Accessibility to Capital Markets and the Sensitivity of Investment to ...

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Abstract. Using a unique data set on corporate governance and relationship banking for listed Korean firms, we examine how the sensitivity of investment to ...

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·33

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow Kwangwoo Park*, Rae Soo Park** and Suk Heun Yoon*** Abstract Using a unique data set on corporate governance and relationship banking for listed Korean firms, we examine how the sensitivity of investment to cash flow can vary depending on chaebol(business group) affiliation, the soundness of corporate governance, and the intimacy of relationship banking. In order to conduct this analysis, we categorize our samples into three groups: 1) a group with easier access to internal capital markets (chaebol group); 2) a group with easier access to bank loan markets (intimate banking relationship group); and 3) a group with easier access to stock market (sound corporate governance group). Then, we investigate investment-cash flow sensitivities by analyzing sample firms in each category. Our results show that cash flow measures play a significant role in investment expenditures for Korean firms. Using the 'flow' concept of cash flow which measures a firm's ability to generate profits, we find that both cash flow and investment opportunities are not significantly affecting corporate investment decisions. On the other hand, using the 'stock' concept of cash flow which measures available funds, we find that cash flow is positively correlated with investment expenditures. And this positive effect is more pronounced for firms in non-chaebol groups, for firms with only a distant relationship with banks, and for firms showing poor corporate governance practices. Our evidence suggests that investment decisions by Korean firms are affected significantly by the 'stock' concept of cash flow and this effect is greater for firms with less easy access to capital markets. This result is consistent with the idea suggested by Fazzari, Hubbard and Petersen (1988). JEL Classification Number: E22, O16, O63 Key Words: Investment-Cash Flow Sensitivity, Corporate Governance, Relationship Banking, Chaebol, Financial Constraints

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I. Introduction Scholars have shown continued interest in the issue of investment-cash flow sensitivities associated with corporate investment decisions. If capital markets are perfect, there will be no relationship whatsoever between corporate investment decision and financing decisions (Modigliani and Miller, 1958). However, in a world of imperfect capital markets, the two decisions tend to interact with each other (Myers, 1977; Myers and Majluf, 1984). In this context, many studies examine the relationship between corporate capital expenditures and internal cash flow, and argue that the capital expenditures respond sensitively to changes in internal cash flow. The existing studies suggest several reasons. First, as Myers and Majluf (1984) argue, under informational asymmetry between inside managers and investors in the market, good firms would like to avoid issuing equity, anticipating that outside investors would view equity financing as resulting from firms' adverse selection. Second, firms trying to borrow from outside would have to pay a higher loan rate or even find their loan demand rationed (Stiglitz and Weiss, 1981) when banks suffer from informational asymmetry. Further, firms with dispersed ownership would have to pay a larger premium for external finance because their managers might consume excessive perquisites instead of maximizing shareholder wealth (Jensen and Meckling, 1976). For these and other reasons in imperfect capital markets, the costs of external finance may exceed those of internal finance, giving rise to firms' greater reliance on the latter. Empirical evidence also suggests that there exists a close relationship between firms' investment behavior and internal finance. The seminal paper by Fazzari, Hubbard and Petersen (1988) reports that there seems to be a positive relationship between firms' capital expenditures and liquidity in imperfect capital markets. The paper goes on to argue that the higher the firm's cost of external finance relative to internal finance, the severer its under-investment problem would become upon some adverse shock on liquidity. The authors then empirically show that firms being forced to decrease dividend amounts and increase retained earnings due to financial constraints exhibit a greater sensitivity of investment to cash flow. Their empirical evidence is supported by a * KAIST Graduate School of Finance (Tel: +82-2-958-3540, E-mail: [email protected]). ** Corresponding Author: Gyeongsang National University (Tel: +82-55-751-5731, E-mail: [email protected]). *** Hallym University (Tel: +82-33-248-1852, E-mail: [email protected]). The authors thank seminar participants at the 2005 Annual Allied Conference of Finance Associations in Korea and two anonymous referees for their useful comments. The usual disclaimer applies.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·35

