The underinvestment and overinvestment hypotheses: An analysis using panel data

Artur MORGADO Instituto Politcnico de Coimbra (Portugal) Julio PINDADO Universidad de Salamanca (Spain)

Address for correspondence: Julio Pindado Dpto. de Administracin y Economa de la Empresa Campus Miguel de Unamuno Universidad de Salamanca 37007 Salamanca Telfono: (923) 294400 294640 Ext. 3506 Fax: (923) 294715 E-mail: pindado@gugu.usal.es

The underinvestment and overinvestment hypotheses: An analysis using panel data

ABSTRACT

In this paper we study the relationship between firm value and investment in order to test the underinvestment and overinvestment hypotheses. The results obtained, using panel data methodology as the estimation method, indicate that the abovementioned relation is quadratic, which implies that there exists an optimal level of investment. As a consequence, firms that invest less than the optimal level suffer from an underinvestment problem, while those firms that have a level of investment higher than the optimum suffer from an overinvestment problem. The aforementioned quadratic relation is maintained when firms are classified depending on their investment opportunities. Moreover, in accordance with the theory, those firms with valuable investment opportunities maintain an optimal level of investment higher than that of those whose investment opportunities are of low quality.

1. INTRODUCTION

In a world of perfect capital markets, Modigliani and Miller (1958) demonstrated that investment, f inancing and dividend decisions are independent. During the last decades, 2

however, the empirical evidence has shown that those decisions are interdependent. Accordingly, some theories that explain the previous evidence have been developed. These theories are based on capital-market imperfections; in particular, with respect to the investment decision, the existence of asymmetric information between the main stakeholders is the foremost imperfection. The role of the asymmetry of information in investment decisions has as its primary basis the theoretical works of Jensen and Meckling (1976), Myers (1977) and Myers and Majluf (1984). The first two papers emphasize the consequences of the existence of post-contract asymmetric information between shareholders and

bondholders, while the paper of Myers and Majluf (1984) emphasizes the role of the pre-contract asymmetric information between current and prospective shareholders. All the abovementioned papers show that informational asymmetries may lead to some investment projects with a positive net present value (NPV) not being undertaken. A second foundation in the study of inefficient investment decisions is the work of Jensen (1986). This paper, starting from the hypothesis of the existence of asymmetric information between managers and shareholders, introduces the so-called problem of overinvestment, as a basic argument of his free cash flow theory. According to this theory there can be negative NPV investment projects that end up being completed. In this way, whenever an underinvestment process or an overinvestment process arises the value of the firm will be affected. Thus, it is worthwhile to hypothesize that the relationship between investment and firm value is not monotonic but rather increases up to one determined optimal level and decreases after this level. Firms will first undertake those investment projects with a positive NPV and the firm value will grow until the positive NPV projects become exhausted. Those firms that continue investing will undertake negative NPV projects and, hence, their market value will 3

decrease. In this context, levels lower than the optimum confirm the underinvestment hypothesis and levels higher than the optimum, the overinvestment hypothesis. To test the main hypothesis put forward in our paper, that is, that the relationship between firm value and investment is quadratic rather than linear, we have developed a model that relates firm value and investment, incorporating a quadratic term of investment in the equation. The results obtained in the estimation of this model allow us to conclude that the abovementioned hypothesis is verified. We also study the relationship between firm value and investment depending on the quality of investment opportunities. In this case, the results also confirm the previous hypothesis and show that the optimal level of investment is higher for those firms with valuable investment opportunities. The remainder of the paper is organized as follows. Section II describes the underinvestment and overinvestment hypotheses in order to develop a model that relates firm value and investment in Section III. In Section IV we present the database, explain the estimation method and discuss the results. Finally, our conclusions are presented in Section V.

