Financial Constraint, Liquidity Management and Investment * Timothy J. Riddiough School of Business University of Wisconsin-Madison [email protected]Zhonghua Wu School of Business Florida International University wuz@fiu.edu This Draft: November 2007 Abstract Investment and liquidity management are analyzed in a sector where firms are exogenously cash flow constrained. Across the entire sector, we find high investment sensitivity to both q and measures of financial market frictions. Liquidity is managed * We thank David T. Brown, Jim Clayton, Morris Davis, Piet Eiccholtz, Erasmo Giambona, Don Hausch, François Ortalo-Magné, Steve Malpezzi, Armin Schwienbacher, James Seward, David Shulman, Ko Wang, Toni Whited and seminar participants at Baruch College, University of Amsterdam, University of Wisconsin-Madison, and the 2006 ASSA meetings for helpful comments. We gratefully acknowledge the Puelicher Center for Banking Education at University of Wisconsin-Madison for its financial support.
Transcript
1. Financial Constraint, Liquidity Management and Investment*
Timothy J. Riddiough School of Business University of
Wisconsin-Madison [email protected] Zhonghua Wu School of
Business Florida International University [email protected] This Draft:
November 2007 Abstract Investment and liquidity management are
analyzed in a sector where firms are exogenously cash flow
constrained. Across the entire sector, we find high investment
sensitivity to both q and measures of financial market frictions.
Liquidity is managed through cash retention (dividend) policy and
access to short-term bank finance, in which bank line of credit
smoothes variation in available cash flow and accelerates
investment. We show that cash flow constraint is not equivalent to
financial constraint, where more (less) financially constrained
firms in our sample exhibit high (low) investment and liquidity
management sensitivity to variables that measure financial market
frictions. Empirical results provide support for debt overhang,
free cash flow and asset tangibility as important financial market
frictions that influence investment outcomes. * We thank David T.
Brown, Jim Clayton, Morris Davis, Piet Eiccholtz, Erasmo Giambona,
Don Hausch, Franois Ortalo-Magn, Steve Malpezzi, Armin
Schwienbacher, James Seward, David Shulman, Ko Wang, Toni Whited
and seminar participants at Baruch College, University of
Amsterdam, University of Wisconsin-Madison, and the 2006 ASSA
meetings for helpful comments. We gratefully acknowledge the
Puelicher Center for Banking Education at University of
Wisconsin-Madison for its financial support.
2. Financial Constraint, Liquidity Management and Investment 1.
Introduction Fazzari, Hubbard, and Petersen (1988) convincingly
argue that internal versus external sources of finance are
imperfect substitutes in the context of funding investment, and
hence that financial constraints impede the efficient allocation of
resources. Their study has had wide impact, and has come under
intense scrutiny. Critics, beginning with panelists that provided
comments and discussion published alongside the original Brookings
paper, have generally focused on three instrumental issues: i)
endogeneity of financial constraint proxies; ii) measurement error
in Tobins q; and iii) omitted variables and channels that provide
more complete information about the link between financial market
frictions and real investment outcomes. Chirinko (1993) concisely
summarizes these concerns by stating, It is unclear whether
significant liquidity and net worth variables are capturing a
structural element heretofore missing in the investment equation or
are merely reflecting a general misspecification. Previous studies
have addressed one or two of these instrumental issues at a time,
but none have addressed all three in a systematic and comprehensive
manner. For example, Whited (1992) and Kaplan and Zingales (1997)
primarily address the financial constraint issue, while Erickson
and Whited (2000) focus on measurement error in q and Almeida,
Campello and Weisbach (2004) emphasize the link between cash flow
sensitivity of cash holdings and financial constraint. The intent
of this study is to address all three issuesendogeneity of
financial constraint proxies, measurement error in q, and omitted
variables/channelssimultaneously and comprehensively in order to
provide additional perspective on the effects of financial
constraint on investment decisions. To address endogeneity in the
financial constraint proxy and measurement error in q, we analyze a
specific sector that provides an attractive natural economic
laboratory: publicly traded 1
3. firms that own commercial real estate assets in an
investment vehicle called a Real Estate Investment Trust (REIT).
These firms are regulated to pay out at least 90 percent of their
GAAP net income as dividends, and most pay out at least 100 percent
of GAAP net income to avoid negative tax effects. This implies that
the entire sector is constrained in its ability to retain cash, and
therefore depends heavily on external finance to fund investment,
which mitigates concerns over confounding effects in identifying
constrained firms. These firms also have well measured q values,
due to the competitive nature of the industry and characteristics
of the underlying commercial real estate assets. The third
instrumental issue revolves around omitted variables and resource
channels. We make two contributions in this regard. First, we
recognize that cash is not a sufficient statistic for available
liquidity. Firms will vary in their capacity and need to hold
liquidity, and may decide to hold less internal liquidity when
low-cost external sources such as bank lines of credit (L/C) exist.
Consequently, firms that might appear to be liquidity constrained
may in fact have more than adequate stores of liquidity when
external sources are recognized. Second, we specify and estimate a
structural model that accounts for endogeneity in cash flow
retention, bank L/C usage, and investment decisions. Cash flow
retention and bank L/C usage together account for a firms liquidity
management policy as related to investment, where simultaneous
consideration allows us to better disentangle cause and effect as
well as to better assess investment-cash flow and other
sensitivities that have been a focus in the literature. A unique
panel data set covering the years 1990-2003 has been assembled to
analyze these issues. Preliminary analysis shows that REITs retain
less cash flow, have a lower stock of cash, and use more bank L/C
than a broad cross-section of other publicly traded firms. In other
words, based on these measures, REITs appear to be financially
constrained. We also find that REIT bank L/C usage increases
monotonically with investment. This suggests that, in the short
run, and given their significant constraints on cash flow
retention, bank L/C substitutes for internal cash in funding
investment. 2
4. Full sample structural 3SLS estimation produces a number of
noteworthy results. First, in the investment equation, q and the
liquidity flow measures of retained cash flow and bank L/C use all
significantly affect investment, with coefficient estimates that
imply high investment sensitivities. Investment sensitivity to q is
such that the elasticity of investment with respect to q is just
shy of one, which places it near what standard q-theory would
predict. Given the cash flow constraints faced by REITs together
with the fact that commercial real estate assets are tangible with
significant debt capacity, high investment sensitivity to both
retained cash flow and bank L/C use is consistent with effects of
asset tangibility (Almeida and Campello (2007)) and incentives to
accelerate current investment in order to create additional
external financing capacity in the future (Hennesey, Levy, Whited
(2007)). Across the full sample, firms are seen to invest at a rate
of approximately 20 percent per year, which exceeds rates of
investment by the broad cross-section of comparison industrial
firms. Moreover, most REITs pay well in excess of the minimum
dividend payout requirement. This raises the issue of whether these
cash flow constrained and equity dependent firms are really
financially constrained. In other words, why is external finance
available and affordable to these firms? We conjecture that limited
discretion on cash retention mitigates adverse selection costs
associated with raising outside finance. This chain of reasoning
implies that, contrary to conventional wisdom that emphasizes the
primacy of information-based costly external finance as a premier
financial market friction, cash flow constraints and equity
dependence are not sufficient conditions for financial constraint.
