Antecedentes

There are at least two theories that have been put forward to explain the role of cash flow in the capital market, namely the capital market monitoring theory proposed by Donaldson (1984), Rozeff (1982), and Easterbrook (1984), and the pecking order theory proposed by Donaldson (1961), Myers (1984), and Myers and Majluf (1984).

The capital market monitoring hypothesis posits that the agency conflicts between managers and shareholders can be alleviated through capital market monitoring. That is when a firm requires funds from the capital market, the firm is required to supply its audited financial statements. This gives the capital market an opportunity to evaluate the performance of the firm. In addition, when securities are issued by the firm, the covenant attached to the securities forms a relationship between the firm and the capital market such that it gives the capital market a legal right to monitor the firm’s future performance on a continuous basis for the life of the securities.

Implicit in this argument is the assumption that the monitoring mechanism of the capital market is efficient. Jensen (1993, pp. 850-870) argues that capital market monitoring is the most effective disciplinary mechanism we have to date. Jensen also provides examples and reasons as to why other disciplinary mechanisms such as the product and factor markets, managerial labour market, and the

internal control systems instituted by the board of directors, are not effective in monitoring managers.

Firms lacking internally generated cash are more likely to depend on the capital market for funds, than those with sufficient internally generated cash. Cash flow dependent firms are expected to make value-maximising investments decisions. Failure to make value-maximising investment decisions will result in firms paying a high ex ante monitoring cost, or high borrowing costs, or even cessation of supply of funds from the capital market in extreme cases. Firm with large internally generated cash flow can dispense with visiting the capital market for external funds, and hence avoid capital market monitoring. A corollary is that firms with low cash flow are more likely to make value-maximising investment decisions compared to firms with high cash flow.

The majority of the research on the role of cash flow is tested in the free cash flow theory context.29 This is due to the fact that both capital market monitoring and free cash flow theory are grounded in agency theory. Distinguishing between the capital market monitoring hypothesis and the free cash flow theory requires an additional factor, viz, growth opportunities. That is to say, high cash flow is a sufficient condition for non-value-maximising behaviour under the capital market monitoring hypothesis. However, cash flow alone is not a sufficient condition for non-value-maximising investment behaviour under the free cash flow argument. Jensen (1986a) defines free cash flow as cash flow in excess of growth opportunities. Hence, by definition, free cash flow can only

29 _{See for example, Chen and Ho (1997), Vogt (1997), Szewczyk, and Testeskos and Zantout}

arise when firms have high cash flow but operate in an environment which lacks growth opportunities.

The pecking order theory, which was first proposed by Donaldson (1961) and subsequently by Myers (1984), and Myers and Majluf (1984), suggests that a hierarchy exists with respect to funding sources such that internal cash flow is the most preferred option, followed by debt, hybrids, and lastly equity.30 For firms with limited cash flow but profitable investment opportunities, the use of internally generated cash to finance investments is the least costly, and hence, value-maximising. This would be the case where the firm has positive NPV projects available, and the use of internally generated cash is cheaper than raising finance on the external market. The pecking order theory argues that both these conditions may apply to firms which, while profitable, suffer from information asymmetry, causing the issue of securities on the external market to be underpriced. Following Myers (1984, p. 581), the pecking order theory can be summarised as follows.

• managers prefer internal finance;

• managers adapt target dividend payout ratios to their firm’s investment opportunities, but because dividends are ‘sticky’ the payout ratio is adjusted only gradually to shifts in available investment opportunities;

30 _{In some cases, companies will pass up a valuable growth opportunity when the cost of issuing}

• sticky dividend policies plus unpredictable changes in profitability and investment opportunities mean that internally generated cash flows may be inadequate to meet investment needs. If this occurs, the company draws first on its cash and marketable securities; and

• if external finance is required, companies issue the safest securities first.31 They start with debt, then hybrid securities, and finally equity as a last resort.

Myers and Majluf (1984) present a model in which managers are aware of the value of the firm’s assets-in-place and its growth opportunities, but investors are not. They demonstrate that the presence of information asymmetry by market participants may lead to persistent undervaluation of equity issues. In this framework, Myers and Majluf show that managers acting in shareholders’ interests will not sell securities when the firm’s stock is underpriced. This leads to an investment disincentive because the undervaluation of equity issued to fund a project may outweigh the project’s worth.32 Therefore, if stocks are undervalued, managers may not issue equity even if it means passing up a valuable growth opportunity. It follows that whenever a share issue is forthcoming, investors will interpret the equity issue as a signal of overvaluation of the current stock price. Recognising managers’ incentives to issue shares whenever they are overvalued, investors interpret the decision to issue securities

31 _{The word “safest” refers to securities whose future value changes least when the manager’s}

inside information is revealed to the market [Myers (1984, p. 584)].

