Investment, Cash Flow and Financing Constraint: An Error Correction and Euler

Equation Approach

Bikash Shrestha
bikashshrestha@kcm.edu.np
Abstract
Financing corporate investment has been shown to be mostly affected by financial
factors. A debate over whether investment-cash flow sensitivity reflects financing frictions
or something else has been ongoing for many years with no real resolution. The study
tests the financing constraint hypothesis controversy based on the Error Correction and
Euler –Equation Model. The study hypothesizes that high sensitive and small firms should
have a positive and greater investment cash flow sensitivity in compare to low sensitive
and large firms. Using panel data of 190 NEPSE listed non-financial Nepalese firms over
the period of 2004 and 2013, representing nineteen firms, four industry types. The
investment and financing behavior of the firms classified as high sensitive and small have
the positive and higher level of coefficients of investment cash flow sensitivity and such
firms appear to be the most financially constrained in Nepalese context. Cash flow, sales
growth and debt level are considered to be the determinants of capital investment at least
for the high sensitive and small firms.
Keywords: Investment, Cash flow, Financing constraints, Sensitivity.

At firm-level business investment, there has been an awareness on the significant

role of financing constraints (Myer & Kuh, 1957). A large and growing body of literature
aimed to develop an adequate proxy to measure the degree of financing constraints a firm
might face. Financing constraints are at the center of a vast literature and studies on the
sensitivity of corporate investment to a firm’s cash flow have been focused since last
century (Myers & Majluf, 1984). The focus of empirical literature on the relation
between investment and internal finance is on the influence of financing constraints.
Most studies in the field estimate investment-cash flow sensitivities (ICFS), defined as
the investment response due to a change in cash flow as financing constraint. An
expansive and developing assortment of writing planned to build up a sufficient
intermediary to gauge the level of financing limitations, a firm may confront by assessing
speculation income affectability characterized as the venture reaction because of an
adjustment in income. Investment–cash stream affectability has been deciphered as an
essential flag of budgetary limitations (Fezzari, Hubbard, & Peterson, 1988). Policy
makers and econometrists want to know whether the investment expenditure of a firm is

1
determined by the availability of its internal cash flow, debt level and sales growth and if
it is, to what extent and how it is determined.

Review of literature

There are two prominent schools of thought regarding measurement of financing

constraints. Numerous researches around the globe are directed to test the applicability of
these thoughts. However, literature is ambiguous whether this influence has a positive or
a negative effect on the relationship and it has in fact become the topic of a spirited
debate in recent years (Hubbard, 1998). The writing recording the affectability of firms'
investment to changes in their inward supports i.e. cash flow, initiated by (Fezzari,
Hubbard, & Peterson, 1988) , is large and growing. They viewed firms as constrained
when external financing is too expensive as in such case, firms must use internal funds to
finance their investments rather than to pay out dividends and identified firms with low
dividends as “Most constrained” and firms with high dividends as “Least constrained.”
They presented evidence consistent to the hypothesis that the sensitivity of a firm’s
investments to its internally generated cash flow is higher by showing that firms having
low dividend payout (their proxy for financial constraints) had higher investment-cash
flow sensitivities than high dividend paying firms. The financing constraint was
measured by the coefficient obtained by regressing investment on cash flow by
controlling for investment opportunities using Tobin’s q and named it investment cash
flow sensitivity. Several studies following (Schiantarelli, 1996); (Hovakimian, 2009);
(D'Espallier, Vandemaele, & Peeters, 2008); (Denis, 2010); (Shrestha, 2015) provided
supporting evidence, using data from a variety of contexts to conclude investment–cash
flow sensitivity as an important signal of financial constraints.

On the other hand, (Kaplan & Zingales, 1997) identified firms without access to
more funds than needed to finance their investment as “Likely constrained” and firms
with access to more funds than needed to finance their investment as “Never
constrained”. Their empirical findings indicate, in contrast, that investment is most
sensitive to internal cash flow for the least constrained firms and should be lower for a
more constrained firm i.e. the investments of “Likely constrained” firms are less sensitive
to cash flows than the investments of “Never constrained” firms. They presented

2
evidence conflicting with the general notion that investment cash-flow sensitivity is a
positive function of the degree of financial constraints and concluded that firms with
ample cash reserves are not really financially constrained, since they can use it to take
desired projects. This was the (Kaplan & Zingales, 1997) disagreement with (Fezzari,
Hubbard, & Peterson, 1988) interpretation. (Vogt, 1994); (Athey & Laumas, 1994);
(Bond & Meghir, 1994); (Gilchrist & Himmelberg, 1995); (Kadapakkam, Kumar, &
Riddick, 1998); (Ericsson & Whited, 2000); (Almeida, Campello, & Weisbach, 2004);
(Bond, Harhoff, & Reenen, 2005) and (Cummins, Hassett, & Oliner, 2006) further
extended similar investment-cash flow sensitivity model by considering differing
measures of firm sizes under distinct institutional arrangement and questioned the
relevance of investment – cash flow sensitivity as an indicator of financial constraints.
This contradicting empirical evidence has inspired many studies to revisit the theoretical
evidence and identify several theoretical and methodological problems that affect the
ICFS-approach. Despite many efforts to resolve these methodological issues, there seems
to be growing disagreement on the usefulness of the ICFS-metric.

