NFC and FC. These results indicates that individual firm’s financial status does change significantly y-b-y.
- 18. Table IV – Regression results for the total sample (1317 firms) Findings Firm’s investment decisions are sensitive to market opportunity (M-B) but are even more sensitive to liquidity variable (CF/NTA) Liquidity and market to book ratio are significant determinants of investment for FC, PFC and NFC groups Investment outlays of the NFC firms are significantly more sensitive to liquidity than that of PFC and FC firms. Estimated coefficients are 0.153, 0.090 & 0.064 with p value 0.0046, 0.000 & 0.083 respectively. p value 0.5890 explains NFC>FC at 058.90% level of sign.
- 19. Table V – Regression results for dividend payout groups Investments of the NFC firms are most sensitive to liquidity followed by PFC firms and FC firms. Coefficients are 0.159, 0.080 & 0.057 with p values 0.002, 0.000 & 0.1378 respectively. p value 0.3834 explain NFC>FC at 38.34 level of significance. Similar explains for the next panels as well.
- 20. The study concludes the accuracy of the classification is 74 percent in predicting dividend payments. The investment decisions of firms with high creditworthiness (least financially constrained) are significantly more sensitive to the availability of internal funds than are firms that are less creditworthy. This strongly supports the small-sample evidence of Kaplan and Zingales (1997). Conclusions
- 21. A strong effort to validate the conclusions of earlier study using varying research methodology. Sound methodology of the study. Statistical tools and models used for the analysis are clearly described. The motivation of the study presented with the evidences of the literatures in a details. Determination of significance level has done which is rare in existing literature. Comments
- 22. Thank you.