Cash flow Risk and Capital Structure Decisions

Researched by;
• Christopher Harris
• Scott Roark

Presented by;
• Muhammad Usman (Roll# 911)
• Khalid Mehmood (Roll#921)
Introduction
• Capital structure
• Combination of debt and Equity.

• Operating cash flow

• Measure of the amount of the cash generated by business operation

• Cash flow volatility

• Firms with near term cash needs more likely to issue debt than equity. (Huang
and Ritter, 2016)
Problems
Recent TRENDS.
• First, there is evidence of an increase in cash flow volatility which may
lead to cash shortfalls for firms. (Bates et al., 2009)
• Second, there is consistent evidence of an increasing number of firms
in the market with negative cash flow. (Ritter, Welch et al., 2002)
Literature Review
• Capital structure theory mostly dominated by discussion of the trade-
off theory and the pecking order theory (Myers ,1984)
• No single model to identify determinants of capital structure (Frank
and Goyal, 2008)
• Six Factors Identified by Frank and Goyal in 2009:
• Median industry debt
• Market-to-book ratio
• Asset tangibility
• Firm profitability
• Firm size
• Expected inflation.
Literature review
Hypostasis
H1. Firm debt has a positive and significant relation to cashflow risk
H2.Thepositive relation between debt in capital structure and cash flow
volatility is greatest among firms with the lowest operating cashflows.
Data, Variable Descriptions and Method
Data
• The data taken for U.S. firms from Compustat database 1960 to 2016.
• The sample chosen with specific firm benchmarks
• Final sample includes 223,399 firm-year observations
• All ratios winsorized at the 1% and 99% levels.
• Variables part of prior literature of capital structure
Variable Description
The Independent Variable:
• TDM = Total Debt ÷ Market Value of Assets

The Dependent Variables:

• Median Industry Debt Level (INDTDM)
• Market to Book Ratio (MB)
• Asset Tangibility (TANG)
• Firm Profitability (PROF)
• Firm Size (SIZE)
• Expected Inflation (INFL)
• Cash flow Volatility Measure (CFV)
• Used to identify the impact of cash flow volatility on firm debt levels
Statistical Summary of the Variables
Statistical Summary of the Quartiles Variables
Statistical Summary of the Quartiles Variables
• Firm size and asset tangibility both grow as operating cash flow
increases.
• Cash flow volatility decreases as operating cash flow increases.
• Tests the 2nd Hypotheses
Empirical Results (Table 3)
Regression Estimation Results (Table 3)
• All coefficients consistent with the predictions by Frank and Goyal (2009)
• With significant at 1% level
• Significant link between cash flow risk and the use of debt in a firm's
capital structure.
• Consistency with the first hypothesis
• Increase in cash flow volatility is linked to a firm increasing
its borrowing as a response
Empirical Results
Regression Estimation Quartiles (Table 4)
• Coefficients with the expected signs and significant at 1% in lowest
quartile
• Coefficient on CFV positive & significant only for firms in lowest two
quartiles of OCF
• No significant relationship b/w debt and CFV for firms in 3rd and 4th
quartiles
• Respond to increase in CFV by increase in debt, if have low OCF
Regression Estimation Quartiles (Table 4)
• May use additional debt as response to CFV, but only if have low OCF
• Extra debt needed to fund necessary expenses when have low OCF
• No extra debt needed for funding when have sufficient OCF
• Firms with low OCF may issue debt
• Firms with higher OCF may use internal resources to meet needs
Conclusion
• Relationship of Cashflow volatility and Capital Structure decision
• Only one way to end the problem.
Any Question?