The studies undertaken in the concerned area have focused on the investment cash
flow sensitivity as a measure of financing constraints faced by firms of developed
financial market across various firms’ categories. On this contrary, this study is directed
towards unveiling the ambiguous nature of the evidence regarding the pattern of
investment-cash flow sensitivity i.e. whether the investment expenditure of a firm is
determined by the availability of its internal finance, and if it is, to what extent and how it
is determined by the availability of its internal cash flow and determining the
determinants of investment in the Nepalese context.

Objectives of the study

The major objective of this study is to explore the controversy of investment cash
flow sensitivity as a measure of financing constraints in Nepalese context. The specific
objectives of the study are to determine the determinants of capital investment and to
analyze the effect of cash flow, debt level and sales growth on the capital investment of
Nepalese nonfinancial firms for whole sample and across high vs. low sensitive and large

3
vs small firms, classified on the basis of firm level estimates of ICFS and the mean value
of total annual sales.

Research design
The research design adopted in this study consists of descriptive and causal
comparative to deal with the issues raised in this study. Descriptive research design
includes fact-finding enquiries of different kinds. It is undertaken in order to ascertain
and be able to describe the present characteristics of the variables of interest and causal
comparative research design has been adopted to oversee the role of financing
constraints, debt level and sales growth in the capital investment across low vs high
sensitive and large vs small firms.

Population and sample of the study

All the Nepalese companies from manufacturing and processing, hotel,
hydropower and trading sectors listed in the Nepal Stock Exchange (NEPSE) has been
taken as the population of the study. The sample selected for the study includes nineteen
enterprises using judgmental sampling. The study does not cover the enterprises from
banking, finance and insurance sectors listed in NEPSE and the other private sectors
enterprises which have the huge influential role in the Nepalese economy and it is one of
the limitation of this study. The final sample has a balanced panel dataset of 190
observations representing nineteen non-financial firms, constituting of about 48 per cent
of the total population. The number of observations for each firm is 10 between 2004 and
2013 (Table 1). In order to be included in the sample, firms had to meet two criteria.
Firstly, only the NEPSE listed non-financial firms were considered as the sampling
frame. Finally, only firms that had complete data for capital expenditures, current cash
flows, beginning-of-period net fixed capital, beginning-of-period market-to-book ratio,
dividend payment and other variables under study for every year of the study period
considered had been selected. The majority of existing studies on the effect of internal
funds on investments focus on non-financial firms i.e. specially manufacturing firms and
the study follows the same practice to facilitate comparison.

4
Firm level estimates of ICFS
Firm-level ICFS model has been used to determine the ex-ante identification of
firms as high and low sensitive firms for each firm on each year of study period for 19
firms under study, that would demonstrate significantly different levels of investment-
cash flow sensitivity under the traditional investment regression approach (Hovakimian,
2009). The construction of ICFS is analogous to the external financing weighted average
market-to-book ratio (Baker & Wurgler, 2002).

⁄
( ⁄ ) ⁄ (1)

In (1), n is the number of annual observations for firms during the study period,
CF denotes cash flow, defined as the sum of the earnings before interest and tax and
depreciation and amortization, and I represent investment, defined as capital expenditures
for firm during the period. Both variables are standardized by K, which is the beginning-
of-period net stock capital/value of total assets. The basis for classifying firms is the
mean value of all sample ICFS. The individual firm with higher the value of mean ICFS
is categorized as high sensitive firms and vice versa. The main interest of the study
centers on the correlation coefficient of cash flow with investment in the correlation
analysis. This coefficient represents the investment-cash flow sensitivity. The study
expects the higher coefficient of cash flow with investment for high sensitive firms in
compare to low sensitive firms.

Splitting firms as per information asymmetry

To allow for comparison with previous studies, the study also classifies firms
according to the degree of asymmetric information problems they face in the financial
markets. According to this criterion, it is assumed that larger firms face fewer asymmetric
information problems in financial markets, thus are less subject to financial restrictions.
The decision to split the sample according to size is justified as follows. Firstly, larger
firms have an easier access to capital markets, due to the possibility of using the firm’s
assets as collateral. Secondly, it is likely that transaction costs for new share or bond
issues decrease according to size. Thirdly, larger companies can use more different

5
sources of funding than small companies, which allow large companies to reduce the risk
of financing. Finally, it is likely that small firms suffer more from the idiosyncratic risk.

