The value of financial flexibility, corporate investment policy and financial distress risk

Abstract

This study investigates the effects of the value of financial flexibility (VOFF) on corporate investment policies and distress risk. I empirically examine three main following research questions: (1) Does VOFF affect level and efficiency of firm’s capital investment, (2) does VOFF impact corporate ability to invest in working capital and the speed of working capital adjustment, and (3) does VOFF explain the variation in a firm’s default probability.

The study is mainly motivated by the well-established theoretical framework that suggests that financial flexibility enables a firm to finance desirable projects in a timely and value-maximising manner when such profitable opportunities arise and it may reduce the likelihood of financial distress under the effects of negative shocks in cash flows (Gamba and Triantis, 2008). However, to date, no systematic investigation has considered whether and to which extent the value, not level, of financial flexibility can affect firm investment, whether VOFF’s effects are the same across different types of investment and how it can explain the variations in failure probability.

I use a sample of 8024 non-financial US firms over the period of 1978-2013 and employ multiple methods under the panel data methodology to answer the research and hypothesis questions. I find that higher VOFF can lead to lower investment level in fixed capital, a higher likelihood of bypassing investment opportunities, and more likelihood of suffering from higher investment distortions, especially underinvestment, in long-term assets. In addition, the negative relation between investment efficiency and VOFF is higher for more financially constrained firms. With regards to the effect of VOFF on firm policy in working capital management, I uncover that firms whose shareholders confer a higher value on financial flexibility suffer from both underinvestment and overinvestment problems, particularly the latter. I also find that VOFF accelerates the SOA of WC and that such factors as WC approach, financial constraint, and types of industry have bearing effects on the relation between VOFF and SOA of WC. I also show that firms with higher VOFF suffer less from the risk of failure. I find that the main mechanism for this negative relation is via a reduction in total leverage, especially short-term debts. I also evince that such factors as firm rigidity (a proxy for operating flexibility), credit-default swaps trading and managerial quality have moderating effects that exert possible influences on the nature and strength of the credit risk-VOFF relation.

The thesis’s results advance the literature in several ways. First, it provides evidence in support of theoretical works that emphasise the precautionary motive of cash holding, the value of liquid assets, and their implications for corporate decisions (Gamba and Triantis, 2008, Riddick and Whited, 2009, Bolton et al., 2011). Second, while existing approaches aim at to measure the level of financial flexibility, I, in contrast, follow a new approach to measure the economic value of financial flexibility by using the stock market reaction as a means to an end to measure VOFF and subsequently utilize this measure to study different issues on corporate investment and credit risk. I view my thesis as an extension to Rapp et al.’s (2014) works by providing new empirical evidence of possible effects of VOFF a firm’s investment policy and credit risk. From a practical viewpoint, this thesis highlights the impacts of financial flexibility on real investment decisions and its risk relevance. The findings also help to explain why financial flexibility is a first-order consideration in making financial decisions among the top CEO around the globe (Graham and Harvey, 2001, Brounen et al., 2004, Campello et al., 2010). Furthermore, since VOFF is found to have significantly explanatory power for the variation in credit risk it can help to increase the information set to predict credit risk by relevant parties such as managers, suppliers, and lenders, among others.

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ORCID for Tapas Mishra: orcid.org/0000-0002-6902-2326

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