Sources of Financial Flexibility:
Evidence from Cash Flow Shortfalls*
Naveen D. Daniel
LeBow College of Business
Drexel University
nav@drexel.edu
David J. Denis
Krannert School of Management
Purdue University
djdenis@purdue.edu
Lalitha Naveen
Fox School of Business
Temple University
lnaveen@temple.edu
September, 2008
Abstract
Faced with cash flows that fall short of the sum of expected dividend and investment levels,
firms must do one of the following: cut dividends, cut investment, or raise funds through security
sales, asset sales or reductions in cash reserves. Our analysis indicates that while very few firms
(6%) cut dividends, the majority (68%) make significant cuts in investment relative to expected
levels. Investment cuts make up for approximately half of the shortfall, with the other half being
covered primarily by debt financing. Net equity issues, reductions in cash balances and asset
sales account for a trivial percentage of the shortfall. Our findings challenge several widely-held
views in the corporate finance literature.
JEL classification code: G35
Key words: dividend policy, investment policy, financial flexibility, cash management
*
Preliminary draft. Comments welcome. We thank Harry DeAngelo, Linda DeAngelo, and seminar participants at
Drexel University, Florida State University, Louisiana State University, Mid-Atlantic Research Conference at
Villanova University, Temple University, and the University of Alabama for helpful comments on earlier drafts.
1.
Introduction
In imperfect capital markets, financial flexibility – i.e., the ability to respond in a timely
and value-maximizing manner to unexpected changes in cash flows and investment opportunities
– is valuable. Consequently, in the presence of such imperfections, firms can be expected to
choose financial policies that preserve the flexibility to respond to unexpected periods of
insufficient resources. In fact, the CFOs surveyed in Graham and Harvey (2001) state that
financial flexibility is the most important determinant of capital structure.
Despite its perceived importance, the primary sources of financial flexibility and their
impact (if any) on corporate financial policies remains controversial. Under one view, costly
external financing leads the firm to maintain healthy cash balances that can serve as a buffer in
times of financial need. Under this view, cash flow shortfalls are met first by reductions in cash
balances and, in some cases, by reductions in dividends. External financing is used only as a last
resort unless the firm can issue risk-free debt. This view has its roots in the model of Myers and
Majluf (1984) and has had its intertemporal implications developed in the empirical literature
that analyzes investment-cash flow sensitivities, the sensitivity of cash balances to cash flow, and
the value of cash holdings.1
An alternative view is that cash holdings themselves are costly because of potential
agency problems. This leads value-maximizing firms to maintain relatively low cash balances
and to preserve unused debt capacity that can be used in times of financial need. Dividends are
kept relatively stable so as to allow the firm continued access to the capital market. Under this
view, cash flow shortfalls are met primarily by new borrowings; reductions in cash balances are
empirically less important and the maintenance of dividends is a first-order priority. This view
1
Section 2 provides a brief literature review that contains examples of these studies.
1
has its roots in the free cash flow theory of Jensen (1986) and has recently been developed more
fully in DeAngelo and DeAngelo (2007).
In this study, we provide direct evidence on how firms use financial flexibility to manage
cash shortfalls. Specifically, we analyze situations in which the firm’s cash flow from operations
is insufficient to meet its expected levels of dividends and investment. By definition, therefore,
these firms must cut dividends, cut investment, reduce their cash reserves, or raise additional
funds through security sales or asset sales. We investigate the relative frequency of each of these
actions and analyze cross-sectional differences in how firms manage the cash shortfall.
Our sample consists of over 16,000 firm-year observations of S&P 1500 firms between
1992 and 2005. Consistent with prior literature [e.g., DeAngelo and DeAngelo (1990)], we
assume that expected dividends are equal to the dividends paid by the firm in the prior year.
Defining investment as the sum of capital expenditures (CAPEX) and research and development
(R&D), we estimate expected investment levels for each firm-year based on the corresponding
median values of asset-scaled CAPEX and R&D for that particular industry.2 We then estimate
the firm’s cash flow shortfall as expected investment + expected dividends – available cash flow,
where available cash flow equals cash flow from operations + R&D × (1–T) – preferred
dividends. Using this definition of shortfall, nearly one-third of all firm-years exhibit cash flow
shortfalls.
Faced with a cash shortfall, we find that firms rely primarily on external financing,
almost exclusively in the form of new debt, to cover the shortfall. By contrast, there is little
evidence that cash holdings are a significant source of funds in these situations. Although
slightly more than half of the firms with shortfalls reduce their cash balances, these reductions
2
We discuss later that our results are robust to alternative definitions of expected investment and expected
dividends.
2
are economically trivial relative to the size of the shortfall. Moreover, firms rarely respond to
shortfalls by cutting dividends or selling assets. Finally, we observe that investment reductions
are common. Sixty-eight percent of firms exhibiting shortfalls reduce investment levels. These
investment cutbacks are economically significant – they constitute 61% of the shortfall and the
resulting investment level is 19% below our estimate of ex ante expected investment. We
recognize that it is difficult to distinguish between investment reductions that are due to a shortrun need for funds and those that are a reflection of a decline in the attractiveness of growth
opportunities. Regardless of how we measure expected investment, however, we find that firms
primarily finance cash shortfalls through debt issues, while reductions in cash holdings,
reductions in dividends, asset sales, and equity issues continue to be economically unimportant
sources of funds.
