Abstract
Using a large data set on investments and accounting information for private firms, we put the balance sheet theory to test. We find that firm cash flow has a positive impact on investment and that the effect is enhanced for firms which are more likely to be financially constrained. We also find that the investment-cash flow sensitivity is significantly larger and more persistent during the first half of our sample period, which includes a severe banking crisis and recession. Our results suggest that financial constraints matter more in periods characterized by adverse economic conditions.
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Notes
The crisis in early 1990s is the most severe financial and economic crisis that Sweden has experienced in modern times. GDP fell for three consecutive years accompanied by a severe contraction of bank credit (see Figure A1 of supplementary material). In contrast, the global financial crisis in 2008 led to a sharp fall in exports but a quick recovery.
Some other criticisms of the investment-cash flow sensitivity literature are that: (1) it is not necessarily true that investment-cash flow sensitivities measure the degree of financing constraints (see Kaplan and Zingales 1997, 2000; Gomes 2001), and (2) the positive coefficient on cash flow disappears when the earnings forecasts of equity analysts are used to construct Q (see Cummins et al. 2006).
GH also develop a second, more structural method to control for possible information in cash flow about investment opportunities (current and future MPK). Following Love and Zicchino (2006), we do not use this alternative method, which has been criticized for not properly identifying the effect of cash flow on investment (see, for example, footnote 11 in Cummins et al. 2006).
Another possible measure of MPK, which is used by GH in their earlier paper, is based on operating income rather than sales. As discussed in Gilchrist and Himmelberg (1999), the operating-income-based measure requires the possibly unrealistic assumptions of zero fixed costs and perfect competition, which makes the measure less reliable.
See, for example, footnote 11 in Chatelain et al. (2003).
For 1996, Statistics Sweden had data-collection problems and the separate variables for investments in machines and buildings are missing.
Looking at the impulse responses, the confidence bands are collapsing around the point estimates for the response of I/K and MPK to an I/K shock. There are two reasons for this. The first reason is that the standard error of the estimate of the effect of an I/K shock in time t on I/K and \(\textit{MPK}\) in time \(t+1\) is very low. The second reason is that the coefficients for the effect of an I/K shock in time t on MPK and CF/K in time t are very small. This means that there is little feedback from MPK and CF/K in period t to I/K in period \(t+1\) and thus very little uncertainty around that estimate. These effects combined lead to the very low uncertainty around the estimate of the effect of an I/K shock on I/K and MPK.
The double sample split gives rise to few observations on the unconstrained firms in the two sub-periods. We therefore obtain a high estimation uncertainty and wide confidence bands for the group of unconstrained firms. None of the impulse responses are distinct from zero at a 99 % confidence level for the unconstrained (high-dividend, large and group) firms, whereas the impulse responses for the constrained (low-dividend, small and non-group) firms are separate from zero at a 99 % confidence level during the recession period but not significant (99 % level) during the non-recession period.
By splitting the firms based on time and dividend payments, we obtain relatively few observations for the sample of high-dividend firms during the recession period (1055 observations). Although we truncate our sample with respect to the 1st and 99th percentile, the estimates for the small sample are influenced by a few large positive values for the cash flow to capital (CF/K) variable which lead to a high estimation uncertainty and very wide confidence intervals. To deal with this, for the sample of high-dividend firms in the recession period, we have chosen to eliminate observations for CF/K that exceed 200 % (3 observations) to obtain more reasonable estimates and associated standard errors.
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The authors gratefully acknowledge helpful comments and suggestions by Anders Åkerman, David von Below, Mikael Carlsson, Martin Flodén, Nils Gottfries, Tor Jacobson, Kai Leitemo, Jesper Lindé, Johan Lyhagen, Iryna Shcherbakova and Karl Walentin, and seminar participants at the Stockholm School of Economics, Sveriges Riksbank and the 13th International Conference on Macroeconomic Analysis and International Finance (University of Crete, May 2009). We are also grateful to Jan Wallander’s and Tom Hedelius’ Research Foundation for financial support and to Inessa Love for sharing panel VAR Stata code. We assume full responsibility for any and all errors in the paper. The opinions expressed in this article are the sole responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank.
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Melander, O., Sandström, M. & von Schedvin, E. The effect of cash flow on investment: an empirical test of the balance sheet theory. Empir Econ 53, 695–716 (2017). https://doi.org/10.1007/s00181-016-1136-y
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DOI: https://doi.org/10.1007/s00181-016-1136-y