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«ERIM REPORT SERIES RESEARCH IN MANAGEMENT ERIM Report Series reference number ERS-2001-86-F&A Publication December 2001 Number of pages 33 Email ...»

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INVESTMENT AND INTERNAL FINANCE: ASYMMETRIC INFORMATION

OR MANAGERIAL DISCRETION?

HANS DEGRYSE AND ABE DE JONG

ERIM REPORT SERIES RESEARCH IN MANAGEMENT

ERIM Report Series reference number ERS-2001-86-F&A

Publication December 2001 Number of pages 33 Email address corresponding author ajong@fbk.eur.nl Address Erasmus Research Institute of Management (ERIM) Rotterdam School of Management / Faculteit Bedrijfskunde Erasmus Universiteit Rotterdam P.O. Box 1738 3000 DR Rotterdam, The Netherlands Phone: + 31 10 408 1182 Fax: + 31 10 408 9640 Email: info@erim.eur.nl Internet: www.erim.eur.nl

Bibliographic data and classifications of all the ERIM reports are also available on the ERIM website:

www.erim.eur.nl

ERASMUS RESEARCH INSTITUTE OF MANAGEMENT

REPORT SERIES

RESEARCH IN MANAGEMENT

BIBLIOGRAPHIC DATA AND CLASSIFICATIONS

Abstract

This paper examines the relation between cash-flow availability and investment spending in the Netherlands. In particular, we are interested whether managerial discretion and/or asymmetric information drive the positive relation between cash-flow and investment spending. This relation is positive for both firms with low and high investment opportunities. It is however significantly larger for firms with low investment opportunities suggesting that the managerial-discretion problem is most important in the Dutch setting. Effective corporate-governance may reduce this agency problem.Specific to the Netherlands, firms with low shareholder influence posit a higher cash-flow-investment sensitivity. The relevance of asymmetric information is confirmed as smaller firms and firms from information-sensitive industries show a larger cash-flow-investment sensitivity.

Library of Congress 5001-6182 Business Classification 4001-4280.7 Finance Management, Business Finance, Corporation Finance (LCC) HG 2028.C45 Cash management; corporation fina

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* Corresponding author: Erasmus University Rotterdam, Department of Financial Management, P.O.Box 1738, 3000 DR, Rotterdam, The Netherlands. We thank Uli Hege, Joep Konings, Theo Nijman, Jerry Stevens, Mark Van Achter, Chris Veld, seminar participants at Tilburg University, the ‘Corporate investment and corporate governance’ meeting in Aarhus (November 1999), and the Southern Finance Association meeting in Destin (November 2001) for helpful comments. Part of this research was conducted while Abe de Jong was visiting Florida State University. Abe de Jong gratefully acknowledges financial support from The Netherlands Organization for Scientific Research (NWO Grant R46-406).

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INVESTMENT AND INTERNAL FINANCE: ASYMMETRIC INFORMATION

OR MANAGERIAL DISCRETION?

Abstract

This paper examines the relation between cash-flow availability and investment spending in the Netherlands. In particular, we are interested whether managerial discretion and/or asymmetric information drive the positive relation between cash-flow and investment spending. This relation is positive for both firms with low and high investment opportunities. It is however significantly larger for firms with low investment opportunities suggesting that the managerial-discretion problem is most important in the Dutch setting. Effective corporate-governance may reduce this agency problem.

Specific to the Netherlands, firms with low shareholder influence posit a higher cash-flow-investment sensitivity. The relevance of asymmetric information is confirmed as smaller firms and firms from information-sensitive industries show a larger cash-flow-investment sensitivity.

21. Introduction

In capital markets without imperfections, no systematic relationship is predicted between cash-flow availability and investment expenditures. Investments should take place whenever they are expected to realise a positive net present value and should not necessarily be linked to cash-flow. The empirical literature starting with the seminal article of Fazzari, Hubbard and Petersen (1988), however, has demonstrated a significant correlation between investment and cash-flow. According to Myers and Majluf (1984), the theoretical underpinning of this empirical regularity is underinvestment.

