China Finance Review International

Investment-internal capital sensitivity, investment-cash flow sensitivity and

dividend payment
Xiaodong Xu, Huifeng Xu,
Article information:
To cite this document:
Xiaodong Xu, Huifeng Xu, (2018) "Investment-internal capital sensitivity, investment-cash flow
sensitivity and dividend payment", China Finance Review International, https://doi.org/10.1108/
CFRI-06-2017-0103
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Investment-
Investment-internal capital cash flow
sensitivity, investment-cash flow sensitivity

sensitivity and dividend payment

Xiaodong Xu and Huifeng Xu
Antai College of Economics and Management,
Received 27 June 2017
Shanghai Jiao Tong University, Shanghai, China Revised 7 December 2017
Accepted 3 January 2018

Abstract
Purpose – On the basis of principal-agent and financing constraints theories, the purpose of this paper is to
construct a unified research framework via mathematical models and to provide a logical and consistent explanation
of the contradictory discovery of the relationship between dividend payment and I-CFO in the previous literature.
Design/methodology/approach – Establishing the economic mathematical models, this paper uses the
comparative static analysis to figure out the equilibrium results, to further testify the conclusions, the authors
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initiate the empirical tests to make the discussion more realistic.

Findings – The authors observe that overinvestment caused by agency problems is the primary reason for
I-C sensitivity when the investment expenditure is less than the internal capital; dividend payout suppresses
the overinvestment caused by the agency problem, thus alleviating the investment’s dependence on the
internal capital. However, underinvestment caused by the financing constraints is the primary cause of I-C
sensitivity when the investment expenditure is greater than the internal capital. The payment of cash
dividends increases the investment shortage caused by the financing constraints, thus increasing the
sensitivity. Further, the authors explore the impact of dividend payments on I-CFO sensitivity. They argue
that dividend payment is not an appropriate measure of financing constraints. Both I-CFO sensitivity and I-C
sensitivity are functions of agency cost and information cost.
Research limitations/implications – This study provides a logical and consistent explanation of the
contradictory discovery of the relationship between dividend payment and I-CFO in the previous literature
and provides a clear framework and reference for future studies on the impact of financial constraints, agency
cost on the investment’s dependence on the internal capital.
Practical implications – The theoretical model of this paper supports this differentiated mandatory dividend
policy and provides reference and evidence for China's financing policies and dividend distribution policies.
Originality/value – This study theoretically and empirically analyzes and verifies the roles of agency cost
and financial constraints on the determinants of I-C sensitivity for the first time. First, different from earlier
literature, this paper puts forward I-C sensitivity as a new measure of investment’s dependence on internal
capital, making the measurement more accurate. In the case of a firm with positive liquidity reserves, using
the I-CFO sensitivity as a measure of external financing constraints could overestimate the firm’s financial
constraints. Second, by constructing an economic static analysis framework, this study analyzes how I-C and
I-CFO sensitivities change with the agency cost, the financing constraints and the dividend payment ratio.
The research provides a basic framework and explanation on the contradictions of the earlier literature.
The results are supposed to serve as a foundation for estimations of investment’s dependence on internal
capital and should be embedded in general empirical tests in future research.
Keywords Investment, Sensitivity, Cash flow, Dividend payments, Internal capital
Paper type Research paper

1. Introduction
The relationship between corporate investment and internal financing is highly topical in
academic research. Modigliani and Miller (1958) point out that in a perfect capital market the
costs of internal and external financing are identical since information between the outsiders
and the insiders is symmetrical. Therefore, capital structure and dividend policy have no
influence on the firm value. However, Myers and Majluf (1984) argue that the cost of external

