Frederick T. Furlong

Michael R. Weiss

English

Research Papers in Economics

FRBSF WEEKLY LETTER
May 11, 1990
Corporate Cash Flow and Investment
Annualized after-tax profits among nonfinancial
corporations fell by about $18Y2 billion from the
fourth quarter of 1988 to the fourth quarter of
1989. This represents a decline of 14 percent.
The resulting decline in nonfinancial-corporate
cash flow (tax accounting basis) also was large:
$15% billion, or a drop of about three percent,
compared with a rise in cash flow of 71/2 percent
in both 1987 and 1988.
Many believe that these declines in corporate
profits and cash flow foreshadow a slowing in the
growth rate of business fixed investment. The
reason for this connection is a matter of debate,
however. The traditional or so-called neoclassical
view is that movements in profits and cash flow
do not cause investment to change, but instead,
are themselves determined by changes in the
same factors that determine investment, namely,
the cost of capital. and aggregate output. Under
this view, then, changes in financial factors are
symptoms that merely foreshadow changes in
investment.
An alternative view is that lower profits and cash
flow can create financing constraints that directly
influence the level of business investment. The
importance of these financing constraints for
aggregate investment is a point of considerable
debate. To contribute to this debate, this Letter
discusses how a firm's cash flow can influence
investment, and examines some empirical evi-
dence concerning the effect of cash flow on
business fixed investment.
Influences 011 illvestment
Over the past three decades, macroeconomic
models of investment have emphasized the
effects of the cost of capital and aggregate out-
put on investment. These models have shown
that business fixed investment can be explained
to a large extent by the behavior of variables
like interest rates and final sales that proxy
for the cost of capital and the level of output.
These models, moreover, have tended not to
include financial variables like profits or cash
flow (which is the sum of after-tax profits and
depreciation) in part because ofthe work by
Modigliani and Miller in the 1950s, which
established the benchmark that in perfect
capital markets the method of financing used
by a firm does not affect the level of its
investment.
However, numerous articles since Modigliani's
and Miller's original work have examined the
conditions under which the sources of financing
would affect a firm's value and investment
behavior. Most of these articles focus on the
effects of the choice between debt and equity
financing, but more recently, several economists
have developed formal models in which the
availability of "inside" (as opposed to "outside")
funds has a direct bearing on the investment
decisions of individual firms.
The basic premise of these models is that insiders
(those who manage the firm) know more than
outsiders do about the true ex ante investment
opportunities of the firm as well as about the true
ex post return. This presents problems when
funding is provided by outsiders because the
insiders have incentives to overstate the ex ante
prospects of the firm and to understate the ex
post returns when there are net losses.
Recognizing this fundamental problem with
"information asymmetry:' insiders and outsiders
enter into contracts and undertake monitoring to
limit insiders' ability to "cheat" when obtaining
fundsff6moutsidefs. These eff()r'ts,nowever;cife
costly and limited in their effectiveness, creating
financing constraints on firms subject to these
information asymmetries. Since inside and out-
side funds are not close substitutes for these
firms, changes in the availability of funds from
insiders will not be offset one-for-one by funding
from outsiders, and, thus, fluctuations in the
supply of inside funds wi!! affect investment. An
increase in inside funds will increase investmentFRBSF
while a drop in inside funds will reduce
investment.
Cash flow and inside funds
Some have suggested that corporate cash flow
provides a measure of the supply of inside funds
available for investment. However, it is likely that
cash flow is a better measure of inside funds for
some firms than it is for others. For example, it
generally is thought that cash flow corresponds
better to the concept of inside funds for smaller
businesses than for larger businesses. At small
businesses, the owners usually are insiders in the
sense that they also manage their firms. Conse-
quently, cash flow, which is a form of owner
equity, represents a supply of inside funds
available for investment in these firms.
At large firms, in contrast, equity holders
frequently are not the managers, and are instead
outsiders vis a vis the firms they own. in this
case, cash flow is not a good measure of inside
funds. At the same time, the piOblems associated
with information asymmetries likely are smaller
in magnitude at large firms than at small firms
since more information is publicly available
regarding the financial condition of large firms
than of small firms.
Accordingly, studies that examine the effect
of financial factors on the investment decisions
of individual firms distinguish among firms
depending on whether information asymmetries
are likely to create financing constraints. These
studies typically find that cash flow has a greater
effect on investment at the firms that are judged
to have larger problems with information asym-
metries, suggesting that the supply of inside
funds is an important determinant of investment
for these firms.
mains inconclusive as to whether the effects
stem from financing constraints associated with
information asymmetries. However, even if infor-
mation asymmetries are important for some firms,
many analysts question their importance for ag-
gregate business investment. First, because there
is reason to doubt that cash flow is a source of
inside funds at large corporations, investment by
these corporations should not be closely linked
to cash flow (at least not because of information
asymmetry). At the aggregate level, this could
make the relationship between cash flow and