Financing constraints due to asymmetric-information problems in the issuance of equity cause the cash-flow-investment dependence. Stiglitz and Weiss (1981), and Greenwald, Stiglitz and Weiss (1984) obtain similar results for debt. More recently, Jensen’s (1986) managerial-discretion problem is found to provide an alternative underpinning for the positive link between cash-flow and investment spending. The reason is that managers’ utility is positively correlated with firm size since this increases their pay, status and power. Overinvestment results due to the availability of free cash-flow. Thus alhough both the managerial-discretion problem and the asymmetric-information problem provide an explanation for the positive influence of cash-flow on firm’s investment spending, most empirical papers uniquely attribute the link between cash-flow and investment to financing constraints related with asymmetric information. The contribution of our paper is to identify the importance of both the managerial discretion problem and the asymmetric information problem for the positive link between cash-flow and investment.





Asymmetric information intensifies financing constraints as in Myers and Majluf’s (1984) problem. A number of empirical studies test for asymmetric-information problems. Building on Fazzari, Hubbard and Petersen (1988), these studies apply a sample split based on an a priori criterion of asymmetric information. In line with theory, the results show that the impact of cash-flow on investment is larger for firms with higher information asymmetries (see e.g. Devereux and Schiantarelli (1990), Oliner and Rudebusch (1992), Schaller (1993), Gilchrist and Himmelberg (1995) and Kadapakkam, Kumar and Riddick (1998)). Thus, the intensity of asymmetric-information problems, and the resulting underinvestment, depends on certain firm characteristics, such as the information-sensitivity of the industry and the bank-firm relationships. Hoshi, Kashyap and Scharfstein (1991) introduce the 3 overinvestment problem explicitly by distinguishing firms with low and high investment opportunities.

The overinvestment problem is expected to be relevant for firms with bad prospects. Vogt (1994) adds to the literature by designing an empirical model that tests when underinvestment or overinvestment is the predominant cause of cash-flow-investment sensitivities. Finally, the degree of Jensen’s (1986) managerial-discretion problem and the implied overinvestment hinges on corporate governance. Hadlock (1998) relates the overinvestment problem to governance as he introduces insider ownership as an explanatory variable for the cash-flow-investment sensitivity.

We investigate the relevance of the asymmetric-information problem vis-à-vis the managerialdiscretion problem. The basis of our empirical investigation is a panel data set of Dutch non-financial firms. The Dutch setting allows us to identify which of the two problems−asymmetric information or managerial discretion−is driving the cash-flow-investment sensitivity. We expect that the managerial discretion problem is highly relevant in the Netherlands. Dutch firms operate in an environment where corporate-governance mechanisms are weak, relative to those in the Anglo-Saxon system. In the Netherlands, firms are characterized by the presence of large blockholders, limited shareholder influence, a multitude of takeover defenses and multiple bank-firm relations. In addition, share ownership by insiders is relatively small in the exchange-listed firms. La Porta, Lopez-de-Silanes and Shleifer (1998) describe for 49 countries the level of shareholder-rights protection. On a scale from zero (no protection) to six (high protection), Dutch firms receive a score of two. This is very low in comparison with the score of five for firms in the US and UK. While the differences with AngloSaxon countries are clear-cut, characteristics of Dutch firms resemble aspects of firms in other continental-European countries. For example, in La Porta, Lopez-de-Silanes and Shleifer (1998), France and Germany also get low scores for shareholder protection (three and one, respectively).

