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Financial Flexibility, Investment Ability, and Firm Value: Evidence from Firms with Spare

Debt Capacity
Author(s): Maria-Teresa Marchica and Roberto Mura
Source: Financial Management, Vol. 39, No. 4 (WINTER 2010), pp. 1339-1365
Published by: Wiley on behalf of the Financial Management Association International
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Financial Flexibility,InvestmentAbility,
and FirmValue: Evidence fromFirms
with Spare Debt Capacity
Maria-Teresa Marchica and Roberto Mura*
Wedocument,
for thefirsttime,thata conservative
leveragepolicy directedat maintaining
can enhanceinvestment
financialflexibility
ability.Our analysisrevealsthatfollowinga period
and increaseabnormalinvestment.
We
of low leverage,
firmsmakelargercapitalexpenditures
arefinancedthrough
newissuesofdebt.Theimpactoffinancial
findthatthesenewinvestments
is bothstatistically
andeconomically
sizable.Further,
flexibility
significant
long-run
performance
testsrevealthatfinancially
Our results
flexible
firmsnotonlyinvestmorebutalso investbetter.
areconsistent
withtheviewthatfinancialflexibility
intheformofuntappedreservesofborrowing
poweris a crucialmissinglinkincapitalstructure
theory.

Thereis a puzzlingempiricalregularity
in thecapitalstructure
literature.
Manyfirmsappear
toborrowless thanthedominant
In
theories
his
influential
Graham
predict.
paper,
(2000) finds,
firmswithlowexpecteddistress
costsuse debtconserva"Paradoxically,
large,liquid,profitable
He also reports
thatthisconservative
behaviorappearstobe persistent.
Similarissuesare
tively."
Minton
and
Wruck
andYang(2008).
discussed,
amongothers,
by
(2001) and Strebulaev
Recentsurveyevidencehas shedsomelightonthismatter
(BancelandMittoo,2004; Brounen,
De Jong,and Koedijk,2004; Grahamand Harvey,2001; Pinegarand Wilbricht,
1989). These
studiessuggestthatitis financialflexibility
thatprimarily
driveschieffinanceofficers'leverage
choices.Respondents
is veryimportant
in enablingtheircompaniesto unsay thatflexibility
dertakeinvestment
in thefuture,
whenasymmetric
information
andcontracting
problemsmight
otherwise
forcethemto foregoprofitable
In otherwords,companiesmay
growth
opportunities.
reservesof untappedborrowing
adopta conservative
leveragepolicyto maintain"substantial

Wethank
Bill Christie(editor)and theanonymous
whosecomments
havesignificantly
thepaper.
referee
helpedtoimprove
Weare indebtedto MichaelBrennan,Harryand Linda DeAngelo,Marie Dutordoir,
Mara Faccio,AnnalisaFerrando,
AndreaGamba,Ian Garrett,
Marc Goergen,AlessandraGuariglia,JohnHutton,EvangelosKharalambakis,
Meziane
Alex Triantis,
Lasfer,WeiMinLiu, Kasper Nielsen,Aydin Ozkan,Ser-HuangPoon,NormanStrong,Alex Taylor,
and
in theFIRS 2008, FMA USA 2008, FMA
SergeyTsyplakov
for helpfuldiscussions.Wealso thankall theparticipants
Europe2008,EFA USA2007,FMA Europe2007,EFMA 2006,andFMA USA2006 "TopTenPercent"SpecialSession,
and PFN 2006 meetings
comments.
Weare also grateful
to theparticipants
in theseminarseriesat
fortheirinsightful
BusinessSchool,theNottingham
EuropeanCentralBank,Cass BusinessSchool,Manchester
Department
ofEconomics,
School,and theUniversity
KindhelpfromDavid Roodman
Sheffield
Management
of Verona
fortheirusefulsuggestions.
oftheCenter
Pic SupportTeamand
forGlobalDevelopment,
RogerWalshofBureauVanDijk,DerekRouseofHemscott
FrancescoCerliencoofReutersis also acknowledged.
Weare also grateful
to Wendy
PamLosefsky,
andAlison
Jennings,
Walters
foreditorialhelp.Theusualdisclaimerapplies.
*Maria-Teresa
Marchicais a LecturerinFinanceat theManchester
BusinessSchool,University
ManchofManchester,
ester,EnglandMl 3 9PL, UK. RobertoMurais a LecturerinFinanceat theManchester
BusinessSchool,University
of
Manchester,
Manchester,
EnglandMl 3 9PL, UK.
FinancialManagement Winter2010 pages 1339 - 1365

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1340

FinancialManagement Winter201 0

intheeventof
power"(ModiglianiandMiller,1963) allowingthemto accessthecapitalmarket
shocks
to
their
investment
set.
positive
opportunity
How can we identify
However,as yet,littleis knownaboutfinancialflexibility.
financially
flexible
Does financial
theinvestment
(FF) firms?
flexibility
reallyimprove
abilityofcompanies?
is thisstrategy
forfirms?Thispaperprovidesempirical
evidenceto
Ultimately,
value-enhancing
addressthesequestions.
FF firmsbyfocusing
on firmswithsparedebtcapacity(SDC).1 Weestimate
First,we identify
a leverageequationfromwhichwe calculatethepredicted
levelof debt.Sincethedemandfor
itendsupintheresidualoftheestimated
financial
is anunobservable
factor,
model,and
flexibility
a systematic
deviationbetweenobservedand estimated
leverage.Forthisreason,we
generates
from
indirectly,
usingnegativedeviations
proposeto capturethedemandforfinancialflexibility
estimated
targetleverage.We classifya firmas FF ifithas sparedebtcapacityfora minimum
ofconsecutive
number
years.
has anyimpacton
whether
thisdegreeoffinancialflexibility
Second,we testeconometrically
firmsthatanticipate
Theprediction
is thatinthepresenceofmarket
investment
frictions,
ability.
valuablegrowthoptionsin thefuture
mayrespondbypursuinga policyof low leveragefora
numberof years.In thisway,FF firmshaveenoughspareborrowing
powerto be able to raise
financialpolicy.To
theconservative
externalfundsand to investmorein theyearsfollowing
we specifya q-modelof investment
testthishypothesis,
plus an
by ourFF dummy,
augmented
shouldhave
theFF dummy
toourflexibility
termwithcashflow.According
interaction
argument,
In addition,
to theextentthatFF firms
a positiveandsignificant
impacton capitalexpenditures.
external
fundsto financetheir
raise
more
can,aftera periodof conservative
easily
borrowing,
As a consequence,
funds.
on
internal
be
less
should
their
investment
dependent
ability
projects,
to cashflow.
ofinvestment
we wouldexpecta lowersensitivity
We provideevidencethata conservative
leveragepolicycan help firmsattaina degreeof
OurresultsindicatethatFF companiesexhibitenhancedinvestment
financialflexibility.
ability.
a sparedebtcapacitypolicyforthree
Ourtestsrevealthatan averagecompanythatmaintains
ourtestsrevealthat
by around37%. Further,
years(FF 3) can increaseitscapitalexpenditures
thelongertheperiodof low leverage,thelowertheeconomicimpactof FF statuson thefirm's
investment
ability.For instance,a companythatmaintainssparedebtcapacityforat leastsix
increasesitscapitalexpenditures
byaround28%. Thismaybe becausetheability
yearstypically
intothefuture
decreasesthefurther
future
ofmanagersto anticipate
they
opportunities
growth
FF
firms.
to
we
follow
method
to
the
results
are
robust
These
classify
go.
bymeansofpositivenetdebtissues.
Also,we findthatcompaniesfinancenewinvestments
sacrifice
that
evidence
Thisprovidesstrong
todayto enhancetheirability
borrowing
companies
This resultis also robustwhenwe takeinto
in thefuture.
to seize bettergrowthopportunities
suchas a cashpolicy.For
thatmayachievefinancialflexibility,
accountotherfinancing
strategies
in
investment
the
cash
of
the
for
when
we
account
decisions,orwhen
instance,
presence (excess)
we considerleveragenetofcash,as inBates,Kahle,andStulz(2009),we stillfindan economic
impactsimilarto ourmainresults.
ofpaperssuggestthat
A number
ofthisstrategy.
effect
we testthelong-run
Third,
performance
human
undiversified
their
to
risk
and
reduce
low
to
ratios
debt
to
protect
managersprefer keep
howhigher
Denis and Sibilkov(2010) demonstrate
in otherways.Forinstance,
'Firmsmayachievefinancialflexibility
firmsto investinvalue-enhancing
cashholdinghelpsconstrained
projects.We do addressthisissuelaterinthetextand
funds.PowersandTsyplakov
ofinternal
(2008) stress
showthatourresultsarerobustevenwhenwe controlfortheeffect
theirdebtearly.Jagannathan,
ofretiring
thatallowfirmsto havetheflexibility
call provisions
theroleof make-whole
how stockrepurchases
(as opposedto cash dividends)allow firmsa higher
Stephens,and Weisbach(2000) underline
degreeoffinancialflexibility.

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InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,