To differentiate between the effects of cash flow constraint and
financial constraint on investment and liquidity management, we
split the sample based on Kaplan and Zingales (1997) methodology
for indexing financial constraint. Based on KZ index scores, we
find the more constrained sub-sample invests less, generates lower
cash flow and has a lower stock of cash, pays fewer dividends,
employs more leverage, and is less likely to maintain relationships
with bank 3
5. lenders and security underwriters. In other words, the KZ
index method appears to accurately classify firms in our sample as
more or less financially constrained. Simultaneous equation
estimation reveals substantial differences between firms that are
more versus less financially constrained. Consistent with arguments
of Gomes (2001), the less financially constrained firms are
responsive to investment signals contained in their stock prices,
while the more constrained firms are not. This outcome refines
results of Baker, Stein and Wurgler (2003), who do not
differentiate equity dependent firms on the basis of financial
constraint. Sensitivity of investment and liquidity management to
proxies for financial market frictions is generally much higher in
the sub-sample of more financially constrained firms. For example,
cash retention policy responds to a number of variables in the
financially constrained sub-sample of firms, including investment.
Establishing a statistically significant link between dividend
policy and investment is a new result (see Fama and French (2002)
for additional background), in which firms decrease their dividend
payout when investment increasespresumably to redirect scarce cash
flow away from shareholders towards capital acquisition. Variables
that cause dividend payout to increase in the more constrained
sub-sample include equity issuance, a positive change in bank L/C
capacity and a positive change in bank L/C use. None of these
variables have any effect on dividend payout in the less
constrained sub-sample. Stark differences between sub-samples also
exist with respect to bank L/C usage. An extra $1 of retained cash
flow causes L/C usage to decrease by more than $1 in the more
constrained sub- sample, whereas retained cash flow has no effect
on L/C use in the sample of less constrained firms. Thus, more
financially constrained firms treat cash as negative short term
debt by saving cash out of cash flow, whereas cash constrained but
less financially constrained firms do not. Consistent with Sufi
(2007), these results suggest that financially constrained firms
closely monitor their bank L/C use due to concerns over covenant
violations that would impose significant additional costs. Bank L/C
use is also highly responsive to investment, leverage and firm age
in the more 4
6. constrained sub-sample, while there is either less or no
responsiveness to these effects in the less constrained sub-sample.
Thus, we show that cash flow constraint is not the same thing as
financial constraint. Sub- sample estimation reveals that cash flow
constrained firms that are classified as financially constrained
are highly responsive to shocks in variables that proxy for
financial market frictions. Higher cash flow results in a
simultaneous paydown in bank L/C use and increase in investment,
achieved in part through reduction in dividend payout. Less
financially constrained firms, in contrast, exhibit stability in
their dividend policy with no sensitivity to investment or L/C use.
These findings point to the importance of agency costs over
information-based costs of external finance in governing investment
and liquidity management policies of financially constrained firms.
Our results are also generally consistent with cash flow focused
liquidity management effects emphasized in Almeida et al. (2004)
and Almedia and Campello (2007). The paper is organized as follows.
Section 2 provides further background on REITs and bank L/C usage.
Hypothesis development and empirical model specification are
addressed in section 3. Data are described and a preliminary
analysis of the data are reported and analyzed in section 4.
Simultaneous system equation estimation for the full sample is
undertaken in section 5, and sub-sample results are considered in
section 6. Section 7 concludes the paper. 2. Further Background on
REITs and Bank Lines of Credit The data employed in previous
studies of corporate investment generally have limited and noisy
variation. One solution to the problem is to apply alternative
specifications and more sophisticated econometric analysis (see,
e.g., Hoshi, Kashyap and Scharfstein (1991), Erickson and Whited
(2000)). A more direct solution is to try to obtain better data. We
emphasize the latter approach, and examine the Real Estate
Investment Trust (REIT) sector. The REIT sector, for several
reasons, provide an attractive natural laboratory to study the
effects of financial market frictions on firm investment. First,
all REITs are cash flow constrained 5
7. by regulation, as they are required to pay at least 90
percent of taxable income to shareholders in the form of
dividends.1 After accounting for the effects of depreciation and
the fact that most REITs pay in excess of the minimum payout
requirement, 65 to 90 percent of current cash flow is typically
paid out as dividends. 2 Cash flow constraints of this magnitude
are typically thought to imply financially constraint due to the
presumed high costs of accessing external finance. Consequently,
based on this logic, exogenously imposed cash flow constraints
substantially reduce endogeneity problems associated with
identifying financially constrained firms. Combined adjustment and
purchasing costs of investment should not exceed the shadow value
of newly installed capital. Shadow value follows from investor
expectations of the marginal contributions of new capital gains to
future profit. In theory, marginal q provides a direct (isomorphic)
measure of the shadow value of capital. Marginal q is generally
unobservable in the data, however, so analysts rely on average q.
If marginal q is badly measured by average q, an investment-cash
flow relation may be a spurious, as current cash flow may contain
information regarding investment opportunities. Hayashi (1982) has
shown that average q is a sufficient statistic for investment when
the following necessary conditions are satisfied: i) there is
perfect competition in factor and product markets, ii) fixed
capital is homogeneous, and iii) product and adjustment costs are
linearly homogeneous. Commercial real estate asset markets and the
firms (REITs) that own these assets satisfy these conditions to a
remarkably close approximation. The factor market is primarily land
and physical capital, with relatively little reliance on human
capital, and these markets are generally quite competitive.