Becht and Mayer (2001) describe ownership structures in the Netherlands, six other continentalEuropean countries, the UK and the US. Blockholdings are dominant in the continental-European countries and ownership is much more dispersed in the Anglo-Saxon countries. With respect to bank influence, the median voting power of banks in the seven continental-European countries is above 20%, and below 10% in the two Anglo-Saxon countries. Thus, Dutch firms have governance mechanisms that are not or hardly present in the Anglo-Saxon setting, but are found in many continental-European countries. Moreover, the sample of Dutch firms exhibits sufficient heterogeneity 4 in these governance structures. This variability in the characteristics allows us to identify the influence of each of the governance mechanisms on overinvestment as predicted in the managerial-discretion problem. However, it remains an empirical question to which extent alternative governance devices mitigate overinvestment.1 In this paper, we first discriminate empirically between the asymmetric-information problem and the managerial-discretion problem for Dutch firms. We approach this by considering the cash-flowinvestment sensitivity of firms with and without good prospects (respectively, the asymmetricinformation problem and the managerial-discretion problem). In particular, we allow for different levels of cash-flow-investment sensitivity in subsamples. For the firms with low investment opportunities we expect managerial discretion to be relevant, while asymmetric-information problems are expected to apply in firms with high investment opportunities. In addition to our subsamples, we allow for an interaction between investment opportunities and cash-flow within the two subsamples.

That is, we permit to have varying degrees of asymmetric-information problems and managerialdiscretion problems within groups of firms, having good and bad prospects respectively. Secondly, we investigate how information-sensitive characteristics shape the asymmetric-information problem and affect underinvestment. Similarly, we analyze how corporate governance alleviates or sharpens the managerial-discretion problem. We expect that effective corporate governance reduces overinvestment problems, i.e. lowers the magnitude of the cash-flow-investment relation.

Our empirical analysis builds on Hoshi, Kashyap and Scharfstein (1991), who investigate a subsample of firms with investment opportunities above and below the median Tobin’s Q ratio. We aim to disentangle the asymmetric-information and managerial-discretion problems by focussing on the differences between these subsamples. We also extend Vogt (1994), who assumes that in the full set of firms either the managerial-discretion or the asymmetric information problem is most relevant.

He allows for a linear interaction between investment opportunities and cash-flow. However, the degree of the asymmetric information and managerial discretion problem may differ within a 1 With respect to the asymmetric-information problem we do not expect strong differences between the AngloSaxon and the Dutch setting. However, two differences may be relevant. First, in the Netherlands, the accounting regulations are less strict, in comparison with rules in the US and UK. Second, although financial markets are welldeveloped in the Netherlands the public availability of firm-specific information in comparison with the US and UK is less. For example, the number of analysts and rating agencies that provide their opinions on firms is lower in 5 subsample, i.e. firms with good or bad prospects. For instance, according to Myers and Majluf (1984), underinvestment increases in investment opportunities. This implies that the coefficient of the interaction of Tobin’s Q and cash-flow may hinge on the level of Tobin’s Q within the sample of firms with good prospects. We choose therefore to investigate the two approaches−subsamples distinguishing firms with good and bad prospects and interaction between investment opportunities and cash-flow−both separately and simultaneously. Moreover, while previous studies investigated a single characteristic (e.g. Hadlock (1998)) we investigate over ten firm characteristics that are expected to influence the cash-flow-investment sensitivity.

We find that cash-flow is an important determinant of investment expenditures. Its impact is significant for firms with good prospects as well as for firms with bad prospects. However, the impact of cash-flow is largest for firms with bad prospects, i.e. low Tobin’s Q, suggesting that the managerial-discretion problem is most relevant in the Dutch setting. In the sample of low-Tobin’s Q firms, with the managerial-discretion problem, we find that the cash-flow-investment sensitivity is higher for firms with lower shareholder influence. The agency problem is reduced by leverage and bank debt. In the high-Tobin’s Q sample, the asymmetric-information problem is more relevant for smaller firms and firms in industries with many intangible assets, as these exhibit a larger cash-flowinvestment sensitivity. In this subsample, firms with more bank d display a higher cash-flowebt investment sensitivity. In sum, we document that the cash-flow-investment sensitivity and its determinants differ between subsamples. Therefore, we provide evidence for the necessity to distinguish between the asymmetric-information and the managerial-discretion problems using subsamples defined on the firm’s prospects.

The remainder of the paper is organized as follows. In Section 2 we further discuss the relation between investment and cash-flow and formulate explicit hypotheses. Section 3 describes our data set, while Section 4 presents the empirical tests of our hypotheses. Section 5 concludes.

the Netherlands. Again, it remains an empirical question to which extent these specifics cause underinvestment.

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