2. THE UNDERINVESTMENT AND OVERINVESTMENT HYPOTHESES

In imperfect capital markets, financing and investment decisions are not independent. In fact, capital-market imperfections, such as informational asymmetries and agency costs, could lead to either underinvestment or overinvestment processes, that is, not all positive NPV projects will be undertaken and some negative NPV projects will not be rejected. Informational asymmetries contribute to several conflicts between the main 4

stakeholders, which give rise to either overinvestment or underinvestment processes. Next, we describe these topics and how they are connected, following Figure I. Given the limited liability of shareholders, they are encouraged to invest in riskier investment projects than those initially defined in the loan conditions. This is due to the fact that riskier projects are expected to give larger benefits which will be mainly enjoyed by the shareholders; whereas if large losses occur, these will be passed on to the bondholders (Jensen and Meckling, 1976). In this case, the well-known problem of asset substitution arises. When post-contract asymmetric information exists, and given the impossibility of developing full contracts, such asymmetry of information could induce costs for shareholders, since bondholders discount the prospective substitution of assets. Thus, either the rise in interest rates, credit rationing or the imposition of limiting conditions in investment or financing terms, may limit the capacity of the shareholders to develop their investment projects. This problem of asset substitution between shareholders and bondholders is, therefore, one of the mechanisms that lead to underinvestment. The conflict between shareholders and bondholders also gives rise to a problem of underinvestment by moral hazard. Given the priority of bondholders in case of bankruptcy, shareholders may find themselves in a situation where bondholders appropriate part of the value created. Therefore, shareholders will have an incentive to abandon NPV projects whenever the NPV is lower than the amount of debt issued (Myers, 1977). Thus, bondholders will try to prevent those suboptimal investment policies being adopted by using several mechanisms, such as debt covenants, the reduction of the stated periods of loan, and greater supervision and control. However, all these procedures only imply a slight mitigation of the problem and, moreover, their cost is ultimately borne by the shareholders. 5

Additionally, the conflict between shareholders and bondholders also gives rise to a problem of underinvestment by adverse selection. This problem arises from the higher premium required by bondholders, since they do not have enough information to distinguish the quality of the different investment projects of the firm (Stiglitz and Weiss, 1981). Thus, if the investment outlay of all positive NPV projects is higher than the internal funds available, the firm might forgo those investment projects rather than issue risky debt. The conflict between current and prospective shareholders may also lead to underinvestment caused by adverse selection. Myers and Majluf (1984) proved that, due to pre-contract asymmetric information between prospective and current shareholders in relation to the investment projects and the assets in place, the firm might forgo positive NPV projects. Owing to informational asymmetries the prospective shareholders are unaware of the firm value and raise the price at which they offer funds. With this price the existing shareholders may lose more if the investment projects are undertaken than they would if the investment projects are abandoned. In summary, the conflicts between bondholders and shareholders and the current and prospective shareholders may lead to underinvestment processes. Moreover, the overinvestment process arises from the conflict between managers and shareholders. When informational asymmetries exist, and taking into account that the mechanisms used to align the interests between shareholders and managers may not be fully efficient, managers may use the free cash flow to undertake negative NPV projects in their own best interest (Jensen, 1986). Note that free cash flow is cash flow in excess of that required to fund all positive NPV projects, hence managers waste these funds instead of paying them to shareholders. Managers will have

incentives to overinvest because of the pecuniary and non-pecuniary benefits associated with the larger dimension of the firm (Jensen, 1986; Stulz, 1990). The empirical evidence on the underinvestment hypothesis was initially developed through the successive studies on the sensitivity of investment to cash flow, especially after the methodological innovative study by Fazzari et al. (1988).1 Almost all these studies
2

find a strong dependence of investment on the availability of internal

funds, this dependence being interpreted as evidence of the underinvestment problem by adverse selection. However, the positive relationship found between investment and cash flow may not arise only from the underinvestment problem by adverse selection. It may also indicate that high levels of cash flow allow managers to undertake negative NPV projects, which would not happen if they had to raise external funds and explain the rationality of their investments. The study by Vogt (1994) allows u s to distinguish both effects and obtain empirical evidence of both problems (underinvestment and overinvestment) depending on the different features of the firms. Thus, the overinvestment hypothesis is confirmed whenever the positive relationship between investment and cash flow is maintained for firms whose investment opportunities are of low quality. On the contrary, for firms with valuable investment opportunities, a positive relationship indicates an underinvestment problem. There are also several papers that obtain empirical evidence on each of the hypotheses using the event study methodology. These studies analyse the reaction of the market to announcements of investment decisions (see for example Doukas, 1995; Vogt, 1997; Chen and Ho, 1997) or to announcements of dividend decisions (see for example Lang and Litzenberger, 1989), distinguishing the firms according to their investment opportunities and/or free cash flow level. In general, these studies provide evidence that abnormal returns are larger for the firms with valuable investment 7

