Excess Cash Flow : A Signal for Institutional

Economic studies which examine the financing patterns of firms, particularly in emerging markets, seldom consider the market environment in which they operate. The most recent Asian financial crisis and its exposure of institutional failures in the context of financial sector liberalization show that these market conditions are vital. The positive relationship between a firm's excess cash flow and investment are well known, but the environment which determines retention of cash as opposed to paying dividends remains unresolved. The results of this survey suggest a framework by which future research in data collection, theoretical analysis, and empirical testing may be undertaken.

Rahul Dhumale is Senior Economist, Federal Reserve Bank.

List of Tables

xii

List of Figures

xv

Acknowledgements

xvi

Introduction

1

(12)

Introduction

1

(3)

India's capital markets

4

(1)

Overview of Indian financial sector reforms

5

(3)

Inflows into India's capital markets

8

(1)

Purpose of study

9

(2)

Plan of study

11

(2)

Internal Finance as a Source of Investment: Managerial/Principal Agent or Asymmetric Information Approach?

13

(10)

Introduction

13

(1)

Asymmetric information approach to investment

14

(2)

Managerial/principal agent theory of investment

16

(2)

Managerial/principal agent vs. asymmetric information: some empirical facts

18

(3)

Further issues

21

(2)

Cash Retention Strategies: Test of Free Cash Flow Theory

23

(59)

Introduction

23

(1)

Purpose

24

(1)

Theories on excess cash flow

25

(6)

Basic assumptions

25

(1)

Free cash flow theory: dividend recommendation

26

(2)

Dividend signalling model

28

(1)

Free cash flow theory: debt recommendation

29

(1)

Empirical evidence for the free cash flow theory

30

(1)

Free cash flow theory and takeovers

31

(1)

Asymmetric information, imperfect capital markets and the `Flight to Quality'

31

(5)

Imperfect capital markets: the lemons problem

32

(1)

Imperfect capital markets: credit rationing

33

(1)

Internal vs. external finance: asymmetric information costs and intermediation

34

(1)

Banking relationships and the asymmetric information problem

35

(1)

Free cash flow theory effects vs. benefits of free cash flow

36

(7)

Asymmetric information in the free cash flow theory framework

36

(1)

Financial flexibility and its benefits

37

(1)

Excess cash strategies

38

(1)

Finance hierarchies

39

(1)

Tax and the finance hierarchy

40

(1)

Using excess cash as collateral

40

(2)

An example of financial fragility and the use of debt

42

(1)

Financial transmission to real economic activity

43

(5)

Mechanisms with real economic consequences: the lending channel

43

(3)

Financial investment accelerator

46

(1)

Inventory response and firm size

46

(1)

Investment effects on the macroeconomic level

47

(1)

Firm model comparing earnings retention, re-investment, and external borrowing

48

(18)

Expected return of the earnings retention strategy

51

(1)

Expected return of the earnings disbursement strategy

51

(1)

Comparison of returns

52

(4)

Estimating benchmark cases for the model

56

(6)

The model's incorporation of the free cash flow theory

62

(1)

The premium φ: costs of asymmetric information

62

(2)

The case of recessions and booms

64

(2)

Empirical examination of earnings retention

66

(14)

Foundations for empirical investigation

66

(1)

Examining actual firm investment behaviour

67

(4)

Examination of past evidence from excess cash predictions

71

(3)

Regression of investment after monetary contraction

74

(1)

Formula for retained earnings

75

(5)

Conclusion

80

(2)

The Cost of Capital: Earnings Retention vs. Leverage

82

(32)

Introduction

82

(1)

Background

83

(5)

Institutional characteristics of financial markets in India

83

(4)

Capital structure: theory

87

(1)

Financing hierarchies

88

(2)

Target leverage models

90

(1)

Agency costs of leverage

91

(2)

Research methodology

93

(4)

Data

94

(1)

Statistical model

94

(3)

Estimation

97

(1)

Results

97

(5)

Discussion

101

(1)

Leverage and profitability

102

(1)

Theory

103

(1)

Research methodology and data

103

(3)

Data

103

(2)

Statistical model

105

(1)

Results

106

(4)

Evaluation

110

(1)

Policy Implications

110

(2)

Conclusion

112

(2)

Earnings Retention as a Specification Mechanism in Predicting Corporate Bankruptcy

114

(37)

Introduction

114

(1)

Bankruptcy management in India: SICA and BIFR

115

(2)

Firm and capital structure management

117

(3)

Alignment of managerial incentives

117

(3)

Bankruptcy effects of corporate leveraging in Indian firms

120

(4)

Corporate bankruptcy procedures in India

124

(8)

Treatment of bankruptcy by India's financial sector

124

Bargaining power between banks and firms

123

(3)

The public interest: subsidies, sacrifices, and accounting practices

126

(3)

Violations of the `absolute priority rule'

129

(3)

Earnings retention in logistic bankruptcy models: test of the free cash flow theory

132

(14)

Introduction

132

(1)

Purpose

133

(1)

Background

133

(1)

Review of the free cash flow theory

133

(1)

Previous studies on bankruptcy models

134

(2)

Research methodology and data

136

(1)

Financial ratio selection

136

(1)

Statistical model

137

(1)

Data

137

(2)

Results

139

(4)

Evaluation

143

(1)

Discussion

144

(2)

Policy implications of reforms in Indian bankruptcy proceedings

146

(3)

Conclusion

149

(2)

Factors Affecting the Market for Corporate Control: The Role of Excess Cash, Diversification, and Predation during Mergers and Acquisitions

151

(31)

Introduction

151

(2)

Takeover policy in India

153

(2)

Signalling effects of earnings retention and diversification on bidder and target returns during acquisition activity

155

(14)

Introduction

155

(1)

Purpose

156

(1)

Background

157

(1)

Takeovers within the free cash flow theory

157

(1)

Determinants of successful takeovers

158

(1)

Research methodology and data

159

(2)

Results

161

(1)

Abnormal returns

161

(3)

Cross section regressions

164

(3)

Evaluation

167

(1)

Discussion

168

(1)

Using the financial structure of firms as a signalling mechanism against takeovers

169

(6)

Introduction

169

(1)

Background

169

(1)

Theory

169

(1)

Predation

169

(1)

Literature Review: Long-purse predation, signalling and contracting

170

(5)

Basic model of no-predation contracting

175

(4)

Further issues

179

(1)

Conclusion and policy implications

180

(2)

Conclusions

182

(9)

Conclusion

182

(1)

Summary of findings

183

(4)

Internal finance as a source for investment

183

(1)

Examination of cash retention strategies

183

(1)

Effects and determinants of debt

184

(2)

Use of earnings retention in predicting corporate bankruptcy models

186

(1)

Factors affecting the market for corporate control

186

(1)

Limitations of study and future work

187

(1)

Further policy implications

188

(3)

Appendix 1. Derivation of model constraints

191

(2)

Appendix 2. Deriving the relationship between investment probability and φ

193

(2)

Notes

195

(7)

Bibliography

202

(10)

Index

212

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Excess Cash Flow : A Signal for Institutional and Corporate Governance

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