1341

thatcomeswithinterest
commitments
payment
capital(Fama,1980),orto alleviatethepressure
1
choose
to
in
increasedebtlevels a manner
thatallows
(Jensen,986). Alternatively,
managers
may
themto pursueempirebuilding(Zwiebel,1996) and to minimizetakeoverrisk(Berger,Ofek,
andYermak,1997).In otherwords,conservative
leverageandhighinvestment
maybe symptoms
ofgreater
agencycosts.
To distinguish
thesevariouspotential
influences
andto investigate
whether
a financing
policy
is valueenhancing,
aimedat financialflexibility
thelaststepoftheanalysisexaminesitsimpact
onbothlong-run
andpostinvestment
First,weuseboththecapitalasset
performance
profitability.
modelto investigate
the
pricingmodel(CAPM) and theFama and French(1993) three-factor
behaviorofJensen's
status
(1986) alphaforFF firmsinthelongrun,aftertheyacquireflexibility
aftertheymakeabnormalinvestments.
If ourflexibility
is correct,
or,alternatively,
hypothesis
we expectthispolicytobe valueenhancing.
of
If,on theotherhand,thispolicyis an expression
we shouldfinda negative
effect
onfirmperformance.
Then,we compare
greater
agencyconflicts,
thecompany's
beforeandaftertheFF statusis acquired,andbeforeand
operating
performance
afterFF companiesmakeabnormalinvestments.
Ourfindings
indicatethatcompaniesthatacquirefinancialflexibility
strongly
through
spare
debtcapacityarenotonlyabletoinvestmorebutalso seemtoinvestbetter.
Long-run
performance
returns
resultsforJensen's
analysisconsistently
positiveandstatistically
significant
(1986) alpha
theCAPM ortheFamaandFrench( 1993) three-factor
modelupto60 months
after
the
usingeither
FF statusidentification,
ofthemethodemployed
toclassifyFF firms.Economically,
irrespective
theimpactonthereturns
ofanFF firmalso seemssizable.According
tothefigures
obtainedfrom
theFamaandFrench(1993) three-factor
themarket
model,FF companiesoutperform
byalmost
30 basis pointspermonth,whichcorresponds
to about7.1% in thefirsttwoyears.Similarly,
we findthatourFF firmsoutperform
themarket
whenwe measuretheirlong-run
performance
aftertheyhavemadeabnormalinvestments.
The economicimpactimpliedby Jensen's(1986)
anabnormal
ofapproximately
13.24%inthefirst
twoyears.
alphasuggests
long-run
performance
firmsexperiencean increaseof morethan18% in operating
within
two
Further,
performance
of
the
of
FF
the
status
and
a
increase
of
in
38%
their
years
acquisition
staggering
profitability
within
twoyearsafteran abnormalinvestment.
Thisenhancesthestrength
ofourconclusions
and
allowsus toruleoutthepossibility
thatmanagerial
entrenchment
driveslowleverageandhigher
investments.
Ourstudycontributes
totheliterature
ina number
ofways.Weprovidedirectevidence,forthe
firsttime,of thevalue of financialflexibility
to companiesby studying
theimpactthispolicy
has on investment
and
These
are
resultswithin
ability
long-run
performance.
veryimportant
recentdevelopments
in thecapitalstructure
literature.
to
and
According DeAngelo
DeAngelo
is thecriticalmissinglinkforan empirically
viabletheory
(2007),"financial
flexibility
[ofcapital
Weprovideverysoundevidencethatcomplements
thishypothesis.
A largefraction
of
structure]."
observedleverageis leftunexplained
theoriesofcapitalstructure.
Ourinability
byconventional
to "measure"theFF factorex antecauses a systematic
spreadbetweenobservedandpredicted
smthattallieswith
leverage.In thisway,ourworkalso providesa rationalefordebtconservativi
thetheoretical
predictions
recently
proposedbyAlmeida,Campello,and Weisbach(2009) and
oftheso-calledlow
DeAngelo,DeAngelo,andWhited(2010), andmayprovidean explanation
leveragepuzzle.
The remainder
of thepaperis organizedas follows.In SectionI, we describethedata and
the
main
In SectionII, we present
theempirical
resultsandall therobustness
present
hypotheses.
testsperformed,
whilein SectionIII, we discussourconclusions.

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FinancialManagement Winter2010

1342

I. Data and Hypotheses


A. Data Collection and Sampling
from1965to 2008.
We construct
oursamplefromall UK listedfirmspresentin Datastream
fromthatoftheotherfirms
is likelytodiffer
Weexcludefinancialfirmsas theircapitalstructure
inoursample.Sincebothleverageandinvestment
modelsincludethelaggeddependent
variable
as a regressor,
we excludecompanieswithfewerthantwoconsecutive
yearsofdata.Firmswith
at the1% levelto
variablesare also excluded.All dataare trimmed
missingvaluesof relevant
whenwe winsorizethedataatthe
Ourresultsarelargelyunaltered
reducetheimpactofoutliers.
for4,290
1% levelrather
thantrimit.Thisresultsinan unbalancedpanelof47,553observations
firms.
returns
data forindividualstocksin the
For theperformance
analysis,we collectmonthly
of
All
and
FTSE
100
Indexesto proxyportfolios
FTSE
Small
for
the
FTSE
Share,
Cap,
sample
Indexestoproxy
smallandlargefirms,
andfortheFTSE GlobalValueandFTSE GlobalGrowth
bill
stocks.We collecttheUK three-month
ofhighandlowbook-to-market
Treasury
portfolios
interest
rate.
ratesto approximate
therisk-free
In an attempt
to controlfortheagencycostsof equityin theleverageequation,we collect,
andboard
information
ownership
bynonmanagers,
bymanagers,
ownership
regarding
byhand,
Data
arecolfor
the
1991-2001.
of
firms
for
a
selected
period
subsample
composition randomly
After
lectedfromthePricewaterhouseCoopers
screening
CorporateRegister(Decemberissue).
we
fromDatastream,
information
itwiththeaccounting
andmatching
thedataforpossibleerrors
this
of
For
observations.
firms
and
of
677
haveanunbalanced
5,660
subsample companies,
panel
riskusingFAME,
on debtrating(Reuters)andbankruptcy
we also collectandmatchinformation
a
with
whichis partoftheBureauvanDijk Electronic
coveragespecific
Publishing^databases,
andZender,2008).2
toUK firms(Lemmon,Roberts,
B. Identificationof FF Firms
evidencethatthesinglemost
choicesprovidestrong
Recentsurveystudiesofcapitalstructure
financial
to
maintain
firms
is
the
desire
decisions
determinant
of
flexibility
by
leverage
important
there
since
as
we
Bancel
and
2001
and
above,
However,
Mittoo,2004).
argued
;
(Graham Harvey,
factorthat
thisis an unobservable
in theliterature,
measureof flexibility
is no well-defined
will
thisfactor
offuture
options.Consequently,
growth
dependslargelyonmanagers'assessment
observed
between
deviations
endup intheresidualofthemodel,whereitwillgenerate
systematic
and estimated
capturetheeffectof financial
leverage.Forthisreason,we proposeto indirectly
from
deviations
targetleverage.
predicted
flexibility
using
firmswithsparedebtcapacityusingFrankand
In thefirststepof theanalysis,we identify
medianindustry
includes
which
baseline
ratio,
leverage,market-to-book
model,
Goyal's(2009)
from
the
data
use
and
Frank
inflation.
and
Goyal(2009)
size,tangibility,
profitability, expected
entire
for
the
not
available
data
are
Similar
inflation.
for
to
theLivingston
Survey proxy expected
timeseriesfortheUnitedKingdomand,as such,we use T-billsinstead.As Frankand Goyal
since
tomatter
billrateis unlikely
withtheTreasury
expectedinflation
(2009) state". . . replacing
correlated."
are
they highly
themodel,
We followtheseminalworkof Arellanoand Bond (1991) by firstdifferencing
We estimateall
variableas instruments.
andthenusingsuitablelaggedlevelsof thedependent
for
Thisallowsus tocontrolsimultaneously
leveragemodelsusingtheGMM-SYS methodology.
thedata.
2WethankFrancescoCerliencofromReutersforkindlyproviding

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and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,

1343

thatmaybe correlated
withtheexplanatory
oftheregressors
andforfixedeffects
theendogeneity
variables(Blundelland Bond,1998; Lemmonet al., 2008). Inclusionof thelaggeddependent
behavior.3
Thebaselinemodelweestimate
is thefollowing:
variableallowsforthefirm's
targeting
LEVit = ot'LEVit-'+ 'Industry
Leverage+ iMtbv+ ^Size + ^Tangibility
+ 6Expected
Inflation+ rji+ r)t+uit.

(1)

Wethencomparethefitted
valuesfromtheregression
analysiswiththeactualvaluesanddefine
as SDC thosefirmsthatexhibita negativedeviationbetweenactualandpredicted
leverage.As
discussedabove,we expectthe systematic
of
these
deviations
to
be
due to the
component
offinancialflexibility
intheleveragemodel.To minimize
unobserved
effect
theimpactofnoise,
we requirethedeviation
tobe largerthan10%. Weperform
a number
ofrobustness
testsinwhich
we requirea minimum
deviationof either5% or 25%. Alternatively,
we followHarford(1999)
andrequireobservedleveragetobe 1.5 standard
deviations
lowerthanthepredicted
value.
to
firm
it
a
as
we
to
have
SDC
for
a
minimum
number
of
consecutive
FF, require
Finally, classify
a policy,notjusta transitory
shocktothecapital
periods.Thisensuresthatweareindeedobserving
structure
ofthefirm.As a baselinespecification,
we use FF 3, whichis theFF dummy
thattakes
a valueofonewhenwe observeat leastthreeconsecutive
in
firm
which
the
is
classified
periods
as SDC. Thereis no theoretical
rationaleforchoosinga specifictimelength.Therefore,
to
assesswhether
theresultsaresensitive
tothechoiceoftimehorizon,
we use a number
ofdifferent
oftwotoa maximum
ofsixconsecutive
proxies,froma minimum
yearsofleverageconservatism.
Thisapproachis notfreeofdrawbacks.
The mostseriousis thatthechoiceofleveragemodel
mayaffecttheestimatedtargetand thedeviationfromit. This,in turn,wouldinfluencethe
of firmsand thesubsequentinvestment
classification
results.To minimizethepossibility
that
theresultsare drivenbythechoiceof a specificleveragemodel,we taketwoimportant
steps.
numerous
robustness
testsusingdifferent
we
First,we perform
leveragemodels.In particular,
thatmayallowfirmsto attaina degreeoffinancialflexibility,
the
tryto controlforotherfactors
mostimportant
of whichis financialslack.Second,we followan alternative
approachsimilar
to Mintonand Wruck(2001) and classifyfirmsas low leveragewhentheirdebtratiois in the
bottom20% ofthedistribution.4
Werefertothisas thepercentile
methodology.
C. Financial Flexibilityand InvestmentAbility
In theirseminalpaper,Modiglianiand Miller(1963) notethatdespitetheexistenceof some
tax advantagesfordebtfinancing,
firmstendnot "to use themaximumpossibleamountof
debtin theircapitalstructure"
due to limitations
bylendersleadingto "theneedforpreserving
In themodifiedversionofthepeckingordertheory(Myers,1984),firmshavetwo
flexibility."
mainreasonsto restrain
themselves
fromissuingdebt:1) to avoidthecostsoffinancialdistress
and2) to maintain
financialslack.Takingtheseideas as a starting
point,we testthehypothesis
thatinthepresenceofmarket
firmsthatanticipate
valuablegrowth
frictions,
optionsinthefuture
mayrespondbypursuinga policyof low leveragefora numberof years.As in Myers(1984),
reservesof borrowing
powerenableFF firmsto raiseexternalfundsand to investmorein the
conservative
financialpolicy.
yearsfollowing
3Numerous
theidea thatfirmshave a targetcapitalstructure.
Grahamand Harvey(2001)
surveystudiescorroborate
that37% ofUS firmshavea flexibletarget
debtratio,whilea further
35% havea stricter
BancelandMittoo
report
target.
De Jong,andKoedijk(2004) reportsimilarfiguresfortheUnitedKingdom.
(2004) andBrounen,
4Mikkelson
and Partch(2003) classifyas "highcash" thosecompaniesthatholdmorethan25% oftheirassetsin cash
andequivalents.
See also lona,Leonida,andOzkan(2004) forUK firms.