The authors would like to thank Editor Huixia Lu and two anonymous reviewers for helpful comments
China Finance Review
about the paper, and the National Natural Science Foundation of China (Grant/Award Numbers: International
71772123, 71620107004, 71390525) and the Science Foundation of Ministry of Education of China © Emerald Publishing Limited
2044-1398
(Grant/Award Number: 15YJA630078) for financial support. DOI 10.1108/CFRI-06-2017-0103
 CFRI financing is higher than internal financing due to the information asymmetry. Therefore,
according to the pecking order theory, internal capital financing should be prioritized and then
comes to the debt and equity financing. Information asymmetry caused by information friction
is the root cause of external financial constraints. The corresponding financing constraints of the
free cash flow theory ( Jensen, 1986), assuming that the conflict of the usage the free cash flow
between managers and shareholders and the likelihood that managers’ will overinvestment is
increasing in the magnitude of cash flow remaining after investing in all positive NPVs. Jensen
(1986) also documented that market regulation on debt insolvency and the rigorous debt terms
facilitate to avoid the abuse of free cash flow. Contrary to the financing constraints theory, free
cash flow theory highlights that external debt financing mitigates agency problems.
Based on the aforementioned theories, the research on the dependence of investment
behavior on internal capital is carried out. The new investment theory also incorporates
financing constraint as a new influencing factor into the traditional investment theory.
Empirical research focuses on the impact of the financing constraints and the agency
problems on the investment after controlling investment opportunities. A pioneering study of
Fazzari et al. (1988) (“FHP” for short) comes up with the idea that I-CFO sensitivity can be a
measure of the effect of investment dependence on internal capital. In recent years, this finding
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has been supported by most empirical studies, a simple and monotonous positive relationship
between investment-cash flow (hereafter, I-C), sensitivity, and financing constraints is well
documented (Whited, 1992; Schaller, 1993; Athey and Laumas, 1994; Degryse and De Jong,
2006). However, Kaplan and Zingales (1997) put forward the exactly opposite conclusion.
They documented that financially constrained firms are more likely to experience lower I-CFO
sensitivity when using the proxy as FHP used in 1988, which is largely supported by Cleary
(1999). Namely, the sensitivity of I-CFO is caused not only by financing constraints but also by
agency problems. The theory of financing constraints represented by FHP and the agency
theory represented by Kaplan and Zingales (1997) formed two different schools about how
investment depends on cash flow, until now there is no consensus.
The aforementioned studies may have two major limitations: first, should I-CFO sensitivity
be used to measure the dependence of investment on internal capital? Using the data from the
USA, Chen and Chen (2012) argue that even in the special period of the credit crisis when
external financing is extremely scarce in 2007-2009, the I-CFO sensitivity of enterprises declined,
raising doubts about the effectiveness of the measure of I-CFO sensitivity as an indicator of
financial constraints. What exactly leads to this measurement bias? The primary reason is that
internal capital includes both the operating cash flow generated in the current period and the
liquidity reserve generated in the prior period, thus we should not measure the dependence of
investment on internal capital by the I-CFO sensitivity. Actually, firms adjust the initial liquidity
reserves to mitigate the impact of cash flow volatility on investment indeed. I-CFO sensitivity
underestimate the extent to which investment is dependent on internal capital. For example,
Harford (1999) point out that cash flow reserves facilitate to alleviate underinvestment. Ding
et al. (2013) employ the Chinese data to highlight that firms choose to adjust liquidity reserve
rather than fixed asset to adapt for investment, especially for financially constrained firms to
mitigate the impact of fluctuations of cash flow on investment. Studies by Almeida et al. (2004)
and Faulkender and Wang (2006) observed that financially constrained firms augment their
liquidity reserves to avert the shock of fluctuations in future cash flows. Research by Denis and
Sibilkov (2009) further suggest that increased liquidity reserves allow firms to better capture
future investment opportunities and consequently increase the firm value. These studies are
consistent with earlier studies by Fazzari and Petersen (1993), who found that firms smooth cash
flow fluctuations by adjusting their liquidity reserves. Keynes (1936) also argue that liquidity
reserves held by firms are based on prudent motivation to reduce transaction costs and
prophylactic motivation to deal with future investment opportunities; the prophylactic
motivation suggests that the liquidity reserve is a tradeoff of the inter-temporal options between
 current and future investments. Han and Qiu (2007) observe that cash holding is dominated by Investment-
prophylactic motivation especially for financially constrained firms. Opting et al. and Bates et al. cash flow
(2009) documented that besides the above two motivations, another one element to motivate sensitivity
cash holding is managers’ incentive to overinvestment for empire building. Therefore, the
liquidity reserve held by the firm not only directly but also indirectly affects the investment level
via overinvestment by managers. A survey of liquidity reserves in 29 countries by Lins et al.
(2010) emphasize that the cash reserve is to hedge the risk of future cash flow fluctuations.
Bigelli and Sánchez-Vidal (2012) argue that bank loan and working capital can function well as
cash substitutes and that firms with more cash reserves also have higher investment
expenditures in the future. Accordingly, the liquidity reserve is also particularly coupled with
investment, which should not be overlooked.
As per the huge number of previous empirical studies, the dividend payout ratio acts as a
proxy to measure financial constraints. However, Alti (2003) argue that the dividend payout
ratio can only be used as a measure of a company’s growth since high-growth firms usually
issue fewer dividends. Farre-Mensa and Ljungqvist (2016) observe that firms with lower
dividend payouts are not charged for higher debt or equity financing costs than firms with
higher dividend payouts. Hence, dividend payout rates are endogenous and cannot be an
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appropriate proxy for financial constraints. As Koo et al. (2017) point out, the higher the
quality of financial reporting, the higher the dividend payout ratio especially for firms with
high free cash flow and institutional ownership, which means that the dividend payout ratio is
to a certain extent decided by better corporate governance and external regulatory
mechanism. We suggest that dividend payout alleviates the manager’s discretionary abuse of
cash flow especially for firms whose internal capital is sufficient to fulfill investment, since
dividends payout helps to mitigate overinvestment. When the investment exceeds the internal
capital, the payout of the dividend decreases the internal capital and the capital supply curve
shifts to the left, leaving the enterprise facing a bigger external financing gap. Apart from this
point, dividend distribution to a large extent aims to meet the stringent requirements of the
CSRC for equity financing. Many listed firms meet the requirements of the CSRC passively by
paying out dividends on the eve of refinancing (Cheng et al., 2017). Based on this point,
dividend payout is not conducive to measure the financial constraints necessarily.
This paper contributes to literature in two ways: first, different from the earlier literature,
this paper puts forward I-C sensitivity as a new measure of investment’s dependence on
internal capital, which is more accurate. Using I-CFO sensitivity as a measure of external
financing constraints could overestimate the firm’s financial constraints if a firm has
positive liquidity reserves. Second, by constructing an economic static analysis framework,
this study analyzes how I-C and I-CFO sensitivities change with agency cost, causing the
financial constraints and the dividend payment ratio to increase. Our research provides a
basic framework and explanation to the contradictions of the earlier literature and improves
one’s understanding of the effect of agency cost and financial constraints on I-C sensitivity,
thereby motivating further empirical research on this question.

2. Theoretical model
We assume, for simplicity, if a firm’s operating cash flow is CFO, liquidity reserves is WC,
internal capital is C, then the relationship equation is introduced as follows:

C t ¼ CFOt þWCt1

It means that a firm’s current internal capital equals the current operating cash flow plus the
beginning working capital. Hubbard (1998) documented that a firm’s investment expenditure
increases as the net worth increases after controlling the information asymmetry, market
interest rates, and investment opportunities, implying that the investment depends on the
 CFRI total net wealth other than the cash flow. Internal capital supports investment opportunity
when the investment is less than the internal capital and the extra free cash flow can be
abused to overinvestment by managers ( Jensen and Meckling, 1976; Jensen, 1986). Free cash
flow is abused to invest the project of negative NPV if the manager has the incentive to empire
building, thus, it is the agency cost that determines I-C sensitivity at this point. On the
contrary, when investment exceeds internal capital and internal funds cannot support a firm’s
investment demand, the investment’s opportunity is ample, and it is the information
asymmetry that makes the investment to rely more on internal capital.
We use Figure 1 to characterize the relationship between I-C sensitivity and agency cost or
financial constraints. The horizontal axis refers to investment level and the vertical axis refers
to the cost of capital. Id1, Id2, and Id3 are the capital demand curves, representing the investment
opportunity; Is1, Is2 denote the capital supply curves and the slopes represent the capital cost
caused by market fraction; C0 denotes the Networth that is available for investment, which
includes the beginning liquidity reserve (working capital) and the current free cash flow;
r denotes the cost of capital; the supply curve has an inflection point in C0 due to the external
market frictions; the slope of capital supply curve becomes steeper as the external financing
gets harder. Suppose that a firm has a constant C0 and the growth opportunity is not so
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sufficient that the investment demand curve is on the left-hand side of C0, that is, Id1 and the
vertical part of the supply curve determine the optimal investment I*; at this time, the firm’s
investment is not affected by the external market fraction. Since there is no external financing,
internal capital (C0) not only satisfies optimal investment but also supports dividends payout to
shareholders since residual free cash flow (C0−I*) exists. However, the managers’ investment
on the project of NPVo0 (overinvestment, empire building) leads the investment demand
curve Id1 move to the right side (namely, Id2). The investment level deviates from the optimal
amount more as the agency cost is getting larger until the free cash flow (C0−I*) is abused to 0;
in the limit, investment equals C0 and the agency cost reaches its maximum. It can be seen that
when the internal capital is sufficient, the agency problem is the most important determinant of
I-C sensitivity. Information asymmetry caused by the market friction is not conducive to
explain investment decisions.
Capital demand curve shifts to the right side with the increase in investment opportunities.
When the demand curve moves right to Id3 and the capital market is perfect, the optimal level
of corporate investment should be I** (see Figure 1). At this point, investment decisions are not
related to the amount of internal cash flow and the change of liquidity. However, in the case of
existing information cost in the capital market, the capital supply curve will tilt upward on the
right side of C0, indicating that firms are required to compensate for the premium of
information asymmetry, the slope of the right side supply curve depends on the information
asymmetry in the capital market. Given the capital supply curve Is1, and the internal capital net