Collectively, our findings imply that debt capacity is the primary source of financial
flexibility for firms facing cash flow shortfalls while other potential source of flexibility are
empirically unimportant.
As such, our evidence challenges some traditional views in the
corporate finance literature. First, our evidence contrasts sharply with the predictions of models
of optimal cash holdings.
These models suggest that, faced with a shortfall, firms will
temporarily draw down cash balances so as to avoid costly external financing. However, our
results indicate that firms in a liquidity crunch finance only a modest portion of the shortfall by
drawing down on cash reserves. The bulk of the shortfall is financed by accessing the debt
market.
Second, our findings appear inconsistent with simple free cash flow arguments that
managers will overinvest if they can [e.g., Jensen (1986)] and that dividends are a relatively poor
constraint on this behavior. Faced with a cash shortfall, firms in our sample frequently cut
3
investment, but virtually never cut their dividend. This evidence implies that dividends appear to
be just as effective as debt in terms of committing managers to a fixed payout.
Third, our finding that cash shortfalls have a large impact on investment levels of
dividend payers undermines a central premise of the literature that examines investment-cash
flow sensitivities (e.g., Fazzari, Hubbard and Peterson (1988)). This literature typically assumes
that dividend payers are relatively unconstrained because they can reduce dividend payments to
finance investment.
In contrast to this view, we find not only that dividend payers cut
investment rather than dividends, but also that dividend payers actually cover a greater
percentage of cash flow shortfalls through investment cuts than do nonpayers.
In short, our results also suggest that financial flexibility in the form of debt capacity
represents an important buffer between cash shortfalls and investment cuts. For a given shortfall,
dividend payers with greater financial flexibility have lower investment cutbacks than do firms
with less financial flexibility. This finding supports the argument in studies such as DeAngelo
and DeAngelo (2006b) that optimal financial policies maintain debt capacity that can be used to
cushion the impact of shocks to cash flows. Apparently, asset sales, reductions in cash balances,
and new equity issues provide little flexibility. The fact that equity does not appear to provide a
similar cushion offers support for models of costly external equity finance.
The rest of the paper is arranged as follows. Section 2 provides a brief review of other
studies related to the tradeoffs among dividend, investment, and capital structure policies.
Section 3 describes our experimental design and provides summary statistics on the data.
Section 4 examines how firms resolve cash flow shortfalls and Section 5 provides a more
detailed look at the sources of cash raised to fund the firm’s shortfall. Section 6 analyzes the
4
effect of firm characteristics on how firms manage shortfalls. Section 7 discusses our findings
and offers concluding remarks.
2.
Background
Various theories in corporate finance have implications for how firms will respond when
faced with a cash shortfall. In this section, we review this literature in the context of our study.
2.1. Cash flow, investment, and payout policy
In perfect capital markets, Modigliani and Miller (1961; henceforth MM) show that firms
will always invest at the first-best level. They then assume that the firm will pay out any residual
cash flows as dividends. Thus, investment policy can affect dividend policy, but not vice versa.
Since there are no financing frictions, firms will always be able to raise capital for all positiveNPV projects, regardless of the level of cash flows. Thus, in the MM world, negative shocks to
cash flows can affect dividends but not investment.
More recent studies in corporate finance focus on two primary frictions, agency costs and
asymmetric information.
In the agency cost framework of Jensen (1986), managers have
incentives to overinvest or otherwise misallocate free cash flow. Firms can commit ex ante not
to overinvest free cash flow by making payouts such as dividends and stock repurchases.
However, Jensen suggests that debt payments are a better commitment device than dividends
because debt payments are contractual obligations whereas dividends can be decreased at the
discretion of managers.
In the asymmetric information framework of Myers and Majluf (1984), managers acting
in the interests of current shareholders have the incentive to avoid issuing equity when the firm’s
5
stock price is sufficiently undervalued. Consequently, conditional on an equity issue, the market
rationally discounts the price of the issuing firm’s shares. In some states of the world, this can
lead the firm to underinvest relative to first-best levels.
Various scholars have recognized that these frictions have the effect of increasing the
cost of external capital relative to that of internal capital. Consequently, firms may be forced to
decrease investment in response to a shortfall in cash because the cost of external finance is too
high (e.g. Fazzari, Hubbard, and Petersen (1988), Froot, Scharfstein, and Stein (1993)).
However, Fazzari, Hubbard, and Petersen (1988) suggest that dividend-paying firms are less
constrained than non-paying firms. This assumption is based on the idea that high-payout firms
have a large dividend cushion that can be used to fund profitable investment opportunities.3
Thus, as in the perfect markets case, any negative cash flow shock will affect dividends, but will
not affect investment levels unless the shock is so large that it could not be covered by cutting
dividends to zero.
2.2. Other sources of financial flexibility
In theory, firms have other sources of financial flexibility that would allow them to
manage a cash shortfall without reducing either dividends or investment. For example, several
studies analyze determinants of cash holdings and argue that firms with high cash flow
variability and greater costs of external finance accumulate and maintain higher cash balances.4
If so, a firm faced with a cash shortfall could avoid cutting dividends and investment by
3
Fazzari et al. (1988), however, conjecture that “if firms are reluctant to cut dividends when cash flow falls….they
may reduce investment somewhat rather than seek costly external financing” (pg. 183). However, they do not
examine if this is true.
