PLANNING AND FUNDING

CORPORATE INVESTMENT

LECTURER: TOMISLAV LADIKA

Advanced Corporate Finance Week 1

 How do firms make investment decisions?

• Common rule of thumb: Invest in any project with NPV > 0

• NPV is discounted value of all project cash flows:

–C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + ….

• Discount rate r is opportunity cost of capital, the next-best return

that firm’s investors could receive elsewhere
– returns should be adjusted for differences in risk before comparing

• NPV > 0 ⇒ Project offers higher return than best alternative

investment opportunity
– Do firms follow this rule when making investment decisions?
 Measuring investment opportunities

• Positive NPV means that value created from investment exceeds

the firm’s initial cost of purchasing capital

• Stock market participants should anticipate this, and bid up firm’s

share price even before investment undertaken

• We can measure investment opps by comparing firm’s market

value to purchase price of its assets

• Tobin’s Q = (Market value of firm)/(Replacement cost of capital)

– replacement cost: price firm would have to pay on market for capital
– Market-book ratio is similar, and sometimes used instead
 How to interpret Q
• Firm with Q > 1 generates more value using capital than other
investors or firms would
– internal value of capital higher than what market willing to pay
– Ex: Shipping firm with Q of 1.5 can buy new truck for 100 and use it
to generate NPV of 50

• Firm with Q < 1 is wasting some capital, better off selling assets

• Q numerator often measured as firm’s market cap plus debt

– should use debt’s market value, but often only book value observed
– denominator is book value of total assets, or PP&E
• book values measure prices firm actually paid to buy assets on market
 Brief overview of Q theory

• Firm owns capital K0 and can spend I0 on new assets

– capital depreciates at annual rate δ

• Next year’s profits are V1 = αK1/(1+r), where K1 = I0 + (1–δ)K0

• Firm also pays capital adjustment cost of (I0 / K0)2

– Ex: Operating more machines requires increasing amount of attention
from management
 Firm’s maximization problem

• Firm chooses I0 to maximize:

αK1/(1+r) – I0 – (I0 / K0)2
s.t. K1 = I0 + (1-δ)K0
• To solve, set up Lagrangian and take derivative w.r.t. I0:
L = αK1/(1+r) – I0 – (I0 / K0)2 + q(I0 + (1-δ)K0 – K1)

𝜕L/𝜕I0 = – 1 – 2(I0 / K0)×1/K0 + q = 0

⟹ I0 / K0 = (q – 1)×K0 /2

• Investment ratio positive only if q > 1

 A few technical details

• In the maximization problem, q = 𝜕V1/𝜕K1. So investment depends

on the marginal profits from one extra unit of capital
– But Q measured as average value of capital (total market value
divided by total capital cost)
– Hayashi Theorem shows that average and marginal Q are the same
under plausible conditions

• What happens when firm has no adjustment costs?

– In maximization problem, q = 1 always
– Any change to q > 1 would cause firm to invest infinite amount, since
there would be no net cost to investment
 Empirical evidence on Q theory

Studies have highlighted several problems with Q theory

1. Q explains little of the variation in investment (regression R2
values are low)
2. Regression estimates of Q’s effect are only consistent with theory
if adjustment costs are huge
3. Numerous other variables are significantly related to investment

• In sum, findings imply that Q matters for corporate investment,

but other factors matter more
 Hypothesis 1: Measurement error in Q

• Measurement error could explain lack of empirical evidence

– In OLS regressions, coefficient is biased toward 0 when variable
contains measurement error, and R2 falls as well
– Bias can also lead to significant coefficients on other variables

• Q likely has some measurement error

– market value of equity may be influenced by factors other than
investment opps
– Q should be based on market value of debt, but often book value used
– book value of assets based on historical prices, and may not reflect
current replacement costs
– most intangible assets have value but are not recorded in financials
 Hypothesis 1: Measurement error in Q

• Erickson and Whited (2000) employ advanced statistical technique

to remove measurement error from Q
– Details of procedure are beyond scope of this class