Id3
Is2
Cost of capital

Id2
Id1 FC Is1

AC

Figure 1. r
Agency problems,
financing constraints
and investment-
internal capital
sensitivity I* I1 C0 I2 I3 I * Capital
 worth C0, the equilibrium level of the firm’s investment is I3; I3−I** is the underinvestment Investment-
caused by external capital friction. The slope of the capital supply curve increases as the cash flow
market information asymmetry increases. If the supply curve moves from sensitivity
Is1 to Is2, the optimal investment level reduces from I3 to I2, leading to actual investment
being closer to the internal capital and the I-C sensitivity . Overall, the I-C sensitivity pertains to
the financial constraint in the case that the internal capital exceeds the investment demand.
To sum up, the basic model supports the agency theory in the area where the investment
is less than the internal capital and contrariwise supports the financial constraints theory in
the area where the investment exceeds the internal capital.
We define the I-C capital sensitivity as below:
(I
C if I oC
I  C sensitivity S ¼ C
I if I 4C

2.1 I-CFO sensitivity and dividends

2.1.1 Without dividends. If the internal capital can support the investment demand
(namely, I oC0), then the basic model is as shown in Figure 2.
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The corresponding curve of Id1 is the demand curve when the agent cost is 0, which
intersects the supply curve at the optimal investment level I*; consequently, the capital cost
is constant r. The cost of capital has no effect on the investment decision by virtue of the
abundance of internal capital. Assuming that the firm’s free cash flow is FCF, the actual
investment level is I, and the overinvestment level is OI, then the internal capital C can be
expressed as follows:
C ¼ I þ FCF ¼ I n þOIþFCF
According to Jensen (1986), free cash flow positively generates agency cost, so we make
OI ¼ ω×FCF, of which ω(ω∈(0, 1)) is to measure the agency cost, and the agency cost is
strictly increasing in ω. From this, we can deduce the equations below:
C ¼ I n þ ðo þ1ÞFCF

CI n
FCF ¼
oþ1
Therefore:
o  
OI ¼ CI n
oþ1
Cost of capital

Id2
Is 1
Id1

 =1

r
Figure 2.
Agency costs and
investment-internal
capital sensitivity
I* I C0 without dividends
Capital
 CFRI CI n o 1 n
I ¼ CFCF ¼ C ¼ Cþ I
o þ1 oþ1 oþ1

I o 1 In
S¼ ¼ þ
C o þ1 oþ1 C

After we take the derivative of ω with respect to the three equations above, we obtain:
@OI @I @S
40; 4 0; 40
@o @o @o
That is, when the investment is less than the internal capital, it is the agency cost that
affects the investment level and makes the I-C sensitivity to change, the I-C sensitivity is
strictly increasing in agency cost. In the limit, free cash flow is all abused, the agent cost →
∞, as ω ¼ 1 and the agent cost → 0, as ω → 0, the firm invests at the optimal level and the
excessive investment does not exist.
If the internal capital cannot support the investment demand (I WC0), then the basic
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model is as shown in Figure 3.

In a perfect capital market, firms do not face the “friction cost” when financing externally
and the external financing cost equals the internal financing cost. The capital supply curve is
the horizontal straight line on the left side of C0, which has no effect on the internal capital level.
As the dotted line shows investment expenditure depends only on investment opportunities;
capital supply curves and demand curves intersect at the optimal investment level. When
information asymmetry exists, financing constraints make the capital supply curve steeper; the
higher the degree of the information asymmetry is, the steeper the supply curve is. The firm’s
actual investment is reduced from I1 to I2 as the firm’s capital supply curve moves from Is1 to Is2.
External financing level and underinvestment are assumed to be EF and UI, respectively, i.e.:
I ¼ C þEF; UI ¼ I I n

Financially constrained firms will face more difficulties in external financing:

@EF @UI
o0; 40
@FC @FC
Since:
C I EF EF
S¼ ¼ ¼ 1
I I I

FC = +-
Is2
Cost of capital

Is 1

Figure 3.
Financing constraints FC= 0
r
and investment-
internal capital Id
sensitivity without
dividends C0 I2 I1 I*
Capital
 Therefore: Investment-
@I @S cash flow
o0; 40 sensitivity
@FC @FC
This suggests that financing constraints lead to insufficient investment when the investment is
greater than the internal capital, resulting in investment’s more dependence on internal capital.
In the limit, when FC approaches infinity, the external financing becomes impossible, and the
firm’s investment is entirely dependent on the current internal capital. When FC ¼ 0, there is no
friction between internal and external financing, and when external financing cost equals the
internal financing cost, investment will be at the optimal level I*. Figures 3 and 4 show that the
sensitivity of I-C increases with the increase of agency costs when the firm does not need
external financing and increases with the increasing of financial constraints in the case where
firm investment requires an external capital. To sum up, we obtain the following corollary:
Corollary 1. The sensitivity of I-C increases with the increasing of agency cost when there
is no external financing and increases with the increasing of financing
constraints when facing external financing, I-C sensitivity presents an upside
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down “U” shape with the increase of investment level, as shown in Figure 4.

2.2 Dividend payout

If the internal capital can support the investment demand (IoC0), dividends reduce internal
capital level. That is, the level of dividend payment is equal to the reduction of internal capital:
C 0 ¼ CFO0 þWC0 ; C 1 ¼ CFO1 þWC1 ; DIV ¼ DC
There are two different cases:
(1) When IoC0−DIV ¼ C1, namely, the investment opportunity is less than the internal
capital level after the dividend payment, as reflected in the basic model (see Figure 5).
The sensitivity of I-C is as follows:
I ð oÞ I ð oÞ
¼ S¼
C1 C 0 DIV
The above equation shows that the sensitivity of I-C is attributable to agency costs and
dividend payments, which is assumed to be independent of each other, the first derivative of

0.8
I-C sensitivity

0.6

0.4

0.2 AC 1
0.8
0 FC 0.6
1
0.8 0.4
0.6 Figure 4.
0.4 0.2 Illustration of
C0 0.2 0 Investment
0 Corollary 1
 CFRI S for DIV and ω, respectively, is as follows:

@S I ðoÞ @S I ð oÞ @I
¼ o0; ¼  40
@DIV ðC 0 DIVÞ2 @o C 0 DIV @o

These show that the fewer the dividends payout and the higher the agency costs are, the
higher the sensitivity of I-C is. Further, we have:

@2 S I ðoÞ @I
¼  o0
@o@DIV ðC 0 DIVÞ 2 @o

The higher the dividend payout, the slower the increase of sensitivity with agency cost,
indicating that the payout of dividends will reduce the sensitivity of the I-C caused by
agency cost. Hence, we have Corollary 2:
Corollary 2. When the investment level is less than the internal capital after the dividend
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payout, the I-C sensitivity increases with agency cost, and with the increase
in dividend payout, the increment of I-C sensitivity is getting slower.
Additionally, the dividend payout reduces I-C sensitivity, namely, cash
dividend reduces overinvestment caused by agency problems.
This relationship is characterized by Figure 6.
A large number of previous empirical studies took the dividend payout ratio as a
proxy to measure the financial constraints. Financial constraints theory represented by FHP
concluded that low dividend payment indicates low financial constraints, and hence low I-C
sensitivity. Counter to FHP, Kaplan and Zingales (1997) and Cleary (1999) concluded that
the lower the financial constraints are, the higher the sensitivity of I-C is, supporting the
agency theory. According to Corollary 2, we can figure out the root reason for the above two
as completely different conclusions:
P1. When the investment is less than the internal capital after the dividend payout,
dividends reduce the investment’s dependence on internal capital. Since the dividend
payment and the financing constraint are independent of each other, dividend
payout ratio cannot be a measure of financial constraints.
(1) Then I∈(C0−DIV, C0), i.e., investment is bigger than C1 and smaller than C0, as
shown in Figure 7.