Competitive market structure is important, since imperfectly
competitive industries will generate quasi-rents that can cause a
spurious correlation between cash flow and investment after
controlling for average q (Abel and Eberly (2001), Cooper and
Ejarque (2003)). 1 Prior to 2000, the dividend payout requirement
was 95 percent. 2 REITs that pay out less than 100 percent of net
income incur an excise tax on the difference, which causes most to
pay at least 100 percent of net income. The average payout in our
data and in other studies is approximately 120 percent of net
income (see also Chan et al. (2003)). The annual flow of
depreciation expense (a non-cash item) is generally between two and
three percent of the assets initial book value, which equates to
between 25 and 40 percent of net operating income. 6
8. A large proportion of real estate asset operating expenses
go to pay utilities, insurance and property taxes, which are
effectively linear in scale. Investment, which in this sector is
primarily the acquisition of built (productive) assets, results in
adjustment costs that are linearly homogeneous. Furthermore,
investment in built assets requires very little time-to-build, and
also contain little option value that potentially distorts the
marginal-average q relation. In addition, regulation requires REITs
to be monoline (non-integrated) companies. This suggests that
imperfect product substitution that confounds many multi-product
firms is less problematic with REITs, which strengthens the link
between average and marginal q.3 Finally, there are no taxes at the
entity level to distort investment incentives. Compounding the
usual marginal qaverage q measurement error problem is that average
q is often badly measured in the data due the reliance on asset
book values to proxy for the replacement cost of firm assets. As
Hartzell, Sun, and Titman (2006) and others have pointed out,
however, book asset value is a relatively accurate measure of
replacement cost with commercial real estate assets. For example,
they report a correlation of .92 between their book asset measure
of q and a net asset value measure of q that is based on market
sales data. To begin to get a sense of the data, Figure 1 shows how
average q varies by year for REITs in our sample, where q is
defined as market value of equity plus book value of debt divided
by asset book value as of the beginning of the year. Quartile
cutoff values are displayed in addition to mean values. Mean and
median q values generally exceed 1.0 over the sample period, but
not by a large amount. It is also apparent that there is
significant cross-sectional variation in q values in the early
years of the sample period (particularly in 1992 and 1993), whereas
this variation decreases after 1994. Figure 1 Here 3 See Hayashi
and Inoue (1991) for more on the issue of imperfect asset
substitution and investment. 7
9. In Figure 2 the time-series of average q and rates of
investment by year as a percentage of year-beginning asset value
are displayed. There is a clear direct contemporaneous relation
between investment and average q, with cross-correlation measured
at .78. Note that investment is in the 10 percent range for most
years, but that the years 1995-98 resulted in higher rates of
investment that generally exceeded 20 percent of year-beginning
book assets. Figure 2 Here In their analysis of the REIT sector,
Ott, et al. (2005) document that only seven percent of firm-level
investment was funded by retained cash earnings, as compared to 70
percent for other publicly traded firms. Because of their inability
to retain cash, REITs rely on outside financing sources to
facilitate investment. Seasoned equity, long-term unsecured debt,
and secured mortgage debt are the claims typically issued to
permanently finance acquisitions (see Brown and Riddiough (2003)
for additional background). In the short term, REITs rely heavily
on bank lines of credit (L/C) to fund investment. 4,5 The typical
funding cycle is as follows. A firm identifies an investment
opportunity, which often requires partial or full payment at
closing. Anticipating these investment opportunities, the firm
arranges a bank L/C with sufficient capacity to meet its liquidity
needs. The bank L/C is drawn down to fund the investment, where the
firm subsequently begins to work with an investment or commercial
bank to secure permanent sources of finance. Once there is
sufficient scale, equity or 4 We have explored whether REITs
utilize the commercial paper market, and have found no evidence
that they do. This is because REITs are generally younger firms
without the AAA and AA credit ratings required to access this
market. The ratings outcomes are in significant part because REITs
are unable to retain cash flow. Thus, it appears that firms which
have access to the commercial paper market are the larger, more
mature firms that are able to retain cash precisely the type of
firms that are not likely to be financially constrained. In
contrast, REITs, which are by definition cash constrained, almost
exclusivily rely on bank L/C for external-source liquidity needs. 5
Bank L/C account for a large proportion of total firm-level bank
debt in the U.S. A recent Federal Reserve Board survey reports that
approximately 80 percent of commercial and industrial loans made by
banks are arranged as short- term bank loan commitments or lines of
credit. According to Martin and Santomero (1987) and Avery and
Berger (1991), the primary stated reasons why firms use bank L/C
are financial flexibility and speed of action. In practice, firms
that are short on cash often use bank L/C to meet their immediate
liquidity needs. See Sufi (2007) for further detail on the
structure of bank lines of credit. 8
10. long-term debt is issued with proceeds used to pay down
bank L/C and hence recreate capacity to fund the next round of
acquisitions. Table 1 compares REITs to other publicly traded firms
(C-Corporations) that are not subject to dividend payout
requirements. We show how five ratios vary and compare by year from
1990 to 2003. The five ratios, all as a percentage of
beginning-year total book assets (K), are net investment (INV),
dividends paid (DIV), net cash flow (NCF), the stock of cash and
liquid securities (CS), and bank L/C capacity (L/C). We also report
how investment correlates with the other reported variables over
the sample period. Table 1 Here Observe the high rates of
investment by REITs in the middle 1990s, and that average
investment by REITs exceeded average investment by C-Corporations
by almost 70 percent during the 1990-2003 sample period.6 As noted
earlier, acquisitions were the largest component of net investment
for REITs over the sample period, whereas capital expenditures and
depreciation (a negative adjustment) were major components of net
investment for C-Corporations.7 As a result of the dividend payout
requirement, paid dividends are significantly higher and retained
cash flow is significantly lower for REITs. Interestingly, as noted
earlier, a significant fraction of REITs pay dividends in excess of
the minimum 90 percent of net income required by regulation.
Specifically, further analysis reveals that 70 percent of REITs pay
at least 100 percent of the net income as dividends in any given
year, with a median payout ratio of 120 percent. This equates to
most firms retaining between 10 and 35 percent of cash flow as
deployable liquidity or an addition to cash stock. 6 Average rates
of investment for REITs in this table do not exactly match those
reported in Figure 2 because different data sources were used to
generate the respective table and figure. 7 Real estate assets are
highly durable with depreciation periods that generally exceed 30
years, whereas assets held by industrial firms typically depreciate
at a much faster rate. Consequently, capital expenditures are
significantly higher for C-Corporations than for REITs. 9
11. Cash stock is significantly lower and bank L/C capacity is
significantly higher for REITs in comparison to C-Corporations.
These two variables also display interesting covariation with
respect to investment. Prior to 1993, equity REITs were a small
sector with a total capitalization of approximately $20 billion.
Rates of growth were relatively slow during this period. As a
result, cash stocks were relatively high and bank L/C capacity was
relatively low. Then, in 1993, rates of investment increased
rapidly. In 1993 and 1994, the data indicate that REITs were able
to tap their cash reserves to help fund investment. By 1995,
however, cash reserves were largely depleted, and bank L/C capacity
increased substantially as an apparent substitute for (deficient)
internal-source liquidity. Finally, in 1999-2003, when investment
rates drop off from previous high levels, bank L/C capacity
likewise declines. Note that cash flow also drops of during this
latter period, which limits REITs ability to replenish their cash
reserves. In comparison, bank L/C capacity and cash stock display a
distinct negative cross- correlation with investment for
C-Corporations. Whereas cash flow constrained REITs are forced to
rely on both internal and external sources of liquidity to help
fund investment, the typical (cash unconstrained) C-Corporation
appears to use its vastly greater internal store of liquidity to
fund investment. And, because unconstrained firms dont require
external-source liquidity to meet their investment needs,
C-Corporations maintain lower L/C capacity relative to the more
cash constrained REITs. REITs thus appear to use bank L/C as a
substitute for cash, and do so as a result of being cash flow
constrained. At the same time, high levels of investment and paid
dividends that exceed the minimum payout requirement suggest that
many of these cash flow constrained firms are not necessarily
financially constrained, in the sense that financial constraints
are thought to cause low rates of investment and create strong
incentives to hoard available cash flow. The availability of
external-source liquidity in the form of bank L/C provides an
intriguing link that may help explain these complex relations.