• Main findings:
– R2 more than doubles after accounting for measurement error
– Coefficient estimates on Q are substantially larger than simple OLS
– Estimates of other variables (e.g., cashflows) small and insignificant

• Peters and Taylor (2017) find that Q works much better when
intangible assets are included
Correcting for Q measurement error

Source: Table 4, Erickson, Jiang, and Whited (2014)

Peters and Taylor (2017) main result

Source: Table 2, Peters and Taylor (2017)

 Hypothesis 2: Financial constraints

• Firms must invest C0 up front, and receive cashflows in future

– But where does initial cash C0 come from?

• Young firms start with almost no cash, and are also not profitable
– main way to fund investment is raising external financing
– mature firms typically hold cash and are profitable, but may face very
large upfront investment costs

• If a firm has difficulty raising external financing, it may pass up

investment opps even when Q is high
 Why might raising financing be costly?
• Pecking order theory predicts that investment is cheaper to finance
using internal funds (i.e., cash) than external

• Key reason is asymmetric info: Firm’s managers know its

condition better than external investors
– if managers are trying to reduce ownership stake by selling shares,
then firm could be in bad condition
– using internal cash signals firm believes its projects will be profitable

• Implication: Firms with volatile cashflows should build up internal

funds, to ensure sufficient liquidity during bad years
– Otherwise firm might be forced to pass up profitable investment opps
 Simple example of precautionary savings
• A firm operates for two years. In each year it has access to two
investment opportunities
– Each project i = {1,2} requires investment of Ii and generates return Ri
in next year (projects last only one year)
– Suppose I1 = I2 = I but R1 > R2 (diminishing returns to investment)

• In each year firm receives cashflows CG = 2I with probability ϑ, or

cashflows CB < I with probability 1 – ϑ

• This year, firm is in good state and receives CG. Firm’s problem:
Should it invest all cashflows, or save some for next year?
– cash is saved at risk-free rate of 0, and there is no discounting
 Simple example of precautionary savings
• Suppose firm invests all cashflows in year 1
– Then in year 2, can only invest in good year Too little cash to
– Expected value: Year 1 invest in bad state

E[V] = CG – 2I + R1 + R2 + ϑ[R1 + R2 + CG – 2I] + (1 – ϑ) CB

= (1+ϑ)(R1 + R2) + (1 – ϑ) CB Year 2

• Instead, firm could invest into only project 1 in year 1.

– Saves CS = CG – I = I, so in year 2 can invest in project 1 in either state
Year 2
– Expected value:
E[V] = CG – CS – I + R1 + ϑ(R1 + R2 + CG – 2I + CS) + (1 – ϑ)(R1 + CS – I + CB)
Extra cash not needed in
Year 1 = 2R1 + ϑ(R2 + CS) + (1 – ϑ)(CB) good state, but allows firm
to invest in bad
 Example of precautionary savings (cont’d)
• Firm better off with precautionary savings when:
2R1 + ϑ(R2 + CS) + (1 – ϑ)(CB) > (1+ϑ)(R1 + R2) + (1 – ϑ) CB
⟹ 2R1 + ϑ(R2 + I) > R1 + R2+ϑR1 + ϑR2
⟹ R1 – R2 > ϑ(R1 – I)

Expressions show firm saves precautionary cash CS when:

1. Second project’s return much lower than first
– value of additional investment in good state is less than saving cash
2. Probability of good state (ϑ) is low
– firm has high likelihood of being constrained in future
 Empirical evidence on financial constraints

• Fazzari, Hubbard, and Petersen (1988) provide early evidence that

financial constraints affect investment

• Split firms into three groups based on dividend payouts

– Firms that pay dividends instead of saving cash are likely not
financially constrained
– Test relationship between annual cashflows and investment across
each subset of firms

• Data shows that effect of cashflows is strongest for most

constrained firms, weakest for least constrained
– Indicates that investment depends on availability of internal funds
FHP (1988) main result
 Kaplan and Zingales (1997) critique

