Financial Flexibility and Investment Ability Across the Euro Area and the UK

• Author: Annalisa Ferrando,Maria‐Teresa Marchica,Roberto Mura
• Published date: 01 January 2017
• Date: 01 January 2017
• DOI: http://doi.org/10.1111/eufm.12091

Financial Flexibility and Investment

Ability Across the Euro Area and

the UK

Annalisa Ferrando

European Central Bank, DG-Economics, Sonnemannstrasse 20, 60314, Frankfurt am Main, Germany

E-mail: annalisa.ferrando@ecb.int

Maria-Teresa Marchica

Alliance Manchester Business School, Crawford House, Booth Street East, Manchester, M13 9PL,

United Kingdom

E-mail: maria.marchica@manchester.ac.uk

Roberto Mura

Alliance Manchester Business School, Crawford House, Booth Street East, Manchester, M13 9PL,

United Kingdom

E-mail: roberto.mura@manchester.ac.uk

Abstract

We use a very large sample of European private and public firms to show that financial

flexibilityattained through a conservative leverage policy is more important for private,

small-medium-sized, and young firms and for firms in countries with less access to

credit and weaker investor protection. Further, using the 2007 financial crisis as a

natural experiment, we show that a higher degree of financial flexibilityallows firms to

reduce the negative impact of liquidity shocks on investment. Our findings support the

hypothesis that financial flexibility improves companies’ability to undertake future

investment, despite market frictions hampering possible growth opportunities.

Keywords: low leverage, financial flexibility, investment, cross-country analysis

JEL classification: G31, G32, D92

We thank John Doukas (the Editor), two anonymous referees, Nataliya Zaiats, and seminar

participants at the European Commission workshop 2015, European Central Bank (ECB),

at the Eastern Finance Association 2013 conference, European Economic Association

2013, World Finance & Banking Symposium 2013, and at the International Finance &

Banking Association 2013 conference. This research was conducted while Marchica and

Mura were visiting the ECB, whose hospitality and support are gratefully acknowledged.

The views expressed in this paper reflect only those of the authors and should not be

attributed to the ECB.

European Financial Management, Vol. 23, No. 1, 2017, 87–126

doi: 10.1111/eufm.12091

© 2016 John Wiley & Sons, Ltd.

1. Introduction

Under perfect capital markets, firms may always invest at their optimum level and

costlessly adjust their financial structures to any unexpected change in liquidity and

growth opportunities. However, when capital markets are imperfect and the cost of

external financing increases, financial flexibility becomes increasingly important.

Generally speaking, financial flexibility relates to the ability of companies to undertake

investment in the future, when asymmetric information and contracting problems might

otherwise force them to forego profitable growth opportunities. Firms may pursue

financial flexibility in several ways: by shaping their capital structure, cash management

or payout policies, and by creating “an intertemporal dependence”between financial and

investment decisions (Almeida et al., 2011; Denis, 2011).

Our paper focuses specifically on financial flexibility attained through a conservative

leverage policy. Survey evidence suggests that financial flexibility is a primary driver of

chief financial officers’leverage choices (Graham and Harvey, 2001; Bancel and Mittoo,

2004; Brounen et al., 2006). Companies may follow a conservative leverage policy to

maintain “substantial reserves of untapped borrowing power”(Modigliani and Miller,

1963, p. 442), which allows them to access the capital markets in the event of positive

shocks to their investment opportunity set. The value of being financially flexible is thus

directly related to the ability of companies to undertake new investment projects: the

more the investment undertaken by financially flexible (FF) firms, the higher the value of

financial flexibility for those firms. Indeed, several empirical studies provide evidence

that supports this statement: the sensitivity of investment to a firm’sfinancial flexibility

status is significantly higher for firms that attained their flexibility through either

conservative leverage (Marchica and Mura, 2010; and de Jong et al., 2012) or a zero-

leverage policy (Bessler et al., 2013).

