1. COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622
Presentation on
The relationship between firm
investment and financial status
Written by: Sean Cleary, Saint Mary’s University, Halifax
Published in: Journal of Finance, Vol. LIV, No. 2, April 1999
30th March, 2011

2. Article Outline
I. Background
A. Evidence of financing hierarchy
B. Conflicting views
C. Motivation
II. Research design
A. Sample characteristics
B. Classification methodology
C. Regression estimation
D. Determination of significance level
III. Discussion of results
A. Results
B. Interpretation
IV. Conclusions

3. Presentation Outline
Background
Motivation of the study
Research Methodology
Major Findings
Conclusions
Comments

4. Investment decisions and financial factors are
related issues.
The controversy found in the literature on the
ground that the relationship is changing.
Modigliani and Miller (1958) - Financial factors are
irrelevant for investment decisions.
Greenwald, Stiglitz, and Weiss (1984), Myers and
Majluf (1984), and Myers (1984) Bernanke and
Gertler (1989, 1990) and Gertler (1992) - Financial
structure may be relevant to the investment
decisions.
Background

5. Fazzari, Hubbard, and Petersen
(1988), Hoshi, Kashyap, and Scharfstein
(1991), Oliner and Rudebusch (1992), Whited
(1992), Schaller (1993), and Gilchrest and
Himmelberg (1995) also are in favor for the
relevance of financial status.
The investment decisions in market imperfection
are sensitive to the availability of internal funds .
Reason: low cost over external funds.
Back…..

6.  Fazzari, Hubbard, and Petersen (1988) - Use
Value Line data, 422 U.S. mfg. firms, 1970 to 1984,
and found that internal funds have cost advantage.
 Hoshi et al. (1991) – Studied on 146 Japanese mfg.
firms and revealed that the investment outlays are
much more sensitive to firm liquidity.
 Oliner and Rudebusch (1992) - Examine 120 U.S.
firms, 1977 to 1983 period and found that
investment is most closely related to cash flow.
Back…..

7.  Schaller (1993) - Studied 212 Canadian
firms, 1973 to 1986, and concluded that firm
investment with dispersed ownership
concentration is the most sensitive to cash flow.
 Whited (1992) & Bond and Meghir (1994) - Use
an Euler equation approach, 325 U.S. mfg.
firms, 1972 to 1986 period & 626 U.K. mfg. firms
from 1974 to 1986 period found exogenous
finance constraint to be particularly binding for
the constrained groups of the firms.

8.  Mayer (1990) - Examined the sources of industry
finance of eight developed countries from 1970 to
1985 and found that:
i) Retentions are the dominant source of financing in all
countries
ii)The average firm in any of these countries does not raise
substantial amounts of financing from security markets.
and,
iii) The majority of external financing comes from bank loans
in all countries.
 Objective of the study
 A major focus of this study is the comparison
of investment-liquidity sensitivities across
different groups of firms.
Back…..

9.  Research Gap
 The contrariety conclusion of Kaplan and
Zingales’s study.
 Implications of the results.
 Limitations of Kapland and Zingles’s study:
 Sample (49 manufacturing firms)
 Value line database
 Too small sub-groups (22, 19 and 8)
 Sorting criteria
 Subjective and possibility of self-serving managerial
statements, etc.
Motivation

10. Approach applied = Kaplan and Zingales Approach
(NFC = increase cash div., NC = large cash position., Unconstrained =
financially healthy firm with low debt & high cash)
Statistical tools
Multiple discriminant analysis (similar to Altman’s Z
factor)
Bootstrap methodology (Sign. level)
Correlation matrix
Regression analysis
Descriptive statistics
Financial constraint index, etc.
Sample size = 1317 firms
Study period = 1987 to 1994
Methodology

11. Sample composition
Listed company view Firms SIC code view Firms
NYSE 709 Mfg. firms (SIC codes 2000–3999) 843
Nasdaq 416 Agri., mining, forestry, & Cons. (SIC codes 1–1999) 99
AMEX or US exchange 192 Retail and wholesale trade (SIC codes 5000–5999) 201
Service firms (SIC codes 7000–8999) 174
Sample size 1317 Sample size 1317
Method…
Basic conditions for samples selection:
a) Banks, insurance companies, other financial companies, and utility
companies is avoided, and
b) Required to have positive values for sales, total assets, net fixed
assets, and market-to-book ratio.

12. i) Standardized discriminant function (ZFC )
ZFC = b1Current + b2FCCov + b3SLACK/K 1 b4 NI%
+ b5 Sales Growth + b6 Debt.
Z score help to classify the entire sample in to 3
groups (Group I – Increase DPS, II – Decrease DPS
and III – No change in DPS)
ii) regression model is also used.
I/Kit = bM/B(M/B)it + bCF/K(CF/K)it + uit
iii) A bootstrapping procedure is used to calculate
empirical p-values
Method…