Is2
Is1
Cost of capital

Id1

Figure 5.
Agency costs and
investment- internal r
capital sensitivity
when the investment DIV = ΔC
is less than the
internal capital after
distribution of
dividends I0 C1 C0
Capital
 Investment-
cash flow
1
sensitivity
0.8
I-C sensitivity

0.6

0.4

0.2

0
1
1 0.8 Figure 6.
0.8 0.6
0.6 Illustration of
0.4 0.4
0.2 0.2 Corollary 2
Dividend payout 0 0 Agency cost
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Is2
Is1
Cost of capital

Id1

r
Figure 7.
Agency costs and
investment- internal
DIV = ΔC
capital sensitivity
when the investment
C1 I1 I0 C0 is between C1 and C0
Capital

Before the dividend payout, the investment demand curve intersects with the capital
supply curve at the level of the actual investment in the area where the sensitivity of the
I-C is caused by the agency cost. After dividends’ payout, the supply curve shifts to the
left-hand side of the demand curve and intersects the steep part of the demand curve,
meaning that the dividend payment changes the elements that determine I-C sensitivity
from the agency cost to the financial constraints; I-C sensitivity after dividend payment is
as follows:
C 1 C 0 DIV C 0 DIV
S¼ ¼ ¼
I1 I 0 DI I 0 bDIV
We vary the parameter β[1] to capture different degrees of financial constraints, and ∂S/
∂βW0, so:
@S bC 0 I 0
¼
@DIV ðI 0 bDIVÞ2
When βo I0/C0, then ∂S/∂DIVo0, and when β ⩾ I0/C0, then ∂S/∂DIV W0. Therefore, the
sensitivity of I-C decreases with more dividends being paid when a firm faces less financial
 CFRI constraints while it increases with more dividends being paid when a firm faces more
financial constraints, so we have Corollary 3:
Corollary 3. After the dividend payout reduces its internal capital to the level below the
level required for investment opportunities, the reason for generating I-C
sensitivity changes from agency cost to financing constraints. When faced
with less financial constraints, the sensitivity of I-C decreases with the
increase of dividend payout; when faces with more financial constraints, the
sensitivity of I-C increases with the increase in dividend payment.
Corollary 3 can be represented by Figure 8.
According to Corollary 3, we can also obtain the following proposition:
P2. When the dividend payout reduces the internal capital to the level that cannot
support the investment opportunity, the influence of dividend payment on I-C
sensitivity varies with the magnitude of financial constraints, so the dividend
payment cannot be a measure of I-C sensitivity and financing constraints.
If the internal capital of the firm cannot satisfy the investment demand (I WC0), then the
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basic model is shown in Figure 9.

In this case, the I-C sensitivity is generated by the financial constraints; after the
payment of dividends, I-C sensitivity is expressed as below:
C 1 C 0 DIV C 0 DIV
S¼ ¼ ¼
I1 I 0 DI I 0 aDIV
Here, we vary the parameter α[2] to capture the different degrees of financial constraints, a
bigger value of α represents a higher degree of financial constraints, because α ¼ ΔI/
ΔC o1, so αoI0/C0, we can obtain the following:
@S aC 0 I 0
¼ o0
@DIV ðI 0 aDIVÞ2

@S aðC 0 DIVÞ
¼ 40
@a ðI 0 aDIVÞ2

0.8
I-C sensitivity

0.6

0.4

0.2
1
ut
Figure 8. 0.5 yo
0 pa
Illustration of 0 0.2 0 nd
0.4 0.6 0.8 1 de
Corollary 3 vi
Financial constraints Di
 Is2 Investment-
Is 1 cash flow
Cost of capital
sensitivity

r Figure 9.
Financing constraints
ΔI = ΔC and investment-
DIV = ΔC internal capital
sensitivity when the
investment is
C1 I2 I0 greater than C0
Capital
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@2 S 2aDIV2 I 0
¼ 40
@a@DIV ðI 0 aDIVÞ4

Corollary 4. When the investment expenditure exceeds the internal capital before the
dividend is paid, the lower the dividend yield and the higher the financial
constraints are, the higher the I-C sensitivity is; I-C sensitivity increases
faster with the dividend payout. Figure 10 can express these three-
dimensional relationships.

2.3 I-CFO sensitivity and dividend payment

The I-CFO sensitivity is the measure of the investment’s dependence on internal capital
according to the previous literature. This section discusses the expressions of I-CFO sensitivity
under the above two sections of the basic model and analysis framework. We find that the
sensitivity of I-CFO, however, does not show a simple and monotonous relationship with agency

0.8
I-C sensitivity

0.6

0.4

0.2

0
1
1
0.8 Figure 10.
0.5 0.6 Illustration of
0.4
0.2 aints
Dividend payout 0 0 cial constr Corollary 4
Finan
 CFRI cost and financial constraints, which means that I-CFO sensitivity cannot be measured as a
proxy of investment’s dependence on internal capital. We also define I-CFO sensitivity as below:
( I
0 CFO if I oCFO
I  CFO sensitivity S ¼ CFO
I if I 4 CFO

2.3.1 Without dividend payout. If the internal capital can satisfy investment demands, the
basic model is as shown in Figure 11.
Suppose CFO is constant, and we discuss two cases: If I oCFO, we have, S′ ¼ I(AC)/CFO,
′
∂S /∂ACW 0. At this point, I-CFO sensitivity is caused by agency cost, the sensitivity of
I-CFO increases as agency costs increase. If CFO oI oC0, we also have, S′ ¼ CFO/I(AC),
∂S′/∂ACo 0. At this time, I-CFO sensitivity is also caused by agency problem; however,
I-CFO sensitivity decreases as the agency cost becomes higher.
To sum up, we have Corollary 5:
Corollary 5. When the level of investment is less than the internal capital, I-CFO
sensitivity exhibits an inverted “U” shape as agency cost increases.
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According to Corollary 1 and Corollary 5, we find that when internal capital exceeds
investment demand, I-CFO sensitivity shows a monotonically increasing relationship with
agency costs; the agency cost and I-CFO sensitivity show an upside down “U” shape
relationship (see Figure 12):
P3. Since I-CFO sensitivity does not show a simple and monotonous relationship with
agency cost, I-CFO sensitivity cannot be used as a proxy of agency cost; the accurate
proxy should be I-C sensitivity.
If internal capital cannot satisfy investment demands (I WC0), the basic model is as shown
in Figure 13.
Suppose CFO is constant, the investment’s dependence on internal capital is caused
by financial constraints, the sensitivity can be expressed as S′ ¼ CFO/I(FC), ∂S'/∂FC W0.
Thus, we have Corollary 6:
Corollary 6. When the investment level exceeds internal capital, the higher the financing
constraints are, and the higher the sensitivity of the I-CFO is.
To sum up Corollary 5 and Corollary 6, I-CFO sensitivity shows an upside down “U” shape
with the increase in the investment level:
Corollary 7. Without considering the dividend payout, the sensitivity of the I-CFO shows
an inverted “U” type as the investment level increases (Figure 14).

