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

AuthorAnnalisa Ferrando,Maria‐Teresa Marchica,Roberto Mura
Published date01 January 2017
Date01 January 2017
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
Maria-Teresa Marchica
Alliance Manchester Business School, Crawford House, Booth Street East, Manchester, M13 9PL,
United Kingdom
Roberto Mura
Alliance Manchester Business School, Crawford House, Booth Street East, Manchester, M13 9PL,
United Kingdom
We use a very large sample of European private and public rms to show that nancial
exibilityattained through a conservative leverage policy is more important for private,
small-medium-sized, and young rms and for rms in countries with less access to
credit and weaker investor protection. Further, using the 2007 nancial crisis as a
natural experiment, we show that a higher degree of nancial exibilityallows rms to
reduce the negative impact of liquidity shocks on investment. Our ndings support the
hypothesis that nancial exibility improves companiesability 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, 87126
doi: 10.1111/eufm.12091
© 2016 John Wiley & Sons, Ltd.
1. Introduction
Under perfect capital markets, rms may always invest at their optimum level and
costlessly adjust their nancial structures to any unexpected change in liquidity and
growth opportunities. However, when capital markets are imperfect and the cost of
external nancing increases, nancial exibility becomes increasingly important.
Generally speaking, nancial exibility relates to the ability of companies to undertake
investment in the future, when asymmetric information and contracting problems might
otherwise force them to forego protable growth opportunities. Firms may pursue
nancial exibility in several ways: by shaping their capital structure, cash management
or payout policies, and by creating an intertemporal dependencebetween nancial and
investment decisions (Almeida et al., 2011; Denis, 2011).
Our paper focuses specically on nancial exibility attained through a conservative
leverage policy. Survey evidence suggests that nancial exibility is a primary driver of
chief nancial ofcersleverage 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 nancially exible is thus
directly related to the ability of companies to undertake new investment projects: the
more the investment undertaken by nancially exible (FF) rms, the higher the value of
nancial exibility for those rms. Indeed, several empirical studies provide evidence
that supports this statement: the sensitivity of investment to a rmsnancial exibility
status is signicantly higher for rms that attained their exibility 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 nancial
exibility varies depending on the degree of nancing frictions companies face. In
their theoretical model, Gamba and Triantis (2008) predict that rms with high level
of nancial exibility should be valued at a premium.Consequently, for rms with
lower cost of external nancing, this premium should be smaller. Therefore, we
reason that, in the presence of market friction, rms that anticipate valuable future
investment opportunities may follow a policy of nancial exibility to preserve their
ability to pursue these future growth options. Once they acquire FF status, these rms
should be able not only to invest more than non-exible ones (Not FF), they should
also be able to invest more the stronger the degree of nancing constraints. In other
words, the value of nancial exibility should be positive and it should be greater
for those FF rms expecting to face more nancing constraints. A further implication
is therefore that, in the presence of exogenous shocks to liquidity in the market, FF
rms should better be able to cope with a rationed capital supply and to avoid
nancial distress.
To test our hypotheses, we use the entire universe of Bureau van DijksAmadeus,
which encompasses a very large sample of 289,839 European companies with at least
4 years of observations in the 18-year interval 19932010. Thanks to reporting
requirements and practices across most European countries, this database gives us the
opportunity to be the rst to investigate the value of nancial exibility across a very
heterogeneous sample of both publicly traded and privately held rms 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.
We rst identify FF rms by focusing on low-leverage rms. We estimate a leverage
equation from which we calculate the predicted level of debt. Since the demand for
nancial exibility is indirectly captured by the negative deviations from estimated
target leverage (LL), we classify a rm as FF if it shows an LL policy for a minimum
number of consecutive years. We nd that 31% of rms in our sample show a
conservative leverage policy for at least three consecutive years (FF3). Second, we test
whether this degree of nancial exibility has any impact on investment ability. In the
presence of market frictions, rms that anticipate valuable growth options in the future
may respond by pursuing an LL policy for a number of years. In this way, FF rms may
have enough spare borrowing power to be able to raise external funds, and to invest more
in the years following the conservative nancial policy. To test this hypothesis, we use
a modied version of the q-model of investment augmented by an FF dummy and its
interaction term with cash ow. The FF dummy is expected to have a positive and
signicant impact on capital expenditure. In addition, to the extent that FF rms can, after
a period of low leverage, more easily raise external funds to nance 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 ow. The results over the entire
sample do indeed show a large impact from FF status on rm 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 rms, to alternative denitions of leverage and growth
opportunities, and to alternative interpretations, such as credit rationing and agency
Once we show that the value of nancial exibility relates to the ability of rms to
invest (i.e., positive investment sensitivity to FF status), we test the hypothesis that
nancial exibility is more valuable for those companies that face higher external
nancing costs. To this end, we classify different subsamples of rms based on their
expected nancing friction. For each subsample, we run our baseline model and compare
the overall impact of FF status on rm 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 rms (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 rms 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 rmsexpected
asymmetric information and contracting problems, which, in turn, negatively affects
corporate nancial and investment decisions (e.g., La Porta et al., 1997; Love, 2003;
Mclean et al., 2012; Mortal and Reisel, 2013). We expect nancial exibility to be
more valuable for rms in countries with lower legal protection. Indeed, our results
For instance, based on National Accounts of each Western European country, we calculate
that, at the end of 2010, the total non-government gross xed 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

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