The present paper takes the additional step of analyzing how the value of financial

flexibility varies depending on the degree of financing frictions companies face. In

their theoretical model, Gamba and Triantis (2008) predict that “firms with high level

of financial flexibility should be valued at a premium.”Consequently, for firms with

lower cost of external financing, this premium should be smaller. Therefore, we

reason that, in the presence of market friction, firms that anticipate valuable future

investment opportunities may follow a policy of financial flexibility to preserve their

ability to pursue these future growth options. Once they acquire FF status, these firms

should be able not only to invest more than non-flexible ones (Not FF), they should

also be able to invest more the stronger the degree of financing constraints. In other

words, the value of financial flexibility should be positive and it should be greater

for those FF firms expecting to face more financing constraints. A further implication

is therefore that, in the presence of exogenous shocks to liquidity in the market, FF

firms should better be able to cope with a rationed capital supply and to avoid

financial distress.

To test our hypotheses, we use the entire universe of Bureau van Dijk’sAmadeus,

which encompasses a very large sample of 289,839 European companies with at least

4 years of observations in the 18-year interval 1993–2010. Thanks to reporting

requirements and practices across most European countries, this database gives us the

opportunity to be the first to investigate the value of financial flexibility across a very

heterogeneous sample of both publicly traded and privately held firms that vary

substantially in size, age, and quality of institutional setting. This sample, from eight

© 2016 John Wiley & Sons, Ltd.

88 Annalisa Ferrando, Maria-Teresa Marchica and Roberto Mura

euro-area countries and the UK, represents a very large proportion of the aggregate

economic activity of Western Europe.

1

We first identify FF firms by focusing on low-leverage firms. We estimate a leverage

equation from which we calculate the predicted level of debt. Since the demand for

financial flexibility is indirectly captured by the negative deviations from estimated

target leverage (LL), we classify a firm as FF if it shows an LL policy for a minimum

number of consecutive years. We find that 31% of firms in our sample show a

conservative leverage policy for at least three consecutive years (FF3). Second, we test

whether this degree of financial flexibility has any impact on investment ability. In the

presence of market frictions, firms that anticipate valuable growth options in the future

may respond by pursuing an LL policy for a number of years. In this way, FF firms may

have enough spare borrowing power to be able to raise external funds, and to invest more

in the years following the conservative financial policy. To test this hypothesis, we use

a modified version of the q-model of investment augmented by an FF dummy and its

interaction term with cash flow. The FF dummy is expected to have a positive and

significant impact on capital expenditure. In addition, to the extent that FF firms can, after

a period of low leverage, more easily raise external funds to finance their projects, their

investment ability should be less dependent on internal funds. As a consequence, we

would expect a lower sensitivity of investment to cash flow. The results over the entire

sample do indeed show a large impact from FF status on firm investment ability. Our

tests reveal that the average company that maintains an LL policy for three years can

increase its capital expenditure by 22.6%. These results are robust to the different

methods we follow to classify FF firms, to alternative definitions of leverage and growth

opportunities, and to alternative interpretations, such as credit rationing and agency

issues.

Once we show that the value of financial flexibility relates to the ability of firms to

invest (i.e., positive investment sensitivity to FF status), we test the hypothesis that

financial flexibility is more valuable for those companies that face higher external

financing costs. To this end, we classify different subsamples of firms based on their

expected financing friction. For each subsample, we run our baseline model and compare

the overall impact of FF status on firm investment. We show that: 1) privately held

companies (after maintaining an LL policy for at least three years) increase their capital

expenditures almost four times more than publicly traded firms (22.6% versus 6.9%);

2) small companies are able to increase their capital expenditures by 16.1%, while large

companies can increase their investment by 15.6%; 3) young FF companies increase

their capital expenditures by 25.7%, while mature FF firms increase them by 9%.

We further our investigation by exploiting the heterogeneity of the quality of

institutional settings in our sample. Lower legal protection increases firms’expected

asymmetric information and contracting problems, which, in turn, negatively affects

corporate financial and investment decisions (e.g., La Porta et al., 1997; Love, 2003;

Mclean et al., 2012; Mortal and Reisel, 2013). We expect financial flexibility to be

more valuable for firms in countries with lower legal protection. Indeed, our results

1

For instance, based on National Accounts of each Western European country, we calculate

that, at the end of 2010, the total non-government gross fixed capital formation of all

countries in our sample was almost 84% of the equivalent aggregate in Western Europe.

Figures for the proportion of overall GDP (83.2%) and total employment (86.2%) are similar.

© 2016 John Wiley & Sons, Ltd.

Financial Flexibility and Investment Ability 89