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FinancialManagement Winter2010

1344

As a firststep,we explorethebehaviorofFF firmsovertimevia a detaileddescriptive


analysis.
If ourprediction
is correct,
we shouldobservethatFF firmsinvestless duringtheconservative
afterreachingFF status.Also,to theextentthat
leverageperiod,and increasetheirinvestments
growth
opportunities
todaytoenhancetheirabilityto seizebetter
companiessacrifice
borrowing
investments.
we should
FF firmsshouldshowan increaseintheirabnormal
inthefuture,
Finally,
aroundthe
observematerialincreasesin netissuesof debt(newdebtissuesminusretirements)
as theyare expectedto financethesewiththe
timewhencompaniesincreasetheirinvestment
fromconservative
leverage.
sparedebtcapacityresulting
in whichcapitalexpenditures
are
we employa q-modelof investment
To testourpredictions,
2009).
regressedon Tobins q and cash flow(Cleary,1999; Alti,2003; Brownand Petersen,
term
andwe add an interaction
ourflexibility
themodelbyincluding
Also,we augment
dummy,
FF firmshave,indeed,enhancedinvestment
withcash flowto testwhether
abilityand a lower
to cashflow.
ofinvestment
sensitivity
similartoBondetal. (2003) tocontrol
ina dynamic
framework
WeemploytheGMM technique
modelis as follows:
The estimated
andfixedeffects.
forendogeneity
Investment
it-' + 'CashFlowit-' + ft Tobin'sqit
it = aInvestment
+ 3FFit + ^CashFlowit.x x FFit) + r'i+ r't+ %,

(2)

in fixedassetsto capitalstock;Cash Flow is the


whereInvestment
is theratioof investments
offixed
dividends
andpreference
beforetax,interest,
ratioofoperating
plusdepreciation
profits
assetsto capitalstock;Tobins q is theratioof book value of totalassetsminusbookvalueof
valueofequitytocapitalstock;r'iis a fixedeffect;
effect;
r]tis a time-specific
equityplusmarket
withmeanzero.5
termassumedtobe seriallyuncorrelated
andvitis a disturbance
theFF dummyshouldhavea positiveand significant
If ourhypothesis
is correct,
impacton
termbetweenFF and cash flow
theinteraction
of firms.Furthermore,
thecapitalexpenditures
funds
thesecompaniescanraiseexternal
sincegiventheirsparedebtcapacity,
shouldbe negative
funds.
on theirinternal
to financeprojectsandareless dependent
D. The Value of Financial Flexibility
As thelast stepof our analysis,we examinetheimpactof a policyof financialflexibility
forfirms.One
thispolicyis value enhancing
whether
to investigate
on long-run
performance
of
correlation
cross-sectional
in
the
lies
limitation
of long-run
potential
analysis
performance
at
aimed
inourcase,as a certain
relevant
events.Thisis particularly
implementing
leveragepolicy
to analyzethe
an investment
bythebusinesscycle.Therefore,
mightalso be determined
strategy
We
time-series
a
of FF firms,we adopt
analysis. analyzethemonthly
performance
long-run
FF statusatthebeginning
achieved
firms
that
of
oftheequallyweighted
excessreturns
portfolios
FamaandFrench(1993)
the
and
the
CAPM
both
Weadopt
24 (36 or60) months.
ofthepreceding
models
three-factor
RpFF,t

Rf,t

= OipFF + pFF(Rm,t ~ Rfj) + SpFFj,

(3a)

5
we assumethereplacement
Forthefirst
method.
observation,
inventory
usingtheperpetual
Capitalstock(K) is measured
we applya
Forthefollowing
observations,
costoftotalnetfixedassets,adjustedforinflation.
costequals thehistoric
assumedto
methodas follows:Kit= ^_i(l - 8) + Iit,where8 is therateof depreciation
standard
perpetualinventory
be 0.08 (Bondetal., 2003).

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Marchica& Mura FinancialFlexibility,


InvestmentAbility,
and FirmValue

+ hpFFHMLt
+ spFFj,
RpFFj Rf,t= aPFF+ bpFF(Rm,tRf,t)+ spFFSMBt

1345

(3b)

whereRpFFjdenotesthemontht return
of an equallyweighted
of all firmsidentified
portfolio
as financially
flexible(pFF) in thepreceding
24 (36 or 60) months,
Rftis theUK three-month
to a monthly
rateof return,
Rmtis thereturnon the FTSE All
Treasurybill rateconverted
ShareIndexin montht,SMBt(HMLt)is thereturn
difference
betweena portfolio
of smalland
firms.If FF firmsare outperforming
themarket,
thenthe
large(highand low book-to-market)
and
in
the
time-series
should
be
than
intercepts
zero,
regressions
significantly
greater
apFF
apFF
thata FF policyis valueenhancing.
suggesting
As a further
test,we followDenis and Denis (1993) and we analyzetrendsin operating
theprofitability
beforeandaftertheFF statushasbeenacquired,and
performance
bycomparing
beforeandafterabnormalinvestments
havebeenmade.Thisallowsus totestwhether
thispolicy
is also valueenhancing
on theoperating
side.

II. Empirical Results


A. Leverage Models
We startouranalysisbyestimating
theleveragemodels,whichareinstrumental
to theidentificationof SDC firms.In thefirstcolumnof TableI, we reportresultsforthebaselinemodel.
In thesecondandthirdcolumns,we presentresultsforaugmented
leveragemodelscontrolling
fora variety
ofotherfactors
thatcanpotentially
contribute
to leveragedecisions(see SectionII.
E laterin thetext).Our GMM estimation
revealsthatthecoefficient
on laggedleveragein all
thespecifications
is positiveand significantly
different
fromzero.The adjustment
coefficient
X
(1 - ) forthebaselinemodelis about0.37. Thisprovidesevidencethatthedynamicnatureof
ourmodelis notrejected.Moreover,
thisindicatesthatcompaniestakeaboutthreeyearsto close
thegap withtheirtargetcorroborating
ourchoiceof examining
theleveragebehaviorof firms
forthreeconsecutive
forUS firmsby
years.Thisresultis verysimilarto thatreported
recently
andRangan(2006).
Flannery
Theresultsacrossall specifications
areinlinewithmostofthefindings
inthecapitalstructure
literature
and
and,as such,arenotcommented
uponforbrevity
(Rajan
Zingales,1995;Flannery
andRangan,2006; FrankandGoyal,2009).
B. Characteristics of FF Firms
As discussedabove,oncetheleveragemodelshavebeenestimated,
we classifyFF firmsonthe
basisoftheavailability
ofsparedebtcapacitycaptured
betweenobserved
bynegativedeviations
andpredicted
thedummy
FF takeson a valueofone when
leverage.As a baselinespecification,
we observeat leastthreeconsecutive
periodsin whichthefirmis classifiedas SDC. The first
observation
intheseriesis notavailablebecausethedataarefirstdifferenced
toruntheleverage
modelsusingGMM. Further,
sincetoassignFF status,
werequirea minimum
ofthreeconsecutive
inwhichfirmsareclassifiedas SDC, thefirstemployable
observations
observation
toclassifyFF
is
one.Thisis themainreasonwhythetotalsamplegoes from4,290firms
companies thefourth
availablefortheleverageequationsto 2,541 in theinvestment
detailed
equation.Comparative
statistics
revealthatthetwosamplesare highlycomparable,
and theprocedurewe
descriptive
followdoesnotbias thesamplein anydirection.
TableII reports
somedescriptive
statistics
whichwetrytounderstand
thecharacteristics
through
of thesamplecompanies.We have 1,178companiesclassifiedas FF, 966 neverclassifiedas

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FinancialManagement Winter201 0

1346

Table I. Leverage Models


Thistablepresents
theestimations
usedtopredict
BookLev is theratiooftotaldebt
target
capitalstructure.
to totalassets,MarketLev is theratioof totaldebtto book valueof totalassetsminusthebook valueof
valueof equity,andIndustLevis themedianindustry
equityplusthemarket
leverageby SIC code andby
is definedatthefour-digit
SIC codelevel.Mtbvis theratioofbookvalueoftotalassetsminus
year.Industry
thebook valueof equityplus themarketvalueof equityto book value of totalassets;Size is thenatural
is theratiooffixedassetstototalassets;Profitability
is
oftotalassetsin 1991prices;Tangibility
logarithm
is proxiedusing
theratioofearnings
beforeinterest,
tax,anddepreciation
(EBITD) tototalassets;Inflation
is
tototalassets;Maturity
thethree-month
billrate;Cash is theratiooftotalcashandequivalents
Treasury
tototal
dividends
theratioofloansrepayable
afterone yeartototaldebt;Dividendsis theratioofordinary
is the
tototalassets;ManagerialOwnership
assets;Taxis totaltaxchargetototalassets;Ndtsis depreciation
of
directors
is
the
sum
the
held
executive
sumofordinary
(%); Blockholding
nonmanagerial
shareholdings by
ofnonexecutives
tothetotalnumber
of
is theproportion
above3%; andBoardComposition
shareholdings
are
robuststandard
errors.The/?-values
withheteroskedasticity
We showregression
coefficients
directors.
providedinparentheses.
BookLevt-x
IndustBookLev
Mtbv
Size
Tangibility
Profitability
Inflation
Cash

Baseline

Extended

0.626
(0,000)
0.421
(0.000)
-0.005
(0.004)
0.002
(0.007)
0.025
(0.077)
-0.009
(0.000)
0.81
(0.001)

0611
(0.000)
0.469
(0.000)
-0.049
(0.000)
0.005
(0.000)
0.070
(0.017)
-0.002
(0.000)
0.61
(0.008)
-0.075
(0.000)
0.025
(0.000)
-0.416
(0.001)
0.007
(0.000)
-0.142
(0.000)

47,553
4,290
Yes
Yes

47,553
4,290
Yes
Yes

Maturity
Dividends
Tax
Ndts
(%)
ManagerialOwnership
(%)
Blockholding
BoardComposition
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects

Extended Plus Ownership8


0.637
(0.000)
0.316
(0.000)
-0.004
(0.077)
0.011
(0.001)
0.051
(0.051)
-0.088
(0.055)
0.77
(0.000)
-0.099
(0.005)
0.042
(0.000)
-0.265
(0.000)
0.002
(0.085)
-0.233
(0.004)
0.0004
(0.002)
0.000073
(0.420)
0.055
(0.000)
5,660
677
Yes
Yes

aIndicates
information.
wehandcollected
forwhich
offirms
a subsample
ownership

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InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,

