Modified Total Interpretive Structural Model of Corporate Financial Flexibility

Abstract

In present dynamic environment, financial flexibility has become an important constituent of corporate finance decisions. Financial flexible firms are ostensibly more resilient to exogenous shock vis-à-vis non-flexible firms. Capital structuring decisions, payout decisions and conservative cash policy are various tactics adopted by financial managers for attaining financial flexibility. Present study attempts to identify key enablers of financial flexibility and structure them into a total interpretive structural model using modified TISM approach. Using literature review, business environment, cost of capital, stage of life cycle, free cash reserves, agency relations, payout policy, and leverage are identified as seven constituents of corporate financial flexibility. Based on their interpretive interdependencies/ relationship, a hierarchical model of financial flexibility is developed exhibiting a holistic view of financial flexibility decisions from triggers to final outcome. The findings result into a four-step novel framework situation-actors-actions-outcome framework of financial flexibility, with business environment and stage of life cycle as situation/ triggers, free cash reserves and agency as actors/precursors, payout and leverage as actions/ decisions and cost of financing as outcome of financial flexibility decision. Model lends credence to financial flexibility as situation-specific decision. It is a reservoir to address exogenous income and investment shocks. Firms generating free cash flow are invariably flexible to meet income and investment shocks. However, firms with fluctuating operations need buffer in form of cash reserves or debt capacity to address the contingencies. Investment in good corporate governance practices can serve as an intangible reserve and an alternative to costly tangible ways such as cash surplus and leverage. Such firms with shareholders’ support are deemed more flexible in payouts, capital structuring, investment decisions and overall operations, and less reliant on external financing.

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Appendices

Appendix 1: Interpretive Knowledge Base of Contextual Relationships

  Pair comparison Knowledge base of interpretive link
1 Environment (F1)-Cost of financing (F2) Firm's environmental its risk exposure influences its cost of capital. Investors as well as lenders expectation of returns and interest rate changes with market dynamism and environmental concerns (Chava, 2014)
Crisis act as an negative shock halting the external funds supply and cost of financing thereby (Duchin et al. 2010)
2 Stage of life cycle (F3) and Cost of capital (F2) Cost of equity resembles U-shaped pattern, higher in the introduction and decline stages and lower during growth and maturity(M. M. Hasan et al. 2015)
3 Stage of life cycle (F3) –Free cash flow (F4) Cash flow patterns exhibit parsimonious indicator of firm life cycle stage (Dickinson, 2011)
Developing firms on nascent stage of growth have less free cash reserves due to reinvestment need. Reversely, matured firms generate more operating cash flows compared to their investment opportunities
4 Free cash flow (F4)-Agency relation (F5) Firms with large free cash flows and low profitable investment opportunities are more contagious to agency conflicts are severe in (Posner et al. 2009)
5 Agency relation (F5)-Free cash reserves (F4) Managers with least investment opportunities are reluctant to disburse cash more quickly and unproductively (Harford, 1999)
Payouts to shareholders tends to reduce managerial control over the resources; conflicting agency relationship compel management to hold cash reserves rather than payout(M. Jensen, 1986a, b)
6 Stage of life cycle (F3)—Agency relation (F5) Transitive;
7 Agency relation (F5)- Payout (F6) Communication problems, lack of information gap creates insecurity among shareholders. To fix these agency issues, shareholders demand fix payout, irrespective of the business needs. Adhering to a rigid payout adversely affects return by constraining investment
8 Free cash flows (F4)-Payout (F6) Transitive;
9 Payout (F6)—Leverage(F7) Firms use capital structure to absorb income shocks and prefer dividend smoothening (Fliers, 2019)
10 Leverage (F7)-Payout (F6) Firms preferring low leverage squeeze their payout finance their expansion plans (Gamaba & Triantis, 2008). As less financial resources are available to disburse as payouts with the firms with build-up debt capacity (Yung et al. 2015)
Firms with publicly traded debt favours dividend smoothening (Aivazian et al. (2006)
Dividend smoothing behaviour is strong with firms having reserve borrowing capacity. Reversely, high levered firms usually have instable dividend policy; their payouts are prone to adverse income shocks (Fliers, 2019)
11 Agency relation (F5)-Leverage (F7) Transitive;
Other significant relationships
12 Leverage (F7) to Cost of capital (F2) Increase in leverage increases the risk perception of equity shareholders, having magnifying impact on overall capitalization rate (Durand, 1952; Myers, 2001; Solomon, 1963)
13 Free cash reserves (F4)- Leverage (F7) Firm’s leverage ratio significantly influenced by its ability to generate financial surplus. Firms with substantial cash holdings prefer low debt (Meier et al. 2013). Reversly, firms generating subsequent deficits compelled to have more debt irrespective of high leverage ratios (Denis & McKeon, 2012)
14 Stage of life cycle (F3)-to leverage (F7) Demand for financial flexibility affects firms’ capital structure decisions. Developing firms that are in the phase of financial flexibility building and maintain low debt; growing firms need to finance their growth opportunities and are in utilization phase and maintain leverage; finally, mature maintain moderation leverage as they in phase of recharging financial flexibility (Lemmon and Zender, 2010; Harris, 2015)
15 Stage of life (F3) and pay-policy  
(F6) Transitive  
16 Environment (F1) to Payout (F6) Changes in market threats, rival policies and product market fluidity decreases firm propensity to payouts. Such firms’ generally have tendency to maintain cash reserves, particularly, when there is restricted access to financial markets. (Hoberg et al. 2014)
Investment needs are allied with business cycles, and accordingly the dividend and repurchase decision (Dittmar and Dittmar (2006)
17 Environment (F1) to Leverage (F7) Transitive
18 Environment (F1)—Agency Relationship (F5) Transitive; Investors protection norms and corporate governance act as substitutes. Governance reforms are likely to have significant impact on reducing agency costs (Morellec et al. 2018)
19 FCR (F4)-Cost of capital (F2) Surplus generating firms are more flexible and least affected by costly external financing
20 Agency (F5) and cost of capital (F2) In emerging markets, firm-level corporate governance and country-level shareholder protection substitutes each other and therefore firms with good corporate governance experience low cost of equity. The shares of firms with good corporate governance are subject to high premium offered by institutional investors (K. C. W. Chen et al. 2009)
21 Business environment (F1)-free cash reserves (F4) Firms with variable and uncertain cash flow and greater costs of external finance maintain higher cash reserves (Harrod, 1999)