4
See, for example, Kim, Mauer, and Sherman (1998), Harford (1999), and Opler, Pinkowitz, Stulz, and Williamson
(1999).
6
temporarily reducing its cash balance. However, DeAngelo and DeAngelo (2006b) argue that
maintaining high cash balances is problematic because such balances increase expected agency
costs.
Another potential source of financial flexibility is the sale of assets. In theory, a firm
facing a cash shortfall might avoid dividend and investment cuts by selling assets. However,
asset illiquidity can make this option prohibitively expensive (Shleifer and Vishny (1992);
Pulvino (1998)).
Finally, a firm may maintain financial flexibility by preserving unused debt capacity.
DeAngelo and DeAngelo (2006b) argue that firms should maintain low leverage levels so as to
preserve the ability to borrow when faced with unanticipated capital needs. Thus, such a firm
facing a shortfall might borrow funds so as to avoid cutting dividends and investment.
DeAngelo, DeAngelo, and Whited (2008) formalize this intuition in their model of capital
structure dynamics. In their model, debt serves as a transitory finance source when firms face
shortfalls caused by random shocks to their investment opportunity set.
Transitory debt
increases allow the firm to undertake unexpected investment opportunities, while subsequent
financing surpluses are used to reduce debt.
3.
Sample Description
We seek to identify situations in which firms face a shortfall in cash flow relative to their
combined needs for expected dividends and investment.
To do so, our primary sample
comprises the S&P 1500 firms listed on Compustat’s Execucomp database for the period 19922005. As in prior studies, we exclude financial firms (SIC codes 6000-6999), utilities (SIC codes
7
4400-4999), and firms that are not publicly traded (CRSP share code not equal to 10 or 11). All
accounting data are obtained from Compustat.
We restrict our main analysis to the Execucomp dataset because it contains data on
managerial compensation, which we use in some of our models to predict expected investment.
Moreover, we are interested in the impact of cash flow shortfalls on dividend policy and most
firms that are not in the S&P 1500 do not pay dividends. Nonetheless, as a robustness check, we
repeat all our analyses using all firms listed on Compustat between 1988 and 2005. (The
statement of cash flows (SCF) is available only from 1988 onwards (pursuant to SFAS 95)). Our
main results are robust to using the broader sample of Compustat firms.
To estimate a firm’s cash shortfall, we require estimates of expected dividends, expected
investment, and cash flow available for dividends and investment (“available cash flow”).
Because R&D expense is already deducted as a pre-tax expense in the income statement, we add
back the after-tax R&D expense to the firm’s operating cash flow as listed in the firm’s statement
of cash flows. That is, we estimate available cash flow as operating cash flow + R&D × (1–t) –
preferred dividend. We estimate the effective tax rate, t, as the ratio of total taxes paid to pre-tax
income, but winsorize the resulting estimates at zero and one to avoid non-meaningful numbers.
Consistent with prior literature (e.g. Healy and Palepu (1990), DeAngelo and DeAngelo
(1990), and DeAngelo, DeAngelo, and Skinner (1994)), we set expected dividends equal to
dividends in the prior year.5 Throughout the paper, we use the term “dividend” to refer to
regular cash dividend payments on common stock. Firms that paid dividends in the prior year
are classified as payers while all others are classified as non-payers. Thus, for non-payers, the
expected dividend is zero.
Our main findings are robust to alternative measures of expected
5
In our sample, firms maintain dividends per share at the prior year’s level in 59% of the firm-years, increase
dividends per share in 38% of the firm-years, and decrease dividends per share in 3% of the firm-years.
8
dividends, including (i) using a Lintner-type (1956) model to estimate the predicted change in
dividends as a function of earnings and the prior dividend (see the Appendix for details), (ii)
excluding special dividends,6 and (iii) controlling for the impact of repurchases and share
issuances on the number of shares outstanding.7
To measure expected investment, we consider both CAPEX and R&D. Our investment
measure (dollar value), therefore, is CAPEX + R&D × (1–t). We take the post-tax value of R&D
since R&D is expensed in the income statement whereas CAPEX is not. Also, as with other
papers (e.g., Bizjak, Brickley, and Coles (1993)), we replace missing values of R&D by zero. We
estimate expected CAPEX as the median ratio of CAPEX/lagged assets of the firm’s industry (2digit SIC) in that year multiplied by the firm’s lagged assets. Similarly, expected R&D equals
the median ratio of R&D/lagged assets for the firm’s industry in that year multiplied by the
firm’s lagged assets. Our use of industry medians allows us to capture the impact of changes in
industry conditions on expected investment levels, while avoiding the negative predicted values
for investment that would arise if we were to use a regression approach to estimate expected
investment levels.
We later consider several alternative measures of expected investment,
including a naïve approach in which expected scaled investment is equal to the prior year’s
scaled investment.
6
We note, however, that special dividends have nearly disappeared over the period spanned by our sample (see
DeAngelo, DeAngelo, and Skinner (2000)). Thus, they have a trivial impact on measures of dividend payouts in our
data.