investment relatively loose.
Second, firms that do not face financing
constraints in terms of raising outside funds
would be expected to take advantage of profita-
ble opportunities passed up by firms that are
constrained in their ability to raise outside funds.
Thus, although a drop in cash flow might force
constrained firms to pass up profitable oppor-
tunities, other firms not constrained by problems
related to information asymmetries likely would
increase investment more than otherwise.
Evidence
The behavior of corporate profits and cash flow
relative to investment in the 1980s also raises
doubts about any simple relationship between
these financial variables and the level of business
fixed investment. Chart 1 shows that real corpo-
rate profits, cash flow, and investment moved
together until the 1980s, when profits and invest-
ment clearly diverged. The relationship between
cash flow and investment also changed, though
less dramatically.
One reason for the lower levels of corporate
profits and cash flow is the increased emphasis
50
90
Billions of
1982 Dollars
(log scale)
400
85
Chart 1
Real Investment and Internal Funds'
60 65 70 75 80
*Quarterly flows, at seaSOnally-adjUsted:~~~ual rates.
**Nonfinancial Corporations
450
Billions of
1982 Dollars
(log scale)
550
150#
Specifically, these studies find that cash flow
affects investment more at smaller firms than it
does at larger firms. They also find that invest-
ment is more sensitive to cash flow at firms that
retain a relatively large portion of their earnings.
In thiscase, a high earnings-retention rate may
indicate that internally generated funds for these
firms cannot easily be replaced with new equity
or debt financing.
Some doubts
The evidence at the firm level, then, provides
some support for investment being related to
cash flow for some corporations, though it re-on debt financing. With a larger share of income
needed to cover interest expenses, it follows that
corporate profits and cash flow would be lower
at any given level of gross income.
have a statistically significant and positive effect
on changes in investment. This result is consis-
tent with the view that financing constraints play
a role in determining aggregate investment.
What these portfolio adjustments suggest is
that many firms have flexibility in how invest-
mentis financed. This means that the level of
business fixed investment may not be limited
significantly by the leve! of profits or cash flow.
Indeed, formal statistical tests indicate that
investment is not tied to the level of profits
or cash flow over the long run.
The magnitude of this effect is somewhat difficult
to pinpoint, however, since changes in real final
sales and changes in cash flow tend to move
together. Nonetheless, it is possible to estimate
a range of values for the impact of financing
constraints. We can obtain a lower-bound byat-
tributing the common information between sales
and cash flow to sales, and an upper-bound by
attributing the common information to cash flow.
This exercise suggests that at a minimum, cash
flow accounts for about 23 percent of the varia-
tion in the forecast error of investment, and at
a maximum, it accounts for 35 percent. Sales
account for 23 percent under the first scenario,
and only 12 percent under the second scenario.
These results suggest that cash flow does
have an important direct effect on investment.
Previous studies, in contrast, generally conclude
that cash flow has only a marginal influence on
aggregate investment. Those studies, however,
subject cash flow to a more stringent test. In our
analysis, the comparable test is to attribute all
the contemporaneous shocks affecting invest-
ment and cash flow to investment. Using this
approach, we find that cash flow accounts for
only about 13 percent of the variation in the
forecast error of investment. It is possible, then,
to obtain statistical results that lessen the impact
of changes in cash flow on investment. Taking
all the evidence together, however, there is good
reason to conclude that cash flow has an impor-
tant, direct effect on business fixed investment. 90 85 80 75
Year
70 65 60
Changes in cash flow and investment
Although the levels of cash flow and profits are
not related to the level of investment, it may still
be the case that changes in the levels of profits,
cash flow, and investment are related. Chart 2
suggests that this indeed has been the case, even
in the 1980s. Moreover, since changes in profits
and cash flow are highly correlated, either one
should offer an adequate proxy for internal
financing constraints. In the statistical analysis
described below, we used cash flow.
Chart 2
Changes in Rea! Investment and Cash Flow
Percent (percent change over four quarters)
20
15
10
5
o
-5
-10
-15
-20 -h---rT-rr-rr-,---,---.-rr-rr-r-r-"-,---rTT-,---rTT",,,
To obtain a measure of the effect of internal
financing constraints on aggregate investment,
our statistical analysis controlled for the other
factors that affect investment, including interest
rates (the corporate bond composite rate) and
real final sales. The results from this analysis
Sljggest that there is a Long runrelationship be-
tween investment and final sales, as the more
traditional models of investment also have found.
Conclusion
Most analysts agree that the declines in cor-
porate profits and cash flow recorded in 1989
are likely to be followed by a reduction in the
growth rate of business investment this year. Our
findings suggest that financing constraints result-
ing from the decline in the availability of inside
funds maybe an importantdirectcbannel
through which the weaker corporate cash
flow will affect investment.
The findings also suggest, however, that financial
factors cannot be ignored. Changes in cash flow
Frederick T. Furlong
Research Officer
Michael R. Weiss
Research Associate
Opinions expressed in this newsietter do not necessarily refiect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Corporate cash flow and investment

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Corporate cash flow and investment

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