10
12. 3. Hypothesis Development and Empirical Model Specification
3.a. Hypothesis Development To motivate our empirical model
specification we appeal to a recent paper by Hennessy, Levy, and
Whited (2007), who develop an internally consistent theory of
dynamic investment with financial market frictions. In their model,
marginal q depends on average q plus factors that account for
distortions associated with costly external finance and debt
overhang problems. In a dynamic setting, financial constraints and
costly external finance create incentives for the firm to invest
now in order to create financial capacity in the future. The
dynamic investment-collateral capacity feature of Hennessy et al.s
analysis has particular relevance to firms such as REITs, which,
besides experiencing significant constraints on cash flow
retention, own tangible-durable collateral that offers significant
debt capacity (see also Almeida and Campello (2007)). For
hypothesis development, we primarily focus on the unique role of
bank L/C as a low- cost liquidity source in a world with the
identified financing frictions. 8,9 As a starting point, it is
important to distinguish between the effects of bank L/C capacity
and usage. Bank L/C capacity is a negotiated outcome that is
strongly influenced by a bank that closely monitors the financial
condition of the firm. We interpret changes in bank L/C capacity as
a proxy for the magnitude of the firms debt overhang problem, where
greater L/C debt capacity implies greater overall debt capacity and
hence smaller debt overhang problems. This in turn implies greater
investment. Conditional on bank L/C capacity, bank L/C utilization
is chosen by the firm in response to current and expected future
investment opportunities. Financially constrained firms will value
future financial capacity created through investment, and intensely
utilize their available L/C capacity to install capital when
investment opportunities are available. Thus, controlling for other
8 As Joe Stiglitz noted in the original general discussion to
Fazzari, Hubbard, and Petersen (1988), liquidity of a firm includes
its lines of credit as well as its stock of cash. This is an
alternative explanation of why the stock of cash has little
explanatory power in the cross-sectional investment equations even
if finance constraints are important. 9 Banks are known to play a
unique role in resolving financial market frictions, and hence can
lessen (or tighten) financial constraints (Fama (1985), James
(1987)). Houston and James (2001) document that multiple bank
relationships relax investment-cash flow sensitivities, but they do
not consider the direct impact of bank finance capacity or
utilization on investment. Others, including notably Sufi (2007),
have considered the link between firm financial characteristics,
bank L/C availability and/or the cost of bank finance, but again a
direct channel between bank finance and investment is largely
unexplored. 11
13. factors including q and bank L/C capacity, we posit that
L/C usage proxies for preemptive investment incentives as they
relate to relaxing financial constraints going forward. This leads
to our first hypothesis: Hypotheses 1: An increase in bank L/C
capacity is positively related to investment. Furthermore,
conditional on L/C capacity, an increase in bank L/C utilization is
positively related to investment. Hypothesis 1 suggests that L/C
usage causes investment in a world with financial market frictions.
Bank L/C usage is also important to financially constrained firms
as a liquidity source to facilitate investment. This suggests that
causation actually goes both ways, in that L/C usage is an
important source of capital and therefore highly sensitive to
actual levels of investment. This results in the following
hypothesis: Hypotheses 2: Bank L/C utilization is particularly
sensitive to and depends positively on actual investment.
Financially constrained firms are thus hypothesized to utilize bank
L/C as a substitute for scarce cash. In a dynamic setting, however,
financially constrained firms must carefully manage their liquidity
to ensure that financial slack is available to fund investment
opportunities as they arrive over time. This is a major focus of
Hennessey et al. (2007), and is also central to the analysis of
Almeida, Campello and Weisbach (2004) in their paper on the cash
flow sensitivity of cash. In this latter paper, cash holdings of
financially constrained firms are sensitive to current cash flow as
they (implicitly) relate to creating financial capacity for
anticipated future investment. In our context, when cash flow is
high, and because the opportunity cost of L/C usage will generally
exceed that of the cash stock, constrained firms will use their
cash flow to reduce their L/C usage in order to economize on cost
and to recreate capacity for the next round of investment
opportunities. In contrast, we would expect less financially
constrained firms have a lower L/C usage rate to begin with and a
greater ability to secure additional L/C capacity to meet liquidity
needs. As a result, they show less propensity to reduce L/C usage.
12
14. After controlling for investment, high cash flow
realizations are thus predicted to be used by REITs to reduce bank
L/C outstanding. That is, L/C use substitutes for cash flow.
Moreover, given that external debt and equity issuances are
infrequent and expensive to undertake relative to utilizing bank
L/C, we expect external security issuances to be used (in part) to
reduce bank L/C outstanding in order to reduce cost and replenish
the liquidity stock. This results in our third hypothesis:
Hypotheses 3: Bank L/C utilization depends negatively on cash flow
as well as equity and debt issuances. In the short term,
financially constrained firms can fund investment from two possible
sources: cash or bank L/C. One possible way to increase cash
available for investment is to reduce the dividend payout. Thus,
dividend policy is hypothesized to respond to the high relative
cost of external finance, and is endogenous as a result. We
summarize this in the following hypothesis: Hypotheses 4:
Financially constrained firms dynamically adjust their dividend
payout downward to fund higher levels of investment. At least two
factors complicate the intuition embedded in this hypothesis.
First, it is important to recognize that limits to debt capacity
and exogenous constraints on retaining cash reduce a firms
discretion to select against outside equity investors. This is in
turn lowers the cost of external finance and hence reduces the need
to retain earnings to finance investment. Second, implications of
financial capacity management as in Almeida et al. (2004) suggest
that cash flow is valuable to financially constrained firms in all
states of the world as a way to hedge against future income or
investment shocks. This will cause dividend payouts to be smoothed,
which will dampen the anticipated negative investment-dividend
payout relation. 3.b. Empirical Model Specification To specify an
empirical model we focus on three financial market frictions
previously discussed: costly external finance, debt overhang, and
collateral borrowing constraints. Furthermore, 13
15. the four hypotheses stated in the previous section
collectively imply a structural relation between investment and
liquidity management as expressed through cash retention policy and
bank L/C usage. This produces the following simultaneous system of
equations to be estimated: Investment = f(Q,RCF,L/CUse,FMF) (1)
RetainedCashFlow = f(Inv,L/CUse,FMF,Instrument) (2) L/CUse =
f(Inv,RCF,FMF,Instrument) (3) where Q denotes average q, RCF
denotes retained cash flow, FMF indicates variables employed to
proxy for financial market frictions that are common across the
system, and Instrument denotes exogenous instrumental variables
used to identify the system. Note that retained cash flow
identifies dividend payout, since the difference between gross cash
flow (an instrumental variable in the RetainedCashFlow equation)
and retained cash flow isolates the dividend payout. Table 2
identifies and summarizes variables that are common across the
three equations, with their interpretation as related to
investment. Retained cash flow and cash stock are used to proxy for
costly external finance and debt overhang problems. Total leverage
proxies for debt overhang problems. Its effect is complicated,
however, by incentives for collateral-constrained firms to invest
more today in order to create additional financial capacity in the
future. Thus the relationship between investment and total leverage
is unclear. Table 2 Here In terms of investment, the change in bank
L/C capacity is considered as a proxy for debt overhang costs, and
is of particular interest in the context of liquidity management
for cash constrained firms. The change in bank L/C usage measures
the firms actual utilization of its external-source liquidity
stock. After controlling for L/C capacity and other relevant
effects, intense 14
16. utilization of available L/C capacity is interpreted to be
consistent with incentives to install tangible collateral today
(accelerate investment) in order to relax financial constraints in
the future. Additional variables to control for the effects of
financial market frictions include Firm age (years after IPO),
which proxies for unspecified financial market frictions such as
time-varying costly external finance or collateral capacity
effects. For example, firms begin their life without any sort of
managerial track record, and therefore may be more financially
constrained than seasoned firms. Equity and debt issuance dummies
are included as controls for major financing events that affect
short-run liquidity management decisions. The purpose of equation
(2) is to isolate determinants of cash flow retention policy as it
interacts with investment and bank L/C utilization. We would expect
cash flow retention policy to be sensitive to proxies for financial
market frictions if firms are truly financially constrained. In
addition to gross cash flow, lagged gross and retained cash flow
are included as instrumental variables in the specification to
account for inertia in the firms dividend policy.10 Change in L/C
use is specified in equation (3). The relation between L/C usage
and investment is of particular interest, as is the relation