Is1
Cost of capital

Id2
Id1

AC
r
Figure 11. CFO
Agency costs and
investment-cash flow
sensitivity without
dividends I1 I2
Capital
 2.3.2 Dividend payout. If a firm’s internal capital can satisfy investment demands (I oC0) Investment-
and if the CFO is constant. There are two cases. cash flow
If DIV∈(0, C0−CFO), namely, 0 oDIV oC0−CFO and CFO oC0−DIV ¼ C1, the basic
model is as shown in Figure 15:
sensitivity
(1) When I oCFO, the agency cost determines the I-CFO sensitivity, we have:

I ðACÞ @S 0 @S 0
S0 ¼ ; 40; ¼0
CFO @AC @DIV

I-C sensitivity
Sensitivity

Figure 12.
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The relationship
I-CFO sensitivity between agency costs
and investment-cash
flow sensitivity when
no cash dividends are
distributed
Agency cost

Id1 Is1
Cost of capital

Is
0

r •
CFO Figure 13.
Financing constraints
and investment-cash
flow sensitivity
C0 I1 I0 I* without dividends
Capital
I-CFO sensitivity

Figure 14.
Agency problems,
financing constraints
and investment-
AC ↑ internal capital
FC ↑ sensitivity when no
cash dividends are
CFO C0 distributed
I
 CFRI The higher the agency cost is, the higher the sensitivity of the I-CFO is, no matter
how much the dividends are paid out.
(2) When CFOoIoC0−DIV, the agency cost also decides the I-CFO sensitivity, we have:

CFO @S 0 @S 0
S0 ¼ ; o0; ¼0
I ðACÞ @AC @DIV
The higher the agency cost is, the lower the sensitivity of the I-CFO is, no matter how
much the dividends are paid out.
(3) When I∈(C0−DIV, C0), the determinant of the investment depends on the internal
capital changes from the agency cost to financing constraints:

CFO @S 0 @S 0
S0 ¼ ; 40; 40
I ðFC; DIVÞ @FC @DIV
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This indicates that the sensitivity of I-CFO increases with the increase in the financing
constraints and the dividend payout. The positive effect of dividend yield on I-CFO is in line
with the findings of Kaplan and Zingales (1997) and Cleary (1999). To sum up the above
basic findings, we can get Corollary 8:
Corollary 8. After the dividends are paid out and the internal capital is greater than the cash
flow if the internal capital is sufficient to support the investment opportunity, the
I-CFO sensitivity is mainly attributable to agency cost; sensitivity of the I-CFO
increases with agency cost, whereas the dividend payout does not affect I-CFO
sensitivity; and if the internal capital is insufficient to satisfy the investment
opportunities, the dominates of I-CFO sensitivity change from agency cost to
financial constraints, the higher the dividend payout, the earlier the financing
constraint problem will happen, and the higher the I-CFO sensitivity is.
If DIV∈(C0−CFO, C0), namely, C0−CFO oDIVoC0, if C0−DIV ¼ C1, so C1 oCFO, the basic
model is as shown in Figure 16.
There are three cases:
(1) When I oC0−DIV, I-C sensitivity is attributable to agency cost, i.e.:

I ðACÞ @S 0 @S 0
S0 ¼ ; 4 0; ¼0
CFO @AC @DIV

Is 2
Id3
Cost of capital

Is 1
Id2
Id1

Figure 15. AC
Agency costs,
financing constraints r
and investment-cash CFO
flow sensitivity when
the investment is less
than C0 and dividends
is less than C0-CFO I0 I1 C1 I2 C0
Capital
 (2) When I∈(C0−DIV, CFO), external financing is desired, at this point, the determinants Investment-
of I-CFO sensitivity change from the agency cost to financial constraints, i.e.: cash flow
I ðFC; DIVÞ @S 0 @S 0 sensitivity
S0 ¼ ; o0; o0
CFO @FC @DIV
This shows that the sensitivity of I-CFO is increasing in financial constraints and
decreasing in dividend payout. The negative impact of the dividend yield on I-CFO
is in accordance with the findings of FHP.
(3) When I∈(CFO, C0), the I-CFO sensitivity is attributable to financial constraints, we have:

CFO @S 0 @S 0
S0 ¼ ; 4 0; 40
I ðFC; DIVÞ @FC @DIV
I-CFO sensitivity increases as the agency cost and financial constraints increase, the positive
impact of dividend yield on I-CFO is in agreement with the findings of Kaplan and Zingales
(1997) and Cleary (1999). According to the above analysis, we can obtain Corollary 9:
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Corollary 9. After the dividend payment and the internal capital are less than the
operating cash flow: if the internal capital after the dividend is sufficient to
support the investment opportunities, the I-CFO’s sensitivity is mainly
determined by the agency cost, the sensitivity of I-CFO is increasing in
agency cost; the dividend payout ratio does not affect I-CFO sensitivity; if
the internal capital after the dividends payout is insufficient to support the
investment opportunities, the determinants of the I-CFO sensitivity change
from the agency cost to the financing constraints. The higher the dividends
yield, the sooner the financing constraint begin to affect I-CFO sensitivity,
the I-CFO sensitivity presents a “U” shape with the increase of financing
constraints, it is minimized when the investment level equals the cash flow
level. Figure 17 can express these two-dimensional relationships.
In the case where the internal capital cannot satisfy the investment demand, I-C sensitivity is
monotonically increasing with the degree of financial constraints, that is, it has a “U” type
relationship with I-CFO sensitivity (see Figure 18). Thus, we obtain the following proposition:
P4. Since I-CFO sensitivity and financing constraints do not present a simple and
monotonous relationship, I-C rather than I-CFO sensitivity can be used as a measure
of financing constraints.