7
Specifically, we compute expected dividends based on the DPS in the last quarter of the prior fiscal year (DPSq4,t-
1). The expected dividend is therefore computed as DPS q 4 ,t −1 ×
4
∑ Shares
q =1
q ,t
where Shares is the number of
shares outstanding at the end of each of the four quarters of the current year. For firms that pay semi-annual or
annual dividends, we do an equivalent computation, based on the prior year’s semi-annual or annual DPS. Thus,
this measure assumes that managers seek to maintain the same DPS and rationally forecast the number of shares that
will be outstanding at any point during the year.
9
A firm’s cash flow shortfall is therefore equal to expected investment + expected
dividends – available cash flow.
As summarized in Table 1, 5,279 firm-years (32%) are
characterized by a positive shortfall. We label these firms ‘shortfall firms,’ and firms with
negative shortfalls as ‘surplus firms.’ The percentage of shortfall firms is approximately equal
among dividend payers (32.8%) and non-payers (31.2%).
On average, the shortfall is $100 Million, or 57% of the firm’s available cash flow.
Among those firms with a shortfall, 51% are dividend payers and 49% are non-payers. The sum
of expected investment and expected dividends for firms with a shortfall (243+40=283) is similar
to that for firms with a surplus (218+55=273). However, available cash flow is substantially
lower in firms with a shortfall. In addition, Table 1 shows that firms with shortfalls exhibit large
reductions in available cash flow relative to the prior year, but little change in expected
investment relative to the prior year. These findings imply that the sample shortfalls are caused
primarily by short-term reductions in operating cash flows rather than increases in expected
investment. By contrast, among those firms with a surplus (i.e. shortfall ≤ 0), the surplus is
caused primarily by an increase in operating cash flows relative to the prior year’s level.
Table 2 provides further information on the magnitude of shortfall relative to expected
levels of investment and dividends, and to the prior year’s cash balance. We limit our analysis in
this table to those firms with a positive shortfall and examine the extent to which it is feasible for
the sample firms to cover the observed shortfall with cuts in investment, dividends, or cash
balances. We again separately analyze dividend payers and non-payers, though our primary
interest is with payers.
As shown in Table 2, the shortfall averages 41.2% of expected investment, 250% of
expected dividends, and 61.3% of the firm’s cash balance at the end of the prior year. For
10
dividend payers, the corresponding percentages are 37.2%, 182.1%, and 70%. Among dividend
payers, 80% of the firms could cover the entire shortfall via investment cuts, 28% could cover
the shortfall entirely with dividend cuts, and 50% could maintain a positive cash balance and still
cover the entire shortfall.8 In more than 62% of the firm-years with shortfalls, the firm’s
combined cash balance and dividend levels exceed the shortfall. In other words, in these cases,
the firm could cover the shortfall without cutting investment or raising funds externally via asset
sales or security issuances.
4.
How do Firms Resolve Cash Flow Shortfalls?
Faced with a cash flow shortfall, a dividend paying firm must do one or more of the
following: cut investment, cut dividends, reduce its cash balance, sell assets, or raise funds in the
capital market. In this section, we provide evidence on how the sample firms resolve their cash
shortfall. Because one of our interests is in the role (if any) of dividend cuts as a source of
financial flexibility, we initially restrict our analysis to the sub-sample of dividend payers. We
measure investment cuts as the difference between expected and actual investment and dividend
cuts as the difference between the expected dividends and the current year’s dividends.
Reductions in cash are measured as the difference in the firm’s cash and short-term investments
in year t-1 and that in year t, where year t is the year of the shortfall. Net external financing is
taken from the statement of cash flows and is measured as the net cash flow from financing
activities, excluding preferred and common dividends. Asset sales (i.e. sales of property, plant,
and equipment and the sale of investments in affiliates) are drawn from the net cash flow from
investing activities portion of the statement of cash flows. We exclude from this quantity both
8
In reporting these numbers, we do not intend to imply that firms would ever completely eliminate investment or
reduce cash balances to zero. We simply report these numbers to give the reader some perspective on the relative
magnitude of the shortfalls.
11
CAPEX and the change in short-term investments (the latter item is considered as part of cash
drawdown). The Appendix provides a comprehensive description of all variables used in this
study, along with their corresponding Compustat data item numbers.
Table 3 presents summary data on how the sample payers resolve cash shortfalls. As
reported earlier in Table 2, the average payer with a shortfall has available cash flow that is $142
million less than the sum of expected dividends and investment. By contrast, for payers with a
surplus, the available cash flow exceeds the sum of expected dividends and expected investment
by $303M.
The data in Table 3 indicate that, on average, firms with a shortfall do not decrease their
dividend – in fact, on average, dividends show a slight increase (dividend cutback = -$1M).
However, firms with a shortfall invest less than their expected level (investment cutback =
$74M). This investment cutback accounts for approximately 61% of the cash flow shortfall.
Notably, the investment cutback is of a comparable magnitude to the level of expected dividends
($74M versus $78M, p = 0.51). In other words, had these firms cut their dividend, they could
have avoided the investment cut.
To cover the remaining shortfall, firms primarily raise external financing (external cash =
$53M) and, to a far lesser extent, sell assets. External financing covers approximately 44% of
the shortfall, while asset sales account for only 4%. Interestingly, shortfalls are not generally
covered by reductions in the firm’s cash balance. In fact, firms add to their cash balances (cash
drawdown = $-9M), perhaps reflecting a temporary increase in cash from external financing.9
9
The sum of the various sources of cash (dividend cutback, investment cutback, external financing, asset sales, and
cash drawdown) does not equal the shortfall because we winsorize each of the variables. To compute the percentage
that a particular source, contributes to the coverage of the shortfall, we divide the average amount from that source
by the sum of the five sources. This ensures that the percentages add up to 100. Thus, for example, we arrive at
investment cutbacks accounting for 61% of the shortfall by dividing the investment cutback ($74M) by the sum of
the cash generated from each source ($122M).