1347

Table II. Descriptive Statistics


Thistablereports
themeansand -tests
on theequalityofmeansof someofthekeycharacteristics
of our
flexiblefirms.It is a dummythattakesthevalue of one whenwe
samplefirms.FF refersto financially
observeat leastthreeconsecutive
periodsin whichthefirmis classifiedas SDC; NFF standsfornever
flexible(i.e., thosefirmsthatnevershowFF statusovertheentireestimation
financially
period);AFF
standsforalwaysfinancially
flexible(i.e., thosefirmswitha low leveragestatusfortheentireestimation
period).Book Lev is theratioof totaldebtto totalassets;MarketLev is theratioof totaldebtto book
valueof totalassetsminusthebook valueof equityplus themarketvalueof equity;Mtbvis theratioof
book valueof totalassetsminusthebook value of equityplus themarketvalue of equityto book value
of totalassets;Size is thenaturallogarithm
of totalassetsin 1991 prices;Tangibility
is theratioof fixed
assetsto totalassets;Profitability
is theratioof earningsbeforeinterest,
tax,and depreciation
(EBITD)
to totalassets;Cash is theratioof totalcash and equivalents
to totalassets;Debt Maturity
is theratioof
loans repayableafterone yearto totaldebt;Dividendsis theratioof ordinary
dividendsto totalassets;
is thestandard
deviationofcash flowin thepreviousfiveyearsscaledbyaveragetotal
EarningsVolatility
assetsoverthesameperiod;Bankruptcy
Risk(Z-Score)is definedfollowing
Altman(1968) (0.012*(current
assets- current
assets+ 0.014*retainedearnings/total
assets+ 0.033*earningsbeforeinterest
debt)/total
andtaxes/total
assets+ 0.006*equity/total
debt+ 0.010*sales/total
Risk(Quiscore)is a
assets);Bankruptcy
variableprovided
FAME
the
data
set
from
BureauvanDijk. The scorerangesfrom0 to 100,wherelarger
by
lowerbankruptcy
risk.Debt Ratingdatawerekindlyprovidedby Reuters.The figures
figuresrepresent
theaveragerating,
whichis a numeric
variablethatassumesa valueof 100forAAA firms,10 for
represent
CCC orbelow,and 0 forunratedfirms.Investment
gradeis definedas a value70 and above(S&P rating
ofBBB orhigher).ManagerialOwnership
is thesumofordinary
heldbyexecutive
directors
shareholdings
is thesumof thenonmanagerial
above 3%; Board Composition
is the
(%); Blockholding
shareholdings
ofnonexecutives
tototalnumberofdirectors.
proportion

BookLev
MarketLev
Mtbv
Size
Tangibility
Profitability
Cash
DebtMaturity
Dividends
EarningsVolatility
Risk(Z-Score)
Bankruptcy
Risk(Quiscoref
Bankruptcy
DebtRating*
ManagerialOwnership
(%)a
Blockholding
(%)a
BoardComposition*
Totalfirms

FF

NFF

AFF

Test of Differencein Means FF


versus NFF (p-value)

0.09
0.08
1.40
12.42
0.35
0.10
0.07
0.45
0.025
0.09
5.00
67.11
78.12
9.71
31.11
0.46
1,178

0.26
0.23
1.32
12.24
0.32
0.04
0.05
0.51
0.016
0.14
2.26
61.43
70
10.85
36.45
0.42
966

0.04
0.04
1.57
10.87
0.36
0.02
0.09
0.44
0.027
0.10
34.75
70.90
85.61
8.40
22.73
0.42
397

(0.000)
(0.000)
(0.001)
(0.855)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.023)
(0.108)
(0.000)
(0.000)

""Indicates
a subsample
offirms
forwhich
wehand-collected
information.
ownership

flexiblein all timeperiods(NFF), and 397 alwaysclassifiedas financially


flexible
financially
We
(AFF).
separateAFF fromFF companiessincetheiractualleverageis alwaysless thanthe
level.Therefore,
itdoesnotseemthatthesefirmsarefollowing
a conservative
predicted
leverage
to
boost
their
future
investment
further
of
policy
abilityas FF firmsare.Unreported
investigation
thedatarevealsthattheUnitedKingdomhas verysimilarnumbers
ofzeroleverageand almost

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1348

FinancialManagement Winter2010

in Strebulaev
andYang(2008). The vastmajority
ofthese
zeroleveragefirmsto thosereported
AFF
to
our
cluster
of
firms.
belong
As expected,FF firmsborrowless thanNFF firms,althoughthe subgroupof AFF firms
FF firmsseem
thelowestlevelsofborrowing
sincetheyarealwaysunderleveraged.
demonstrates
NFF
inmeans
in
terms
of
over
firms
as
the
test
of
difference
tohavea smalledge
growth
options
NFF
assetsthanthe
whilelittle
revealsa/7-value
ofzero.FF firmsalso seemtohavemoretangible
size.Inlinewiththeleverageregression
difference
results,
appearstoemergeintermsofcompany
orcashholdingtendto
thatcompanieswithgreater
thedescriptive
profitability
analysisindicates
debtthanNFF firms.This
oflong-term
borrowless.FF firmsalso appeartohavea lowerfraction
theattempt
debtmayreflect
oflowerleverageandhighershort-term
combination
byFF firmsto
andRaman,2005;
minimizeunderinvestment
2003; Datta,Iskandar-Datta,
problems(Johnson,
Marchica,2007). However,FF firmstendto pay higherdividendsthanNFF firms.This is in
linewiththeevidenceprovidedby Grahamand Harvey(2001) whoreportfinancialflexibility
difference
is detectedin the
to be moreimportant
to dividend-paying
companies.An important
valuefinancial
Itmightbe arguedthatfirmswithmoreuncertain
ofearnings.
earnings
volatility
forthisconjecture
as FF firmshavemorestable
no support
more,butourresultsoffer
flexibility
ofa positivelink
withtheexpectation
consistent
thanNFF firms.
Thisresultis,however,
earnings
andMittoo,2009).
ofearnings(Bancel,Bhattacharyya,
betweendividendpayoutandstability
riskthefirmis exposedto,
thatmayrevealthebankruptcy
We also inspectsome features
intheirleverage
to behave(more)conservatively
an incentive
andthatcouldtherefore
generate,
FF
firms
are indeedless
find
that
we
Altman
z-score
calculate
the
When
we
(1968),
policy.
at any
NFF
firms
is
from
the
difference
file
for
and
to
significant
statistically
bankruptcy,
likely
robustness
level.As a further
conventional
test,we collectthevariableQuiscore,a measureof
riskprovidedbytheFAME-BureauvanDijk Database.The scorerangesfrom0 to
bankruptcy
risk.Again,FF firmshave
lowerbankruptcy
where
like
thez-score,largerfigures
100,
represent
As a finalstep,we
is statistically
andthedifference
a highervaluethanNFF firms,
significant.
forthe
andPetersen
information.
SimilartowhatFaulkender
collectdebtrating
(2006) document
thatthe
document
thefigures
UnitedStates,veryfewUK companieshavea debtrating.
However,
is againstatistically
averageratingforFF firmsis 78.12 versus70 forNFF firms.Thedifference
notmoreexposed
FF
firms
are
that
tests
These
the
1%
level.6
at
preliminary suggest
significant
andgovernance
turn
to
when
we
than
other
tomarket
ownership
companies.Also,
imperfections
affected
firms
seems
of
no
cluster
find
that
we
by "entrenched
characteristics,
particularly
for
all
10%
is
around
board
which,
accordingto the
groups,
ownership
managers."Average
area.Similar
the
falls
inside
of
UK
the
Mura
on
firms,
alignment
(2007)
performance
studyby
andaverageblockholding.
canbe drawnfromthefigureson boardcomposition
conclusions
level.Wefollow
attheindustry
Wealsoinspectthedatatosee ifthereis anyparticular
clustering
of
A largeproportion
concentration.
and analyzeindustry
SIC code classification
thetwo-digit
is
The
service
Codes
sector
the
to
FF firms,
industry
20-39).
41%, belongs
manufacturing (SIC
17%
find
we
also
while
Codes
18%
at
approximately
70-89),
represented approximately (SIC
services,
and 12% inthetradeandthetransportation,
electric,
communications,
gas,andsanitary
about
for
account
construction
and
and
Codes
50-59
40-49). Finally,mining
(SIC
respectively
1%.
less
than
has
and
12% ofFF firms(SIC Codes 10-17),whileagriculture,
forestry, fishing

variablethatassumesa valueof 100 forAAA firms,10 forCCC or below,and 0 forunrated


6Theratingis a numeric
is
firms.Investment
grade definedas thevalue70 andabove(S&P ratingofBBB orhigher).

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InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,

1349

C. Understanding the Behavior of FF Firms


firms'choicesovertime.We startby definingt as the
Figure1 presentsgraphsdescribing
timeat whichFF firmsare assigneda valueof one afterthreeyearsof SDC. Then,we analyze
and financialdecisionsfromt - 2 to t + 2. Priorto t,FF
theirbehaviorin termsof investment
firmsappearto be investing
less thanin t -+-1 and t + 2 (PanelA). In particular,
theyappearto
in
an
and
sudden
increase
their
investments
1
between
t
and
t.
experience important
Thisis further
corroborated
whenwe turnto industry-adjusted
investment
(Adjlit)in PanelB.
firm
of
"in
Thepattern
investment excess"oftheindustry
meanconfirms
thatFF firmsfeature
a markedincreasein theirinvestment,
in particular
betweent - 1 and t. In Panel C, we report
for(industry
investment.
Thesearecapitalexpenditures
thatarelarger
figures
adjusted)abnormal
in valuethanthenormin thefirm'slife(Mayerand Sussman,2004). To identify
thesespikes,
we generatea proxyfornormalinvestment
(NIA) by calculatingtheaveragevalue of
activity
investments
thecentral
industry-adjusted
(Adjlit)overthree-year
periods,butexcluding
year,that
J
- JM+1.7 Thisrepresents
the
norm
investment
forthe
is, NIAij =
(industry-adjusted)
lJ~x+2
investment
at timet withNIAit
Then,we comparethecompany's(industry-adjusted)
company.
and definean investment
as abnormalif itsvalue is at leasttwicethevalue of NIA. In other
words:
f Adjlij
Abnormal
Investment
ij = <
0
[

ifAdjlij > INIAij


otherwise.