Id3 Is2
Cost of capital

Is1
Id2
Id1

Figure 16.
Agency costs,
financing constraints
r and investment-cash
flow sensitivity when
the investment is
CFO
less than C0 and
dividends are between
I1 I2 I3 C0-CFO and C0
Capital
 CFRI

I-CFO sensitivity I ∈(–-, C0 – DIV ) I ∈[C0 – DIV, CFO) I ∈[CFO, C0)

Figure 17.
Illustration of
C-DIV CFO DIV/I
Corollary 9

I-C
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Sensitivity

Figure 18. I-CFO

Investment-internal
capital sensitivity, I ∈[C0 – DIV, CFO) I ∈[CFO, C0)
investment-cash
flow sensitivity and
financing constraints
FC

When I WC0, suppose CFO is constant, the basic model is shown in Figure 19.
Figure 19 suggests that the I-CFO sensitivity is attributable to the financial constraints,
we have:
CFO @S 0 @S 0
S0 ¼ ; 40; 40
I ðFC; DIVÞ @FC @DIV

This indicates that the sensitivity of the I-CFO is increasing in financial constraints and the
dividend payout ratio. The positive impact of the dividend yield on I-CFO sensitivity is

Id1
Cost of capital

Is1

Figure 19.
Financing constraints r .
and investment-cash CFO
flow sensitivity when
the investment is
greater than C0 C1 C0 I1 I0
Capital
 consistent with the findings of the previous literature like Kaplan and Zingales (1997) and Investment-
Cleary (1999). To sum up the above findings, we have Corollary 10: cash flow
Corollary 10. When the investment level is greater than the internal capital, the sensitivity
sensitivity of the I-CFO generated by the financing constraints is strictly
increasing in dividend payout.

3. Empirical evidence
To make the results more convincing, this section aims to add some empirical evidence to
test the above main corollaries, based on the whole A share stocks with the exclusion of the
financial companies and companies whose net worth is negative from 2009 to 2014; the
financial data are from the China Stock Market and Accounting Research Database,
we obtain 2,342 firms’ (9,964 firm-year observations) unbalanced data. The following models
are constructed to test the conditional dependency of I-C sensitivity:
It Networtht Networtht
¼ a0 þa1 þa2  AC þa3 Tobin0 s Q
K t1 K t1 K t1
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þa4 SalesGrowth þyearfix þindustryfix þet (1)

It Networtht Networtht
¼ b0 þb1 þb2  FC þb3 Tobin0 s Q
K t1 K t1 K t1
þb4 SalesGrowthþyearfix þindustryfix þet (2)
We partition the sample into two groups according to the relative size of the investment level
and the net internal capital level. If the firm’s investment level is lower than the internal
capital, we classify the firm as Group 1, or otherwise, Group 2. In Group 1, α1 and α2 determine
the I-C sensitivity, and in Group 1, β1 and β2 determine the I-C sensitivity. We expect α1 and β1
to be positive in both subsamples; however, we assume α2 to be negative and β2 to be
insignificant in Group 1 and α2 to be insignificant and β2 to be negative in Group 2 (Table I).

3.1 Univariate test

Panel A of Table II reports the mean and median difference test of corporate governance, we
find that Group 2 is better governed since the number of meetings held by the board of
directors, the number of general meetings, the size of supervisory board, the number of
board members, the number of independent directors in Group 2 are higher than in Group 1,
suggesting that the agency cost in Group 2 is lower than Group 2. Panel B of Table II reports
the mean and median difference test of financial constraints, compared to Group 2, the
financial conditions are better than in Group 1 since the current ratio, quick ratio,
conservative quick ratio, and cash ratio in Group 1 are higher than in Group 2; overall,
Group 2 is more financially constrained than Group 1.
The difference tests in Table II together illustrate that the classifications of this paper are
reasonable to distinguish between two different situations: when the investment is less than
the internal capital, the company’s agency problem is more serious than the financing
constraints; and when the investment is larger than the internal capital, the company’s
financing constraint problem is more serious than the agency problem.
Tables III and IV present the empirical results of model (1) and model (2), the coefficients
of Networth are both significantly positive, indicating that the investment depends on
internal capital; indeed, the coefficients of Networth × AC in Group 1 are negative while not
noteworthy in Group 2, suggesting investment’s dependence on internal capital is
attributable to agency cost in the firms whose investment level is lower than the internal
 CFRI Variable Definitions

Panel A: dependent variable

I Investment expenditure ¼ cash paid to acquire fixed assets, intangible assets, and other long-
term assets/net fixed assets of the last period
Panel B: independent variables
CFO Operating free cash flow ¼ net cash flows from operating activities/net fixed assets of the last period
WC Working capital ¼ (current asset−current liability)/net fixed assets of the last period
Networth Networth ¼ CFO+WC
DDiv A proxy of agency cost, the higher the DDiv, the lower the agency cost is, DDiv ¼ (dividend
payout ratio of the current year−dividend payout ratio of the last year)/dividends payout ratio
of the last year
Abperk A proxy of agency cost, the higher the Abperk, the higher the agency cost is
ICR Interest coverage ratio. A proxy of financial constraints, the higher the ICR, the lower the
financial constraints, ICR ¼ (net profits + financial expenses)/financial expenses
Panel C: control variables
Tobin’s Q Tobin’s Q ¼ market value/total asset
SalesGrowth SalesGrowth ¼ (operating income of the current year−operating income of the last year)/
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operating income of the last year

Table I. Year Dummy variable of the year
Variable definitions Industry Dummy variable of the industry

capital. Additionally, the coefficients of Networth × FC in Group 2 are significantly positive

while not noteworthy in Group 1, indicating that investments are more dependent on
internal capital when the firms are more financially constrained.
The regression results state that when the internal capital is sufficient, the dependence of
investment on internal capital is mainly caused by the agency problem. The more serious
the agency problem is, the greater the dependence of investment on internal capital is. When
the internal capital is insufficient to support investment, the dependence of investment on
internal capital is mainly caused by the financing constraints. The more serious the
financing constraints are, the more the investment depends on the internal capital.