12
To examine whether these results are driven by a few firms that have large cutbacks,
Table 3 also reports the percentage of firms that raise money from each source. The third row of
the table indicates that 68% of firms with a cash shortfall cut back on their investment (relative
to expected levels) and 60% of them raise external cash. These numbers are both statistically
and economically different from 50%. Thus our results do not appear to be driven by a few
outliers. We also find that only 6% of firms with shortfalls cut back on dividends. In contrast, in
unreported results, we find that 26% of the shortfall firms increase their dividends. About 52%
of the shortfall firms raise money through asset sales and 53% finance the shortfall by drawing
down on cash balances. In short, the sample firms appear to cover cash shortfalls primarily by
scaling back investment plans and raising money in the external capital market.
Firms with a surplus appear to behave differently. On average, surplus firms increase
their dividends and invest more than their expected level. They are net repurchasers of debt and
equity, they invest in other assets, and add to cash balances. The fifth row gives an indication of
how the surplus is spent. Surplus firms use 4% of their surplus to fund dividend increases and
20% to invest in excess of their expected levels. They also retire debt and/or repurchase equity
(24%), increase non-operating assets (35%), and add to cash balances (17%). Moreover, these
patterns are pervasive across firms. We find that 43% of surplus firms increase their dividends,
57% increase investments, and between 61% and 64% retire debt and equity, add to nonoperating assets, and add to their cash balances. It is noteworthy that the behavior of shortfall
and surplus firms is asymmetric with respect to dividends, but symmetric with respect to
investment. Firms seem to adjust investment based on cash flows. However, dividends seem to
be adjusted (upwards) only when there is a surplus.
13
The large cutbacks in investment in firms with cash flow shortfalls, coupled with the
paucity of dividend cuts, appear at odds with the traditional views that (i) dividends are a
residual policy, and (ii) investment policy in dividend paying firms is relatively unconstrained. It
is possible, however, that our findings are due to a misspecification of expected investment.
That is, perhaps we overstate expected investment in shortfall firms and understate it in surplus
firms. This leads to the appearance that firms with shortfalls are cutting back on investment
when, in fact, they are not, whereas surplus firms appear to increase investment when they are
not.
To test this possibility, we repeat our analysis, but now define expected investment in
three different ways. First, we assume that the firm’s ratio of investment to assets remains
constant. Therefore, expected CAPEXt = (CAPEXt-1/Assetst-2) ×Assetst-1 and expected R&D =
(R&Dt-1/Assetst-2) ×Assetst-1. Second, we assume that the firm’s expected investment ratio in
each year is the industry median ratio for that year plus the deviation from the industry median in
the prior year. Thus, for example, CAPEXt/Assetst-1 = CAPEXt/Assetst-1 for the median industry
firm + (CAPEXt-1/Assetst-2 for the firm – CAPEXt-1/Assetst-2 for the median firm). This allows
for firm-specific deviations of investment ratios from the industry median. Third, following
Coles, Daniel, and Naveen (2006), we estimate expected CAPEXt/Assetst-1 and R&Dt/Assetst-1
ratios using coefficient estimates from a regression of lagged investment ratios on a set of control
variables. Specifically, we first regress the CAPEXt/Assetst-1 and R&Dt/Assetst-1 ratios on firm
size, lagged and contemporaneous market-to-book ratio, sales growth, leverage, lagged and
contemporaneous annual stock returns, CEO pay-performance sensitivity (delta), the sensitivity
of CEO wealth to stock return volatility (vega), CEO cash compensation, CEO tenure, and year
14
and 2-digit SIC dummies.10 Note that unlike Coles et al. (2006), we deliberately do not include a
measure of cash flow as a regressor since we separately examine the impact of cash flow
shortfalls on investment and dividend levels.
Our results are not sensitive to this choice,
however. We obtain qualitatively similar results if we include cash flow as a regressor when
estimating expected investment.
Table 4 reports how firms resolve cash flow shortfalls under the alternative measures of
expected investment. Our main inferences remain unchanged. Regardless of how we define
expected investment, in untabulated results, we find that between 34% and 36% of the sample
firms exhibit a cash flow shortfall. More importantly, the results in Table 4 show that, regardless
of the investment measure, firms fund their shortfall primarily through investment cutbacks and
through external financing. The reductions in investment are economically large relative to prior
levels and to industry benchmarks. By contrast, fewer than 6% of the firms with shortfalls cut
their dividend and reductions in cash holdings are economically trivial, on average.
Table 5 explores the extent to which firms resolve cash flow shortfalls differently
depending on the size of the shortfall. We sort dividend payers into quintiles on the basis of the
shortfall, then report how firms resolve the shortfall within each quintile.
For these and
subsequent results, we return to our original measure of expected investment.