• Empirically refute FHP (1988)’s results, showing that financial

constraints may not affect investment-cashflow sensitivity

• Re-classify firms based on discussion of constraints in 10-K filings

– many “constrained” firms mention no problems raising funds

• Find cashflows associated with investment across all firms,

regardless of financial constraints
– indeed, association strongest for least constrained firms

• Additional problem with FHP (1988): Cashflows can be correlated

with investment opps, thus biasing regression estimates
 Constraints and precautionary savings

• Another issue with FHP (1988): If firms engage in precautionary

savings, then estimated effect of cashflows could be negative!
– reason is that constrained firms invest less when cashflows high, to
fund more investment when cashflows low
– cashflows depend on both current and future investment opps

• Almeida et al. (2004) develop new theory showing constrained

firms should save more out of annual cashflows
– “Cashflow sensitivity of cash”: Test relationship between cash
holdings and cashflows
– association likely unbiased by error in measuring investment opps
Almeida et al. (2004) main result

Source: Table 3, Almeida, Campello and Weisbach (2004)

 More recent evidence

• Newer papers exploit exogenous shocks to corporate liquidity or

internal funds
– Results show that financial constraints matter for investment

• Lamont (1997) examines investment following 1986 oil price crash

– finds that oil companies cut investment in their non-oil subsidiaries
– oil price crash exogenous to these subsidiaries’ investment opps

• Rauh (2006) shows that firms that must increase contributions to

employee pension fund also cut Capex
– exploits law requiring firms with pension assets just below threshold
to raise contributions
– RDD design compares firms just above and below threshold
Rauh (2006) RDD design
Rauh (2006) main result
 Cash holdings: A challenge to theory

• Public firms’ cash holdings have risen dramatically since 1980s

– in U.S., level is higher than any point in past century except WW2

• Policymakers highly frustrated that firms are hoarding cash

instead of investing to create jobs, growth
– central banks have driven savings rates on cash to record lows

• Explanations that could reconcile this trend with traditional

investment theories:
– Positive NPV investment opps less frequent than before 1980
– Financial constraints pose greater threat since 1980
– Something else changed around 1980?
Dramatic rise in cash holdings
Cash holdings in historical context

[Figure 1, Graham and Leary (2018)

Concurrent decline in investment spending

[Figure 4, Gutierrez and Philippon (2016)]

 Common explanations for cash holdings

• Prior academic literature put forth numerous explanations:

1. Precautionary savings to avoid future constraints

2. Reduce transaction costs from issuing bonds/stock
3. Agency problems: CEOs don‘t want to give back cash
4. Avoid taxes by hoarding cash abroad

• General view is that precautionary savings and taxes are strongest

drivers of cash holding growth
Cash rising mostly at innovative firms

[Figure 3, Graham and Leary (2018)

Innovative firms hold more cash at IPO

[Figure 2, Begenau and Palazzo (2017)

US-EU gap only among high-R&D firms

[Figure 1, Pinkowitz et al. (2016)

 Summary of recent trends

• Cash holdings/Assets are at record highs, while CapEx spending

consistently lower than predicted by Q

• Trends started in 1980s, concentrated among innovative firms

– Cash holdings have risen mostly at high-R&D firms
– High-R&D firms hold much more cash at IPO
– Most US and EU firms hold similar cash levels, except for highest
R&D firms

• Common explanation: Innovative firms are more constrained

– R&D creates intangible assets, which are poor collateral for raising
external financing
 Can intangibles and human capital explain
recent trends?
• Doettling, Ladika, and Perotti (2019) offer alternative explanation
based on how intangible assets created

• Intangibles produced using employees’ knowledge and creativity

– such “human capital” investment doesn’t require spending much
cash up front
– high R&D firms are not constrained, because they do not require
much external financing

• But employees can take intangibles when moving to another firm

– firms grant deferred pay to retain employees (e.g., stock options)
– need to hold onto project cashflows until pay vests