Bayraktar-April08-2008 | Book Value | Regression Analysis

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   International Journal of Revenue Management, (forthcoming in 2008). Investment, Alternative Measures of Fundamentals, and Revenue Indicators Nihal Bayraktar * , +  April 08, 2008 Abstract : The paper investigates the empirical significance of revenue management indetermining firm-level fixed capital investment when investment opportunities arecontrolled for by two of the recently-introduced empirical fundamentals: profitabilityshocks and the gap measure between the desired and actual capital stocks (mandatedinvestment rate). Tobin's q is also included in the analyses for the purpose of comparison.The data set, which is constructed from the COMPUSTAT database, includes U.S. basedmanufacturing firms. The results show that financial variables are important determinantsof investment but they are not as significant as claimed by some empirical studiesfocusing on capital market imperfections. The explanatory power of financial variables inthe investment process declines with increasing significance of fundamentals. Anotherinteresting result is that the level of investment by expected-to-be financially constrainedfirms, identified by commonly used a priori measures of financial constraints, tends to berelatively less sensitive to changes in financial variables compared to changes infundamentals even though the opposite is predicted in the literature. This result questionswhether investment-cash flow sensitivity can be a good measure of financial constraints,as well as whether some of the firm characteristics used in identifying financiallyconstrained firms in the literature are sufficient. Keywords : revenue management, investment, fundamentals, financial variables, financing constraints . JEL Classification Number : E22 * Penn State University Harrisburg, School of Business Administration, Middletown, PA 17057, USA. E-mail: + I am grateful to Senay Agca, John Haltiwanger, and Plutarchos Sakellaris for their generous support andadvice and to John Shea for numerous comments and suggestions. Any errors are my own.  2 1. Introduction Empirical fundamentals, such as average Tobin's q , have produced disappointingempirical results in explaining the investment process of firms in the neoclassicalinvestment literature. Even though the Q theory shows that a firm's marginal q should bethe only determinant of investment, a well-developed empirical literature shows thatinvestment is sensitive to a firm's internal fund management after controlling for Tobin's q , i.e. the ratio of asset market value to replacement cost of capital. Possible explanationsfor this high investment-internal fund sensitivity are investigated in two groups: thepresence of financial market imperfections, or the existence of measurement problemsrelated to Tobin's q , which prevent it from fully capturing investment opportunities.In the first group, the financial market imperfections literature assumes that firms'net worth determines their financial position. When a firm's net worth is low, this firmcan be considered financially constrained. The reason is that it is likely to face anasymmetric information problem in financial markets, which makes it difficult for themto find enough external funds to finance their investment projects. Even if they could findexternal funds, they would be too expensive compared to the opportunity cost of internalfunds. Financial contraints lead firms’ investment decisions to be highly correlated withtheir internal funds. In the literature, it has been shown that the premium on externalfinance varies inversely with the firm's net worth such that a fall in net worth causes thepremium on external finance to increase, which may lead to a reduction in investment.Some examples of these studies are: Bernanke and Gertler (1990), Bernanke, Campbelland Whited (1990), Whited (1992), Hu and Schiantarelli (1998), Gilchrist andHimmelberg (1998), Jaramillo, Schiantarelli, and Weiss (1996), Eisfeldt and Rampini(2007), Caggese (2007a), Bohacek (2007), Lorenzoni and Walentin (2007), andHennessy, Levy, and Whited (2007).Firms with high net worth, on the other hand, are expected to have a smallerasymmetric information problem. Thus, they can find enough external funds to financetheir capital adjustment, and follow the investment process suggested by changes infundamentals. This implies that the investment decision of firms with high net worthwould be independent of the availability of their internal funds. Indeed, the empiricalliterature investigating financial market imperfections shows that firms that are classifiedas financially constrained present a larger sensitivity of investment to internal funds evenafter investment opportunities are controlled for by fundamentals such as Tobin's q .Kashyap, Lamont and Stein (1994), Carpenter, Fazzari and Petersen (1998), Hoshi,Kashyap, and Scharfstein (1991), Schiantarelli (1996), and Hubbard (1998) among othersstudies these issues.In the second group of studies, the presence of measurement error problems of fundamentals is given as an alternative explanation to high sensitivity of investment tofinancial variables. The lack of importance of fundamentals in determining investmentcan be reasoned by their low quality of capturing firms' investment opportunities.Different authors argue that when measurement errors are controlled for, fundamentalsbecome significant determinants of investment. Thus, as long as proper measures of   3investment opportunities are introduced, cash flow or other financial variables are notexpected to add any new information in investment regressions. Kaplan and Zingales(1995 and 1997), Gomes (2001), Erickson and Whited (2000), Cooper and Ejarque(2003), Abel and Eberly (2003), Caggese (2007b), and Grenadier and Wang (2007) studythis issue. In order to overcome measurement error problems, new measures of fundamentals are introduced in the literature. For example, Gilchrist and Himmelberg(1995 and 1998) introduce a Fundamental Q measure, which is the present discountedvalue of future