Four results stand out. First, on average, even the firms with the highest shortfall
increase their dividends. Only 8% of these firms cut dividends. Second, investment cutbacks
and external financing remain the primary means of resolving the shortfall. The investment
cutback as a percentage of the shortfall does not appear to increase monotonically with shortfall
but this appears to be driven by the low shortfall groups which have average shortfalls of only
$5M and $20M (since we are dividing the investment cutback by a very small number). Third,
10
All variables are defined in the Appendix and the coefficient estimates are reported there as well.
15
only when the shortfall becomes very large do firms resort to raising money from the sale of
non-operating assets. Fourth, reductions in cash balances do not appear to be a significant source
of funds for any of the groups.
In Panel B, we again examine whether the above results are widespread in the crosssection. We compute the percentage of firms in each group that raise money from each of the
five sources. We find that 5% of the firms in the lowest level of shortfall cut their dividends.
Even in the highest shortfall group, only 8% of firms cut their dividends. We find, however, that
as we move from the lowest quintile to the highest, the percentage of firms that cut back on
investment monotonically increases from 60% to 78%. In all but the lowest quintile, the fraction
of firms that raises external finance remains roughly the same (around 61%-63%). Thus, it
appears that, as the shortfall gets larger, firms are more likely to resort to investment cutbacks
rather than outside financing to bridge the shortfall.11 Neither non-operating cash nor cash
drawdowns seems to be a significantly source of funding, consistent with our earlier results
(except for the highest shortfall group – 62% of firms in this quintile tap into non-operating
cash).
The bottom line is that, regardless of the size of the shortfall, firms finance only a trivial
proportion of the shortfall through reductions in cash reserves or reductions in dividend
payments.
Rather, cash shortfalls are covered primarily via reductions in investment and
increases in external financing.
When the shortfall is particularly large, these sources are
supplemented with cash generated from the sale of equity investments in affiliates (“nonoperating assets”).
11
Our results are qualitatively similar if we use our alternative measures of expected investment as in Table 4. We
also obtain similar qualitative results if we scale the size of the shortfall by total assets.
16
5.
A Closer Look at the Sources of Funds used to Cover Cash Shortfalls
In this section, we provide a more in-depth analysis of the sources of external finance, the
types of investment cutbacks, and the nature of asset sales used to cover cash shortfalls. In Table
6, we first sort dividend payers into quintiles on the basis of their shortfall. In panel A, we report
the components of external financing, primarily net cash from equity and net cash from debt. As
demonstrated in Table 5, external financing increases with the size of the shortfall. The results in
panel A indicates that this comes through debt rather than equity. As the magnitude of the
shortfall increases, firms do issue more stock (column 1), but also repurchase more shares
(column 2), leaving net equity (column 3) as increasingly negative.12 Thus, regardless of the
magnitude of the shortfall, firms, on average, do not appear to rely on equity to cover the
shortfall. Rather, net external financing takes the form of debt. As reported in Column (6), net
debt issues increase monotonically with the magnitude of the shortfall. On net, this external debt
financing increases the firm’s debt ratio by 4.2%, on average. The increase is larger for firms
with larger shortfalls. Overall, these findings are consistent with Fama and French (2002) who
find that short-term variations in earnings and investments are largely absorbed by debt.
In Panel B, we examine the break up of investment reductions. Recall that our measure
of investment is CAPEX + R&D × (1–t). Because Himmelberg and Petersen (1994) suggest that
firms may find it harder to adjust R&D in response to fluctuations in cash flow, we examine
whether the reductions in investment that we observe are driven by reductions in CAPEX. In
addition, we gauge the economic magnitude of such cutbacks by estimating the ratio of
investment cutback to the level of expected investment. Perhaps not surprisingly, we first
12
While at first glance this may be surprising, it is possible that these firms facing a cash flow shock and, in turn, an
earnings shock, could be managing their earnings per share upwards by repurchasing shares. This ensures that firms
meet their dividend thresholds (Daniel, Denis, and Naveen (2007)). See Kahle (2002), Bens et al. (2003), and
Hribar, Jenkins, and Johnson (2006) for earnings management through share repurchases.
17
observe that as the magnitude of the shortfall increases, the investment cutback as a percentage
of expected investments typically increases. For firms in the quintile with the largest shortfall,
investment is 22% below expected levels. In general, the percentage reductions in R&D relative
to expected levels are larger than those for CAPEX and R&D.
Nonetheless, the cuts in both
R&D and CAPEX are economically meaningful.
Finally, in panel C we disaggregate net asset sales into its individual components: (i) net
cash from affiliates – i.e, the sale and purchase of investments in unconsolidated subsidiaries and
joint ventures, (ii) net cash from property, plant, and equipment (PPE) – i.e., cash from the sale
of PPE less purchases of assets by acquisitions,13 and (iii) net cash from miscellaneous investing
activities, which includes cash received due to the separation of subsidiaries – i.e., carve outs.
Although our earlier results imply that net asset sales are not, on average, an important
source of funding for firms with cash shortfalls (except, perhaps, among those firms with the
largest shortfalls), we observe a slightly different picture once we disaggregate this funding
source. Net cash from affiliates (column 3) and net cash from the sale of PPE (column 6) are
negative for all shortfall groups and become more negative as the size of the shortfall increases.
However, cash from miscellaneous investing activities (column 7) is positive for all shortfall
groups, indicating that firms with shortfalls raise money through this source. Notably, the cash
raised in this category constitutes about 50% of the shortfall for all the shortfall groups. This
result is consistent with studies such as Allen and McConnell (1998) that find that firms engage
in equity carve outs when they are liquidity constrained.