A total annual sale is used to represent size of firms. A firm has been included in
the group of large firms if it has a value greater than mean total annual sales for all the
firms under study, else wise in the group of small firms. Firms with greater size
command more resources and get more analysts’ coverage than firms with smaller size.
Hence, they are less likely to be constrained by internal cash flow.

The models

I. Error-correction model
The error-correction model adopted in the study follows the one proposed by
(Bond, Elston , Mariesee, & Mulkay , 2003).
Iit/Kit-1 = b1(Iit-1/Kit-2) + b2ΔlnSalesit + b3ΔlnSalesit-1 + b4(lnKit-2 –lnSalesit-2) + eit (2)

Where I represent the firm’s investment in fixed assets; K is the firm’s stock of capital;
ΔlnSales corresponds to the natural logarithm of sales growth; lnK is the natural
logarithm of the stock of capital and (eit) is the error term. The subscripts i and t
correspond to firm and time, respectively. In order to analyze the impact of internal funds
on investment decisions of firms, they further suggested to add current and lagged cash
flow (CF) to (2). In this study, the lagged debt (D) variable has also been included.
Hence, the investment equation becomes:

Iit/Kit-1 = b1(Iit-1/Kit-2) + b2ΔlnSalesit + b3ΔlnSalesit-1 + b4(lnKit-2 –lnSalesit-2) + b5(CFit/Kit-

1) + b6(CFit-1/Kit-2) + b7(Dit-1/Kit-1) + eit
(3)

The intuition behind including a cash flow in the specification, relates to its ability
to relax binding financing constraints. Therefore, the main interest of study centers on b5
and b6 in equation (3). These coefficients represent the investment-cash flow sensitivity.
A firm that is unconstrained and large is indifferent between using internal or external
sources of financing since there is no difference in the cost of the funds. On the other
hand, a financially constrained and small firms facing higher cost of external financing,
or suffering from capital rationing, is not indifferent to the source of financing and

6
prefers the use of less expensive internal funds to using more expensive external funds. If
such a firm generates larger cash flow in a period, it will be able to invest more and vice
versa. The wedge in the cost of internal and external financing makes internal funds the
first choice of financing and generates a positive relationship between investment and
cash flow. Unconstrained and large firms have the freedom to optimally adjust its
investment according to its investment opportunities measured by sales growth.

As far as the expected relationship between the dependent variable and the
explanatory variables is concerned, a positive relationship between the following
variables would be expected:
(i) Investment (I) and sales growth (ΔLnSales).
(ii) Investment (I) and cash flow (CF). However, it is expected a differentiated impact (in
terms of magnitude) of cash flow on investment expenses of firms, depending on the
classification criteria adopted.

On the other hand, a negative relationship would be expected:

(i) Between firms’ investment (I) and the error-correction term (kit-2 – sit-2). In fact, when
the capital stock is above its desired level, it is expected a lower investment in the future.
(ii) Between firms’ investment (I) and its debt level (D). This can be explained by the fact
that the greater the debt the greater the proportion of operating earnings devoted to
service debt, and less funds are left for investment.

II. Euler-equation model

Another specification adopted for the econometric investment equation is based on
the Euler approach. Moreover, the Euler equation approach takes into account explicitly
the recurrent nature of a firm’s decisions and reduces the information conditions to those
necessary to determine the optimal course of investment, using the information available
in each period (Palenzuela & Iturriaga, 1998).The empirical specification adopted for the
econometric investment equation is based on (Bond & Meghir, 1994):

(I/K)it = b1(I/K)it-1 + b2(I/K)2it-1 + b3(CF/K)it-1 + b4(S/K)it-1 + b5 (D/K)2it-1 + eit

(4)

7
 Where I represent the firm’s investment in fixed assets; CF is cash flow; S
corresponds to sales; and D is debt of the firm. All variables are divided by the stock of
capital (K) to address the problem of heteroscedasticity and (eit) is the error term. The
subscripts i and t correspond to firm and time, respectively. Under the null hypothesis of
no financing constraints, it would be expected the following signs for the parameters
estimates: b1 > 1; b2 <0; b3 < 0; b4 > 0; and b5 > 0. Under the alternative hypothesis,
investment spending is positively related to cash flows through the effect of financing
constraints.

Reliability analysis

The variables developed using the multi-item scales have to be evaluated for their
reliability. In the study, the assessment of the reliability of the variables generated using
multi-item scales is carried out by using Cronbach’s alpha. The table one summarizes the
values of Cronbach’s alpha for the multi-item scales variables used in the study. The
reliability value of asset tangibility, leverage, cash flow, dividend payout ratio, market to
book ratio, interest coverage, probability of bankruptcy, and investment cash flow
sensitivity are observed to be 0.652, 0.633, 0.716, 0.641, 0.597, 0.643, 0.822 and 0.758
(Table 2) respectively and are observed to be higher than the prescribed acceptance value
(Cronbach, 1951); (Bagozzi & Yi, 1988); (Nunnally & Bernstein, 1994).