number of subsequent studies including Hoshi, Kashyap and Scharfstein (1991) and Almeida, Campello and Weisbach (2004). In contrast to the findings by Fazzari, Hubbard and Petersen (1988), Kaplan and Zingales (1997) and Cleary (1999) show evidence that less financially constrained firms exhibit a greater investment-cash flow sensitivity than more financially constrained ones. Firms with sufficient internal funds are free to make investment decisions by using such funds, demonstrating a greater degree of such sensitivity. On the other hand, financially constrained firms have no option but to invest only in core investment projects, demonstrating a low degree of such sensitivity. Firms facing greater financial constraints are more likely to enter into a 'minimal investment level' stage in which they are making investments only at a minimum level, resulting in a lower degree of such sensitivity. Chirinko and Kalckreuth (2002) include firms with negative (-) cash flow in their analysis and show the distinctive results that firms with poor performance tend to be inactive in their investments and their investment-cash flow sensitivity is low, supporting the notion of Kaplan and Zingales (1997). Meanwhile, Almeida, Campello and Weisbach (2004) argue that firms with financial constraints should exhibit positive sensitivity of investment to cash flow, while firms without financial constraints should not have any significant relationship between investment and cash flows. The existing literature on the effect of financial constraints on capital investment typically employs a category or grouping methodology.1) In this methodology, based on financial constraints sample firms are divided into two groups where one group is likely to have a significant difference in costs between internal funding and external funding while the difference is small in the other group. Then, the sensitivity of investment to cash flow is calculated and compared for those two groups. The criteria for financial constraints that divide sample firms vary from paper to paper. Firm characteristics are used in many studies such as the payout ratio for Fazzari, Hubbard and Petersen (1988), credit ratings for Whited (1992), affiliation in business groups for Hoshi, Kashyap and Scharfstein (1991), firm age for Oliner and Rudebusch (1992), and ownership structure for Schaller (1993). On the other hand, macroeconomic 1) Using Tobin's q and cash flow variables to examine their effects on capital investment may lead to a situation where there is appropriate interpretation of empirical results. Average q may not meet the sufficient conditions required in Hayashi (1982) and have measurement bias. To avoid this sort of ambiguity in interpretation, Fazzari, Hubbard and Petersen (1988) employ a grouping methodology where they adopt an ex ante criteria and divide the whole sample into two groups based on the level of the sensitivity of investment to cash flows. In this methodology, although measurement errors in obtaining variables will result in erroneous coefficient estimates, the fact of the coefficients in the two groups having the same measurement errors is likely to guarantee unbiased-ness.

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credit conditions driven by the business cycle are employed in Gertler and Hubbard (1988) and Kashyap, Lamont, while Stein (1994) and Cleary (1999) use multivariate analysis such as Z-score. Moyen (2004) claims that the reason for contrasting results on the sensitivity having appeared in the literature is likely to have arisen from differences in the criteria on financial constraints. For example, if we consider outside funding as a criterion for financial constraints, firms without the ability to borrow from outside will have a high degree of sensitivity of investment to cash flow as liquidity constraints are small, which is consistent with the view of Kaplan and Zingales (1997). On the other hand, if we use the dividend payout ratio as our criterion, the results will be identical to those of Fazzari, Hubbard and Petersen (1988). This seems to imply that a discussion of investment-cash flow sensitivities requires us to examine the relationship between the two variables in association with the criteria to be chosen to measure firms' financial constraints. In this line, the current paper suggests some new criteria for measuring financial constraints or accessibility to capital markets that have not yet been explored in the literature. It then goes on to empirically analyze their relevance with respect to investment-cash flow sensitivities. It is well known that Korean firms have shown excess demand for funds in the past in order to aggressively finance their growing business in capital markets with serious informational asymmetries. Korean firms would have liked as a first choice to use internally generated funds where available, but would have also liked to have financed their investments from external capital markets. The existing empirical studies such as Kim (1993), Gong (1996), Park and Shin (1998), Park and Yoon (2000), Kang and Lim (2001), and Kim (2002) all address Korean firms' excess demand for funds in the past in one way or another. Under the circumstances, if we define the financial constraints facing Korean firms as their 'accessibility' to external and internal capital markets, then it seems to make sense to predict that firms with poor access are likely to exhibit a greater investment-cash flow sensitivity. This is because in this case the question of whether they can successfully finance their investment projects very much depends on the availability of internal funds. On the other hand, for firms with good access to capital markets, their availability may not be as critical. Hoshi, Kashyap and Scharfstein (1991) classify sample firms in Japan based on whether or not they have an interconnected corporate group (keiretsu) affiliation, which is viewed as a proxy for being without financial constraints. In our study, we also use corporate group (chaebol) affiliation for Korean firms as a proxy for their having access to internal capital markets and hence for being without

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·37

financial constraints. Our paper, however, is distinguished from earlier studies in that we concurrently consider the sample firms' accessibility to equity market as well as bank loan market and explore respective investment-cash flow sensitivities. In addition, the current paper is believed to contribute to better understanding of the issues underlying the above-mentioned debate between Fazzari, Hubbard and Petersen (1988) and Kaplan and Zingales(1997) in that we are bound to test how Korean firms’investments have responded to internal cash flow in capital markets with severe imperfections. In this paper, we analyze how the sensitivity of investment to cash flow can vary depending on corporate group (chaebol) affiliation, the soundness of corporate governance, and the intimacy of relationship banking by making use of unique Korean firm level data. For the analysis, we categorize our samples into three groups: 1) a group with easier access to the internal capital markets within a chaebol group; 2) a group with easier access to the bank loan market (intimate banking relationship group); and 3) a group with easier access to the external stock market (sound corporate governance group). We then investigate investment-cash flow sensitivities in each category. We predict that chaebol affiliated firms will be less likely to face financial constraints as they have access to the so-called internal capital markets. This is in line with the view taken by Hoshi, Kashyap and Scharfstein (1991) and by Park and Shin (1998). Therefore, chaebol affiliated firms are classified as being less financially constrained. On the other hand, when individual firms raise funds from external capital markets, it may be that funding costs increase or their access to the markets becomes difficult due to information problems, agency problems, or both. In these circumstances, any mechanism that can mitigate such problems will make external funding less expensive and lead firms to be less financially constrained. First, banks can screen their client firms ex ante upon loan application. In addition, banks can also monitor them ex postas a way of controlling their moral hazard behavior (Diamond, 1984; Fama, 1985; James, 1987; Yoon and Park, 1999). Further, the information problems between banks and their client firms can be more easily resolved if the two parties have successfully engaged in a long and intimate banking relationship. In such a case, client firms can enjoy a continued supply of liquidity from their banks (Petersen and Rajan, 1994; Cole, 1998; Weinstein and Yafeh, 1998). Also, the steady relationship will provide a positive signal to the capital markets so that client firms can enjoy improved credit worthiness (Petersen and Rajan, 1994), can have their collateral requirements reduced (Berger and Udell, 1992; Boot and Thakor, 1994), and can