Appendix 2: Steps of Partitioning and Identification on Hierarchical Level

Iteration I: identification of first level elements
  Reachability set Antecedents set Interaction set  
F1: Business environment 1, 2, 4, 5, 6, 7 1 1  
F2: Cost of financing 2 1, 2, 3, 4, 5, 6, 7 2 I Level
F3: Stage of life cycle 2,3,4,5,6,7 3 3  
F4: Free cash reserves 2,4,5,6,7 1,3,4,5 4,5  
F5: Agency relationships 2,4,5,6,7 1,3,4,5 4,5  
F6: Payout policy 2,6,7 1,3,4,5,6,7 6,7  
F7: Leverage 2,6,7 1,3,4,5,6,7 6,7  
Iteration II: identification of second level elements
F1: Business environment 1,4, 5,6,7 1 1  
F3: Stage of life cycle 3,4,5,6,7 3 3  
F4: Free cash reserves 4,5,6,7 1,3,4,5 4,5  
F5: Agency relationships 4,5,6,7 1,3,4,5 4,5  
F6: Payout policy 6,7 1,3,4,5,6,7 6,7 II Level
F7: Leverage 6,7 1,3,4,5,6,7 6,7 II Level
Iteration III: Identification of third level elements
F1: Business environment 1,4, 5 1 1  
F3: Stage of life cycle 3,4,5 3 3  
F4: Free cash reserves 4,5, 1,3,4,5 4,5 III Level
F5: Agency relationships 4,5 1,3,4,5 4,5 III Level
Iteration IV: Identification of fourth level elements
F1: Business environment 1 1 1 IV Level
F3: Stage of life cycle 3 3 3 IV Level

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Agrawal, A. Modified Total Interpretive Structural Model of Corporate Financial Flexibility. Glob J Flex Syst Manag 21, 369–388 (2020). https://doi.org/10.1007/s40171-020-00253-7

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Keywords

  • Agency problems
  • Corporate financial flexibility
  • Capital structure
  • Environment
  • Free cash flows
  • Modified total interpretive structure modelling
  • Payout