opportunities. However, the evidence on the free cash flow effect is not so clear (see Chen and Ho, 1997).3 The underinvestment and overinvestment problems have also been studied through other perspectives. For instance, Lang et al. (1996) obtain favourable evidence on the overinvestment hypothesis, when finding that high ratios of indebtedness limit the development of investment projects only for the firms whose investment opportunities are of low quality. Nohel and Tarhan (1998) also find evidence in accordance with the free cash flow theory by studying the effect of the reacquisition of shares on the operational performance of firms. Adedeji (1998) obtains mixed evidence on the underinvestment hypothesis by studying the simultaneous interrelation between the investment, financing and dividend decisions. Finally, Miguel and Pindado (2001) conclude that, in a context of asymmetric information, firms are worried either by the underinvestment problem or by the overinvestment problem depending on their cash flow and debt levels, thus corroborating the trade-off between underinvestment and overinvestment considered by Stulz (1990). As a consequence of the abovementioned empirical evidence, nowadays there is a generalized consensus on the distortions that informational asymmetries introduce into the investment decision. Thus, contrary to the hypothesis of perfect capital markets maintained by Modigliani and Miller (1958), informational asymmetries could lead to underinvestment or overinvestment processes. Both problems will affect the firms value since, on the one hand, positive NPV projects will not be undertaken and, on the other hand, negative NPV projects will not be rejected. Hence, when a firm becomes affected by an underinvestment problem, if an additional investment is undertaken the market value should increase. If the problem is one of overinvestment, any additional investment must negatively affect the wealth of the shareholders. Assuming as a 8

reasonable hypothesis that the investment projects of greater NPV will always be undertaken in first place, even in the managers own best interest (Stulz, 1990), the market value will increase until a certain investment level is reached. After that optimum the market value will start to decrease. Therefore, the main hypothesis to prove in our paper is: the relationship between market value and investment is quadratic, implying that there exists an optimal level. Levels below the optimal one will confirm the underinvestment hypothesis while higher levels will confirm the overinvestment one (see Figure II).

3. SPECIFICATION OF THE MODEL

In order to test the hypothesis mentioned in the previous section, we develop a model that relates the value of the shares of the firm to its main financial decisions, taking into account the behaviour of the investment variable described above: (V it /K i,t-1)=0 + 1(I it /K i,t-1) + 2(I it /K i,t-1)2 + 3(B it /K i,t-1) + 4(D it /K i,t-1) + eit (1) where V it is the market value of the shares of firm i at the end of period t, Iit is the investment undertaken by firm i in period t, Bit is the increment of the market value of the long-term debt, Dit are the dividends paid in period t, and finally Ki,t-1 is the replacement value of the assets at the end of period t-1.4 The model defined in equation (1) relates investment and firm value, controlling the other two main financial decisions of the firm, that is, financing and dividends decisions, which could affect firm value due to the existence of market imperfections. The expected relationship between increment of debt and firm value is positive, since, 9

whenever the bankruptcy probability is not very high, an increment of debt will have a positive effect on the wealth of the shareholders because new debt means obtaining new tax-shields. The expected relationship between dividends and firm value is also positive, because in addition to the possible effects in relation to the imperfections, dividends are a source of value creation for the shareholders of the firm. Note that the well-known capital-market arbitrage condition stipulates that the net after-tax return for shareholders may be obtained in two ways: from capital appreciation and from current dividends (see Whited, 1992; Blundell et al., 1992). As we have commented in the previous section, the overinvestment and underinvestment processes are not exclusive and must affect the market value of the firm. Thus, if a firm is facing by an underinvestment problem, a marginal increase in investment must positively affect the market value of the shares, while the effect will be negative if the problem is one of overinvestment. Therefore, an optimal level of investment will exist, which is reflected in the model since we incorporated in equation (1) the investment variable and its square. Consequently, if, after estimating the model, we differentiate the firm value variable with respect to the investment variable, we would obtain: Vit K I it it 1 = + 2 1 2 K I it it 1 K it 1