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lower their funding costs (Berger and Udell, 1995; Petersen and Rajan, 1994). We therefore anticipate that firms maintaining a close relationship with a bank (or banks) will be less likely to face financial constraints and have better access to external capital markets. In a similar vein, firms with sound corporate governance practices are believed to be more effective in preventing management (or controlling shareholders) from exhibiting moral hazard behavior. This will in turn allow them to raise funds more easily in the external equity market (La Porta, et al, 2002; Shleifer and Wolfenzon, 2002; Lan and Wang, 2003).2) Investors in countries where regulations governing investor protection are well in place are supposed to demand a lower expected return relative to countries without such regulations. Therefore, firms operating in such a country are able to pay less for equity financing and hence rely more on it in order to take advantage of growth opportunities (La Porta, et al, 1997; Rajan and Zingales, 1998). Some authors have also shown that firms with greater investment (or growth) opportunities and hence with larger demand for external finance tend to improve their corporate governance practices to give positive signals to the external capital markets with the aim of lowering the cost of capital (Klapper and Love, 2003; Black, Jang and Kim, 2006; Durnev and Kim, 2005; Park, Park, and Hwang, 2005). Hence, it is anticipated that firms with good corporate governance practices will have better access to the equity market and hence face less financial constraints.3) Importantly for the current paper, we show that cash flow measures play a significant role in determining investment expenditures. Using the 'flow' concept of cash flow that measures a firm's ability to generate profits, we find that neither cash flow nor investment opportunities are significantly related to corporate investment decisions. On the other hand, using the 'stock' concept of cash flow that measures funds availability in a firm, we find that cash flow is positively correlated with investment expenditures. It appears that for firms with greater financial constraints, investment decisions are positively related to the accessibility of capital markets as well as the amount of cash flow measured by the stock concept. And this positive effect is more pronounced for firms in non2) Lan and Wang (2003) describe two ways that controlling shareholders pursue private benefits. First, as implied in Jensen (1986), they mis-use free cash flows. Second, they make over-investment for the future private consumption. Controlling shareholders have incentives to over-invest due to the increased net private benefits from increased firm size. 3) Giannetti (2003) examines the bond markets of eight European countries and find that the degree of creditor protection provisions and the ability to borrow in the bond markets have a positive relationship. This finding implies that the degree of outside investor protection is crucial factor in gaining access to the public capital markets in Europe.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·39

chaebol groups, for firms with remote relationship with banks, and for firms showing poor corporate governance practices. In sum, our evidence suggests that investment decisions by Korean firms are affected significantly by the 'stock' concept of cash flow and this effect is greater for firms with more difficult access to the capital markets. This result is consistent with the idea suggested by Fazzari, Hubbard and Petersen(1988). This paper is organized as follows. Section II describes the data and methodology for the empirical analysis. Section III presents the empirical results on investment-cash flow sensitivities. Section IV rounds off the paper with some conclusions.

II . Data and Methodology 1. Sample Firms and Data Sample firms used in this study consist of those listed on the Korea Stock Exchange as of the end of fiscal year 2002. The data on corporate governance practices is from a unique and comprehensive survey administered on July 2003 by the Korea Corporate Governance Service (KCGS). The KCGS is a non-profit organization jointly sponsored by Korea's six securities related institutions including the Korea Stock Exchange, and has been regularly conducting surveys on the diverse dimensions of corporate governance practices including the protection of minority shareholder rights. In contrast to many prior surveys of corporate governance practices done by for-profit investment banks, the survey data we use is uniquely administered by the KCGS, an independent and nonprofit organization interested in the development and promotion of corporate governance practices. Further, the data set is believed to be free from selection bias because it basically incorporates all firms listed on the KSE. The questionnaire consists of five sub-groups and 300 points: (a) shareholder rights protection (90 points for 25 items), (b) board composition and operations including the existence of the audit committee and the outside directors nominating committee(100 points for 30 items), (c) corporate disclosure (50 points for 18 items), (d) auditor organization (30 points for 9 items), and (e) payout policies (30 points for 4 items). Among 426 listed firms taking part in the 2003 survey, we take only 357 non-financial firms that satisfy our firm characteristic data requirements.

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We obtain ownership data on the largest shareholders and their affiliated shareholders from the Korea Listed Companies Association, and other financial statement variables from the Korea Investor Services (KIS) database. The data on listed companies affiliated with a corporate group (or chaebol) comes from the Korea Fair Trade Commission. We estimate the intimacy of relationship banking as the five year average ratio of bank loans from the bank the firm had borrowed from most (hereinafter "the relationship bank") to the firm's total debt. Having searched for firms with pertinent bank loan data, we are left with only 203 listed firms. Table 1 shows summary statistics of the sample firms used in our study.