Analysis of data

Twelve of the 19 selected firms were observed to be low and seven firms were
high sensitive with the ICFS mean value of 0.022 and 0.413 respectively (Table 3). The
cut off value was the 0.166, mean of ICFS for whole sample firms (Table 4) for
determining the firms as high and low sensitive firms. The trading sector enterprises
namely Salt Trading Ltd. and Bishal Bazaar Company Ltd. are observed to have negative
cash flow sensitivity values of -0.019 and -0.061 respectively (Table 3). The main interest
of the study centers on the coefficients of cash flow with investment and on debt level
and sales growth.

The table five exhibits the mean difference in FA/TA (asset tangibility) to be
insignificant and the mean difference in TD/TA (leverage), CF (cash flow), investment,

8
dividend payout, market to book ratio (proxy for growth opportunities), interest coverage,
PB or Z score (proxy for probability of bankruptcy), ICFS, size (measured in terms of
total annual sales), and age are observed to be significant at 0.001 level of significance
across the high and low cash flow sensitive firms whereas the mean differences for all the
variables are observed to be significant across large and small firms.

The regression analysis (Table 6) for the whole sample firms and the firms
classified as per the ICFS. Panel A depicts the regression results using the error
correction model and panel B depicts the regression result using Euler equation model.
As seen in panel A, internal cash flows have an impact on investment of all the samples
under study with the coefficients of current cash flow (0.117) and lagged cash flow
(0.072) and are significant at five and one per cent level of significance respectively. The
impact of internal cash flows on investment expenses of constrained firms is higher
(0.507) and significant than for the unconstrained firms (0.267). In fact, for high sensitive
firms, the estimated coefficient on the cash flow variable is almost double than that for
low sensitive firms.

As expected, the coefficients on the error correction term are negative for all
samples, unconstrained and constrained firms. The coefficients of investment and its debt
level is found to be negative and significant for all sample firms and high sensitive firms,
which can be explained by the fact that the greater the debt, the greater the proportion of
operating earnings devoted to service debt, and less funds are left for investment.
However, the coefficient of investment and debt level of the low sensitive firm is found
to be positive (0.065) but insignificant.

The Euler equation assumes that, in the absence of financing constraints, the
parameter of the cash flow variable should be negative and the parameter of the debt
variable should be positive. From the panel B in (Table 6), it is observed that the
coefficients of cash flow and the debt level for investment is 0.172 and -0.0047 which are
significant at one per cent level of significance, indicating that Nepalese non-financial
firms are financially constrained when studied at the aggregate level. However, when the
sample is segregated on the basis of ICFS, the low sensitive firms are observed to be in
the absence of financing constraint as the coefficient of cash flow is -0.025 and the

9
parameter of the debt level variable is 0.016 though both the coefficients are insignificant
but the coefficients of cash flow and debt level to investment is found to be 0.213 and -
0.096 both significant at one per cent level of significance indicating that firms highly
sensitive to cash flow are more financially constrained.

As seen in panel A (Table 7), internal funds have an impact on investment

expenses of firms that face more severe information problems in financial market. The
coefficient of cash flow for small and large firms is 0.315 and 0.162 and observed to be
significant. In fact, for small firms, the estimated coefficients on the cash flow variable is
almost double than that for large firms. The coefficients of investment and its debt level
is found to be negative and significant for small firms with the values of -0.104, which
can be explained by the fact that the greater the debt, the greater the proportion of
operating earnings devoted to service debt, and less funds are left for investment.
However, the coefficient of investment and debt level for large firms are positive and
insignificant. The coefficients of one lagged sales and two lagged sales are also positive
and significant for small firms with lower coefficients for large firms supporting the
findings that the sales of the firms have positive effect on the investment in capital
expenditures of the firms.

The coefficient of lagged investment is observed to be positive and significant for

large firms with the values of 0.304, however the coefficients for small firms of lagged
investment is negative but insignificant. In fact, when the capital stock is above its
desired level, it is expected a lower investment in the future. As expected, the coefficients
on the error correction term are negative for small firms. The output from Euler equation
of panel B (Table 7) reveals that the parameter estimates of cash flow variables for large
firms is insignificant with values of -0.049 and the parameter estimates of debt level for
such firms is found to be positive which fulfills the assumptions of Euler equation model
of the absence of financing constraints. The parameter estimates of cash flow and debt
level of the small violate the assumption of Euler equation model, thus are considered the
financially constrained. The result is further supported by the higher coefficient of lagged
coefficient of investment for large (2.328) in compare to small (1.536).