between L/C usage and retained cash flow. Instrumental variables in
this equation are year-beginning total L/C capacity and
year-beginning total L/C use. We would expect a positive relation
between the change in L/C use and available total L/C capacity and
a negative relation between the change in L/C use and the
outstanding L/C debt level. This system of equations that account
for interactions between liquidity management and investment allows
us to collectively assess hypotheses 1 through 4. Critical
relations between investment and L/C use or capacity, as
articulated in hypotheses 1 and 2, are contained in equations (1)
and (3). If REITs are truly financially constrained, we would
expect high sensitivity of L/C use to investment given the
importance of bank L/C in facilitating investment for these cash-
constrained firms. Predictions associated with Hypothesis 3, which
addresses the relation between 10 The inclusion of lagged retained
cash flow as an instrumental variable in the net cash flow equation
creates concerns regarding estimation consistency and bias in the
system of equations. This issue will be addressed in detail in the
estimation section of the paper. 15
17. bank L/C use and cash, are captured by equation (3). The
relation between investment and dividend payout as articulated in
Hypothesis 4 is contained in equation (2), where the maintained
hypothesis predicts that cash flow retention (dividend payout)
moves directly (inversely) with investment. 4. Data and Preliminary
Results 4.a. Data Our primary data source for model estimation is
the SNL REIT database. This database provides detailed information
on REIT investment, bank L/C availability and usage, and firm
financial characteristics. To be included in the sample, a firm has
to meet the following criteria: (1) listed on NYSE, AMEX or NASDAQ;
(2) elected REIT tax status at the beginning of each sample year;
(3) registered with the National Association of Real Estate
Investment Trusts (NAREIT), the industrys trade association; and
(4) classified as an equity REIT by NAREIT.11 Given a sample period
of 1990 through 2003, the original sample from the SNL REIT
database has 3,667 firm-year observations. Capital offering data
(equity and public debt issuance) from the NAREIT Capital Offering
database is hand-matched into the SNL data set. These data consist
of 156 equity IPOs, 1,401 seasoned equity offerings, and 950 public
debt offerings. We also obtain firm-level REIT bank L/C information
from Loan Pricing Corporations DealScan database. We eliminate
observations that do not fit within the following bounds: 0.3
18. than real estate interests.12,13 The final data set
produces an unbalanced panel consisting of 1,257 firm-year
observations from 1990 to 2003. Summary statistics are presented in
Table 3. Average investment of just under 20 percent over the
sample period indicates significant growth at the firm and sector
level. 14 The mean Q value is 1.217, which is not terribly high
given the rapid rate of investment by many firms during the sample
period. One explanation for the lower Q values is that Q is better
measured in our data due to book asset values that more accurately
reflect replacement cost. Average cash flow net of dividends is
only 1.64 percent of assets, while the average stock of cash and
marketable securities is only 1.89 percent of assets.15,16 This
reaffirms that REITs are unable to retain significant amounts of
cash as a result of dividend payout requirements. Note that, even
with severe constraints on cash retention, both variables exhibit
significant cross-sectional variation. Total leverage as measured
by long-term debt is approximately 40 percent of firm assets on
average. Table 3 Here Median firm age is only eight years,
reflecting the fact that a significant number of IPOs occurred over
the sample period.17 Equity and public debt issuances occur in 36.3
and 21.7 percent of firm-years during the sample period,
respectively. These percentages are well above rates observed with
C-Corporations, and reflect REITs substantial growth during the
sample period combined with their inability to retain significant
amounts of cash. 12 For example, one observation which we
eliminated had a cash stock value of .993. This firm was apparently
in liquidation mode, as its asset base was declining significantly
in the two years leading up to the .993 observation. 13 In
addition, one observation with an annual change in L/C capacity of
17.35 times year-beginning book assets was eliminated. This firm
experienced close to a 100-fold increase in book assets in one
year, with total L/C capacity increasing from zero to 20 percent of
year-end book assets. 14 Note that data used in this section,
culled primarily from the SNL REIT data base, is different from the
data used in Table 1 to compare REITS and C-Corporations. That data
were derived primarily from Compustat and DealScan data bases,
where we also did not apply the selection-screening criteria stated
above. 15 Retained cash flow is defined as GAAP net income plus
depreciation and amortization minus paid dividends. 16 Significant
increases and decreases in assets in a given year caused by
(dis)investment are the reasons for the relatively high max and min
values, particularly in the flow variables. 17 As of 2003, a firm
could have been in existence a total of 43 years as a REIT
(original REIT legislation was passed in 1960). The SNL REIT
database counts age from the firms IPO date, so some firms that
initially went public as a C- Corporation converted to REIT status
at some later date prior to the start of our sample period in 1990.
17
19. The average changes in bank L/C capacity and actual bank
L/C usage as a percentage of assets are 7.20 and 1.54 percent per
year, respectively. 18 Note that the median value for both
variables is zero. There are significant differences in the
composition of the two median values, however. The change in L/C
use is zero 14.2 percent of the time, where a significant
proportion of those observations are from earlier in the sample
period by firms that do not actively utilize their bank lines. In
comparison, the change in L/C capacity is zero 42.7 percent of the
time. This larger percentage reflects the fact that capacities are
not always renegotiated on an annual basis. 4.b. EricksonWhited
Test of Q Measurement Quality Investment models that account for
financial market frictions often posit that average q is
informative and well measured, in the sense that the necessary
conditions stated in Hayashi (1982) are satisfied and data used for
empirical testing accurately describe the true current value of the
capital stock. Although these presumptions are typically
problematic, we have argued that the REIT data are both informative
and well measured. This in turn implies that: i) only variables
that measure financial market frictions are required to augment the
classical investment equation specification (no additional controls
for real market effects are required), and ii) coefficient
estimates should more accurately reflect true economic magnitudes
associated with the relevant variables, including Q. To test our
assertions, we apply a generalized threshold test supplied by
Erickson and Whited (2005) that allows us to assess coefficient
sign robustness of regressors as they depend on the measurement
quality of our proxy for Tobins q. The basic idea is to posit that
Tobins q is unobservable while other variables are observable. A
proxy is chosen for the unobservable 18 As noted earlier, one
observation with a change in L/C capacity value of 17.35 was
eliminated from the sample. The next largest observation, which is
the maximum in our data set used for model estimation, is 4.68. In
this case there was approximately a ten-fold increase in book
assets over the year, accompanied with L/C capacity that roughly
doubled. Thus, extremely rapid firm-level growth that sometimes
occurred is the primary cause of the large percentage increases in
L/C capacity. There are six other observations in the sample with a
change in L/C capacity that was at least twice year-beginning book
assets. 18
20. regressor, thus causing the true value of q to be measured
with error. For our purposes, we assume that the measurement error
in q is uncorrelated with the disturbance term from an OLS
regression. Threshold estimates are used to assess whether the
signs of other regressors might be affected by the
errors-in-variable problem. A threshold estimate near zero implies
that the hypothesis that the coefficient of interest has the
incorrect sign can be rejected, whereas a coefficient estimate near
one makes it hard to reject the hypothesis that the coefficient of
interest is zero. A coefficient in between zero and one is
indeterminate. Thus, for our purposes, the null hypothesis is that
the coefficient sign of the variable of interest (cash flow, for
example) is zero and therefore not robust to the errors-in-variable
problem. If the test does not reject the null hypotheses, then one
can infer that Tobins q is sufficiently well measured so as to
produce a reliable coefficient sign in an OLS investment equation
estimation. Column A of Table 4 reports OLS estimation results for
the investment equation. Note that the coefficient for average q is
statistically as well as economically significant. The size of the
coefficient at .139 is particularly noteworthy, and is several
magnitudes larger than q coefficient estimates generated by OLS
investment models that utilize industrial data (see, e.g., analysis
contained in Erickson and Whited (2005)). Indeed, the size of the
coefficient is such that the elasticity of investment with respect
to Q is near one, which is what theory would predict.19 Table 4
Here Using estimates supplied to us by Toni Whited, in columns (B)
and (C) we report threshold value estimates together with standard
errors of the estimates. We find that all of the statistically
significant variable coefficients reported in Table 4 pass the
Erickson and Whited (2005) robustness test based on partial
correlations.20 That is, the test allows us to reject the null
hypothesis that the 19 Using the coefficient estimate of .139, a
mean investment rate of .20 and a mean q value of 1.22, an
elasticity measure of 0.848 is obtained. 20 A simple correlation
test can be used as an alternative to the partial correlation test.