32 _{Myers and Majluf (1984) note two exceptions to their conclusion that offerings signal bad}

news. The first exception occurs when the value of assets-in-place is known with certainty by outsiders. In this case, the decision to issue securities signals new investment. The stock price reaction to the security issues is non-negative, since negative NPV projects are rejected. The second exception occurs when growth opportunities are so valuable that the firm cannot afford to pass them up in any state of nature. In this case the decision to issue conveys no information, so there should be no price reaction.

as bad news about the firm’s ‘intrinsic’ value, so the stock price falls. Debt is not likely to be subject to such a degree of misvaluation because of the fixed interest and repayment commitments imposed on the firm. Hence the use of internal cash, however limited, to fund investments is value-maximising.

Empirical evidence supporting the pecking order theory is substantial. For instance, Fazzari, Hubbard and Peterson (1988) provide evidence that internally generated cash flow is an important determinant of investment for US firms. Fazzari et al’s results are subsequently endorsed by Baskin (1985, 1989) in American firms, and Remolona (1990) who investigates the pecking order hierarchy in America, Britain, Germany, and Japan. In the context of equity issues, Asquith and Mullins (1986), Masulis and Korwar (1986), and Mikkelson and Partch (1986) all report negative market responses associated with equity issues in the US. In Australia, Allen (1991a, 1991b), and Chiarella Pham, Sim and Tam (1991) report evidence that debt is preferred over equity issues.33

Fama and French (1999) provide further evidence supporting the pecking order theory. Fama and French test the dividend and leverage predictions of the pecking order and tradeoff theories. Fama and French find several similar predictions from both models, for instance, their results support the prediction from both theories such that more profitable firms have higher dividend payouts and firms with more investments have lower dividend payouts, holding constant other variables. However, they document an important evidence which supports the pecking order theory and rejects the tradeoff theory. That is, they report that

33 _{Also see Allen (1993), Fazzari, Peterson (1993), Calomiris, Hubbard (1995), and Christie and}

more profitable firms utilise less debt. This is an important contrast to the tradeoff theoru which predicts that more profitable firms are more levered. On the other hand, the pecking order theory predicts that more profitable firms are less levered.

In the context of a firm’s capital structure, Shyam-Sunder (1988), Shyam-Sunder and Myers (1992), and Allen and Clissold (1997), find evidence that the pecking order theory explains the changes in firms’ capital structures more accurately than simple target adjustment formulations.

Opler, Pinkowitz, Stulz and Williamson (1999) examine the determinants of corporate holdings of cash among listed US firms from 1971 to 1994, and document how firms change their cash holdings over time. They report that firms with strong growth opportunities, firms with riskier activities, and small firms hold more cash than other firms, whereas, firms that have the greatest access to the capital market, such as large firms and those with credit ratings, tend to hold less cash. Their findings are consistent with Vogt (1994) who finds evidence that cash flow dependent firms are usually characterised by small-sized firms.34

34 _{Jalilvand and Harris (1984) argue that small firms are more likely to suffer from cash}

constraints than large firms because small firms have limited access to the capital market. This is because small firms are less visible and therefore less favoured by capital markets. Because of the less visibility, information asymmetry becomes a significant problem for small firms, and consequently small firms have limited access to capital markets and face significantly higher transaction costs of security issues. Therefore, small firms tend to have untapped profitable investment opportunities. Given the reasoning above, small firms are likely to utilise internal cash flow to fund physical asset expenditure, and any physical asset expenditure announcements should be associated with a positive market reaction.

A subsequent study by Vogt (1997) finds evidence that firms announcing capital expenditure increases are associated with a significant positive abnormal return of 0.45% over a two-day window. However, subsequent analysis reveals that the positive and statistically significant abnormal returns found in the sample of firms announcing increases in capital expenditures is concentrated in the smallest of the sample firms, and in firms with low cash flow. In contrast, abnormal returns for the largest firms in the sample are negative, though not significant.

Both Vogt’s (1997) and Opler et al’s (1999) results are consistent with the pecking order theory postulated by Myers (1984), and Myers and Majluf (1984). As noted earlier, small firms are most likely to face liquidity constraints, hence, they are also the most likely to forgo profitable investment spending in the event of cash flow shortages. As cash flow increases, the ability to undertake profitable capital investment projects also increases. Consequently, capital expenditure announcements are associated with positive abnormal returns.

Of note, Vogt’s (1997) findings do not reject the capital monitoring theory that abnormal returns are negatively related to a large firm’s ability to finance capital expenditures with cash flow. Both high cash flow firms and large firms experience lower abnormal returns than their low cash flow and small sized counterparts. This evidence indicates that the capital market does not react favourably to firms which are subject to lower capital market monitoring that make capital expenditure announcements.

The testing of the pecking order hypothesis requires the identification of sources of finance. Due to lack of data with respect to sources of finance, the pecking order hypothesis is not tested in this thesis, and the examination of the role of cash flow in the capital market is conducted in the context of capital market monitoring hypothesis.35