(2)

then, making the first derivative equal to 0 and solving for the investment variable, we obtain: I it 1 K = 2 it 1 2 (3)

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Finally, if the second partial derivative of the firm value variable with respect to the investment variable is negative, the value obtained from equation (3) will be a maximum. Vit 2 K it 1 = 2 2 2 I it K it 1

(4)

Accordingly, in order to obtain a maximum from equation (3), 2 should be negative. Also, for the optimal level of the investment determined in equation (3) to be positive, 1 should be positive. Consequently, if the signs of these coefficients hold when equation (1) is estimated our main hypothesis will be proved. If the previous hypothesis is verified, we can also, in agreement with the theory, put forward an additional hypothesis: that the optimal level of investment will be different depending on the quality of investment opportunities. To be exact, the abovementioned optimal level will have to be higher for those firms that have valuable investment opportunities. In order to test this hypothesis, we define a dummy variable for each firm, DQi, which is equal to 1 for those firms that during the period have an average Tobins q less than one, and 0 otherwise. Thus, we extended the specification of the model in equation (1) by incorporating a dummy variable that interacts with the linear and quadratic terms of the investment variable. This dummy variable represents the quality of investment opportunities. Therefore, the new model would be as follows: (V it /K i,t-1) = 0 + (1 + 1DQ i) (I it /K i,t-1) + (2+ 2DQ i) (I it /K i,t-1)2 + 3(B it /K i,t-1) + 4 (Dit/Ki,t-1) + eit (5)

Thus, we classify the firms in two groups: when Tobins q is less than 1, firms are classified as non-valuable project firms (hereafter, NVP firms), otherwise they are classified as valuable project firms (hereafter, VP firms). In this new model, 1 and 2 11

are the coefficients that define the optimal level of investment for VP firms, since for those firms DQi is equal to 0. Hence, the optimal level for VP firms will be obtained using equation (3). However, for NVP firms DQi takes the value of 1, therefore the optimal level will be obtained through the following equivalent equation: Iit 1 + 1 K = 2( + ) 2 2 it 1 (6)

Based on this new model, as it appears in Figure III, we therefore put forward the following additional hypothesis: the optimal level of investment for VP firms, (Iit/Ki,t-1)q>1, will be higher than the optimal level of investment for NVP firms, (Iit/Ki,t1) q<1

. Moreover, if we define (Iit/Ki,t-1)* as the optimal level of investment for the whole

sample of firms, logically, we expect to obtain that (Iit/Ki,t-1)q<1 < (Iit/Ki,t-1)* < (Iit/Ki,t-1)q>1, as can be observed by comparing Figures II and III.

4. EMPIRICAL EVIDENCE

4.1 DATA In our empirical study we used a data panel of Spanish non-financial quoted companies. The main source of information is the database from the CNMV (Spanish Security Exchange Commission). More specifically, we used the data collected in the form of biannual information on all non-financial quoted companies. Furthermore, data on the market value of the company shares were extracted from the Daily Bulletin of the MSE (Madrid Stock Exchange). In order to avoid endogeneity and unobservable heterogeneity, we constructed a data panel of Spanish non-financial quoted companies for the period ranging from 1990 12

to 1999. Therefore, we constructed an unbalanced panel comprising 135 companies for which the information is available for at least six consecutive years between 1990 and 1999. This is a necessary condition to have a sufficient number of periods to be able to test for second-order serial correlation, as Arellano and Bond (1991) pointed out. The structure of the panel, by number of annual observations per company, is given in Table 1. Hence, as Table 1 shows, we have 1,233 observations; however, the models were only estimated for 1,098 of them since we lost one year of data owing to the way in which some of the variables were constructed (see appendix). Table 2 shows the companies in the sample allocated to ten sub-sectors according to their main product. Finally, Table 3 provides summary statistics (mean, standard deviation, maximum and minimum) of the variables used in the estimation.