10
Major findings

The study attempted to test the investment practices among the Nepalese non-
financial firms with special emphasis on role of financing constraint, debt level and sales
growth on capital investment. Based on the analysis of the collected data, the major
findings of the study are summarized as:

1. The mean capital investment expenditure, cash flow, ICFS, size, age, debt level,
interest coverage and probability of bankruptcy between high and low sensitive
firms are observed to be significantly different except asset tangibility and mean
values all the variables under study are significantly different across large and
small non-financial Nepalese enterprises.
2. The error correction regression coefficients of cash flow on capital investment is
observed to be positive, higher and significant for high sensitive firms, suggesting
these firms are more financially constrained in compare to low sensitive firms
(0.507 and 0.267 respectively) and (0.164** and 0.121 respectively). Similarly,
the coefficients were observed to be (0.315* and 0.162 and 0.289 and 0.114)
respectively for effect of cash flow on capital investment across small and large
firms. These evidences support the hypothesis propounded by (Fezzari, Hubbard,
& Peterson, 1988) in Nepalese context and contradicts the (Kaplan & Zingales,
1997) findings.
3. The role of sales growth and debt on capital investment of the firms were
observed to be significant with coefficients of 0.112* and -0.113* respectively for
high sensitive firms, indicating the capital investment of such firms positively
depends on sales growth and inversely depend on the debt level. The similar result
was observed for small firms with the coefficients of 0.371* and -0.104*.
Whereas, the coefficients were 0.086* and 0.065 for low sensitive firms and
0.102* and 0.017 large firms.
4. The Euler equation regression coefficients of cash flow, sales and debt level were
observed to be 0.213, 0.102* and -0.096* respectively for high sensitive firms
whereas -0.025, 0.028* and 0.016 were observed respectively for low sensitive

11
 firms. It clearly shows the high sensitive firms are more financially constrained
than the low sensitive firms.
5. The similar results were observed from Euler equation regression, with the higher
coefficients for small firms for the variables cash flow, sales and debt level
(0.108*, 0.127* and -0.007 respectively) against the result of -0.049, 0.085***
and 0.073 for large firms, which clearly supports the findings of (Fezzari,
Hubbard, & Peterson, 1988) in financing constraints hypothesis controversy in
Nepalese context.

Discussion

The regression coefficients of cash flows using Error correction model is observed
to be positive, higher and significant (0.507) for high sensitive firms as compared for low
sensitive firms (0.267). As expected, the coefficients on the error correction term are
negative both; low (-0.128) and high sensitive firms (0.316). This obtained result is
consistent with the findings of (Bond, Elston , Mariesee, & Mulkay , 2003), who had the
intuition behind including a liquidity variable in the Error correction specification, i.e.
cash flow, relates to its ability to relax binding financing constraints. The Euler equation
regression coefficient of cash flow on investment is observed to be positive and
significant (0.213) for high investment cash flow sensitive firms whereas the coefficient
is observed to be negative but insignificant (-0.025) for low sensitive firms. The
regression coefficient of total debt for high sensitive firm is observed to be negative and
significant (-0.096) for high sensitive firms however the coefficient for low sensitive
firms is observed to be positive but insignificant (0.016), fulfilling the assumptions of
Euler equation that, in the absence of financing constraints, the parameter of the cash
flow variable should be negative and the parameter of the debt variable should be
positive.

For robustness check, using Error correction model further confirms that the small
firms in terms of annual sales are financially constrained as they tend to have higher
coefficient of cash flow (0.315) respectively as in particularly described by (Fezzari,
Hubbard, & Peterson, 1988) in compare to 0.162 for large firms. Using Euler equation

12
model, the regression coefficient of cash flow is also observed to be positive and
significant with value of 0.108 for small firms, whereas the coefficient is observed to be
negative but insignificant for large firms. Similarly, the regression coefficient of total
debt is observed to be negative and significant with values of -0.007 for small firms,
however the coefficients for large firm is observed to be positive but insignificant,
fulfilling the assumptions of Euler equation that, in the absence of financing constraints,
the parameter of the cash flow variable should be negative and the parameter of the debt
variable should be positive.

The obtained data result from both the regression equations does not corroborate
the argument of (Kaplan & Zingales, 1997) suggesting that investment expenses of
financially distressed firms could be sensitive to cash flow variations. These finding gives
support to the hypothesis of the existence of financing constraints on financial markets at
least for certain types of firms, which is clearly in accordance with consistent findings of
(Fezzari, Hubbard, & Peterson, 1988), (Bond & Meghir, 1994), (Gilchrist &
Himmelberg, 1995), Schaller (1993), (Vogt, 1994), (Schiantarelli, 1996) and (Almeida,
Campello, & Weisbach, 2004) . Thus, at least in Nepalese context, the managers of the
non-manufacturing firms should consider the cash flow, debt level in order to make the
investment decision

Conclusion

By estimating firm-level investment-cash flow sensitivity and using them to

classify into the groups of high and low sensitivity firms and by further classifying the
firms on the basis of asymmetric information problems they face in the financial markets.
A firm has been included in the group of large firms if it has a value greater than mean
total annual sales for all the firms under study, else wise in the group of small firms in
order to allow for comparison with previous studies. Through the data analysis of the
capital investment and financing behavior of firms, the study concludes that the
investment cash flow sensitivity can be used as the measure of financing constraints as
high sensitive and small firms had high investment cash flow sensitivity (measured by the
coefficient of cash flow) in compare to low sensitive and large firms. These evidences
support the hypothesis propounded by (Fezzari, Hubbard, & Peterson, 1988) in Nepalese

13
context and contradicts the (Kaplan & Zingales, 1997) findings in financing constraints
hypothesis controversy.