The partial correlation test is more appropriate to our setting, as
Erickson and Whited (2005) state: individuals who prefer or require
the 19
21. non-q explanatory variable coefficients are zero as a
result of errors-in-variables problems associated with our q
measure. These test results thus provide additional evidence
supporting our claim that Tobins q is well measured using data from
the REIT sector, and that investment equation results are more
reliable than those encountered in many other studies of the
effects of market frictions on investment. 5. Full Sample
Structural Model Estimation This paper has two primary objectives.
The first is to analyze the endogenous effects of liquidity
management on investment, and the second is to assess whether cash
flow constraint is the same thing as financial constraint. This
section emphasizes the former objective by focusing on full sample
results, while the following section emphasizes the latter
objective by analyzing sub- samples. Concern over the effects of
endogenous dividend payout policy on investment has existed since
Fazzari, Hubbard, and Petersens (1988) initial work. Although it is
true that, in our data, REITs are constrained to pay out a
significant portion of their gross cash flow as dividends, most
REITs actually pay well in excess of the required minimum, with
significant variation in actual paid dividends (see Chan et al.
(2003)). This suggests that cash retention policy is potentially
endogenous as it relates to investment. Bank L/C usage is also
likely to be endogenous, since we know that REITs use their bank
L/C to fund investment (Brown and Riddiough (2003)). We estimate a
linear system based on equations (1) through (3) using a 3SLS
procedure. The endogenous variablesinvestment, retained cash flow,
and L/C useare estimated in a first stage. Because two of the
endogenous variables are used to estimate the third endogenous
variable in each of the three equations, we pool all other
variables to be used as instruments in the first stage estimation
(including all fixed effects). This approach is conservative, in
the sense that the pooling of all non-endogenous variables as
instruments can increase the standard errors of the endogenous
conceptual device of holding all else constant in order to form
prior opinions about the relationship between two variables may be
more comfortable dealing with the partial correlation. 20
22. variables to bias against statistical significance. To
address this latter issue, we also estimated the system using an
iterated 3SLS procedure (see Hausman (1975)). Three stage least
squares and iterated 3SLS estimation results for the sample are
displayed in Table 5. All model specifications include year and
firm property type fixed effects in addition to an intercept term.
Table 5 Here Investment equation results are reported in panel A.
The coefficient estimate on Q decreases slightly from the OLS model
coefficient estimate reported in Table 4, but remains relatively
large and statistically significant. High investment-q sensitivity
is consistent with results of Baker, Stein and Wurgler (2003), who
find that equity dependent firms display a higher sensitivity of
investment to q than non-equity dependent firms. Our finding makes
sense in that equity-dependent firms like REITs repeatedly access
external capital markets, and therefore must be careful to react
appropriately to capital cost-investment signals contained in the
firms stock price. At the same time that investment shows
significant sensitivity to Q, a number of variables meant to proxy
for financial market frictions, including variables measuring the
endogenous effects of liquidity on investment, also exert a strong
influence on investment. In particular, the coefficient on retained
cash flow implies extreme investment sensitivity to available cash
flow. This sensitivity of investment to retained cash flow can be
explained by the tangibility of real estate as loan collateral and
its effects on financial constraint. 21 Almeida and Campello (2007)
show that 21 We have also considered the possibility of data or
specification issues in explaining the high sensitivity of
investment to retained cash flow. After examining histograms of all
variables reported in Table 5 for the potential distorting effects
of outliers, and eliminating 31 observations that might influence
the results, we find that our results are robust to the potential
effects of outliers (this holds for retained cash flow as well as
all other variables). We also examine the model specification, in
which we use lagged retained cash flow as an instrument in the
retained cash flow equation. This variable is included because
dividend policy is known to be smoothed, where current dividend
payouts typically depend on the previous periods dividend payout
(see Lintner (1956)). The use of lagged endogenous variables as
instruments is, however, known to potentially produce inconsistent
and biased coefficient estimates in simultaneous equation
estimation, since the lagged instrument in question may be
correlated with the system disturbances. To address this issue, we
conduct two diagnostic tests. First, we conduct a Sargan-Hansen
misspecification test that assesses the effect of the lagged
retained cash flow instrumental variable on the investment (as well
as L/C use) equation. The test does not reject the null hypothesis
that the instrument is an over-identifying restriction, thus
lending credibility that the 21
23. investment sensitivity to cash flow for financially
constrained firms is increasing in asset tangibility. Because REITs
hold very high percentages of highly tangible real estate, their
credit multiplier can be expected to exceed that of most industrial
firms that primarily hold plant, equipment and human capital (see
Giambona and Schwienbacher (2007) for analysis of the effects of
harder versus softer forms of collateral on debt capacity). The
coefficient on cash stock is significant with a positive
coefficient sign that exceeds unity. Investment is therefore quite
sensitive to this variable, which is perhaps not surprising given
firm constraints on retaining earnings. Firms that issue equity
during the year invest over 14 percent more than firms that do not
issue equity. Public debt issuance, on the other hand, has no
affect on investment, supporting results in Brown and Riddiough
(2003) who find that equity issuance with REITs is more often used
to fund investment while public debt issuance is more often used to
reconfigure the firms capital structure. Bank L/C capacity is
intended to measure the change in the external-source liquidity
stock available to fund investment. Hypothesis 1 asserts that this
variable proxies for debt overhang effects, in the sense that the
bank lender closely monitors the firm and sets L/C capacity
accordingly. This variable enters significantly with a positive
coefficient sign, consistent with the hypothesized relation. Bank
L/C use has a positive and statistically significant coefficient
sign. The interpretation of the L/C usage result is, conditional on
controlling for changes in L/C capacity in anticipation of
investment, firms that more intensely utilize their available L/C
capacity invest more. We interpret this result as supporting
predictions of Hennessey et al. (2007), who argue that constrained
firms have incentives to invest in debt capacity in order to relax
financial constraints in the future. Retained cash flow equation
estimation results are displayed in panel B of Table 6. As noted
earlier, dividend payout as a percentage of net assets is implicit
in the estimation results, where one lagged instrumental variable
does not unduly affect the results. The second test assesses serial
correlation in the system disturbance term. A Durbin-Watson test
fails to reject the hypothesis that there is no serial correlation
in error terms. 22
24. simply substitutes one minus the coefficient on current
gross cash flow (1) and multiplies all other coefficients by minus
one (1) to obtain coefficient estimates in a dividend payout
equation. Hypothesis 4 asserts that costly external finance causes
financially constrained firms to lower their dividend payout when
investment opportunities are greater. Investment is found to have
no significant statistical effect on dividend policy in the full
sample estimation, however. That is, estimation results imply that
retained cash flow causes investment for these cash
constrained/equity dependent firms, but that investment itself does
not cause a reduction in dividends in order to increase retained
cash flow. System estimation indicates that firms with a greater
stock of cash simultaneously invest more and pay more dividends,
suggesting that dividend policy may be used in part to moderate
free cash flow concerns of outside investors. Firm age is weakly
statistically significant, where older firms pay lower dividends.