13. Total
Sample
Group 1
Increase DPS
Group 2
Decrease DPS
Group 3
No change in DPS
Net fixed assets $650m $1076m $913m $630
Current ratio 2.57 2.40 2.36 2.71
Debt ratio 0.22 0.20 0.26 0.23
Fixed charge coverage 12.1 16.8 7.4 9.9
Net income margin(%) 3.0 6.8 1.0 1.0
Market to Book ratio 2.18 2.64 1.62 1.97
Sales growth(%) 10.1 11.4 1.6 10.3
Slack/K 1.71 1.42 1.45 1.92
Cash flow/K 0.47 0.58 0.27 0.42
Investment/K 0.26 0.26 0.19 0.24
Discriminant score (Z) -0.31 0.17 -0.87 -0.61
Table I - Sample Summary Statistics
(1988-1994)
Panel A: Selected Financial Ratio Means
Finding: Firms with reducing dividends appear to be more
financially constrained. (Low where as high is desire)

14. Dividend Group Total
Sample
1988 1989 1990 1991 1992 1993 1994
1. increased DPS 3241
35.1%
547
41.5%
543
41.2%
478
36.4%
408
31.0%
411
31.2%
420
31.9%
434
33.0%
2. increased DPS 636
6.9%
58
4.0%
68
5.2%
94
7.2%
127
9.6%
110
8.4%
91
6.9%
91
6.9%
3. no change in DPS 5344
58.0%
717
54.5%
706
53.6%
745
56.6%
782
59.4%
796
60.4%
806
61.2%
792
60.1%
Panel B: Number of Firms per Dividend Group
Finding: Largest number of firms 547 occurred in 1988 in
first group and 127 firms in second group for the
year 1991.
This evidence supports the notion that firms face
changing levels of financial constraints every
year.

15. CF/FA CR DR FCC INV/FA M – B R NIM SG Slack/FA D Score
CF/FA 1
CR .11 1
DR -.18 -.33 1
FCC .21 .19 -.43 1
I/FA .37 .17 -.23 .18 1
M to BR .21 .02 -.12 .21 .24 1
NIM .34 .08 -.14 .24 .13 .10 1
SG .19 .02 -.01 .11 .24 .20 .21 1
Slack/FA .38 .47 -.33 .13 .40 .08 .02 .05 1
D Score .32 -.07 -.29 .32 .18 .19 .80 .55 -.08 1
Table II - Correlation among variables
Measure liquidity ratio but it is surprising (-ve)
High correlation between D. Score and NIM followed by SG
Finding: 26% of the cases are misclassified in predicting
whether firms will cut or increase their dividend.

16. Table III - Selected Financial Ratio Means for
Financially constrained Groups
(1988-1994)
Predicted
Group 1
Predicted
Group 2
FC Firms PFC
Firms
NFC
Firms
Net fixed assets $803m $591m $507m $787m $656m
Current ratio 2.37 2.51 2.74 2.37 2.62
Debt ratio .18 .28 .31 .22 .14
Fixed charged coverage 18.3 4.8 3.0 8.8 24.6
Net income margin(%) 7.2 -1.2 -4.8 4.2 9.6
Market to Book ratio 2.58 1.50 1.65 1.91 2.99
Sales growth(%) 15.1 -.6 -2.3 9.0 23.5
Slack/K 1.30 1.30 1.93 1.46 1.75
Cash flow/K .52 .24 .23 .42 .75
Investment/K .27 .19 .21 .24 .33
Discriminant score(Z) .51 -1.45 -1.77 -.21 1.05

17. Findings:
 Financial ratios are superior for the NFC group,
inferior for the FC group and the PFC in between.
 The observed average turnover rates are 40.9, 52.3,
and 37.3 percent per year.
 Firms are classified at least one year is 75, 83 and 74
percent for the NFC, PFC, and FC respectively.
 Only 17 firms are classified as PFC for all 7 years, and
only 49 and 80 are classified as NFC and FC.
 These results indicates that individual firm’s financial
status does change significantly y-b-y.

18. Table IV – Regression results for the total
sample (1317 firms)
Findings
 Firm’s investment decisions are sensitive to market opportunity
(M-B) but are even more sensitive to liquidity variable (CF/NTA)
 Liquidity and market to book ratio are significant determinants
of investment for FC, PFC and NFC groups
 Investment outlays of the NFC firms are significantly more
sensitive to liquidity than that of PFC and FC firms. Estimated
coefficients are 0.153, 0.090 & 0.064 with p value 0.0046, 0.000
& 0.083 respectively.
 p value 0.5890 explains NFC>FC at 058.90% level of sign.

19. Table V – Regression results for dividend
payout groups
 Investments of the NFC firms are most
sensitive to liquidity followed by PFC firms
and FC firms. Coefficients are 0.159, 0.080 &
0.057 with p values 0.002, 0.000 & 0.1378
respectively.
 p value 0.3834 explain NFC>FC at 38.34
level of significance.
 Similar explains for the next panels as well.

20.  The study concludes the accuracy of the
classification is 74 percent in predicting dividend
payments.
 The investment decisions of firms with high
creditworthiness (least financially constrained)
are significantly more sensitive to the availability
of internal funds than are firms that are less
creditworthy.
 This strongly supports the small-sample evidence
of Kaplan and Zingales (1997).
Conclusions

21.  A strong effort to validate the conclusions of earlier
study using varying research methodology.
 Sound methodology of the study.
 Statistical tools and models used for the analysis are
clearly described.
 The motivation of the study presented with the
evidences of the literatures in a details.
 Determination of significance level has done which is
rare in existing literature.
Comments

22. Thank you.