(4)

Thisprocedureensuresthatwe are capturing


investments
thatare largerthanthecompany's
but
it
also
allows
us
to
control
whether
the
firm
is
also
morethanitscompetitors.
norm,
spending
Once theabnormalinvestments
havebeen identified
foreach FF firm,we plottheiraverage
valuesbeforeandafterthefirmis assignedFF status.PanelC indicatesthat,aroundt,FF firms
a verysignificant
increasein theirabnormalinvestments.
Forinstance,on average,
experience
abnormalinvestments
increasefrom0.021 in t - 1 to 0.027 in / -f 1, or by about27%. This
thehypothesis
thatFF firmshaveusedtheirpreserved
a
maysupport
borrowing
powerthrough
conservative
somecurrent
tobe able topursuelarger
leveragepolicy,andsacrificed
investment,
future
growth
options.
PanelsD andE shedmorelightregarding
howfirmsfinancetheseinvestments.
We document
a sharpincreaseintheirtotalborrowing
betweent - 1 andt + 2 (PanelD), whichcorresponds
to
a declinein thegap betweenactualandpredicted
leverage(PanelE). Fromtime,FF firmsare
muchcloserto their(estimated)
as thevaluesforthedeviations
areclose to zero.PanelF
target,
confirms
thistrend,
as FF firmsappearto markedly
increasenewnetdebtissuesbetweent- 1
and ,leadingto theclosureof thedeviationfromthe(estimated)targetleverage.This further
corroborates
ourinitialhypothesis
FF firmsare
that,aftera periodof conservative
borrowing,
better
placedto exploittheexternal
capitalmarkets.
One argument
thatmayconfuteourhypothesis
is thatfirmsrestrain
theirborrowing
butuse
equityissuestoinvest.Forinstance,
MayerandSussman(2004) andTsyplakov(2008) document
thatequityisthepreferred
choiceforsmallfirms'financing
abnormal
whileprofitable
investment,
and largefirmshavea clearpreference
fordebtoverequity.DeAngeloand DeAngelo(2007)
of sizablefuture
arguethatiftheprobability
capitalneedsis large,managersmayissue equity
ratherthanexhaustdebtcapacity.To controlforthispossibility,
we analyzethetrendsin net
thatfirmsdo notappearto use new equityissuesto finance
equityissues.Panel G illustrates
7Thesameexercisewas performed
thanthreeyears,anditreachedsimilarconclusions.
usingfiverather

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FinancialManagement Winter2010

1350

Figure 1. FirmBehavior Over Time


Thesefigurespresentan analysisof financially
flexiblefirms'choicesovertime,whereFF is calculated
Attimet,FF is a dummy
fromthebaselinespecification.
hasa negative
deviation
equaltooneifa company
fromitstargetlargerthanat least 10% of all undershooting
firmsforthreeconsecutive
years,and zero
beforeandafterthistime(fromt- 2 to t + 2). Investment
is the
otherwise.
Wethenplotfirmcharacteristic
Investment
is thedeviationof Investment
fromthe
ratioof investment
to capitalstock;Industry-Adjusted
is definedovera pattern
ofthreeyearsofindustry-adjusted
investment
Investment
mean;Abnormal
industry
is calculatedin theextreme
data.The averagevalueof investments
years(NIAit= (AdjIt-'+ AdjIt+i)/2).
value in thecentralyearis at leasttwicethe
Thus,thereis a spikein thispattern
onlyiftheinvestment
between
averageoftheextremes;
Leverageis theratiooftotaldebttototalassets;Deviationis thedifference
theactualandpredicted
levelofleverageforeachfirm;NetDebtIssuesis theratioofnetdebtissuedineach
yearto totalassets;andNetEquityIssues is theratioofnetequityissuedin each yearto totalassetsCash
is theratioofearningsbeforeinterest,
to totalassets;Profitability
is theratiooftotalcashandequivalents
tax,anddepreciation
(EBITD) tototalassets.
Panel A. Investment

^^^^^

0.1 T-

- 0.090.08 -

| 0.07
S 0.06 -

*r~~^
1

t-2

t-1

0.05 -I

1-

-,

t+1 t+2

Investment
Panel B. Industry-Adjusted

% 0.027 H

1 0.022% 0.017 I

0.012 '

^*
1

y*r^*~~*
1

t-2 t-1 t t+1 t+2

Panel C. AbnormalInvestment

^^^^^^^^^

g 0.03 -,
0.028
|
| 0.026

| 0.024| 0.022

0.02 -I

+^

1
,
t-2 t-1

*-.