4. Conclusions
Most of the previous literature takes the sensitivity of I-CFO as a measure of financing
constraints, ignoring that liquidity reserve has an important role in internal financing.
Although most of the literature adds the liquidity reserve as a control variable to the
investment estimation model (Hoshi et al., 1991; Ding et al., 2013; Chang et al., 2014; Cull
et al., 2015), to explore the impact of cash holdings on investment decisions, however, the
method to estimate the dependence of investment on internal capital still makes false
judgments on the real situation, resulting in underestimation of the effect of investment’s
dependence on internal capital, especially for the firms whose liquidity reserve is positive.
In fact, a study by Denis and Sibilkov (2009) found that high-cash-held companies have
higher investment expenditures than low-cash-held companies, and this effect is more
pronounced among financially constrained firms, meaning that except for the current cash
flow, the liquidity reserve from the last period is also a source of investment. Lewellen and
Lewellen (2016) found that the correlation between investment spending and prior-period
cash flows is stronger than the current period’s cash flows because the prior period’s cash
flow level contained more information about investment opportunities and management’s
expectations; hence, not only the current cash flow but the liquidity reserve is also an
important factor in determining the level of investment. The cash flow is not only used for
the fixed assets investment, dividend distribution and debt, and equity financing, but is
 Variables Group n Mean Median Min. Max. Diff. χ2
Investment-
cash flow
Panel A: corporate governance sensitivity
Number of board meetings 1 8,396 9.16 9.00 1 48 −0.27*** 13.377***
2 3,320 9.43 9.00 2 57
Number of supervisory board
meetings 1 4,017 5.35 5.00 1 16 0.17*** 18.329***
2 1,925 5.18 5.00 1 18
Number of shareholder meetings 1 8,407 2.93 3.00 1 14 −0.29*** 43.039***
2 3,321 3.22 3.00 1 15
Size of supervisory board 1 8,383 3.61 3.00 1 13 −0.49*** 396.098***
2 3,305 4.09 3.00 1 12
Number of committees 1 8,405 3.91 4.00 1 8 −0.01 5.180**
2 3,317 3.92 4.00 1 7
Management shareholding ratio 1 8,127 0.13 0.001 0 0.90 0.10*** 600.534***
2 3,136 0.04 0.000 0 0.81
Size of board 1 8,383 8.75 9.00 4 18 −0.54*** 163.978***
2 3,305 9.29 9.00 4 18
Ownership concentration (Z-score) 1 8,407 13.37 4.54 1 1080.1 −4.94*** 17.703***
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2 3,321 18.31 5.38 1 615.86

Duality 1 8,316 1.75 2.00 1 2 −0.09*** –
2 3,272 1.84 2.00 1 2
Number of independent directors 1 8,384 3.21 3.00 1 7 −0.17*** 122.280***
2 3,305 3.38 3.00 1 8
Panel B: financial constraints
Current ratio 1 8,407 3.26 1.88 0.066 204.74 2.28*** 3216.121***
2 3,321 0.98 0.80 0.018 36.16
Quick ratio 1 8,407 2.58 1.32 0.027 179.58 1.87*** 2746.474***
2 3,321 0.71 0.54 0.013 33.84
Cash ratio 1 8,402 1.45 0.18 −0.199 167.54 1.14*** 1800.618***
2 3,320 0.31 0.26 −0.009 23.91
Conservative quick ratio 1 8,407 2.25 1.11 0.002 175.12 1.69*** 2785.278***
2 3,321 0.55 0.41 0.004 28.76
CFO/current liability 1 8,407 0.26 0.15 −49.64 34.76 0.18*** 276.284***
2 3,321 0.08 0.07 −4.21 2.57
Cash flow interest coverage 1 8,407 6.59 1.04 −9,052 88,334 −0.34 26.464***
2 3,321 6.92 1.65 −6,914 20,772
CFO/liability 1 8,407 0.22 0.13 −14.24 17.2 0.18*** 412.536***
2 3,321 0.05 0.05 −2.65 1.58
Leverage 1 8,407 0.70 0.65 0.01 15.25 −1.71*** 3438.347***
2 3,321 2.41 1.60 0.05 153.40
Interest coverage 1 8,407 4.66 2.17 −10,997 97,970 −0.11 9.833***
2 3,321 4.76 1.94 −17,633 35,887 Table II.
Notes: Duality equals 1 if the chairman and the CEO serve concurrently, or otherwise 0. *,**,***Significant Mean and median
at 10, 5 and 1 percent levels, respectively difference test

also used for working capital investment (Chang et al., 2014). Empirical studies find that
liquidity reserves account for a high proportion of the company’s total assets and play a
crucial role in corporate governance, as shown by Drobetz et al. (2010), in the decade of
1995-2005, the average cash reserves of 45 states’ listed companies make up about 12.6
percent of the total assets. Of these, Italian companies hold about 10 percent of their total
assets in cash, and in the USA, where the external capital markets are highly developed,
also accounted for 8-10.5 percent of their total assets (Kim et al., 1998; Opler et al., 1999;
Foley et al., 2007; D’Mello et al., 2008). The above research provides empirical evidence that
I-C sensitivity can be used as a measure of financing constraints. Different from the
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CFRI

Table III.

cost on I-C sensitivity

The impact of agency
Group 1 Group 2
Abperk DDiv Abperk DDiv

Networth 0.0414*** (0.0008) 0.0419*** (0.0008) 0.0408*** (0.0008) 0.3690*** (0.0136) 1.114*** (0.0268) 0.3680*** (0.0136)
Networth × AC 0.0650*** (0.0229) 0.0110*** (0.0042) 0.280 (0.225) −0.0646 (0.1400)
AC 0.182 (0.145) 0.1070*** (0.0363) 0.645 (0.533) −0.3460 (0.5420)
SalesGrowth 0.0001*** (0.0000) 0.0001*** (0.0000) 0.0001*** (0.0000) 0.0000*** (0.0000) 0.0000*** (0.0000) 0.0000*** (0.0000)
Tobin’s Q 0.0066*** (0.0025) 0.0058** (0.0025) 0.00674*** (0.0025) 0.0117*** (0.0026) 0.0163** (0.0068) 0.0117*** (0.0026)
Constant 0.524*** (0.122) 0.394*** (0.0675) 0.5170*** (0.122) 1.5820*** (0.218) 4.654*** (0.200) 1.5800*** (0.225)
Year Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes
Observations 8,513 8,471 8,513 3,211 1,015 3,211
Adj. R2 0.3016 0.3023 0.3034 0.2198 0.6809 0.2197
F-value 154.19 147.82 143.61 38.67 87.56 35.77
Notes: *,**,***Significant at 10, 5 and 1 percent levels, respectively
 Group 1 Group 2
Investment-
cash flow
Networth 0.0414*** (0.0008) 0.366*** (0.0136) sensitivity
Networth × FC 0.0000 (0.0000) 0.0002*** (0.0001)
FC 0.0000 (0.0000) 0.0010*** (0.0003)
SalesGrowth 0.0001*** (0.0000) 0.0000*** (0.0000)
Tobin’s Q 0.00667*** (0.0025) 0.0115*** (0.0026)
Constant 0.524*** (0.122) 1.571*** (0.225)
Year Yes Yes
Industry Yes Yes
Observations 8,513 3,211 Table IV.
Adj. R2 0.3015 0.2216 The impact of
F-value 142.32 36.15 financial constraints
Notes: *,**,***Significant at 10, 5 and 1 percent levels, respectively on I-C sensitivity