4.2 ESTIMATION METHOD The models specified in Section III are estimated by using panel data methodology in order to avoid endogeneity and unobservable heterogeneity. If we ignore the endogeneity issue we will obtain a spurious correlation between investment and firm value. Hence, in order to avoid this problem, we estimate our models by using the generalized method of moments (GMM), which allows us to control for problems of endogeneity by using instruments. In our case, we use as instruments all the right-hand side variables in the models lagged twice or more. Moreover, because firms are heterogeneous, there are always characteristics influencing firm value that are difficult to measure or hard to obtain, which do not enter into our models. Therefore, if we do not control for this heterogeneity, we will run the risk of obtaining biased results, as shown in studies by Moulton (1986, 1987). Unlike cross-sectional analysis, panel data methodology has the great advantage of allowing us to control for unobservable heterogeneity through 13

an individual effect, i. Hence, we took first differences of the variables in order to eliminate the individual effect. We also included the dummy variables dt to measure the time effect, so as to control the effect of macroeconomic variables on firm value. Consequently, we split the error term into three components: the individual effect, i, the time effect, dt, and, finally, the random disturbance, it. As a result, the final specification of the models to estimate is as follows: (Vit /K i,t-1) = 0 + 1(I it /K i,t-1) + 2(I it /K i,t-1)2 + 3(B it /K i,t-1) + 4(D it /K i,t-1) + dt + i + it (7) (Vit /K i,t-1)=0 + (1 + 1DQ i) (I it /K i,t-1) + (2+ 2DQ i) (I it /K i,t-1)2 + 3(B it /K i,t-1) + 4 (Dit/Ki,t-1) + dt + i + it (8)

The estimation was carried out using DPD98 for GAUSS written by Arellano and Bond (1998). In order to check for potential mis-specification of the models we use the Sargan statistic of over-identifying restrictions, which tests for the absence of correlation between the instruments and the error term. Another specification test used is the m 2 statistic, developed by Arellano and Bond (1991), to test for lack of secondorder serial correlation in the first-difference residuals. Finally, besides the aforementioned specification tests, Table 4 provides two Wald tests: the first (z1) is a test of the joint significance of the reported coefficients, while the second (z2) is a test of the joint significance of the time dummies. As can be seen in Table 4, our models pass all the abovementioned tests.

4.3 RESULTS The results obtained verify our main hypothesis. As can be seen in column I of Table 4, 1 is positive and 2 is negative, both coefficients being significant. These results indicate that the relationship between investment and firm value is quadratic rather than 14

linear. That is, a marginal increase in investment has a positive effect on the wealth of shareholders whenever the optimal investment level has not yet been exceeded. This level reflects the beginning of the exhaustion of positive NPV projects. According to the results shown in column I of Table 4 and substituting the values obtained for the coefficients 1 and 2 into equation (3), we find that the optimal level of investment is 0.4558. This implies that, in general terms, firms keep investing in positive NPV projects until this level is reached, and hence the value of their shares keeps rising. However, once this optimal level has been reached firms undertake negative NPV projects and, thus, the value of their shares decreases. In this way, the results obtained confirm both the underinvestment and the overinvestment hypotheses. The former for those firms whose level of investment is lower than the optimum, therefore located in Figure II to the left of (Iit/Ki,t-1)*. The latter for those firms whose investment level is located to the right of (Iit/Ki,t-1)*. The fact that the investment level is located to the left of the optimum indicates that the firms suffer from financial constraints which do not allow them to undertake all the positive NPV projects at any time. Therefore, these firms are facing an underinvestment process. The financial constraints suffered by those firms are due to the higher premium required by bondholders or prospective shareholders. This higher premium is due to either the conflict between shareholders and bondholders or the conflict between current and prospective shareholders. On the contrary, when the firms investment level is located to the right of the optimum, this indicates that the firms are undertaking negative NPV projects. These negative NPV investments do not increase the wealth of shareholders. Hence, they are only undertaken to maximize the objective function of the managers, and so firms are in the face of an overinvestment process. The overinvestment process arises when managers waste free cash flow instead of paying 15

