The impact of negative cash flow and influential observations on investment–cash flow sensitivity estimates

Journal of Banking accepted 5 December 2002AbstractKaplan and Zingales Quart. J. Econ. 112 (1997) 169 and Clearly J. Finance 54 (2) (1999)673 diverge from the large literature on investmentcash ow sensitivity by showing thatinvestment is most sensitive to cash ow for the least nancially constrained rms. We exam-ine if this result can be explained by the fact that when rms are in suciently bad shape(incurring cash losses), investment cannot respond to cash ow. We nd that while Clearysresults can be explained by such negative cash ow observations, the KaplanZingales resultsare driven more by a few inuential observations in a small sample. We also record a decline ininvestmentcash ow sensitivity over the 19771996 period, particularly for the most con-strained rms.2003 Elsevier B.V. All rights reserved.JEL classication: G31; G32Keywords: Financing constraints; Cash ow; Investmentq Earlier versions of the paper were circulated under the title Resolving the InvestmentCash FlowSensitivity Puzzle: Negative Cash Flows and Inuential Observations .* Corresponding author. Tel.: +1-934-924-3434; fax: +1-934-243-5021.E-mail addresses: (G. Allayannis), (A. Mozumdar).1 Tel.: +1-703-538-8414.0378-4266/$ - see front matter 2003 Elsevier B.V. All rights reserved.doi:10.1016/S0378-4266(03)00114-6902 G. Allayannis, A. Mozumdar / Journal of Banking Gilchrist and Himmelberg, 1995), membership in corporategroups (Hoshi et al., 1991; Calem and Rizzo, 1995; Shin and Park, 1998), banking relationships (Houstonand James, 2001), and age and dispersion of ownership (Schaller, 1993). See Hubbard (1998) for a reviewof this literature.3 Fazzari et al. (2000) make a similar point in their response to KZ. Specically, they point out thateven when rm cash ows are extremely low or negative, gross investment cannot be less than zero. Thismay introduce a censored regression bias in the estimated investmentcash ow sensitivities if the impactof such negative cash ow observations is not accounted for in the estimation procedure.G. Allayannis, A. Mozumdar / Journal of Banking and 0.19 and0.211, respectively, when they are excluded (the dierence being statistically insignif-icant). This indicates that the Cleary (1999) result is materially aected by the inclu-sion of negative cash ow observations. 4 We obtain similar results in an alternativespecication, where instead of omitting negative cash ow observations, we includean additional interaction term between the negative cash ow dummy variable andthe cash ow variable to account for the impact of negative cash ow observationson estimated sensitivities.The result on the uniformity of investmentcash ow sensitivity across constraintcategories found in the Cleary sample when negative cash ow observations are ex-cluded is of additional interest because it is also dierent from the evidence in FHPand other earlier studies that showed a positive relation between nancing con-straints and investmentcash ow sensitivity (e.g., estimated sensitivities of 0.461and 0.230 for the most constrained and least constrained groups, respectively, inFHP). A possible explanation is that there has been a reduction over time in the im-pact of nancing constraints on rm investment. We examine this possibility usingdata for all manufacturing rms with continuous coverage by Compustat for the pe-riod 19771996, and nd evidence supporting such a conclusion: after excluding neg-ative cash ow observations from the sample, the investmentcash ow sensitivity issignicantly higher for more constrained rms than less constrained rms (0.586 ver-sus 0.213) over the 19771986 period, but they are similar for the two groups (0.196versus 0.175) and the dierence statistically insignicant over the 19871996 period.The paper thus makes two contributions to the literature. First, it reconciles thendings of KZ and Cleary (1999) with earlier results, and shows that the level of in-ternal wealth as proxied by cash ow is a major determinant of investment, and has a4 Note that for a rm with cash losses in some years, we do not exclude observations for all years, butonly for those specic years in which cash ow was negative.904 G. Allayannis, A. Mozumdar / Journal of Banking 6i.e., investmentcash ow sensitivity (dI=dW ) is greater for rms facing a bigger costdierential (k) between internal and external funds. But again, it is easy to nd in-stances where this condition would be violated. From (2), we obtaind2I CEkFII CEEE FIII CEEdk dW CEE FII 3CEEkFIICEE