1
1
1
t t+1 t+2

~~~~

{(Continued)

Thistrendis inlinewith
sharerepurchases.
FF firmsseemtoundertake
newinvestments.
Rather,
and
Oswald
theUK market
recentevidenceregarding
Young(2004).
by
In PanelH, we observea sharpdropin theircash positionbetweent - 1 and t + 1, where
t is themomenttheyare classifiedas FF. Cash dropsby about16%, from7.40% in t - 1 to

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1351

and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,

Figure 1. FirmBehavior Over Time (Continued)


Panel E . DeviationfromTarget

Panel D. Leverage

U.I O

-j

0.11 |* 0.09
0.07

4f

j^

*V^/

0.05 J

1 1 1
1 1 .
t-2 t-1 t t+1 t+2

'

U 1

Q)

^ -0.01-0.02
|
I -0.03-

"O-04-0.05 -I

r^^*

I 0.003
/
5
/
~0-002'
t-2 J t t+1 t+2
1
1
J ____
_0
007
|

U.U

T~-

0.055 0.05 -I

"*"
- "

011"
"

O-007
|
s

0.005 J

^V.

^^^^>

.
, .
1 .
t_2 t_-| t t+1 t+2
Panel I. Profitability

^^^

1
1
t-2 t-1

0.013 i

Panel H. Cash

0.075 -

Panel G. NetEquityIssues

0.008

'

r~~^^
/

Panel F. NetDebtIssues

0.013 -j

'

t-2 t-1 t t+1 t+2

1
1
1
t t+1 t+2

U. I *t

~j

"

"

.fe 0.12

* 0-06
0.04 -I

"

^__^

1
1
t-2 t-1

1
1
1
t t+1 t+2

6.31% in t + 1. This mayindicatethatFF firmsalso use some of theirliquidassetsagainst


trendwhich
theirinvestment
ontheotherhand,displaysan increasing
opportunities.
Profitability,
does appearto increasemarkedly
aftert goingfrom9.4% to 10.7% betweent - 1 and t + 1
(PanelI).
in investment
As a preliminary
testof our hypothesis,
we analyzewhether
thedifferences
In TableIII, we presenta
andabnormalinvestment
acrosstimearealso statistically
significant.
number
oftestsperformed
The maindifference
acrossdifferent
oftheFF dummy.
specifications
lies in thethreshold
on
the
deviation
from
imposed
targetleverageto classifya firm
negative
as SDC. ForFF(5%), thethreshold
is 5%; FF{10%) is our"baseline"specification
of theFF
in
a
firm
if
which
is
first
classified
as
SDC
it
minimum
of
has
a
10%
dummy
negativedeviation
fromtheestimated
FF
and
are
froma
dummies
targetleverage.FF{25%)
FF(1.5SD)
resulting
minimum
deviationof25% and 1.5 unitsof standard
It
can
be
seen
that
deviation,
respectively.
of
the
follow
firm
we
to
a
as
we
find
that
and
FF, always
investment,
regardless
approach
classify
abnormalinvestment
in particular,
demonstrates
a markedand statistically
increase
significant
aftertheFF statushas been achieved.For instance,forthebaselinespecification,
we findan

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FinancialManagement Winter2010

1352

Table III. Investmentand Abnormal InvestmentChanges Over Time


Thistablereports
thechangesininvestment
andabnormal
investment
beforeandafter
thefinancial
flexibility
t corresponds
tothe
statusis acquiredandpresents
/-tests
ontheequalityofmeans.Thecentralobservation
moment
whenFF firmsareassigneda valueofone.FF is a dummy
hasa negative
equaltooneifa company
deviationfromitstargetforthreeconsecutive
FF{5%) is a dummy
equal to one
years,andzerootherwise.
ifa companyhas a negativedeviationfromitstargetlargerthanat least5% forat leastthreeconsecutive
years.FF {10%) is a dummyequal to one ifa companyhas a negativedeviationfromitstargetlargerthan
at least 10% forat leastthreeconsecutive
years.FF(25%) is a dummyequal to one if a companyhas a
years.FF(1.5SD)
negativedeviationfromitstargetlargerthanat least25% forat leastthreeconsecutive
is a dummy
equal to one ifa companyhas a negativedeviationfromitstargetlargerthanat least1.5 units
to capital
is theratioof investment
of standard
deviationforat leastthreeconsecutive
years.Investment
of
investment
data.
of
three
Investment
is
defined
over
a
Abnormal
stock;
pattern
years industry-adjusted
is calculatedin theextreme
The averagevalueof investments
years(NIAit= AdjIt-'+ Adjlt+')I2).Thus,
valueinthecentralyearis at leasttwicetheaverageof
thereis a spikeinthispattern
onlyiftheinvestment
theextremes.

Investment
Abnormal
Investment

f- 2

f+ 1

% Change

0.070
0.016

0.087
0.020

24.29
22.60

Test of Differencein Means t - 2


1
_____ versus t + (p-value)
(0.000)
(0.000)
FF {10%)

Investment
Investment
Abnormal

0.069
0.022

0.090
0.028

29.69
27.10

(0.000)
(0.000)
FF{25%)

Investment
Investment
Abnormal

0.071
0.017

0.090
0.021

26.76
23.11

(0.000)
(0.000)

FF{L5SD)
0.070
Investment
Abnormal
Investment 0.016

0.085
0.019

21.42
15.99

(0.000)
(0.000)

betweent - 2 and
and 23% in AbnormalInvestment
increaseof about30% in Investment
of 21 yearsand plottheir
In a further
test,we isolateFF firmsthatsurvivefora minimum
t
is now thetimewhenwe
where

t
10
and
between
H-10,
deviationfromtargetleverage
behavior
more
us
to
observe
This
allows
investment.
observean abnormal
closelytherebalancing
investment
the
new
finance
to
has
borrowed
after
the
of leverage
opportunity.
large
company
overshoot
is made,companiesmomentarily
Figure2 reportsthatafterthe largeinvestment
in
the
one
is
the
to
t
The
observation
theirtargetleverage.
positivequadrant
only
corresponding
we also observe
fromtarget
a positivedeviation
However,
leverage(i.e.,overshooting).
indicating
It seemsto
its
estimated
below
firm
back
the
takes
that
trend
andopposite
an immediate
target.
to
the
back
and
least
firm
to
the
for
3-4
takeapproximately years
prejump
partly) go
adjust(at
to the
in t + 6, theobserveddeviation(-0.00743) is of similarmagnitude
levels.Forinstance,
at
if
look
we
hold
results
Similar
t
6
value
longerperiods.The
(-0.0071).
corresponding
value for
the
whereas
is
about
in
t
10
observed
deviation
-0.0104,
corresponding
average
finance
to
in
debt
increase
this
that
view
the
corroborates
This
10
is
-0.0101.
t+
large
strongly

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InvestmentAbility,
and FirmValue
Marchica& Mura FinancialFlexibility,

1353

Figure 2. Long-Term Rebalancing of Capital Structure


ofcapitalstructure
offinancially
a long-term
flexiblefirms
Thisfigurepresents
analysisoftherebalancing
FF is a dummyequal to one if a companyhas a
whereFF is calculatedfromthebaselinespecification.
firmsforthreeconsecutive
negativedeviationfromitstargetlargerthanat least 10% of all undershooting
t corresponds
to themomentwhenFF firmsmake
years,and zero otherwise.The centralobservation
We thenplotthedeviationfromthetargetleveragefrom10 yearsbeforeto 10
abnormalinvestments.
are definedas follows:we generatea proxyfor
yearsafter(fromt - 10 to t + 10). Abnormalinvestments
normalinvestment
investments
over
activity
(NIA) by calculatingtheaveragevalue of industry-adjusted
thenorm(industry-adjusted)
investment
three-year
periodsbutexcludingthecentralyear.Thisrepresents
forthecompany.
investment
attimetwithNIAitanddefinean investment
Then,we comparethecompany's
as abnormalifitsvalueis at leasttwicethevalueof NIA and zerootherwise.
Deviationis thedifference
betweentheactualandpredicted
levelofleverageforeachfirm.
Deviation fromTarget Leverage

0.015
0.01

l'

0.005

I '

%
s>

'
'
n^ * Jo A

I
I

<o <o >

<b 3

K>

-0.005

-0.015

K JMiV 3

>

<b A

<b q> o

'

^*

-0.02

thenewinvestment
a temporary
deviationfromthelong-term
low leveragetargetto
represents
whichthecompanyreverts.
This is consistent
withtheargument
of DeAngelo,DeAngelo,and
Whited(2010) who maintainthatthetargetis made of two components,
a permanent
and a
one. The former
is thelong-run
to
transitory
targetcompaniesareat beforethejumpandrevert
afterthelargeinvestments
are made.The temporary
deviationfromthislong-run
targetis the
transitory
component
allowingfirmsto actuallycarryouttheseabnormalinvestments.
The resultwe reportis in linewithGraham(2000) whoreports
thatcompaniesthatpreserve
debt
to
boost
future
investments
tend
to
substantial
eveninthe
spare
capacity
preserve
flexibility
havebeenmade.
periodsaftertheinvestments
Theseareall verysignificant
ourinitialhypothesis
thatat
piecesofevidenceandtheyconfirm
leastsomecompaniessacrificecurrent
and
use
this
borrowing
sparedebtcapacityto be able to
afford
tomorrow.
This lendsstrongempiricalsupportto
larger(and possiblybetter)investment
thesurveyevidenceregarding
A
structure.
financial
capital
flexibility
strategy
appearstoimprove

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FinancialManagement Winter2010

1354

theabilityof firmsto investin and "pursuenewprojectswhentheycomealong"(Grahamand


Harvey,
2001).
D. InvestmentModels
We nowturnto theinvestment
modelestimations.
HavingdefinedtheFF dummyin theway
we describeit in SectionII.B, it is worthunderlining
thatin theq-model,we investigate
the
correlation
betweeninvestment
at timet and thedummyFF definingleverageconservativism
theinvestment
decision(i.e.,betweent - 3 andt - 1). Thisshouldaddresstheconcern
preceding
to investment.
thattheFF dummy
(and,consequently,
leverage)is endogenous
of
the
modelincluding
Table IV indicatestheresultsof different
investment
specifications
withFrankandGoyal's(2009)
thecalculationoftheFF dummiesusingthetargetmethodology
modeldiscussedabove. In Panel A, we reporttestsin whichtheFF
baselinebook-leverage
dummiesaredefinedon thebasis of SDC spanningbetweentwoand six years.In PanelB, we
is alwaysdefinedonthreeyearsofSDC, butwe require
further
testswheretheFF dummy
report
towhatwe describedabove(5%, 25%,
inthedeviation
fromtarget,
different
thresholds
similarly
in thisfield(i.e., Cleary,Povel,and
In linewithmostoftheliterature
1.5 standard
deviations).
betweenInvestment
and Tobins
Raith,2007),we observea positiveandsignificant
relationship
withtheprediction
thatgrowthopportunities
play a relevantrole in investment
q, consistent
thatthe
on cash flowis alwayspositiveand significant
decisions.The coefficient
suggesting
on internal
atleastpartially,
mayresultinfirmsrelying,
imperfections
presenceofcapitalmarket
fundsto invest.
acrossall specificaFF statusarepositiveandstatistically
Thedummiesindicating
significant
thatthesecompaniesinvestmoreaftera periodofconservative
tionsindicating
leverage.Further,
between
to cash flow,as represented
we findthattheinvestment
by theinteraction
sensitivity
Thisresultsuggests
FF dummiesand cash flow,is alwaysnegativeand statistically
significant.
andthattheirabilitytoinvest
thatFF companiesareless exposedtocapitalmarket
imperfections
and agencycostsproblemsthanitis for
no morejeopardizedbyasymmetric
is, at a minimum,
sizeable.Indeed,ceteris
otherfirms.The impactof theFF statusdummyis also economically
itsinvestment
increases
flow
cash
FF
with
an
by
0.17)
(approximately
average
company
paribus,
increasegiventhattheaverageratioof
about0.029 in absoluteterms(FF3).S Thisis a striking
to capitalstockis 0.079. In otherwords,an averagefirmcan investapproximately
investment
status.9
37% moreafteracquiringfinancialflexibility
As discussedabove,forrobustness
leverage
purposes,we testforvariousspansofconservative
of deviationfromtargetleverageto defineFF. A low leveragepolicy
and variousthresholds
economicimpact,whichtendsto decreasealmost
forthreeyearsseemsto yieldthestrongest
toforeseegrowth
theabilityofmanagers
the
fact
that
reflect
with
time.
This
options
may
linearly
whose
firms
this
could
in
the
future.
are
these
the
further
represent
decreases,
Alternatively,
away
not
need
did
to
the
extent
materialize
did
not
Therefore,
they
expected.
originally
options
growth
theirFF statusfora longerperiod.The resultsare similar,albeitslightly
to relinquish
smaller,
whenwe use marketratherthanbook leverage.For instance,theeconomicimpactforFF3 is
32%.
estimated
at approximately
froman
theresultsstemming
EvidencefromPanelB is verysimilartothatinPanelA although
FF definedon thebasisofverysmalldeviations,
FF(5%), seemstoyieldthesmallesteconomic
(2000): 0.034 x 1-0.028 x 0.167 = 0.029.
followingWooldridge
value
thecorresponding
whenwe focuson themedianfirm.Forinstance,
9Theeconomicimpactis ofsimilarmagnitude
forFF3 inTableIV is 45.98%.

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Marchica& Mura FinancialFlexibility,


InvestmentAbility,
and FirmValue

1355

Table IV. Investment Models