2. Methodology In order to analyze the relationship between investment and cash flow, this study makes use of an investment equation model that has been used in many previous studies. While most of them use a panel data model, we transform it into the following cross-sectional regression model due to data limitations:

Table 1 Firm characteristics Total assets (billion KRW) Sales (billion KRW) Sales growth rate Leverage ratio

Summary Statistics of Sample Firms Mean

Median

Minimum

Maximum

968 972 0.1579 0.4711

170 155 0.0594 0.4827

14 7 -0.7930 0.0878

53,941 40,511 12.864 0.9801

0.688

0.410

0.028

14.145

0.375 111.32

0.339 109

0.002 61

1.000 217

Shareholders protection index

42.34

43

20

69

Capital expenditure ratio (I/K) Cash flow 1 (CF1/K)

0.317 0.188

0.036 0.157

0 -0.713

9.29 1.346

Cash flow 2 (CF2/K)

0.249

0.118

0.001

2.267

Growth opportunity (MV/BV) Banking relationship index Corporate governance index

Notes : Sales growth rate is defined as (salest/salest-1)-1, leverage ratio is defined as total debt/total assets, MV/BV is market value of equity/book value of equity, banking relationship index is the past five year average ratio of bank loans from the relationship bank to the firm’s total debt, and both corporate governance index and shareholders protection index are obtained from the KCGS survey. I denotes capital expenditures, and K denotes fixed asset value. CF1 denotes EBITDA, and CF2 denotes the sum of cash equivalents and marketable securities. All numbers are as of the end of fiscal year 2002.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·41

( KI ) = β+ β( CFK ) + β( CFK ) + β( MV BV ) + ε 1

i

0

1

2

i

2

i

3

i

i

(1)

In equation (1) i represents a sample firm, I denotes capital expenditures, K denotes fixed asset value, CF1 is EBITDA, and CF2 is the sum of cash equivalents and marketable securities. MV and BV are defined as the firm's market value and book value of equity, respectively. By following the approach in Hoshi, Kashyap and Scharfstein (1991), we adopt two different concepts of cash flow for analysis. The first is the flow concept of cash flow that measures a firm's ability to generate profits, and the second is the stock concept of cash flow that measures surplus funds available to the firm. To represent firm's growth opportunities, we adopt the ratio of market value of equity to book value of equity instead of Tobin's Q. All the investment and cash flow variables are standardized by the initial capital. From here our empirical analysis proceeds as follows. First, we analyze the regression coefficients of variables that are correlated with firms' liquidity, and see if they indeed have positive values. For an additional robustness test, we do the same analysis making use of only those firms that have positive cash flow. The purpose of this analysis is to ensure that our result does not suffer from the potential weakness pointed out by Chirinko and Kalckreuth (2002), i.e., that some outlier samples with negative cash flow might exert an overwhelming influence on the paper's result. Second, we construct three categories depending on firms' accessibility to various capital markets, i.e., corporate groups with chaebol affiliation and those without, firms with intimate relationship with a bank and those with only a remote such relationship, and firms with good corporate governance practices and those with poor governance practices. We then analyze and compare the sensitivities between the groups in each category. As previously mentioned, Fazzari, Hubbard and Petersen (1988) find that the more financial constraints firms face in the external capital markets, the more they depend on internal finance and hence the greater the sensitivity of investment to cash flow would become. In contrast, Kaplan and Zingales (1997) find that the fewer financial constraints they face, the greater the sensitivity. In what follows, a firm belonging to any of the largest 30 chaebol groups will be considered as having easier access to the internal capital market. A firm having been maintaining an intimate (close and long lasting) relationship with any bank (relationship bank) will be considered as having easier access to the external debt market. And a firm which has scored high marks on corporate

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governance surveys will be regarded as having easier access to the external equity market. Correlation Coefficients

Table 2 1 1

2

3

4

5

6

7

8

Capital expenditure ratio (I/K)

2

Cash flow 1 (CF1/K)

0.052

3

Cash flows 2 (CF2/K)

0.196

4

Growth opportunity (MV/BV)

0.065 -0.195

5

Shareholders protection index

-0.12 -0.028 -0.162

0.072

6

Corporate governance index

0.135

0.044

7

Banking relationship Index

8

Total assets

9

Sales growth rate

-0.088

0.312

0.029 -0.013 -0.185 0.005

0.067

0.046

0.068 -0.043 -0.316 -0.215

0.046 -0.103 -0.057 0.012

0.399

0.586

0.578 -0.430

0.041 -0.031 -0.036 -0.029

0.051 -0.052

Notes : Numbers are Pearson correlation coefficients. The bold figures indicate significance at the 5% level.