these funds to shareholders; this behaviour is caused by the conflict between shareholders and managers. All the other variables in the model also show significant coefficients. The increment of debt variable has a positive coefficient, due to the new tax-shields obtained. The coefficient for the dividends variable is also positive. This latter result indicates that the dividends paid in the period are one of the sources of value creation for shareholders, as stipulated in the capital-market arbitrage condition. Column II of Table 4 provides the results of the estimation of model II, developed to study the relationship between firm value and investment depending on the quality of investment opportunities. Before discussing these results let us point out that 1 and 2 are, respectively, the coefficients for the investment and the square investment variables for VP firms, while in the case of NVP firms the coefficients for the abovementioned variables are (1+ 1) and (2 +2). Therefore, as 1 is positive and 2 is negative, we can affirm that the relationship between firm value and investment is quadratic for VP firms. However, before interpreting the coefficients for NVP firms, we must perform two linear restriction tests in order to check whether these coefficients are significantly different from zero. As Table 4 shows, the null hypothesis H0: 1+ 1 = 0 is rejected, since the t1 statistic takes the value of 32.3175, and the null hypothesis H0: 2 +2 = 0 can also be rejected, since the t2 statistic takes the value of 35.4839. Therefore, both (1+1)=0.3869 and (2 +2)=0.6867 are significantly different from zero, and their signs allow us to confirm the previous quadratic relationship also for NVP firms. Furthermore, by substituting the values obtained for 1 and 2 in equation (3), we find that the optimal level of investment for VP firms is 0.7774. The optimal level of investment for NVP firms is 0.2837, as can be verified by substituting (1+ 1) and (2 16

+2) in equation (6). These results support the relationship between investment and firm value posed in model I, where the optimal level of investment obtained for the whole sample of firms is 0.4558. Thus, in agreement with our second hypothesis, the following is verified: (Iit/Ki,t-1)q<1 < (Iit/Ki,t-1)* < (Iit/Ki,t-1)q>1. Finally, in model II, the significance and sign of the other variables remain, thus confirming the results obtained in model I.

5. CONCLUSIONS

This paper tests the following main hypothesis: the relationship between firm value and investment is quadratic, which implies that an optimal level of investment exists; levels lower than the optimum confirm the underinvestment hypothesis and higher levels the overinvestment one. The results obtained allow us to conclude that the abovementioned hypothesis is fulfilled. In fact, there exists an optimal level of investment, which is the level where the positive NPV projects are exhausted. Therefore, firms that exceed that value find themselves in an overinvestment process, created by the divergence of interests between shareholders and managers and facilitated by the existence of asymmetric information. In contrast, firms that do not reach that value find themselves in an underinvestment process, which implies that the existence of asymmetric information increases the price of the external financial resources, hence the firms forgo positive NPV projects. In this case, the underinvestment process is also facilitated by the existence of asymmetric information but it arises from the conflict between shareholders and bondholders and the conflict between current and prospective shareholders.

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Finally, our study also allows us to conclude that firms with valuable investment opportunities can undertake larger investments until reaching the optimal level, whereas firms without valuable investment opportunities have an optimal level of investment far below that of the previous ones, which confirms an exhaustion of their positive NPV projects.