ThistablepresentsGMM resultsfortheq-modelof investment
withfinancialflexibility
statusdummies
ofthe"baseline"book leveragemodel(TableI, Column1). The dependent
computedfromtheestimation
variableis Investment,
definedas theratioofinvestment
tocapitalstock;CashFlow is theratioofcashflow
to capitalstock;Tobins q is theratioofmarket
valueofassetsto capitalstock;FF2(3-6) is a dummy
equal
to one ifa companyhas a negativedeviationfromitstargetlargerthanat least 10% of all undershooting
firmsfor2 (3-6) consecutive
years,andzerootherwise.
FF{5%) is a dummy
equalto one ifa companyhas
a negativedeviationfromitstargetlargerthanat least5% forat leastthreeconsecutive
years.F F (25%) is
a dummy
equal to one ifa companyhas a negativedeviationfromitstargetlargerthanat least25% forat
leastthreeconsecutive
years.FF(L5SD) is a dummyequal to one ifa companyhas a negativedeviation
fromitstargetlargerthanat least 1.5 unitsof standard
deviationforat leastthreeconsecutive
years.We
conductedall estimations
withheteroskedasticity
coefficients
usingtheGMM-DIFF.We showregression
robuststandard
errors.The/?-values
areprovidedinparentheses.
PanelA. FF DummiesBased on theSDC StatusSpanningbetweenTwoand Six Years
Investment^
CashFlowt_x
Tobins q
FF
FF* CashFlowt.x
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects
Economicimpact(mean)

FF2

FF3

FF4

FF5

FF6

0.169
(0.000)
0.112
(0.000)
0.003
(0.012)
0.031
(0.000)
-0.033
(0.000)
26,626
2,541
Yes
Yes
32.37

0.176
(0.000)
0.119
(0.000)
0.003
(0.007)
0.034
(0.000)
-0.028
(0.000)
26,626
2,541
Yes
Yes
37.25

0.179
(0.000)
0.100
(0.000)
0.003
(0.010)
0.031
(0.000)
-0.035
(0.001)
26,626
2,541
Yes
Yes
31.95

0.176
(0.000)
0.099
(0.001)
0.003
(0.005)
0.026
(0.000)
-0.022
(0.006)
26,626
2,541
Yes
Yes
28.36

0.175
(0.000)
0.096
(0.000)
0.003
(0.006)
0.033
(0.014)
-0.066
(0.045)
26,626
2,541
Yes
Yes
27.90

PanelB. FF DummiesBased on Different


Thresholds
in theDeviationfromTarget
Investmentt-i
CashFlowv_i
Tobins Q
FF
FF* Cash Flowv_,
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects
Economicimpact(mean)

FF3{5%)
0.194
(0.000)
0.118
(0.000)
0.003
(0.000)
0.037
(0.000)
-0.078
(0.035)
26,626
2,541
Yes
Yes
30.43

FF3(25%)
0.181
(0.000)
0.081
(0.000)
0.003
(0.000)
0.035
(0.000)
-0.022
(0.000)
26,626
2,541
Yes
Yes
39.79

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FF3(1.5SD)
0.195
(0.000)
0.096
(0.000)
0.003
(0.000)
0.033
(0.000)
-0.023
(0.000)
26,626
2,541
Yes
Yes
37.04

FinancialManagement Winter2010

1356

dueto thefactthatverysmalldeviations
aresimplyaffected
impactofFF3. Thisis probably
by
in
which
turn
waters
down
the
result.10
noise,
E. The Role of InternalFunds
A number
ofcashholdinginobtaining
financial
ofstudiesemphasizetheimportance
flexibility
Faulkender
and
find
thatthemarginal
and reducingunderinvestment
Wang(2006)
problems.
thanforunconstrained
firms.Theyalso
value of cash is substantially
higherforconstrained
In
a
recent
for
firms
with
that
this
result
is
paper,Denisand
highgrowth
options.
report
stronger
firms
to undertake
levels
of
financial
slack
allow
constrained
Sibilkov(2010) report
thathigher
with
Faulkender
and
Wang(2006) in thatcash
projects.Theirresultsalso tally
value-increasing
In a similarvein,
firms.
thanforunconstrained
holdingsare morevaluableforconstrained
in
thenegative
model whichfirmscanmitigate
GambaandTriantis
(2008) proposea theoretical
effectof financialconstraints
liquiditypolicy,althoughtheirmodel
throughan appropriate
Harford(1999) findsthatcash richcompanies
expressly
neglectsagencycosts.Alternatively,
are moreexposedto theoverinvestment
problemand thattheytendto makevalue-decreasing
acquisitions.
Wetrytotacklethisissueintwoways.First,we includecashanda proxyforexcesscashinto
modeltocontrolforthepotential
ourinvestment
impactoffinancialslack.In thefirstcolumnof
cashflowwithcash.In thesecondcolumn,we includethemboth
PanelA, TableV, we substitute
In thethirdandfourth
intheregression.
columns,we repeatthesameexercise,butwe includea
cashregression
thanthelevelofcash.To do that,we runan auxiliary
proxyforexcesscashrather
cashandclassifyfirmswithpositivedeviations
similarto Opleretal. (1999) to obtainpredicted
is adoptedinHarford
as cashrich.A similarprocedure
fromtarget
(1999) andDenisandSibilkov
modelto controlforthefact
(2010). We thenuse thisproxyforcashrichnessin theinvestment
to invest.
thanleverageto attainfinancialflexibility
thatsomefirmsmayuse excesscashrather
our origThe resultsfromthesetestsare in line withthepreviousevidencecorroborating
that(at least) the firmswe defineas FF are using spare debt capacityas
inal hypothesis
and enhancetheirinvestment
theirmain vehicleto attainfinancialflexibility
ability.Both
but across
the
with
and
cash and excess cash are statistically
sign,
expected
significant
the economicimpactof the FF statusremainssimilarto the previous
all specifications,
estimates.
way.By construction,
Second,we tryto testfortherole of internalfundsin an alternative
whenpredictedleverageis calculatedin our baselinemodeland low leverageand FF firms
foras it is notamongthe
controlled
thecash positionof thefirmis notdirectly
are classified,
of
determinant
variablesin thebaselinemodel.If cash (or excesscash) wereto be an important
would
this
of
financial
need
in
firms
for
those
decisions
flexibility),
stronger
(especially
leverage
FF dummywouldalready"contain"
end up in theresidualof themodel.Thus,theestimated
betweenthe
test
and
the
the
cash
information
previous maynotdiscriminate
position
regarding
roleplayedby theinternalfundsand thatof sparedebtcapacityas theyare bothembedded
of ourresults,we estimatea target
testtherobustness
to further
in theFF dummy.
Therefore,
that
other
factors
of
a
model
mayhelpfirmsachievefinancial
by variety
augmented
leverage
ofitsdebtanditsdividend
the
with
firm's
cash
the
We
include
maturity
along
holding,
flexibility.
"cleaned"ofthispotential
now
model
is
the
of
residual
The
Table
leverage
I).
payout(Column2,
medianto
iromindustry
10Inan unreported
leveragein difference
test,we replicatetheaboveanalysisbytransforming
in determining
effects
bettercontrolforpotential
sparedebtcapacity.The resultsare similarto thosereported
industry
above.

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Marchica& Mura FinancialFlexibility,


InvestmentAbility,
and FirmValue

1357

Table V. Robustness Tests: The Role of InternalFunds


ThistablepresentsGMM resultsfortheq-modelof investment
withfinancialflexibility
statusdummies
fromvariousalternative
In PanelA, theinvestment
modelis augmented
withcash
computed
specifications.
variables.The dependent
variableis Investment,
definedas theratioof investment
to capitalstock;Cash
Flow is theratioofcash flowto capitalstock;Tobins q is theratioofthemarket
valueof assetsto capital
stock;FF 3 is a dummy
equaltoone ifa companyhas a negativedeviationfromitstarget
largerthanat least
10% of all undershooting
firmsforthreeconsecutive
Cash is theratioof total
years,and zero otherwise;
cashandequivalents
to totalassets;Excess Cash is computedusingan auxiliarycash regression
to obtain
cashandto classifyas cashrichthosefirmswithpositivedeviations
fromthetarget.In PanelB,
predicted
theFF dummy
is obtainedusingalternative
oftheleveragemodel.Column1 reports
results
specifications
withtheFF dummy
derivedfromtheextendedleveragemodel(TableI, Column2). In Column2, we repeat
thesameexercise,butwe use a proxyforexcesscashrather
thancash,as describedabove.In Column3, we
runtheleveragemodelsubstituting
leveragewithNetDebtdefinedas leverageminuscash.In Column4, we
runtheextendedleveragemodelaugmented
witha proxyforcash flowvolatility
(Cf Volat)definedas the
standard
deviationofcashflowinthepreviousfiveyearsscaledbyaveragetotalassetsinthesameperiod.
The lastcolumn(Percentile)reportsresultswheretheSDC dummyis one whenobservedleverageis in
thebottom20% ofthedistribution.
We conductall estimations
usingtheGMM-DIFF.We showregression
coefficients
withheteroskedasticity
robuststandard
errors.Thep-valuesareprovidedinparentheses.
PanelA. TheRole ofInternalFundsin theInvestment
Model

Investmentt-X
Tobins q
FF3
OwA,_i
FF3* Casht-i
CashFlowt-X

Cash

Cash Plus
Cash Flow

0.193
(0.000)
0.003
(0.000)
0.031
(0.000)
0.035
(0.001)
-0.030
(0.087)

0.190
(0.000)
0.002
(0.003)
0.041
(0.000)
0.041
(0.020)

FF3*CashFlowt_]
ExcessCasht^i

0.127
(0.000)
-0.068
(0.026)

FF3*ExcessCasht_x
Observations
Numberoffirms
Firmfixedeffects
Yearfixedeffects
Economicimpact(mean)

26,626
2,541
Yes
Yes
32.36

26,626
2,541
Yes
Yes
37.64

Excess
Cash
0.181
(0.000)
0.003
(0.000)
0.031
(0.000)

0.024
(0.057)
-0.017
(0.009)
26,626
2,541
Yes
Yes
39.38

Excess Cash Plus


Cash Flow
0.159
(0.000)
0.002
(0.004)
0.035
(0.000)

0.112
(0.000)
-0.050
(0.030)
0.009
(0.094)
26,626
2,541
Yes
Yes
35.01
{Continued)

and we proceedto reclassify


low leverageand FF companies.Table V, Panel B,
disturbance,
Column1 reports
theresultsofthisexercise.
Once again,ourfindings
lendno supportto theviewthatthe"missinglink"in ourleverage
modelis cashrichness.The resultsin Column1 are in linewithourbaselinespecification,
and

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FinancialManagement Winter2010

1358

Table V. Robustness Tests: The Role of InternalFunds (Continued)


PanelB. TheRole ofInternalFundsinDetermining
theFlexibility
Status
Extended Model

Excess Cash

Net Debt

Cf Volat

Percentile

FF3*CashFlowt.{

0.176
(0.000)
0.119
(0.000)
0.003
(0.007)
0.033
(0.000)
-0.028

0.165
(0.000)
0.129
(0.000)
0.004
(0.015)
0.034
(0.000)
-0.050

0.162
(0.000)
0.136
(0.000)
0.005
(0.008)
0.037
(0.000)
-0.069

0.135
(0.000)
0.151
(0.000)
0.007
(0.002)
0.040
(0.000)
-0.087

0.190
(0.000)
0.074
(0.001)
0.003
(0.000)
0.049
(0.000)
-0.121

Observations
Number
offirms
Firmfixedeffects
Yearfixedeffects
Economic
(mean)
impact

26,626
2,541
Yes
Yes
35.98

Investment^
CashFlowt-i
Tobins q
FF3

(0.000)

(0.014)

26,626
2,541
Yes
Yes
32.57

(0.002)

26,626
2,541
Yes
Yes
32.35

(0.008)

26,626
2,541
Yes
Yes
32.33

(0.005)

26,626
2,541
Yes
Yes
36.41

theeconomicimpactoftheFF proxyis verycloseto ourbaselineresult,36%. We also replicate


cashholdingwithexcesscash(as definedabove)intheleverageequation,and
thistestreplacing
theresultsdo notvarysignificantly
(PanelB, Column2).
indetermining
netdebt.For
a
number
of
that
Further,
papersargue cashpositionsareimportant
firms
to hoard
US
document
an
and
Stulz
instance,
Bates,Kahle,
by
(2009)
increasing
tendency
To
their
for
their
structure.
which
have
cash,
support argument,
capital
important
implications
may
a significant
decreaseinleveragewhenlookingatnetdebtmeasures(leverageminus
theyreport
revealsalmost
measuresofdebttoassets.Data inspection
cash)as opposedtothemoretraditional
we
and
Stulz
identicaltrendsforUK firmstothosereported
(2009). Therefore,
byBates,Kahle,
of
the
definition
model
the
extended
to
address
this
concern
using
leverage
byreestimating
try
netdebtsuggestedby Bates,Kahle,and Stulz(2009).n The resultsof theinvestment
analysis
The FF dummyand theinteraction
offerlittlesupportforamendingouroriginalspecification.
and theeconomicimpactis similarto ourbaseline
termhave a similareffecton investment,
32%
(TableV, PanelB, Column3).
usingleverage,
specification
Intheirrecent
and
paper,DeAngelo DeAngelo(2007) arguethatfirmswithmoreunpredictable
ourdescriptive
morethanotherfirms.Although
financialflexibility
value
analysis
may
earnings
findslittlesupportforthisview,we tryto controlforthispossiblyomittedvariablein our
ofcashflowto controlfor
theleveragemodelwiththevolatility
leverageequation.We augment
thisalternative
inthefourth
columnofPanelB, againconfute
Theresults,
thispotential
influence.
while
theinteraction
and
FF
is
still
The
of
our
results.
positive significant,
dummy
explanation
theprevious
in
line
with
is
economic
The
estimated
and
termis significant negative.
impact
figures(32%).
A finalcriticism
ofourapproachmaybe thattheleveragemodelis stillsomehowmisspecified