II . Empirical Analysis Table 2 shows correlation estimates between the main variables used in the study. We first note that there exists no significant relationship between capital expenditure and cash flow 1, but a positive relationship exists between capital expenditure and cash flow 2. This implies that the sample firms respond sensitively to their liquidity condition when making investments, and especially to cash flow as measured by the stock concept. Firm size is the only variable that shows a significant relationship with capital expenditure except for cash flow 2, but it has no significant relationship with cash flow as measured by the flow concept. However, firm size turns out to be significantly related to three variables representing capital market accessibility, implying that there could exist close link between firms' size and their ability to finance. But since their coefficients point in opposite directions, we can see that the differences in investment-cash flow sensitivity, if any, are not necessarily related to firm size.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·43

Tables 3-1 and 3-2 display characteristic values of firms that are categorized by access to internal and external capital markets. Total assets as well as sales are viewed as representing firm size, and show significant differences between the two contrasting groups in all three categories. In a sense, this result shows Table 3-1

Difference Tests with Respect to the Accessibility to Internal Capital Market

Firm characteristics and liquidity category

Chaebol group

Non-chaebol group

Difference test

Number of observations

62

295

Total assets (billon KRW)

3,217 [12,068]

496 [1,390]

(5.07)** [0.001]**

Sales (billon KRW)

3,815 [10,850]

375 [1,298]

(6.96)** [0.001]**

Dividend/cash flow

0.093 [0.075]

0.107 [0.079]

(0.43) [0.647]

Retained earnings

0.775 [0.833]

0.803 [0.839]

(0.67) [0.291]

MV/BV

0.857 [0.576]

0.653 [0.397]

(1.36) [0.001]**

Sales growth rate

0.0512 [0.0614]

0.1805 [0.0593]

(1.48) [0.884]

Leverage ratio

0.5743 [0.5805]

0.4494 [0.4589]

(5.13)** [0.001]**

131.14 [126.0]

107.15 [108.0]

(5.92)** [0.001]**

0.2167 [0.1736]

0.4054 [0.3691]

(5.44)** [0.001]**

Investment expenditure ratio (I/K)

0.054 [0.005]

0.373 [0.060]

(2.29)* [0.001]**

Cash flow 1 (CF1/K)

0.173 [0.147]

0.191 [0.160]

(0.53) [0.876]

Cash flow 2 (CF2/K)

0.126 [0.094]

0.276 [0.131]

(3.09)** [0.005]**

Corporate governance index Banking relationship index

Notes : The table displays the mean values of corresponding variables, and figures in [ ] show their median. In the last column, figures in ( ) are t-values and those in [ ] are p-values of Wilcoxon rank sum test. In the first column, dividend/cash flow is dividend payout amount/EBITDA, retained earnings are 1- (dividend payout amount/net income), MV/BV is market value of equity/book value of equity, sales growth rate is (salest/salest-1)-1, leverage ratio is total debt/total assets, banking relationship index is the past five year average ratio of outstanding bank loans from the relationship bank to the firm’s total debt, and the corporate governance index is obtained from the KCGS survey. I denotes capital expenditures, and K denotes fixed asset value. CF1 denotes EBITDA, and CF2 denotes the sum of cash equivalents and marketable securities. All numbers are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

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Table 3-2

Difference Tests with Respect to Accessibility to External Capital Markets

Firm characteristics and liquidity category

Accessibility to external equity market Good Bad corporate corporate governance governance

Accessibility to external debt market

Difference test

Intimate banking relationship

Remote banking relationship

Difference test

Sample size

184

173

102

101

Total assets (billion KRW)

1,665 [25,883]

228 [1,367]

(3.58)** [0.001]**

168 [1,263]

1,907 [2,280]

(2.53)* [0.001]**

Sales (billion KRW)

1,696 [2,533]

204 [1,184]

(3.93)** [0.001]**

179 [1,324]

1,633 [1,963]

(2.75)** [0.001]**

Dividend/cash flow

0.126 [0.089]

0.082 [0.059]

(1.76) [0.001]**

0.087 [0.078]

0.075 [0.084]

(0.43) [0.893]

Retained earnings

0.779 [0.813]

0.819 [0.892]

(1.26) [0.001]**

0.819 [0.845]

0.835 [0.843]

(0.53) [0.936]

MV/BV

0.697 [0.500]

0.679 [0.385]

(0.15) [0.001]**

0.588 [0.433]

0.692 [0.479]

(1.14) [0.229]

Sales growth rate

0.0719 [0.0614]

0.2495 [0.0554]

(1.26) [0.729]

0.2532 [0.0586]

0.1827 [0.0599]

(0.29) [0.966]

Leverage ratio

0.4658 [0.4809]

0.4767 [0.4864]

(0.52) [0.757]

0.4410 [0.4596]

0.5044 [0.5254]

(2.41)* [0.018]*

Banking relationship Index

0.3583 [0.3208]

0.3904 [0.2096]

(1.03) [0.187] 106.73 [107.5]

114.51 [109.0]

(2.43)* [0.140]

Corporate governance index Investment expenditures (I/K)

0.222 [0.024]

0.419 [0.080]

(1.83) [0.001]**

0.313 [0.062]

0.391 [0.022]

(0.47) [0.010]*

Cash flow 1(CF1/K)

0.231 [0.178]

0.142 [0.137]

(3.37)** [0.001]**

0.179 [0.171]

0.209 [0.159]

(0.78) [0.773]

Cash flow 2(CF2/K)

0.268 [0.127]

0.230 [0.113]

(1.03) [0.930]

0.267 [0.149]

0.259 [0.153]

(0.15) [0.951]

