Financial frictions, investment endogeneity and the external financing – cash flow relationship

Financial frictions, investment endogeneity and the external financing – cash flow relationship

This paper using a large panel of Pakistani non-financial firms over the period 2000–2013 examines the role of financial constraints in establishing the relationship between cash flows and external financing. The paper also investigates the credit multiplier effect for financially constrained and unconstrained firms. We use three different measures namely Kaplan and Zingales index (hereafter KZ index), the debt to asset ratio, and the interest coverage ratio to classify the firm-year observations into financially constrained and unconstrained.

Our results indicate that the external financing decisions of firms are negatively, significantly related to internal funds availability. The finding of the substitutionary relation between internal funds availability and external financing has been viewed as evidence supporting the pecking order theory of capital structure. However, the results reveal that this negative external financing – cash flow sensitivity is less for financially constrained firms. This finding has been inferred as evidence suggesting the interdependence of external financing and investment decisions of financially constrained firms. We also find that for financially unconstrained firms, the negative sensitively of external financing increases with tangibility. On the other end of the continuum, for financially constrained firms, the negative sensitivity of external financing to cash flow either decreases or at least turns positive as the tangibility of assets increases.

The rest of the paper is structured as follows. Section “Literature Review” presents the literature review. Section “Data and Methodology” describes the data and the empirical methodology applied to carry out the empirical analysis. Section “Empirical Results” presents our main empirical results. Finally, Section “Conclusions” concludes.

Literature review

The previous literature on the capital structure decisions of firms documented significant evidence regarding the role of financial frictions in firms’ financing decisions (Fazzari et al. (1988), Hubbard (1998), and Faulkender & Petersen (2006)). Fazzari et al. (1988) are the pioneer to examine the relationship between investment, internally generated funds (cash flow) and financial constraints. By sorting US firms over the year 1970–1984, they conclude that financial constraints play a significant role in defining the direction and the extent of the relationship between investment and cash flow. However, Faulkender & Petersen (2006) used a large sample of US firms over the period 1986–2000 and find that small firms are more credit constrained than large firms and the financially unconstrained firms use more leverage in their capital structure as compared to financially constrained firms.

They explained that most highly financially constrained and unconstrained firms both exhibit higher sensitivity of investment to cash flow than the middle class firms do

Several later studies also do not support the findings of Fazzari et al. (1988). For example, Kaplan & Zingales (1997) found that the relationship between financial frictions and the investment-cash flow sensitivity is nonlinear. They develop new index to classify the firms into financially constrained and unconstrained types, popularly known as KZ index. Diverging from the large body of the existing literature of the sensitivity of investment to cash flow, they show that the investment decisions of the least financially constrained firms are most sensitive to cash flow. Several other empirical papers including Kadapakkam et al., (1998) and Cleary (1999) supported these findings. In particular, Cleary (1999) examining a large sample of listed firms provided evidence that the investment decisions of high (less) creditworthy firms are more (less) sensitive to internal cash flow availability.

However, Allayannis & Mozumdar (2004) examined the robustness of the results of Kaplan & Zingales (1997) and Cleary (1999) by arguing that the investment decisions of firms with cash losses cannot be sensitive to the availability of internal funds (cash flows). They shown that although Cleary’s results are strongly robust to such negative cash flow sample, the Kaplan–Zingales results are generally the result of the presence of a few influential observations in a relatively small sample. Further, the authors find a significant decline in the sensitively of investment to internal funds availability. In particular, they show that this decline is more substantial in case of most constrained firms.