This is consistent with firm age proxying for reputation or other
effects that moderate information or agency frictions between
management and outside investors. Interestingly, dividend policy
does not react to an equity or long-term debt issuance in the
current period, suggesting that issuances are used to directly
address investment and balance sheet concerns rather than to modify
dividend policy in the short term. The coefficient estimate on
current period gross cash flow indicates the marginal propensity to
retain cash flow, where an incremental dollar of gross cash flow
results in 87 cents being paid as dividends and 13 cents being
retained internally. Given a required payout percentage of
approximately 60 percent of total gross cash flow, and presuming
that the payout constraint is not binding at the margin, our
results suggest dividend payout on a marginal dollar of gross cash
flow that is well above the required minimum. Why do these cash
flow constrained/equity dependent firms behave this way? One
plausible explanation is that free cash flow combines with muted
pecking order effects (which reduces the cost of external finance)
in such a way that shareholders prefer that management go through
the public securities issuance process to validate investment
23
25. value rather than modify dividend payouts so that a greater
percentage of investment can be internally funded. A negative sign
on lagged gross cash flow and a positive sign on lagged retained
cash flow indicates persistence in dividend payout policy, in the
sense that firms with higher lagged gross cash flows pay higher
current dividends and firms with higher lagged retained cash flows
(lower lagged dividend payouts) pay lower current dividends. More
generally, these results combined with the insignificance of most
other variables in this equation implies that REITs manage their
dividend payout policy to a significant extent by distributing free
cash flow but otherwise maintaining stable payouts over time.
Lastly, consider L/C use equation estimation results displayed in
panel C of Table 6. Investment is seen to exert a strong positive
effect on L/C utilization, where a $1 increase in investment
results in a $.32 increase in L/C use. This result is consistent
with Fama and French (2002), who find that firms use short-term
debt to absorb short-term variation in investment. Causality
between investment and L/C use therefore goes in both directions,
supporting assertions contained in Hypotheses 1 and 2. Retained
cash flow displays a negative sign and is statistically
significant. The magnitude of the coefficient implies an almost
exact one-to-one substitution relation between cash flow and L/C
usage, supporting assertions contained in Hypothesis 3. Structural
estimation therefore suggests an intuitively appealing channel
between liquidity and investment, in which cash is a strong
substitute for L/C use, while, at the same time, cash and L/C use
accelerate investment in tangible assets. Dividend policy, on the
other hand, seems unresponsive to investment, suggesting a complex
interplay between free cash flow, debt overhang and tangible
asset/preemptive investment effects for these cash constrained
firms. Other L/C use relations are as follows. Cash stock has a
strong economic but marginally statistically significant
substitution effect on L/C use. Leverage (as measured by long-term
debt) is seen to have no effect on L/C use, however. This finding
is better understood in the context of total 24
26. L/C capacity and availability, both of which significantly
impact L/C usage. A significant positive relation between
beginning-period L/C availability and current period L/C usage
suggests that less remaining slack in bank L/C capacity creates
debt overhang that constrains usage going forward. Thus, once L/C
capacity is set, L/C usage responds to available short-term (bank
L/C) debt, but not to long-term debt. Equity and long-term debt
issuance cause a reduction in L/C use. This is consistent with
Brown and Riddiough (2003), who find that equity issuances are more
often used to fund investment while long-term unsecured debt
issuances are more often used to reconfigure the firms liability
structure. Equity issuance thus reduces the need to use bank L/C to
fund investment, whereas a long-term debt issuance is more often
used to reduce bank L/C outstanding to prepare for further
investment in the future. Summarizing, we wish to highlight the
following results from the full sample simultaneous system equation
estimation procedure: 1) Investment is highly responsive to signals
contained in stock prices, as measured by average q; 2) Investment
is also highly responsive to retained cash flow, where asset
tangibility and debt capacity can explain the result; 3) Bank L/C
plays an important role in investment through both capacity
creation and incremental usage, suggesting that debt overhang and
preemptive investment are relevant financial market frictions; 4)
Dividend policy does not (statistically) respond to investment,
firms distribute available cash at a rate that is well above the
payout requirement, and dividend payouts display significant
inertia as related to previous period payout policy; and 5) Bank
L/C use is highly responsive to investment, and cash flow is a
direct substitute for L/C use. 6. Is Cash Flow Constraint the Same
Thing as Financial Constraint? Some confusion exists in the
literature as to what exactly constitutes financial constraint.
Generally speaking, for our purposes, a financially constrained
firm is one that experiences financial market frictions that
distort investment decisions. Financial market frictions are
believed 25
27. to reduce the responsiveness of investment to signals
contained in stock prices, and to simultaneously increase
responsiveness to other factors such as available liquidity. With
the literatures emphasis on cash as the sole source of firm
liquidity, cash is often synonymous with financial constraint,
implying that cash flow constrained firms experience greater
financial market frictions and therefore are less responsive to q.
Our data suggest that cash flow constraint does not necessarily
imply financial constraint. Full sample estimation results
demonstrate high sensitivity of investment to Q. Furthermore, as
seen in Table 1, meager retained cash flows and cash stocks did not
prevent these firms from undertaking significant amounts of
investment and distributing dividends well in excess of the
required minimum level. Consequently, the existence of cash flow
constrained firms that may or may not be financially constrained
provides us the opportunity to conduct new and refined assessments
of the effects of financial market frictions. There are now two
competing approaches to classifying firms as financially
constrained. Kaplan and Zingales (1997) gather financial data over
the 1970 to 1984 time period on the 49 constrained firms in the
Fazzari et al. (1988) sample. They then run an ordered probit to
estimate a model that identifies and weights factors that produce a
measure of the degree of financial constraint. Lamont et al. (2001)
dub this the KZ index, and summarize the method in the appendix to
their paper. More recently, Whited and Wu (2006) criticize the KZ
index approach, and provide a classification scheme of their own
which they argue is superior to the KZ index. Exogenously imposed
dividend payout requirements and the fact that our data come from a
single sector classification rather than across a number of
different sectors do not lend themselves to the Whited and Wu
approach. Consequently, we apply the KZ index approach to ordering
firms in our sample. Table 6 displays summary statistics for the 50
percent of REITs in our sample that are classified as more versus
less financially constrained. Firms that are classified as less
financially constrained are seen to invest more (even though Q
ratios are similar between the two sub-samples), generate higher
cash flow, have greater cash stocks, pay higher dividends, are less
leveraged, are 26
28. more likely to have longer bank and security underwriter
relationships, and have greater access to bank lines of credit.
Interestingly, less financially constrained firms are approximately
the same age on average and are smaller than firms classified as
more financially constrained. 22 We conclude from this exercise
that, based on a simple analysis of factors that are typically
thought to indicate greater or lesser financial constraint, the KZ
index works well at classifying firms in our sample. Table 6 Here
Sub-samples are created by sorting firms into the top and bottom 50
percent of firms based on their KZ index score.23 Simultaneous
equation estimation using 3SLS is used to generate the results,
which are reported in Table 7. In comparing the results, clear
differences between the two sub-samples are immediately apparent.