Notes : The table displays mean value of corresponding variables, and [ ] shows their median. In the last column, figures in ( ) are t-values and those in [ ] are p-values of Wilcoxon rank sum test. In the first column, dividend/cash flow is dividend payout amount/EBITDA, retained earnings are 1- (dividend payout amount/net income), MV/BV is market value of equity/book value of equity, sales growth rate is (salest/salest-1)-1, leverage ratio is total debt/total assets, banking relationship index is the past five year average proportion of bank loan balance from the relationship bank out of firm’s total debt, and corporate governance index is obtained from the KCGS survey. I denotes capital expenditures, and K denotes fixed asset value. CF1 denotes EBITDA, and CF2 denotes the sum of cash equivalents and marketable securities. All numbers are as of the end of fiscal year 2002. while * and ** show significance at the 5% and 1% levels, respectively.

the interrelation between the access to various capital markets and firm size, as mentioned before. However, the fact that large firms are likely to belong to chaebol groups and exercise good governance practices, but maintain a rather remote relationship with their banks suggests that the relationship between the

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·45

accessibility to various capital markets and firm size does not always run in the same direction. On the other hand, in the case of dividend payout ratio, retained earnings and the two cash flow variables, we observe no significance in the differences between the two contrasting groups nor indeed any consistency. Notably, in the cases of the two variables at the bottom of Table 3-1, the CF2 variable shows some significant differences between firms in the chaebol group and those in the non-chaebol group whereas the CF1 variable shows no meaningful differences. In fact, CF2 turns out to be very low for firms in the chaebol group. This result implies that when these firms need to raise capital, they may be able to satisfy their needs within the corporate group boundary by taking advantage of an internal capital market. The result therefore can be understood as indirect evidence for the existence of internal capital markets.

Sensitivity Analysis on All Sample Firms

Table 4 Category

All firms

CF1/K

0.012 (0.05)

Firms with positive cash flows 0.192 (0.59)

CF2/K

0.548 (3.46)**

0.513 (3.03)**

MV/BV

0.049 (0.98)

-0.072 (-0.99)

Adj. R2

0.033

0.032

F-value

5.036**

4.675**

Sample size

357

335

Notes : The table displays regression coefficients of OLS, and ( ) shows t-values. Dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is market value of equity/book value of equity. All numbers are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

These results indicate that categorizing the sample firms in terms of their accessibility to various capital markets depends on the difference in their financial constraints, and not on some general characteristics such as firm size. So it may be safe to say that the probability that our results are influenced by other control variables is low. Further, it is worthwhile to note that we are not able to find a significant relationship among firms' dividend policies, future investment opportunities and their liquidity condition. This suggests a possibility that, differently from in Fazzari, Hubbard and Petersen, financial constraints facing firms associated with these variables do not have much relevance to the

46·Economic Papers Vol.10 No.2

investment-cash flow sensitivity of Korean firms. That is, our results in what follows are largely independent of firm size and dividend payout ratio, which were often used as proxies for financial constraints in earlier studies. In order to confirm the relationship between capital expenditure and cash flow, we make use of the regression equation (1), and provide the results in Table 4. Here we can see that the flow concept of cash flow or growth opportunities has no significant influence upon investment expenditure. In contrast, the stock concept of cash flow is significantly and positively related to investment expenditure. Another issue of interest regarding the samples is that some outliers which have negative cash flow can influence investment-cash flow sensitivity. However, our results based on the samples excluding the outliers are very similar to those based on the whole sample. This once again supports our earlier argument that, for Korean firms, capital expenditure is more sensitive to constraints on funds availability and liquidity than to their ability to generate future income or growth opportunities. Of the two cash flow variables, only CF2, the stock concept of cash flow, turns out to show significance. This implies that internal cash flow generated from operations can not be freely used for investment purposes, but that surplus cash flows can be. One plausible reason for this is that in the Korean capital markets the liquidity condition of a firm depends more on currently available liquidity than on uncertain future cash flows. This result is consistent with many earlier findings in the Korean literature on the importance of liquidity constraints as well as excess demand for Table 5

Sensitivity Analysis with Respect to Accessibility to Internal Capital Market

Category

Chaebol group

Non-chaebol group

CF1/K

-0.274 (-1.16)

0.055 (0.22)

CF2/K

0.016 (0.07)

0.505 (2.84)**

MV/BV

0.004 (0.13)

0.067 (1.16)

Adj. R2

-0.027

0.028

F-value

0.457

3.829**

Sample size

62

295

Notes : The table displays regression coefficients of OLS, and ( ) shows t-values. The dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is market value of equity/book value of equity. All figures are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·47

funds in Korean capital markets (Kim, 1993; Kong, 1996; Park and Shin, 1998; Park and Yoon, 2000; Kang and Lim, 2001; Kim, 2002). To check whether there is a difference in the investment-cash flow sensitivity with respect to the severity of financial constraints facing firms, we divide all sample firms into two groups with respect to their access to the capital markets. Firstly, in order to measure the effects of the difference in the accessibility of the internal capital market, we divide all sample firms into two groups, chaebol group and non-chaebol group, depending on whether or not a firm belongs to any of the biggest 30 chaebols. Firms belonging to a chaebol group are considered to experience good liquidity conditions thanks to the internal capital market, and thus to be less financially constrained. The regression results are displayed in Table 5. Neither cash flow variables is significant for firms in the chaebol group, but CF2 is significantly positive for firms in the non-chaebol group. This result, seemingly consistent with the ideas of Fazzari, Hubbard and Petersen (1988), implies that the harsher the financial constraints on constraints on firms, the more sensitive to cash flow their investment expenditures become. This result is also consistent with Hoshi, Kashyap and Scharfstein (1991). In the absence of an internal capital market, firms in non-chaebol group appear to respond negatively to the lack of internal funds in their investment decisions.