13
Acquisitions includes increase in investments in consolidated subsidiaries as well as purchase of physical assets,
but the break-up of investment across these two groups is not available in Compustat. So this could either be
classified as contributing to net cash in affiliates or net cash in PPE. We decide to include acquisitions in the latter
group since purchase of physical assets is likely to be a bigger contributor to acquisitions.
18
6.
The Impact of Growth Opportunities, Financial Flexibility, and Prior Dividend
Policy
Our earlier results establish that, on average, firms with cash shortfalls treat the
maintenance of dividends as a priority and resolve the shortfall primarily with a combination of
investment reductions and external debt financing.
Nonetheless, these average findings
potentially mask important heterogeneity in the manner in which firms resolve cash shortfalls.
In this section, we examine the impact of growth opportunities, financial flexibility, and prior
dividend policy on the manner in which firms resolve the shortfall. For each characteristic, we
sort payers into two equal-sized groups based on the median value of the characteristic. We then
report in Table 7 the magnitude of the shortfall and the percentage of the shortfall covered by
each source of funds.
We first consider the effect of growth opportunities. We expect that firms with better
growth opportunities are less likely to cut investment and more likely to cover the shortfall with
external financing and dividend reductions. To proxy for growth opportunities, we compute the
ratio of the firm’s market value (market value of equity + book value of total assets – book value
of equity) to the book value of its assets and sort all payers with a positive shortfall into two
groups based on the lagged value of this variable. As expected, firms with a higher market-tobook ratio cover a lower percentage of the shortfall with investment cutbacks than do firms with
lower market-to-book ratios (48% versus 70%). Nonetheless, these firms still finance nearly half
of the shortfall via reductions in investment relative to expected levels.
Moreover, these
cutbacks are economically meaningful. Investment in firms with high market-to-book ratios is
13% below expected levels. (These data are not reported in the table.)
19
The data also indicate that high growth companies with shortfalls are much more likely to
cover the shortfall via external financing. In fact, high market-to-book firms cover 85% of their
shortfall with external cash, as compared to 14% for the low market-to-book firms.
One
explanation for this is that the high-growth firms face lower costs of external finance because the
market recognizes the value of their growth opportunities.
Interestingly, there is little evidence that growth opportunities affects the likelihood of
firms cutting dividends or drawing down on their cash balance to cover the shortfall. Low
market-to-book firms leave dividends unchanged, on average, while high market-to-book firms
actually increase dividends slightly in response to the shortfall. Both high market-to-book and
low market-to-book firms increase their cash balances in the year of the shortfall.
Turning to measures of financial flexibility, we expect that firms with a shortfall are less
likely to cut investment if they have more financial flexibility. We consider three different
measures of financial flexibility: leverage (ratio of debt to assets), cash holdings (ratio of cash to
assets), and z-score. Firms with low leverage are presumably more likely to have spare debt
capacity, thereby allowing them to borrow funds and avoid large reductions in investment.
Similarly, firms with high cash holdings can draw down on these balances without having to
resort to extensive investment cutbacks.14 Finally, to the extent that firms with a lower z-score
have a higher probability of bankruptcy, this makes it more costly to cover the shortfall through
external financing.
Consistent with these conjectures, we find that firms cover a greater percentage of their
shortfall with external financing when they have lower leverage (69% vs. 31%) and higher z-
14
We have also computed the numbers in Table 7 using measures of excess leverage and excess cash, where the
excess is measured relative to the median firm in the same 2-digit SIC industry. Using these measures, the
differences in the relative importance of investment cuts between the high leverage and low leverage and high cash
and low cash firms are slightly larger than what we document in Table 7.
20
scores (84% vs. 13%). Firms with higher cash holdings do cover a greater percentage of the
shortfall with cash drawdowns than do firms with low cash holdings. However, even the high
cash holdings firms cover only 10% of the shortfall by reducing their cash balance. These
patterns impact the extent to which firms cut back on planned investment. While firms with high
leverage cover 72% of their shortfall with reductions in planned investment, firms with low
leverage cover only 38% of the shortfall with investment cuts. Similarly, while firms with low zscore cover 67% of the shortfall with investment cuts, this percentage is only 33% for firms with
high z-scores. Finally, firms with low cash holdings cover 66% of the shortfall with investment
cuts while firms with high cash holdings cover 53%.
Thus, although investment cuts are
material regardless of the sub-sample examined, financial flexibility in the form of either unused
external financing capacity or greater cash on hand has an important impact on the degree to
which shortfalls are financed with investment cuts. Again, firms do not appear to cut dividends
to cover the shortfall, regardless of their financial flexibility.