First, observe that the explanatory power of the system (as
measured by the weighted R-squared) of the more financially
constrained sub-sample of REITs exceeds that of the less
constrained REITs. Ignoring the effects of Q on investment for the
moment, this outcome suggests that investment and financing
policies of the more constrained REITs react more systematically to
financial market frictions than do the less constrained REITs.
Table 7 Here Consider investment equation results, as seen in
columns (1) and (4) of Table 7. Investment sensitivity to q is
significant and positive in the less constrained sub-sample,
whereas it is insignificantly different from zero in the more
constrained sub-sample. This is consistent with predictions of
Gomes (2001), who argues that financial constraints reduce
investment sensitivity to q. In contrast, investment is highly
sensitive to retained cash flow in the more constrained sub- 22 To
calculate KZ index scores we follow the methodology of Lamont et
al. (2001), which results in using lagged values (t-1) for gross
cash flow, cash stock, dividend ratio, and debt ratio as well as
beginning period total book assets (t-2) to scale each of these
values. This approach causes mean values for these variables to
differ from means reported in Table 3. 23 We also examined the top
versus bottom one-third of firms as sorted by KZ index score, with
similar results. 27
29. sample, and is insignificant in the less constrained
sub-sample. Leverage as measured by long-term debt to total book
assets is statistically significant in the more constrained
sub-sample, in which more levered firms invest more. Changes in
bank L/C capacity and use are significant in both sub- samples, but
investment sensitivity to these variables is much higher in the
more constrained sub- sample. The combined effects of retained cash
flow and L/C usage in the more constrained sub- sample suggest that
investment responds quickly and strongly to the liquidity flows of
these firms. This finding is consistent with predictions of Almeida
and Campell (2007) in their static analysis of the effects of asset
tangibility and financial constraint on investment as well as
Hennessey, Levy, and Whited (2007) in their dynamic analysis in
which investment today increases debt capacity and hence relaxes
financial constraints in the future. Differences between the two
sub-samples are also apparent in the retained cash flow equations
seen in columns (2) and (5). Other than the prior periods dividend
payout policy, less constrained firms react only to cash stock in
determining the current periods cash retention level. Even current
period gross cash flow has an insignificant effect on retained cash
flow, indicating that less constrained firms effectively pay out
100 percent of marginal gross cash flow as a dividend. In contrast,
payout-retention policy of the more constrained firms is seen to
depend on a number of factors, including investment. Consistent
with the proposed relation in hypothesis 4, investment has a
positive effect on cash retention (negative effect on dividend
payout) in this sub- sample, while, simultaneously, higher retained
cash causes greater investment. Our finding of a causative relation
between short-term variation in investment and dividend payout is
notable, as other studies have been unable to isolate the commonly
hypothesized relation (see, e.g., Fama and French (2002)). Older
firms pay lower dividends and firms that issue equity pay higher
dividends in the more constrained sub-sample. These more
constrained firms also utilize liquidity gained through 28
30. positive changes in bank L/C capacity and usage to increase
dividend payouts. Interestingly, these more constrained firms pay
out only 42 percent of the marginal change in gross cash flow as
dividends. All of this occurs at the same time that there is strong
reference to previous periods retention-payout decisions. Finally
consider the L/C use equations in columns (3) and (6). Again, there
are clear differences between the two sub-samples, in which more
constrained firms display greater sensitivity to the system-wide
effects. For example, L/C use is much more sensitive to investment
and net cash flow in the more constrained sub-sample. This is
consistent with the need of financially constrained firms to
simultaneously fund investment with available liquidity as well as
manage their available debt capacity to avoid costly covenant
violations (Sufi (2007)). The more constrained firms are also
sensitive to leverage and firm age. The only variable that
generates higher L/C use sensitivity among the less constrained
firms is public debt issuance. The interpretation of this latter
result is that less constrained firms use the public debt issuance
proceeds to reduce L/C use, whereas the more constrained firms are
unable or unwilling to reduce their L/C use with issuance proceeds.
All together, our findings show that cash flow constraint is not
the same thing as financial constraint. All firms in our sample are
cash flow constrained and equity dependent. Cash flow constrained
firms that experience fewer financial constraints as measured by KZ
index score are highly responsive to investment signals contained
in their stock prices, but are mostly unresponsive to other
variables that proxy for financial market frictionsincluding cash
flow. There does appear to be interdependence between L/C usage and
investment with the less constrained firms, but the effects are
much less pronounced than with the more constrained firms. In
comparison, the more constrained firms are unresponsive to
investment signals contained in their stock prices, but display
extreme sensitivity in all three structural equations to a number
of variables that proxy for financial market frictions. 29
31. Thus, firms that are equity dependent and financially
unconstrained firms are sensitive to signals contained in stock
prices, which refines earlier findings of Baker et al. (2003). In
contrast, financial market frictions overwhelm stock price signals
to drive investment, cash retention and bank L/C use policies of
severely constrained firms. Predictions contained in hypotheses 1
through 4, which collectively state that investment, dividend
policy, and L/C usage are endogenously determined and that there
are significant interactions between variables, are supported by
the sub-sample of more financially constrained REITs. For example,
more financially constrained firms pay out less cash as dividends
and pay down bank L/C faster with available cash, which is
consistent with precautionary saving motives identified by Almeida
et al. (2004). Consequently, our findings show that more
financially constrained firms are more short-term focused than the
less constrained firms and, in effect, take what they can get. In
contrast, the sub-sample of less constrained firms show a
longer-term focus with less sensitivity to proxies of financial
market frictions. 7. Conclusion We examine the role of liquidity
management as it affects investment by cash constrained firms. By
employing a structural model to account for endogeneity, we find
that investment and liquidity management interact in interesting
and heretofore unexplored ways. For example, bank lines of credit
are found to smooth variation in cash flow and accelerate
investment. We also show that cash flow constraint is not
equivalent to financial constraint, as firms that are both cash
flow constrained and financially constrained behave very
differently from firms that are cash flow constrained but are not
financially constrained. The sub-sample of more constrained firms
shows high sensitivity to variables that proxy for financial market
frictions, lending support for agency- based explanations of costly
external finance over information-based explanations. 30
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34. Figure 1. Distribution of Tobin's Q from 1992 to 2003 4 3.5
3 2.5 2 1.5 1 0.5 0 1992 1993 1994 1995 1996 1997 1998 1999 2000
2001 2002 2003 MinQ P25Q MedianQ MeanQ P75Q MaxQ This figure
displays the distribution of Q values by year for firms in the
sample. Tobins Q is defined as the market-to-book ratio, i.e.,
(market equity + book debt) / total book assets. All values are as
of the beginning the year. MinQ and MaxQ are the minimum and
Maximum Q in a given year; P25Q and P75Q are Q at the 25 and 75
percentile; and MedianQ and MeanQ are the mean and median Q. The
data source is from the SNL's REIT Financial database. 33
35. Figure 2. Q and Investment from 1992 to 2003 1.5 1 1.4 0.8
1.3 0.6 1.2 1.1 0.4 1 0.2 0.9 0.8 0 1992 1993 1994 1995 1996 1997
1998 1999 2000 2001 2002 2003 Q (left axis) Investment (right axis)
This figure displays the average Q and average rate of investment
by year for firms in the sample. Q is defined as (market equity +
book debt) / total book assets as of the beginning of the year.
Investment is calculated as net investment / total book assets. Q
is shown on the left axis and investment is shown on the right
axis. The data source is from the SNL's REIT Financial database.
34