Table 6 Category

Sensitivity Analysis with Respect to the Accessibility to External Capital Markets Corporate governance

Banking relationship

Good

Bad

Intimate

Remote

CF1/K

0.327 (1.17)

0.212 (0.59)

0.389 (1.37)

0.312 (0.44)

CF2/K

0.269 (1.88)

1.070 (3.25)**

0.392 (1.76)

1.311 (2.78)**

MV/BV

-0.125 (-1.52)

0.096 (1.37)

0.175 (1.11)

-0.166 (-0.85)

Adj. R2

0.038

0.058

0.043

0.068

F-value

3.417*

4.497**

2.527

3.447*

Sample size

184

173

102

101

Notes : The table displays the regression coefficients of OLS, and ( ) shows t-values. The dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is market value of equity/book value of equity. All numbers are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

48·Economic Papers Vol.10 No.2

Table 6 displays the results of sensitivity analysis after categorizing sample firms by their accessibility to external capital markets. For firms with good corporate governance practices and hence having better access to the external equity market, and firms with an intimate banking relationship and hence having better access to banking services, liquidity does not seem to be the primary constraint. However, for firms with unsound corporate governance practices or with only a remote banking relationship, liquidity or funds availability seems to be a major factor in investment decisions. Good corporate governance practices or an intimate banking relationship would contribute to the mitigation of the information and agency problems mentioned earlier, allowing a firm to have easier access to external capital markets and perhaps to pay a lower cost of capital.

Table 7 Category

Robustness Tests on the Sensitivity Analysis Shareholder protection Good firms

Bad firms

CF1/K

0.150 (0.48)

-0.054 (-1.42)

CF2/K

0.419 (1.85)

0.776 (3.72)**

MV/BV

0.106 (1.38)

-0.048 (-0.85)

Adj. R2

0.019

0.062

F-value

2.198

4.727**

187

170

Sample size

Notes : The table displays the regression coefficients of OLS, and ( ) shows t-values. The dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is the market value of equity/book value of equity. All figures are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

In order to check the relevance of the corporate governance index as a proxy to measure accessibility to the equity market, we categorize sample firms into two groups in accordance with the shareholder protection index and analyze the differences in their sensitivity. As mentioned earlier, the survey data of the KCGS include many items concerning corporate governance practices of the listed firms. In the equity markets, investors concerned about informational disadvantage are likely to be interested in shareholder protection. Therefore, the higher the shareholder protection index, the safer outside investors feel, and thus

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·49

the less expensive a firm's cost of equity would become. Table 7 presents the results of our analysis, which are very similar to those in Table 6. Firms whose equity costs are anticipated to be higher because of lower investor protection indices seem to suffer significantly from liquidity problems.

Table 8

Sensitivity Analysis with Respect to Co-Accessibility to Two External Capital Markets Intimate banking relationship

Category

Remote banking relationship

Good corporate governance

Bad corporate governance

Good corporate governance

Bad corporate governance

CF1/K

1.129 (1.24)

0.312 (1.88)

0.189 (1.07)

1.258 (1.01)

CF2/K

0.214 (0.49)

-0.061 (-0.34)

-0.074 (-0.69)

3.016 (3.37)**

MV/BV

-0.269 (-0.65)

0.228 (2.43)*

-0.019 (-0.49)

-0.214 (-0.47)

Adj. R2

0.034

0.052

-0.032

0.188

F-value

1.548

1.974

0.477

4.777**

Sample size

48

54

51

50

Notes : The table displays the regression coefficients of the OLS, and ( ) shows t-values. The dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is market value of equity/book value of equity. All numbers are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

To check the effects of the accessibility of both external capital markets at the same time, we categorize all sample firms into four subgroups using accessibility to the respective markets as two criteria. Table 8 displays the results. For firms with easy access to both external markets, financial constraints do not seem to affect their investment decisions. But firms with limited access to either external market seem to take into consideration their liquidity condition when making investments. Our findings suggest that accessibility to any external capital markets becomes a necessary condition for a firm's investments, and that the two external capital markets, i.e., the stock market and bank loan market are substitutes.