Further, the sales growth had positive and significant effect on capital investment
of the samples under study and the coefficients were positive and higher for the high
sensitive and small firms and the debt level had negative and significant effect on capital
investment for high sensitive and small firms, whereas it was observed to be positive and
insignificant for low sensitive and large firms. These evidences support in concluding that
cash flow, sales growth and debt level are the determinants of capital investment at least
for the high sensitive and small firms.

14
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Fixe:Le Cas Espagnol. Revue D'Economie Industrielle, 25-48.
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International Evidence. Oxford Review of Economic Policy, XII, 70-89.
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16
 Appendices
Table 1
Selected Non-Financial Enterprises in Sample1
S.N. Enterprises Study Period Observations
1 Soaltee Hotel Ltd. 2004-2013 10
2 Oriental Hotel Ltd. 2004-2013 10
3 Yak and Yeti Hotels Ltd. 2004-2013 10
4 Taragaon Regency Hotels Ltd. 2004-2013 10
5 Salt Trading Ltd. 2004-2013 10
6 Bishal Bazaar Company Ltd. 2004-2013 10
7 Butwal Power Company Ltd. 2004-2013 10
8 Arun Valley Public Ltd. 2004-2013 10
9 Chilime Hydropower Ltd. 2004-2013 10
10 National Hydro Ltd 2004-2003 10
11 Himalayan Distillery Ltd. 2004-2013 10
12 Nepal Bitumin Ltd. 2004-2013 10
13 Unilever Nepal Ltd. 2004-2013 10
14 Fleur Himalayan Ltd. 2004-2013 10
15 Nepal Khadya Udhyog Ltd. 2004-2013 10
16 Sri Ram Sugar Mills Ltd. 2004-2013 10
17 Nepal Lube Oil Ltd. 2004-2013 10
18 Bottlers Nepal Ltd (Terai) 2004-2013 10
19 Bottlers Nepal Ltd (Balaju) 2004-2013 10
Total 190

1
The sample includes 19 non-financial firms listed in NEPSE. Firms selected as sample for the study represent from manufacturing
and processing, trading, hotel and hydropower sector as classified by NEPSE.

17
Table 2
Reliability Analysis2

Variables Measurement items Cronbach's Alpha

FA/TA 2 0.652
TD/TA 2 0.633
CF 3 0.716
DPR 2 0.641
MBR 2 0.597
CI 2 0.643
Z 5 0.822
ICFS 5 0.758

2
The table depicts the reliability analysis of the major variables under study developed by using multi-item scales. FA/TA (Asset tangibility) is
the ratio of fixed assets to total assets; TD/TA (leverage) is the ratio of total debt to total assets; CF (cash flow) is defined as the sum
of earnings before interest, tax and depreciation and amortization; DPR (dividend payout ratio) is defined as ratio of dividend paid of
firm i during time t to net income of firm i during time t; MBR (market to book ratio) is defined as the ratio between (market value of
equity) / (book value of assets), as of the beginning of the year; CI (interest coverage) is defined as the ratio between EBIT/Interest
expenses as of the beginning of the year, Z is the probability of bankruptcy obtained by using the Altman model and ICFS is the
investment cash flow sensitivity.

18
Table 3
Investment Cash Flow Sensitivity Classification3

S.N. Enterprises ICFS S.N. Enterprises ICFS

Panel A: Low Sensitive Firms Panel B: High Sensitive Firms
1 Soaltee Hotel Ltd. 0.057 1 Taragaon Regency Hotels Ltd. 0.352
2 Yak and Yeti Hotels Ltd. 0.036 2 Himalayan Distillery Ltd. 0.668
3 Salt Trading Ltd. -0.019 3 Nepal Bitumin Ltd. 0.284
4 Bishal Bazaar Company Ltd. -0.061 4 Fleur Himalayan Ltd. 0.473
5 Butwal Power Company Ltd. 0.066 5 Nepal Khadya Udhyog Ltd. 0.343
6 Arun Valley Public Ltd. 0.005 6 Sri Ram Sugar Mills Ltd. 0.369
7 Chilime Hydropower Ltd. 0.049 7 Nepal Lube Oil Ltd. 0.401
8 National Hydro Ltd 0.046
9 Unilever Nepal Ltd. 0.006
10 Bottlers Nepal Ltd (Terai) 0.021
11 Bottlers Nepal Ltd (Balaju) 0.037
12 Oriental Hotel Ltd. 0.019
Mean 0.022 Mean 0.413

3
The table presents the Investment Cash Flow Sensitivity classification, calculated to determine the ex-ante identification of firms as
high and low sensitive firms for each firm on each year of study period for 19 firms under study. The firms with higher the whole
sample mean value of investment cash flow sensitivity (0.166) are considered as high sensitive firms and vice versa.