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Adedeji, A. (1998) Does the pecking order hypothesis explain the dividend payout ratios of firms in the UK?, Journal of Business Finance & Accounting, 25, 1127-55. Arellano, M. and Bond, S. (1991) Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations, Review of Economic Studies, 58, 277-97. Arellano, M. and Bond, S. (1998) Dynamic Panel Data Estimation Using DPD98 for GAUSS: A Guide for Users, Institute for Fiscal Studies, London. Blundell, R., Bond, S., Devereux, M. and Schiantarelli, F. (1992) Investment and Tobins Q: Evidence from Company Panel Data, Journal of Econometrics, 51, 233-57. Chen, S. and Ho, K. (1997) Market Response to Product-Strategy and Capital-Expenditure Announcements in Singapore: Investment Opportunities and Free Cash Flow, Financial Management, 26, 82-8. Cleary, S. (1999) The Relationship Between Firm Investment and Financial Status, The Journal of Finance, 54, 673-92. Del Brio, E., Perote, J. and Pindado, J. (2000) Measuring the Impact of Corporate Investment Announcements on Share Prices, SSRN Working Paper N. 234578. Doukas, J. (1995) Overinvestment, Tobins q and Gains from Foreign Acquisitions, Journal of Banking and Finance, 19, 1285-303. Fazzari, S., Hubbard, R. and Petersen, B. (1988) Financing Constraints and Corporate Investment, Brooking Papers on Economic Activity, 1, 141-95. Hubbard, R. (1998) Capital-Market Imperfections and Investment, Journal of Economic Literature, 36, 193-225. Jensen, M. and Meckling, W. (1976) Theory of the Firm: Managerial Behavior, Agency Cost and Ownership Structure, Journal of Financial Economics, 3, 305-60.

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Jensen, M. (1986) Agency Costs of Free Cash Flow: Corporate Finance and Takeovers, American Economic Review, 76, 323-9. Kaplan, S. and Zingales, L. (1995) Do Financing Constraints Explain Why Investment Is Correlated With Cash Flow?, NBER Working Paper N. 5267. Lang, L. and Litzenberger, R. (1989) Dividend Announcements. Cash Flow Signalling vs. Free Cash Flow Hypothesis?, Journal of Financial Economics, 24, 181-91. Lang, L., Ofek, E. and Stulz, R. (1996) Leverage, Investment and Firm Growth, Journal of Financial Economics, 40, 3-29. Lewellen, W. and Badrinath, S. (1997) On the measurement of Tobin's q, Journal of Financial Economics, 44, 77-122. Miguel, A. and Pindado, J. (2001) Determinants of Capital Structure: New Evidence from Spanish Panel Data, Journal of Corporate Finance, 7, 77-99. Modigliani, F. and Miller, M. (1958) The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, 48, 261-97. Moulton, B. (1986) Random Group Effects and the Precision of Regression Estimates, Journal of Econometrics, 32, 385-97. Moulton, B. (1987) Diagnostics for Group Effects in Regression Analysis, Journal of Business and Economic Statistics, 5, 275-82. Myers, S. (1977) Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147-76. Myers, S. and Majluf, N. (1984) Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have, Journal of Financial Economics, 13, 187221. Nohel, T. and Tarhan, V. (1998) Shares Repurchases and Firm Performance: New Evidence on the Agency Costs of Free Cash Flow, Journal of Financial Economics, 49, 187-222. Perfect, S. and Wiles, K. (1994) Alternative Constructions of Tobin's q: An empirical comparison, Journal of Empirical Finance, 1, 313-41. Stiglitz, J. and Weiss, A. (1981) Credit Rationing in Markets with Imperfect Information, American Economic Review, 71, 393-410. Stulz, R. (1990) Managerial Discretion and Optimal Financing Policies, Journal of Financial Economics, 26, 3-27. Vogt, S. (1994) The Cash Flow/Investment Relationship: Evidence from U.S. Manufacturing Firms, Financial Management, 23, 3-20. Vogt, S. (1997) Cash Flow and Capital Spending: Evidence from Capital Expenditure Announcements, Financial Management, 26, 44-57.

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Whited, T. (1992) Debt, Liquidity Constraints and Corporate Investment: Evidence from Panel Data, The Journal of Finance, 47, 1425-60.