FII 27and there are no theoretical arguments to guarantee that this expression is posi-tive. 11The fact that there are no theoretical restrictions on the signs of d2I=dk dW and2 2constraints and investmentcash ow sensitivity is completely indeterminate. Fur-ther analysis of the model, however, suggests that in an empirical context, we canqualify this indeterminacy result to some extent, and develop predictions about9 We show in Section 5 that negative cash ow observations are also associated with negative real salesgrowth, indicating that these two proxies for nancial distress are strongly correlated.10 This correlation between nancial distress and nancial constraints is particularly problematic inempirical work. For example, Kaplan and Zingales (2000) argue that nancial distress is a form ofnancing constraints, and Povel and Raith (2001) suggest that low cash ow is a component of nancingconstraints. (We thank one of the referees for pointing this out to us.).11 If CE; k is additively separable, i.e., CE; k f E gk, then CEk CEEk d2I=dk dW 0. IfCE; k is multiplicatively separable, i.e., CE; k f Egk, then CEk fEgk 0, CEEk fEEgk 0, thesecond term on the RHS of (7) is positive, and the rst term is negative if FIII 0 and/or CEEE 0 )condition (6) may or may not be satised.G. Allayannis, A. Mozumdar / Journal of Banking 1. 12 Substi-tuting these functions into Eq. (7), we show that d2I=dk dW is positive forW 1 q=2k and negative for W k1 and wW ; k2 wW ; k1, 8W . When thecash ow level changes by DW , the change in investment for rm-i is DIi. In Fig. 1,DI1=DW DI2=DW . In the limit asDW ! 0 and k2 ! k1, d2I=dk dW 0 at W WH (Fig. 1), while d2I=dk dW I W ; k2, 8W , k1 0, 8W .908MarginalReturns(),MarginalCost (1+)1G. Allayannis, A. Mozumdar / Journal of Banking Kt 1 Kt 18where It=Kt 1 is investment during year t, scaled by beginning-of-year capital stock;Wt=Kt 1 is cash ow during year t, scaled similarly; Qt is beginning-of-year Tobin s Q,used as a proxy for investment opportunities, and FIRMDUM and YEARDUM arerm and year dummies. 14 The coecient c does not measure the slope of the curvefor any specic value of internally generated cash W . Rather, it measures the average1314In actual empirical work, it is customary to use a group of rms with similar levels of k.Erickson and Whited (2000) have recently critiqued this specication by arguing that researchers donot have a true measure of marginal Q and resort to using average Q instead, leading to a bias in theestimated coecients. They propose a measurement error-consistent estimator that uses the information inthird and higher order moments of the regression variables to overcome this problem.910 G. Allayannis, A. Mozumdar / Journal of Banking & Finance 28 (2004) 901930slope over the entire observed range of W . Clearly, its value depends upon this range.Consider the investmentcash ow sensitivities of two rms as shown in Fig. 3. Theinvestmentcash ow prole of the more constrained rm (rm-2) is more steeplysloped, i.e., it has higher dI=dW , when cash ow W is positive. However, investmentas a function of cash ow attens out, and its investmentcash ow sensitivity be-comes lower than that of the less constrained rm (rm-1) when cash ow turnsnegative. If observations from the left tail of the distribution (the low-cash ow orthe distressed state observations) are excluded, then d2I=dk dW 0 ) dc=dk 0,i.e., the more constrained rms have higher investmentcash ow sensitivity. Incontrast, when a large number of observations from the left tail are included (as inKZ and Cleary, 1999), the signs of d2I=dk dW and dc=dk cannot be determineda priori.The empirical analysis is complicated by the fact that W and k are not indepen-dent. The more constrained (high-k) rms are also more likely to have low realiza-tions of W . Therefore, when low-W observations are included in the sample, theestimated coecient c is reduced more for the high-k rms. Alternatively, when neg-ative cash ow observations are excluded from the sample, more constrained rmsshould exhibit greater investmentcash ow sensitivity.3. The Kaplan and Zingales (1997) and Cleary (1999) evidence revisited3.1. The Kaplan and Zingales (1997) evidence revisitedIn this section, we examine the role of negative cash ow observations on the KZresults. A second concern about the KZ results relates to the small size, and conse-quently, the possible lack of cross-sectional variation in their sample. Hubbard(1998) argues that since KZ use the subset of rms that were already identied byFHP as being most nancially constrained, and then further categ