of firms.A
deviationsfromit,and theclassification
theestimated
and thatthisaffects
target,
of the
distribution
numberofpapershaverunsimilaranalysesto oursrelyingon thestatistical
1!WethankMaraFacciofor
test.
thisrobustness
suggesting

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and FirmValue
InvestmentAbility,
Marchica& Mura FinancialFlexibility,

1359

values.For instance,Mintonand Wruck(2001)


variableunderstudyto discriminate
high/low
if
in
firm
its
value
is
thebottom20% ofall firmsforfiveconsecutive
as
low
a
leverage
classify
this
all ourinvestment
to
control
for
issue,we reestimate
potential
regressions
years.Therefore,
Minton
and
Wruck
firms
as
low
as
do
(2001). The resultsinthelastcolumn
leverage
classifying
ofTableV, PanelB indicatethatthebasicstorybehindourresultsholds.The financialflexibility
a conservative
attained
more
through
leveragepolicyseemstoenablefirmstoinvestsignificantly
inthefollowing
of
the
definition
of
years,irrespective
leverage.12

F. Long-Run Performance Analysis


As we discussedabove,somepapershavesuggestedthatmanagershavea tasteforlow debt
ratiosas a consequenceof theirlack of diversification
(Fama, 1980). However,managersmay
also use highleverageinstrumentally
to reducetheriskof takeover(Bergeret al., 1997) or to
13
ofboth
pursueempirebuildingprojects(Zwiebel,1996). In otherwords,themaindeterminant
conservative
rather
thanfinancial
entrenchment,
leverageandhighinvestment
maybe managerial
To sortoutthesevariouspotential
we use threealternative
tests.
influences,
flexibility.
to controlforequityagencycosts,we rerunall theanalysisbeginning
with
First,in an attempt
theleveragemodelandincluding
and
characteristics
Column
ownership governance
(TableI,
3).
The results(notreported
forbrevity)
are in linewiththosepresented
thusfar.Forinstance,
the
economicimpactoftheFF dummy
calculatedon threeyearsof SDC is approximately
38%.
onlong-run
This
Second,we examinetheimpactoffinancialflexibility
performance. allowsus
totestdirectly
whether
theflexibility
and
abnormal
investments
aregoodforshareholders.
policy
IftheFF companiesinvestmorebecauseofmanagerial
entrenchment
then
(i.e.,empirebuilding),
we shouldfindthattheyunderperform
inthelongrun.Conversely,
iftheincreasein investment
is valueenhancing,
thenwe shouldsee thesecompaniesoutperforming
themarket.
We proceedin twosteps.First,we testforlong-run
after
performance companiesacquireFF
status.Second,weperform
thesametest,butwe studylong-run
afterFF firmsmake
performance
abnormalinvestments
as definedabove.
TableVI reports
time-series
estimates
ofpfffromboththeCAPM andtheFamaandFrench
model.
FF
firms
are
defined
over
three
theresults
(1993)
yearsoflowleveragestatus.Wepresent
withFF statuscalculatedusingboththetargeting
andthepercentile
method(PanelA).
across
Overall,theresultsindicatethat,afteracquiringFF status,FF firmsdo outperform
different
measures(24, 36, and60 months,
PanelA). Thissupports
ouroriginalhypothlong-run
esis thatthelow leveragepolicywe capturecreatesvalue,and is indeeddrivenby an efficient
investment
rather
thanmanagerial
entrenchment
behavior.
Forinstance,
forward-looking
strategy
whenwe considertheFamaandFrench(1993) three-factor
the
model,FF companiesoutperform
market
a mateby an averageof 30 basis pointspermonth.In economicterms,thisrepresents
rialexcessreturn
of about7.1% in thefirsttwoyears.Further
resultson long-run
performance
abnormal
investments
forthisinterpretation
following
providestrong
support
(PanelB). Jensen's
ofthemethodfollowed
(1986) alphais alwayspositiveand statistically
significant,
irrespective
Wealso test,butdo notreport
forbrevity,
ourinvestment
hypotheses
usingtheEulerequationas opposedtotheq-model.
in fixedassetswithinvestments
Also,in another
in R&D to obtaina proxyfor
test,we combineinvestment
unreported
"totalinvestment."
All resultsarein linewiththosepresented
inthetables.
13In a recent
role thatdebt(along withincentivecompensation)
paper,Zhang(2009) discussestheimportant
has in
overinvestment.
limiting

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FinancialManagement Winter201 0

1360

Table VI. Long-Run Performance


Thistablepresents
of alphasfromCAPM and Famaand French(1993) three-factor
time-series
estimates
forequallyweighted
offinancially
flexiblefirms(FF3).
regressions
portfolios
RpFFj

~~
Rf,t= apFF + pFF(Rm,t Rf,t)+ GpFF,t

~
RpFF,t Rf,t= ClpFF+ bpFF (Rm,t Rf,t) + SpFFSMBt + hpFFHMLt + 6pFFj.

of all firmsidentified
as financially
of theequallyweightedportfolio
RpFFj denotesthemontht return
24 (36 or60) months;
billrateconverted
flexible
Treasury
Rftis theUK three-month
(pFF) inthepreceding
to a monthly
rateof return;
thereturnon theFTSE All ShareIndexin montht; SMBt
Rm,trepresents
ofsmallandlarge(highandlowbook-to-market)
difference
betweena portfolio
firms,
(HMLt)is thereturn
whichareproxiedbytheFTSE SmallCap and FTSE 100 Indexes(FTSE GlobalValueandFTSE Global
flexiblefirms.It is a dummyequal to one if a companyhas a
GrowthIndexes).FF refersto financially
firmsforthreeconsecutive
negativedeviationfromitstargetlargerthanat least10% ofall undershooting
investment
data.
ofthreeyearsof industry-adjusted
is definedovera pattern
Investment
years.Abnormal
is calculatedintheextreme
Theaveragevalueofinvestments
years(i.e.,(AdjIt-' + AdjIt+')/2).Thus,there
valuein thecentralyearis at leasttwicetheaverageofthe
is a spikeinthispattern
onlyiftheinvestment
areinparentheses.
extremes.
Thejp-values
Targeting Method

Window

CAPM ot'

Fama and French a

Percentile Method
CAPM a

Fama and French a

StatusIs Acquired
FinancialFlexibility
PanelA. Long-Run
After
Performance
+24 months
+36 months
+60 months

0.00323
(0.015)
0.00287
(0.025)
0.00245
(0.043)

0.00297
(0.000)
0.00246
(0.003)
0.00168
(0.030)

0.00364
(0.011)
0.00346
(0.014)
0.00307
(0.021)

0.00335
(0.007)
0.00315
(0.006)
0.00217
(0.020)

Investments
Abnormal
PanelB. Long-Run
After
Performance
+24 months
+36 months
+60 months

0.00380
(0.008)
0.00353
(0.011)
0.00344
(0.010)

0.00552
(0.025)
0.00438
(0.046)
0.00232
(0.044)

0.00405
(0.008)
0.00389
(0.008)
0.00373
(0.007)

0.00240
(0.048)
0.00208
(0.045)
0.00185
(0.038)

in thiscase. FF firmsseemto
The economicimpactis even stronger
to classifyFF firms.14
13.24%.
themarket
byapproximately
outperform
theacquisitionof the
following
Third,in TableVII we examinethechangesin profitability
investment
thecreationof abnormal
FF status(Panel A) and following
(Panel B). The results
intheirprofitability
increase
an
ourpreviousevidence.Companiesappeartoexperience
confirm
more
ofmorethan18% aftertheFF statushas beenacquiredbut,
theyare able to
importantly,
two
within
boostof about38% in operating
yearsfromthe
performance
generatea remarkable
timeoftheirabnormalinvestment.
wherethisis
ofabnormalinvestment
definition
robustness
14For
purposes,we repeatedtheanalysisusingan alternative
median.The resultsarelargelyunaltered.
aboveindustry
definedas investments

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Marchica & Mura Financial Flexibility,Investment Ability,and Firm Value

1361

Table VII. Long-Run Profitability


Thistablepresents
ofFF firmsbeforeandafter
percentage
changesinProfitability
(operating
performance)
theFF statusis acquired(PanelA) or afterabnormalinvestments
havebeenmade(PanelB). FF refersto
flexiblefirms.It is a dummy
financially
equal to one ifa companyhas a negativedeviationfromitstarget
firmsforthreeconsecutive
is
largerthanat least 10% of all undershooting
years.AbnormalInvestment
definedovera pattern
ofthreeyearsofindustry-adjusted
investment
data.Theaveragevalueofinvestments
is calculatedin theextreme
years(i.e., (AdjIt-' + Adjlt+')I2).Thus,thereis a spikein thispattern
onlyif
theinvestment
valueinthecentralyearis at leasttwicetheaverageoftheextremes.
is theratio
Profitability
ofearnings
beforeinterest,
tax,anddepreciation
(EBITD) to totalassets.
Level at
- 1

% Change
between
f - 1 and
t+ 1

Test of Difference % Change


in Means f - 1
between
versus t + 1
f- 1
and
f+ 2
(p-value)

Test of Difference
in Means t - 1
versus t + 2
(p-value)

PanelA. Profitability
aroundtheFinancialFlexibility
StatusAcquisition
Profitability
Targeting
Method
Profitability
Percentile
Method

0.094

13.81%

(0.000)

18.32%

(0.000)

0.110

4.71%

(0.000)

10.51%

(0.000)

PanelB. Profitability
aroundtheAbnormal
Investments
Profitability
Targeting
Method
Profitability
Percentile
Method

0.092

18.10%

(0.000)

38.32%

(0.000)

0.118

7.71%

(0.000)

29.78%

(0.000)

III. Conclusion
In thispaper,we studytheinteraction
betweenfinancialflexibility
andinvestment
Our
ability.
based
on
the
ideas
of
that
argument,
ModiglianiandMiller(1963) andMyers(1984), maintains
inthepresenceoffinancialconstraints,
firmsthatanticipate
valuablegrowth
optionsinthefuture
reservesofborrowing
respondbyaccumulating
power.Througha conservative
leveragepolicy,
maintain
a
thatallowsthemto havebetteraccess to
companies
degreeof financialflexibility
theexternal
market
whenfacedwithpositiveshocksto theirinvestment
set.Recent
opportunity
studies
thedeterminants
ofcapitalstructure
to thisviewin
survey
regarding
givestrongsupport
thatfinancialflexibility
is systematically
as themostimportant
factoron whichCFOs
reported
base theirleveragedecision.
Ourintertemporal
offirmbehaviorcorroborates
thesehypotheses.
Aftera period
investigation
ofleverageconservatism,
FF firmssignificantly
increasetheircapitalexpenditures
withrespect
topreviousyears.Mostnotably,
we identify
a sharpincreaseintheirabnormalinvestments.
Our
resultsindicatethatfirmsfinancethisinvestment
withpositivenetdebtissues.

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1362

FinancialManagement Winter2010

The resultsof ourempiricaltestsare also consistent


withourpredictions.
We reportstrong
evidenceofsignificant
linksbetweenfinancing
andinvestment
decisions.Ourfindings
indicate
thataftera periodof sparedebtcapacity,FF firmsare able to investsignificantly
more.We
thattheimpactof theflexibility
factoris sizablein economicterms.An average
demonstrate
firmis able to increaseitsinvestment
37%. This is an important
result,and
by approximately
conservative
itprovidesa rationaleformanyfirms'apparent
leveragebehavior(Graham,2000;
MintonandWruck,2001; Almeida,Campello,andWeisbach,2009).
are an
theseinvestments
We also perform
a long-run
analysisto testwhether
performance
find
We consistently
valueenhancing.
of"empirebuilding,"
as opposedto genuinely
expression
themarket
andexperience
an increaseinoperating
thatfirmsclassifiedas FF tendtooutperform
methodfollowedto
in subsequent
years.Thisresultis robustto theclassification
performance
classifyfirmsas FF.
similarresultstoours.Theyreport
In a recentworking
paper,DenisandMcKeon(2009) report
evidencethatcompaniesuse sparedebtcapacitytomeetlargepositiveshockstotheirinvestment
to oursampleof UK companies,theirsetof US
and similarly
sets.Subsequently,
opportunity
firms(slowly)rebalancetheirleveragetowardthelong-term
target.
Overall,ourresultsofferstrongempiricalsupportforthesurveyevidenceand indicatethat
in theformof untappedreservesof borrowing
financialflexibility,
power,is a crucialmissing
withDeAngelo,
In particular,
ourevidenceis broadlyconsistent
linkin capitalstructure
theory.
to respondto
debt
firms
use
In
their
Whited
and
model,
capacity
spare
(2010).
DeAngelo,
them
while
investment
with
needs
associated
shocks,
allowing
anticipated
imperfectly
"funding
cashbalances."Thisis consistent
toeconomizeonthecostsofissuingequityandofmaintaining
theex
modelinwhichtheoptimaldebtlevelfora firmincorporates
witha "modified"
trade-off
firm's
ex
ante
The
future
costof borrowing
anteopportunity
optimum
underinvestment).
(i.e.,
thevalueoftheoptionofusingdebtcapacityto borrowex postandto move
debtlevelreflects
fromtargetleverageto meetimperfectly
buttemporarily,
funding
anticipated
away,deliberately
needs.

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