previous literature (Cull et al., 2015; Moshirian and Vadilyev, 2013; Ağca and Mozumdar,
2017), ours provides a more accurate measurement.
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By building up a static analysis framework of economics, this paper analyzes the sensitivity
of I-C and I-CFO conditional on agency costs, financing constraints, and dividend payout ratio,
providing a logically consistent basic explanation for the mixed results found by the earlier
literature. We find that when the investment expenditure is less than the internal capital, the
main factors that affect the investment’s dependence on the internal capital are the dividend
distribution rate and the agency cost. The former reduces the level of internal capital that can
provide to invest while the latter one deviates investment level from the optimal level, the
combined effect led to the dependence of investment expenditure on internal capital.
The agency cost increases the sensitivity of I-C, while the dividends reduce the I-C by inhibiting
overinvestment. Another case is that when the investment expenditure is greater than the
internal capital, the main factors that influence the dependence of the investment on internal
capital are the dividend distribution rate and the financial constraints. The former reduces the
level of internal capital available for investment, while the latter increases the capital cost of
external financing. The combined effect of these two elements leads to the dependence of
investment spending on internal capital. Among them, the underinvestment caused by the
financing constraint improves the sensitivity of I-C. The issuance of cash dividend further
enhances the sensitivity of I-C by aggravating underinvestment. In addition, the relationship
between the distribution of dividend and the sensitivity of I-C is not simple and monotonic,
and therefore cannot be used as a measure of the financing constraints. The analysis and
illustration extend our understanding of the association between internal capital and
investment expenditure, yet we also highlight the need for additional empirical to further
stretch this line of research.
The findings of this paper have very strong practical implications as well, especially for
emerging market countries with underdeveloped capital markets. China is experiencing the
transition from a planned economy to a market economy. Capital is one of the most important
production factors; the access to achieve the capital is changing all the time that firms must
build up their own capital market. However, for the realization of multiple social goals, the
government strictly controls the capital market. For instance, the establishment of commercial
banks must be approved by the China Banking Regulatory Commission, who also appoint and
promote the executives of commercial banks, and thus can intervene in the operation of the
banks. In addition, the development of China’s equity market is also in the stage of startup and
the refinancing of equity financing in listed companies is also highly regulated. For instance,
public firms must satisfy the condition of “three-year profitability with an average ROE of at
least 6 percent “provisions. In this context, the external financing is particularly difficult hence
 CFRI internal financing plays a crucial role in the development of the firms. Companies with surplus
funds tend to retain them in order to seize investment opportunities in the future. In addition,
the CSRC’s “Decision on Amending Certain Provisions on Cash Dividend Distribution of Listed
Companies” in 2008 stipulated that “the profit distributed in cash in the recent three years
should not be less than the 30% of average distributable profit realized in the recent three
years,” When refinancing, this regulation reduces the agency costs caused by free cash flow on
the one hand, and also increases the underinvestment of financially constrained companies on
the other hand. This policy does not require companies with more cash flow to pay more, but
does make firms to pay out a substantial dividend focus on the eve of refinancing (Cheng et al.,
2017). Therefore, the effective implementation of the policies needs to take into account
the governance and external financing conditions. In 2013, CSRC released Article 5 of the
“Guideline for the Regulation of Listed Companies – Cash Dividends of Listed Companies,”
which fully considered the company development stage and investment plan and put forward
the differentiated cash dividend policy, allowing different cash dividend policies according to
the characteristics of the industry, stage of development, self-management mode, profitability,
and whether the firm has any expenditure arrangement or not. On the one hand, the
implementation of this policy has important practical significance for the improvement of the
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mandatory dividend policy in 2008, taking full account of the underinvestment of companies
with insufficient cash flow. On the other hand, this policy alleviates the overinvestment of firms
with sufficient cash flow. The theoretical model of this paper supports this differentiated
mandatory dividend policy and provides reference and evidence for China’s financing policies
and dividend distribution policies.

Notes
1. When the investment level is between the internal capital before and after the payment of the
dividend, ΔI ¼ Kγ/Kγ+Kα×DIV, ΔI ¼ Kγ/Kγ+Kα×f(Id)×DIV Kγ is the slope of the supply curve for
the right side, which measures the financing constraints, Kα is the absolute value of the demand
curve slope, Id and Kα are constant when the investment opportunity keep unchanged, so β ¼ Kγ/
Kγ+Kα×f(Id), which measures the financial constraints, and its monotonically.
2. When investment opportunity is higher than the internal capital, Kγ is the slope of the supply
curve on the left side, measuring the financial constraints, Kα is the absolute value of the slope of
the demand curve and is constant when the investment opportunity keeps unchanged. We make
DIV ¼ ΔC, and ΔI ¼ Kγ/Kγ+Kα×ΔC, so α ¼ Kγ/Kγ+Kα is the monotonic increasing function of
financial constraints.

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Further reading
Andrén, N. and Jankensgård, H. (2015), “Wall of cash: the investment-cash flow sensitivity when capital
becomes abundant”, Journal of Banking & Finance, Vol. 50 No. 1, pp. 204-213.
Chen, Q., Chen, X., Schipper, K., Xu, Y. and Xue, J. (2012), “The sensitivity of corporate cash
holdings to corporate governance”, The Review of Financial Studies, Vol. 25 No. 12,
pp. 3610-3644.
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and q”, Journal of Political Economy, Vol. 108 No. 5, pp. 1027-1057.
Fazzari, S.M., Hubbard, R.G. and Petersen, B.C. (2005), “Investment cash flow sensitivities are useful:
a comment on Kaplan and Zingales”, Quarterly Journal of Economics, Vol. 115 No. 2,
pp. 695-706.
Gugler, K. and Peev, E. (2010), “Institutional determinants of investment-cash flow sensitivities in
transition economies”, Comparative Economic Studies, Vol. 52 No. 1, pp. 62-81.
Lian, Y.J. and Cheng, J. (2007), “Investment-cash flow sensitivity: financial constraints or agency
costs?”, Journal of Finance and Economics, No. 2, pp. 37-46 (in Chinese).
Moyen, N. (2004), “Investment-cash flow sensitivities: constrained versus unconstrained firms”,
Journal of Finance, Vol. 59 No. 5, pp. 2061-2092.
Pan, M. and Jin, Y. (2003), “Information asymmetry, equity system arrangements and over-investment
of listed firms”, Journal of Financial Research, No. 1, pp. 36-45 (in Chinese).
Rauh, J. (2006), “Investment and financing constraints: evidence from the funding of corporate pension
plans”, Journal of Finance, Vol. 1 No. 1, pp. 33-71.
Whited, T. and Wu, G. (2006), “Financial constraint’s risk”, Review of Financial Studies, Vol. 19 No. 2,
pp. 531-559.
 Xu, X.D. and Zhang, T.X. (2009), “Corporate governance, free cash flows and inefficient investment”, Investment-
Journal of Finance and Economics, Vol. 35 No. 10, pp. 47-58 (in Chinese). cash flow
Zhang, X.X. and Wu, C.F. (2005), “Does financing constraints affect the cash holding policy of China’s
listed companies? From cash-cash flow sensitivity analysis”, Management Review, Vol. 18
sensitivity
No. 10, pp. 59-62 (in Chinese).
Zheng, J.H., He, X.Q. and Wang, H. (2001), “Financing constraints of listed companies: empirical
analysis from the perspective of ownership structure”, Finance Research, No. 11, pp. 92-99
(in Chinese).

Corresponding author
Huifeng Xu can be contacted at: huifeng09@yeah.net
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