profit rates. They show that investment is more sensitive to thisfundamental compared to Tobin's q , but financial variables are still significantdeterminants of investment.Recent papers based on investment models with non-convex adjustment costshave also introduced alternative empirical measures of fundamentals. Two of them areprofitability shocks and the gap measure between the desired and actual capital stocks(mandated investment rate). Caballero, Engel and Haltiwanger (1995), Cooper andHaltiwanger (2005), and Cooper and Ejarque (2003) are the papers studying these newmeasures of fundamentals. These fundamentals are compared with Fundamental Q andTobin's q in Bayraktar (2002). They are found to be more significant in explaininginvestment compared to Tobin's q and Fundamental Q . Bayraktar, Sakellaris, andVermeulen (2005) show that financial variables are also important in determininginvestment in addition to fundamental determinants, using a structural investment modelbased on both convex and non-convex adjustment costs, where fundamentals aremeasured by profitability shocks.Since the recently-introduced alternative fundamentals present a forward-lookingbehavior of firms, they are expected to better capture investment opportunities comparedto Tobin's q . To test this hypothesis, in this paper, we investigate whether the relativesignificance of firms' financial position in the investment process may change wheninvestment opportunities are controlled for by these new fundamentals. The answer tothis question helps us better understand the relationship among fundamentals, investment,and financial variables. The aim is to shed light on the extent to which the investment-financial variable sensitivity can be linked to capital market imperfections versusmismeasured fundamentals.The analyses in this paper are based on a reduced form investment equation, inwhich both fundamental determinants of investment and revenue indicators are taken asexplanatory variables. A panel data set at the firm level is constructed from theCOMPUSTAT database. The data set includes U.S. manufacturing firms for the period of 1983-1996. The fundamental determinants of investment are represented by profitabilityshocks and the gap measure. It should be noted that a Fundamental Q measurecalculated by Gilchrist and Himmelberg (1995, 1998) is not included in the paper sincethey have already reported that the significance of financial variables drops wheninvestment opportunities are captured by Fundamental Q . Tobin's q is also included forthe purpose of comparison. Financial variables are represented by the ratio of cash flowto capital, sales to capital, and working capital to capital.  4The empirical results show that revenue management and financial variablesindicators are still important determinants of investment, but they are not as significant asclaimed by studies focusing on capital market imperfections. The findings indicate thatthe explanatory power of financial variables in the investment process declines withincreasing significance of fundamentals. On the one hand, the explanatory power of financial variables in a reduced form investment equation is the lowest when investmentopportunities are measured by the gap between the desired and actual capital stocks. Asinvestigated in Bayraktar (2002), this fundamental measure is the most significantempirical determinant of investment when compared with other fundamentals. Tobin's q ,on the other hand, is the weakest determinant of investment, and financial variables havethe highest explanatory power for investment when Tobin's q is the proxy for investmentopportunities. Thus, this result implies that the previous empirical failure of fundamentalsagainst financial variables might be caused by measurement errors in fundamentals.When investment opportunities are captured better, the statistical and economicsignificance of financial variables drops.Similar analyses are repeated after firms are classified into different groups usingtwo alternative, commonly used a priori criteria used to identify financially constrainedfirms. The firm characteristics are the level of capital stock and the number of employees.The empirical results based on these sub-samples report how the response of investmentto fundamentals, and to revenue indicators changes, depending on whether firms belongto a financially constrained or relaxed group. It is expected that firms with financialconstraints exhibit significant investment-cash flow sensitivity compared to firms thatappear less financially constrained. An interesting result is that when profitability shocksand the mandated investment rates are the fundamentals, the sensitivity of investment tofinancial variables tends to be lower for financially constrained firms even though theopposite is expected in the literature. However, when Tobin's q is the fundamentalmeasure, the results are as expected in the literature, such that financial variables aremore important in determining investment for firms taking place in a financiallyconstrained group. One implication of this result is that high investment-cash flowsensitivity may not be seen as evidence of financial constraints. This high sensitivity forfinancially constrained firms might be caused by the fact that investment opportunitiesare captured by insufficient measures of fundamental such as Tobin's q . This has beenalso shown by Kaplan and Zingales (1995 and 1997). They indicate that firms classifiedas less financially constrained exhibit significantly greater investment-cash flowsensitivity than firms classified as more financially constrained. The results in our paperalso imply that a priori criteria used in classifying firms may not be that successful inidentifying financially constrained ones.The rest of the paper is organized as follows. Section 2 gives information aboutthe relationship between investment, fundamentals, and financial variables. In Section 3,details on the data set and variables are given. In Section 4, the empirical results arepresented. Section 5 concludes.
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