FOOTNOTES
1 2 3 4

Hubbard (1998) offers an excellent review of those studies. The exceptions are the studies by Kaplan and Zingales (1997) and Cleary (1999). See Del Brio et al. (2000) for a more complete overview and additional evidence. A more detailed definition of the variables can be found in the appendix.

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TABLE 1 STRUCTURE OF THE SAMPLE Number of annual observations per company 10 9 8 7 6 Total Number of companies 76 22 24 5 8 135 Number of observations 760 198 192 35 48 1,233

TABLE 2 SAMPLE DISTRIBUTION BY SUB-SECTOR CLASSIFICATION Sub-sectors Energy Extractive Industry Transport Industry Textile Industry Building Trade and Services Food Industry Metal Industry Chemical Industry Paper Industry Number of companies 14 3 14 3 22 35 21 8 9 6 % of companies 10.37 2.22 10.37 2.22 16.30 25.93 15.56 5.93 6.67 4.44

TABLE 3 SUMMARY STATISTIC Mean Standard deviation (V it /K i,t-1) (I it /K i,t-1) (I it /K i,t-1)2 (B it /K i,t-1) (D it /K i,t-1) 0.8869 0.0609 0.0758 0.0175 0.0184 1.2857 0.2686 0.6967 0.1977 0.0305 0.0061 -0.8204 0.0000 -1.1657 0.0000 21.2218 3.8364 14.7181 4.6467 0.4075 21 Minimum Maximum

TABLE 4 ESTIMATION
Model I: (V it /K i,t-1) =0 + 1(I it /K i,t-1) + 2(I it /K i,t-1)2 + 3(B it /K i,t-1) + 4(D it /K i,t-1) + dt + i + it Model II: (V it /K i,t-1) = 0 + (1 + 1DQ i) (I it /K i,t-1) + (2+ 2DQ i) (I it /K i,t-1)2 + 3(B it /K i,t-1) + 4(D it /K i,t-1) + dt + i + it

Number of companies = 135; Number of observations = 1.098 I Constant (I it /K i,t-1) (I it /K i,t-1)2 (B it /K i,t-1) (D it /K i,t-1) DQi*(I it /K i,t-1) DQi*(I it /K i,t-1)2 z1 z2 m2 Sargan 14475 (4) 21286 (8) -1.548 118.49 (108) -0.11082* (0.0141) 0.44016* (0.0150) -0.48281* (0.0066) 1.73516* (0.0542) 15.56776* (0.2533) II -0.11617* (0.0098) 0.48305* (0.0095) -0.31069* (0.0036) 1.28198* (0.0285) 17.06528* (0.1878) -0.09344* (0.0156) -0.37605* (0.0189) 22787 (6) 100034 (8) -1.580 125.80 (132)

Notes: i) Heteroskedasticity consistent standard asymptotic error in parentheses. ii) * indicates significance at the 1% level. iii) z1 is a Wald test of the joint significance of the reported coefficients, asymptotically distributed as 2 under the null of no relationship; z2 is a Wald test of the joint significance of the time dummies; degrees of freedom in parentheses. iv) m2 is a serial correlation test of second order using residuals in first differences asymptotically distributed as N(0,1) under the null of no serial correlation. v) Sargan is a test of over-identifying restrictions, asymptotically distributed as 2 under the null; degrees of freedom in parentheses.

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Figure I

Asymmetric Information

Conflict Between Shareholders and Bondholders

Conflict Between Current and Prospective Shareholders

Conflict Between Shareholders and Managers

Asset Substitution Jensen and Meckling (1976)

Moral Hazard Myers (1977)

Adverse Selection Stigliz and Weiss (1981)

Adverse Selection Myers and Majluf (1984)

Free Cash Flow Jensen (1986)

UNDERINVESTMENT PROCESSES

OVERINVESTMENT PROCESSES

23

Figure II

(Vit/Ki,t-1)

(Iit/K i,t-1) Underinvestment (Iit/K i,t-1)

*

Overinvestment

Figure III

(Vit/Ki,t-1)

(Iit/K i,t-1) (Iit/K i,t-1) q<1 (Iit/K i,t-1) q>1