19
Table 4
Summary of Descriptive Statistics4

Variables Observation Minimum Maximum Mean Std. Deviation

FA/TA (Times) 190 0.030 0.742 0.649 0.279
TD/TA (Times) 190 0.100 0.936 0.726 0.456
Cash Flow (Million Rs.) 190 -72.240 1142.15 263.403 304.212
Investment (Million Rs.) 190 0.000 931.04 73.509 142.147
Dividend Payout (Times) 190 0.000 0.78 0.191 0.225
Market to Book Ratio (Times) 190 0.020 10.43 2.117 1.797
Interest Coverage (Times) 190 0.000 10.23 3.507 2.581
Z 190 -3.800 10.16 3.242 2.861
ICFS Value 190 -0.070 0.72 0.166 0.208
SIZE (Sales) 190 14.790 4619.85 846.725 1018.675
AGE 190 4.000 48.00 21.295 10.510

4
The table summarizes the descriptive statistics of the variables for total sample. FA/TA (Asset tangibility) is the ratio of fixed assets
to total assets; TD/TA (leverage) is the ratio of total debt to total assets; cash flow is defined as the sum of earnings before interest,
tax and depreciation and amortization; investment is defined as capital expenditures for firm i during period t; dividend payout is
defined as ratio of dividend paid of firm i during time t to net income of firm i during time t; market to book ratio is defined as the
ratio between (market value of equity) / (book value of assets), as of the beginning of the year; interest coverage is defined as the ratio
between EBIT/Interest expenses as of the beginning of the year; Z is the probability of bankruptcy obtained by using the Altman
model, ICFS value is the investment cash flow sensitivity, size is the annual sales of the firms under study and age is the number of
years from the time of its incorporation based as per the annual general meetings held.

20
Table 5
Independent Sample t-test across Low and High Sensitive and Large and Small Firms 5

Classification ICFS SIZE

Variables Mean Difference Mean Difference
FA_TA -0.034 0.097**
TD_TA -0.315* 0.210*
Cash Flow 273.477* -454.627*
Investment 67.308* -69.430*
Dividend Payout 0.207* -0.175*
Market to Book Ratio 1.712* -0.082
Interest Coverage 2.812* -0.904**
PB 3.196* -2.462*
ICFS 0.391* 0.174*
SIZE 610.011* -1548.840*
AGE 10.662* -5.027*
*. significant at 0.01 level (2 tailed). **. significant at 0.05 level (2 tailed)

5
The table presents independent sample t-test (mean difference) of portfolios sorted by ICFS and Size for the variables under study.
The basis of sorting the portfolios was the mean value of ICFS and annual sales. The firms with higher the mean values of ICFS
(0.166) and annual sales (846.725) are considered as high sensitive and large firms and vice versa.

21
Table 6
Regression Analysis for all Sample Firms and as per ICFS Classifications6
Panel A: Error Correction Model for All Samples and Firms Classified as per the ICFS
Variables All Sample Low ICFS High ICFS

0.029* 0.074* -0.008

It-1/Kt-2
(22.308) (3.902) (-0.981)
0.577* 0.086* 0.112*
ΔlnSalest-1
(6.985) (7.350) (2.188)
0.124*** 0.113 0.187*
ΔlnSalest-2
(1.816) (1.227) (5.974)
-0.362* -0.128** -0.316*
lnkt-2- ΔlnSalest-2
(-4.629) (-2.162) (-3.830)
0.117** 0.267* 0.507*
CFt /Kt-1
(2.086) (2.837) (4.961)
0.072* 0.121 0.164**
CFt-1/Kt-2
(2.243) (1.373) (2.089)
-0.081* 0.065 -0.133*
TDt-1/Kt-1
(-2.636) (1.090) (-3.634)
Adj. R Square 0.353 0.375 0.534
F Value 12.849 9.819 9.019
Sig. Value 0.000 0.000 0.000
Panel B: Euler Equation Model for All Samples and Firms Classified as per the ICFS
Variables All Sample ICFS Low ICFS High

2.255* 2.123* 1.467*

It-1/Kt-1
(14.085) (9.436) (5.915)
-2.372* -2.686* -1.180*
(It-1/Kt-1)2
(-10.246) (-8.214) (-6.378)
0.172* -0.025 0.213*
CFt-1/Kt-1
(3.568) (-1.113) (3.737)
0.064* 0.028* 0.102*
St-1/Kt-1
(4.238) (2.545) (2.615)
-0.047* 0.016 -0.096*
(TDt-1/Kt-1)2
(-4.196) (1.467) (-5.134)
Adj. R Square 0.437 0.528 0.359
F Value 25.102 24.488 9.896
Sig. Value 0.000 0.000 0.001

*. Significant at 0.01 level (2 tailed). **. Significant at 0.05 level (2 tailed). ***. Significant at 0.1 level (2 tailed).