50·Economic Papers Vol.10 No.2

Table 9

Sensitivity Analysis with Respect to Accessibility to Both Internal and External Capital Markets

Panel A: Firms in Chaebol Group Good corporate governance

Bad corporate governance

Intimate banking relationship

Remote banking relationship

CF1/K

0.056 (0.55)

-2.862 (-3.19)*

-0.095 (-8.61)**

-0.525 (-1.29)

CF2/K

-0.013 (-0.16)

1.691 (1.05)

0.042 (6.77)**

0.073 (0.21)

MV/BV

-0.006 (-0.50)

0.487 (1.76)

0.031** (29.22)

-0.007 (-0.12)

Adj. R2

-0.129

0.486

0.998

-0.051

F-value

0.233

4.470*

750.71*

0.562

Sample size

21

12

5

28

Good corporate governance

Bad corporate governance

Intimate banking relationship

Remote banking relationship

CF1/K

0.674 (1.24)

0.474 (0.89)

0.396 (1.36)

0.447 (0.50)

CF2/K

0.178 (0.65)

1.993 (3.58)**

0.376 (1.64)

1.314 (2.26)*

MV/BV

-0.139 (-0.57)

0.087 (0.32)

0.181 (1.11)

-0.238 (-0.67)

Adj. R2

0.019

0.111

0.040

0.054

F-value

1.502

4.771**

2.315

2.378

Sample size

78

92

97

73

Panel B: Firms in Non-chaebol Group

Notes : The table displays the regression coefficients of OLS, and ( ) shows t-values. The dependent variable is I/K where I denotes capital expenditures and K denotes fixed asset value. CF1 denotes EBIDTA, and CF2 denotes the sum of cash equivalents and marketable securities. MV/BV is market value of equity/book value of equity. All numbers are as of the end of fiscal year 2002 while * and ** show significance at the 5% and 1% levels, respectively.

Table 9 shows the results of regression analysis on the investment-cash flow sensitivity considering the accessibility to both internal and external capital markets. In Panel A, firms in the chaebol group have easy access to their internal capital market and are not significantly affected by the accessibility to external capital markets. Noticing here that for firms in the chaebol group that also maintain an intimate banking relationship, CF2 turns out to be significant. However, this seems to be due to the small size of the sample. Importantly for the paper, for firms in the non-chaebol group in Panel B, the accessibility to external markets does seem to matter. Since firms in the non-chaebol group have no access to an internal capital market, accessibility to any external capital

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·51

market can help and hence this becomes an important standard for liquidity conditions. This result seems consistent with those shown in Table 8. We can therefore argue that accessibility to either internal or any external capital markets effectively eliminates liquidity constraints on Korean firms. Combining the results in Table 4 through Table 9, we find that for Korean firms the accessibility to capital markets can be a proxy measure for financial constraints. In addition, between the two concepts of cash flow, that of the stock concept has great explanatory power concerning the investment expenditures of Korean firms. If firms find it easy to come to the internal or external capital markets and thus suffer less financial constraints, liquidity conditions cannot be a determining factor when they decide to invest. But if firms find it difficult to raise funds because of limited access to the capital markets, the liquidity level exerts a significant influence upon their investment decisions. For Korean firms, access to any capital market can mitigate their financial constraints. The stricter the financing constraints firms face, the higher their investment-cash flow sensitivity becomes. This result is consistent with the ideas put forward by Fazzari, Hubbard and Petersen (1988).

IV. Conclusions This paper examines how the sensitivity of investment to cash flow can vary depending on corporate group (chaebol) affiliation, the soundness of corporate governance practices, and the intimacy of relationship banking. In order to conduct this analysis, a unique data set on corporate governance and relationship banking for listed Korean firms is employed. We categorize our sample firms into three groups: 1) a group with easier access to the internal capital markets within a chaebol group; 2) a group with easier access to the bank loan market (intimate banking relationship group); and 3) a group with easier access to the external stock market (sound corporate governance group). We then investigate how the cash flow of sample firms in each category affects their investment decisions. Our paper is different from earlier studies in that we analyze the investmentcash flow sensitivity of firms operating in three radically different financial environments. That is, we consider the internal capital markets that have been known to exist within Korean chaebol groups as well as two external capital markets, i.e., the equity market and the bank loan market. We then classify our

52·Economic Papers Vol.10 No.2

sample firms into two groups in each of the three categories depending on their access to each market in order to analyze their investment-cash flow sensitivity. We find that corporate capital investments are not significantly affected either by firms' investment opportunities or by the flow concept of cash flow to measure their ability to generate profits. However, by using the stock concept of cash flow to measure available funds, we find that cash flow is positively correlated with investment expenditures. Further, this positive effect is more pronounced for firms in non-chaebol groups, for firms with only remote relationship banking, and for firms with poor corporate governance practices. This result is viewed as being consistent with the ideas propounded by Fazzari, Hubbard and Petersen (1988). Several implications follow from our empirical results. First, as far as the investment behavior of Korean firm which used to face continued financial constraints are concerned, liquidity factors such as the availability of internal funds seem to have had greater explanatory power than investment opportunities and growth potential, etc. The same can be said for the stock concept of cash flow compared with its flow counterpart. Second, firms whose access to both internal and external capital markets is limited turn out to show the greatest significance to investment-cash flow sensitivity, which is understood to provide further evidence in support of Fazzari, Hubbard and Petersen (1988). Third, for our sample firms, the internal and external capital markets seem to complement each other, and thus financial constraints facing firms in one market can be relieved by increased accessibility to any other market. This paper is not without its weaknesses and limitations, but deserves attention as the basis for further research. Due to the limited availability of the panel data set, the over-time behavior of investment-cash flow sensitivity could not be examined. Also, analyzing some proxies for investment variables such as R&D expenditures might have proved valuable for the purpose of robustness testing. Finally, analysis of how our three financial constraints criteria interact with each other would have been interesting.

Accessibility to Capital Markets and the Sensitivity of Investment to Cash Flow·53

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