6
The table depicts the regression analysis for the whole sample and for the firms classified as per the ICFS. The Error-
correction model adopted in this study follows the one proposed by (Bond, Elston , Mariesee, & Mulkay , 2003):
Iit/Kit-1 = b1(Iit-1/Kit-2) + b2ΔlnSalesit + b3ΔlnSalesit-1 + b4(lnKit-2 –lnSalesit-2) + b5(CFit/Kit-1) + b6(CFit-1/Kit-2) + b7(TDit-
1/Kit-1) + eit Where I represents the firm’s investment in fixed assets; K is the firm’s stock of capital; ΔlnSales
corresponds to the natural logarithm of sales growth; lnK is the natural logarithm of the stock of capital and (e it) is the
error term. The subscripts i and t correspond to firm and time, respectively. The Euler equation model adopted for the
econometric investment equation is based on (Bond & Meghir, 1994) : (I/K)it = b1(I/K)it-1 + b2(I/K)2it-1 + b3(CF/K)it-1
+ b4(S/K)it-1 + b5 (TD/K)2it-1 + eit Where I represents the firm’s investment in fixed assets; CF is cash flow; S
corresponds to sales; and D is debt of the firm. All variables are divided by the stock of capital (K) to address the
problem of heteroscedasticity and (eit) is the error term. The subscripts i and t correspond to firm and time, respectively.
The values in parentheses are t-statistics.

22
Table 7
Regression Analysis for Firms as per Size Classifications 7

Panel A: Error Correction Model for Firms Classified as per the Firm Size
Variables Small Large
-0.031 0.304*
It-1/Kt-2
(-1281) (4.288)
0.371* 0.102*
ΔlnSalest-1
(5.189) (2.425)
0.196** 0.097
ΔlnSalest-2
(1.996) (1.622)
-0.549* -0.351*
lnkt-2- ΔlnSalest-2
(-4.388) (-8.032)
0.315* 0.162*
CFt /Kt-1
(3.879) (3.074)
0.289* 0.114
CFt-1/Kt-2
(6.964) (1.560)
-0.104* 0.017
TDt-1/Kt-1
(-3.838) (1.568)
Adj. R Square 0.331 0.621
F Value 8.063 13.155
Sig. Value 0.000 0.000
Panel B: Euler Equation Model for Firms Classified as per the Firm Size
Variables Small Large
1.536* 2.328*
It-1/Kt-1
(4.712) (6.888)
-1.304* -2.161*
(It-1/Kt-1)2
(-7.204) (-22.051)
0.108** -0.049
CFt-1/Kt-1
(2.077) (-1.492)
0.127* 0.085***
St-1/Kt-1
(6.048) (1.882)
-0.007*** 0.073
(TDt-1/Kt-1)2
(-1.795) (0.954)
Adj. R Square 0.437 0.280
F Value 16.865 5.123
Sig. Value 0.000 0.001

*. Significant at 0.01 level (2 tailed). **. Significant at 0.05 level (2 tailed). ***. Significant at 0.1 level (2 tailed).

7
The table depicts the regression analysis for the firms classified as per annual sales. The Error-correction model adopted in
this study follows the one proposed by (Bond, Elston , Mariesee, & Mulkay , 2003) : Iit/Kit-1 = b1(Iit-1/Kit-2) +
b2ΔlnSalesit + b3ΔlnSalesit-1 + b4(lnKit-2 –lnSalesit-2) + b5(CFit/Kit-1) + b6(CFit-1/Kit-2) + b7(TDit-1/Kit-1) + eit Where I
represents the firm’s investment in fixed assets; K is the firm’s stock of capital; ΔlnSales corresponds to the natural
logarithm of sales growth; lnK is the natural logarithm of the stock of capital and (eit) is the error term. The subscripts i
and t correspond to firm and time, respectively. The Euler equation model adopted for the econometric investment
equation is based on (Bond & Meghir, 1994) : (I/K)it = b1(I/K)it-1 + b2(I/K)2it-1 + b3(CF/K)it-1 + b4(S/K)it-1 + b5
(TD/K)2it-1 + eit Where I represents the firm’s investment in fixed assets; CF is cash flow; S corresponds to sales; and
D is debt of the firm. All variables are divided by the stock of capital (K) to address the problem of heteroscedasticity
and (eit) is the error term. The subscripts i and t correspond to firm and time, respectively. The values in parentheses are
t-statistics.

23