Another factor that could impact how firms resolve cash flow shortfalls is their prior
dividend policy. DeAngelo and DeAngelo (1990) and DeAngelo and DeAngelo (2006b) argue
that the managers of firms with a long history of paying dividends have greater incentives to
avoid dividend cuts. If so, it is possible that firms with shorter dividend histories will be more
willing to cut dividends and, therefore, avoid deeper investment cuts. Dividend history is
defined as the number of uninterrupted years over which the firm has paid dividends. The
average firm in our sample has a dividend history of 22 years. A second variable that we use to
capture the firm’s dividend policy is the dividend payout ratio. It is likely that firms with higher
dividend payout ratios have clienteles that are more concerned with maintaining the dividend
level. Thus, it is possible that these firms are less willing to cut dividends to finance cash
21
shortfalls. We do find that firms with a longer dividend history rely more on investment
cutbacks relative to firms with a shorter dividend history (69% versus 50%). Also, firms with
higher payout cut back on investments to a greater extent than those with a low payout (62%
versus 59%), but in this case, the difference is not very large. However, regardless of the length
of dividend history or the payout ratio, firms do not cut their dividend, on average.
To this point, our analysis has focused on dividend payers since we are primarily
interested in the tradeoff (if any) between dividends and investment.
As a final analysis,
however, the bottom panel of Table 7 contrasts the behavior of dividend payers with that of nonpayers. Because payers are larger firms than non-payers, the average shortfall for payers is about
two-and-a-half times larger than that of non-payers ($142M versus $56M). Contrary to the
commonly-held view that dividend payers are less financially constrained than non-payers,
payers finance a greater percentage of the shortfall through investment cutbacks (61% versus
32%) and a lower proportion of the shortfall through external cash (44% versus 67%). Nonpayers and payers also differ in terms of their cash drawdowns. Non-payers use existing cash
balances to finance 10% of their shortfall, whereas payers increase their cash balances.
Overall, we find some significant cross-sectional differences in how firms resolve cash
shortfalls. Consistent with intuition, firms with greater growth opportunities and more financial
flexibility finance a greater percentage of the cash shortfall with external financing and a lower
percentage with investment cuts than are firms with poorer growth options and less financial
flexibility. Reductions in cash balances rarely finance a significant portion of the shortfall, but
are larger in firms with higher beginning cash balances. Asset sales appear to be important only
among firms with low z-scores. The one notable constant in our results is that, regardless of the
sub-sample that we examine, firms do not resolve cash shortfalls by reducing dividends.
22
7.
Discussion and Conclusions
Our findings provide evidence on the primary sources of financial flexibility. In the face
of significant cash flow shortfalls, firms virtually never cut their dividend and finance only a
trivial portion of the shortfall via reductions in cash reserves. Instead, these firms rely primarily
on external debt financing to resolve the shortfall. As such, our findings challenge several
widely-held views that guide much of the corporate finance literature.
First, models of optimal cash holdings imply that cash balances are set so as to serve as a
buffer in times of liquidity shortages. It is assumed that faced with a shortfall, firms will
temporarily draw down these cash balances so as to avoid costly external financing. Our
findings suggest that firms in a liquidity crunch finance only a modest portion of the shortfall by
drawing down cash reserves, but do access the external capital market if they appear to have debt
capacity. This suggests that financial flexibility in the form of debt capacity has a significant
impact on the costs of external finance and that agency costs of cash holdings are economically
important.
Second, though the notion that firms are reluctant to cut dividends is certainly not new, it
is typically assumed that this is a byproduct of dividend policies that are set so that it is unlikely
that the firm’s cash flow would ever necessitate a reduction in the dividend. In the event of such
a liquidity crunch, the presumption is that firms would treat investment policy as being of firstorder importance and treat dividends as the residual. Our findings strongly contradict this
presumption in that firms behave as if the maintenance of dividends is of first-order importance
and appear to treat investment policy as more of a residual.
23
Third, the literature on the interaction of financing and investment decisions commonly
assumes that dividend payers are less financially constrained than are non-payers.
This
assumption is based on the view that faced with a cash shortfall, dividend payers can always cut
their dividend to meet investment needs rather than using costly external financing. This view
appears to be flawed in the sense that once firms pay dividends, they appear to be more likely to
cut investment than to cut dividends.
Finally, a standard assumption in agency cost-based models is that managers will always
invest if they can and that dividends are a relatively poor constraint on this behavior. Again, the
overwhelming reluctance of managers to cut dividends contradicts this assumption. Faced with a
cash shortfall, managers exhibit a strong preference for cutting investment. We recognize that it
is difficult to identify the ‘right’ level of investment. Regardless of whether managers ‘get it
right,’ however, the fact that managers are willing to cut investment when they could have
avoided doing so is noteworthy in that dividends appear to be a meaningful constraint on free
cash flow spending.
Our findings suggest that debt capacity represents the primary source of financial
flexibility.
As such, they have implications for corporate capital structure dynamics.
Specifically, our results suggest a transitory role for debt financing such that debt ratios increase
in response to cash shortfalls, then evolve in subsequent period according to the evolution of the
firm’s cash flow stream. That is, firms experiencing subsequent financing surpluses will use the
surplus to pay down the debt, whereas those with subsequent financing shortfalls may even take
on more debt temporarily. Thus, the time-series variation in debt ratios should be linked closely
with the evolution of the firm’s cash flows. This transitory role of debt is emphasized in
24
DeAngelo and DeAngelo (2006b) and modeled more formally in DeAngelo, DeAngelo, and
Whited (2008).
25
Appendix
This appendix defines the variables and the methodology used in the study. Stock return data and
quarterly dividend data are taken from CRSP, firm-level data from Compustat, and compensation
data from Execucomp. Compustat data items are defined as data#.
A1. Compustat data item numbers and definitions of main variables used in the study
Variable
Sales
Assets
Operating Cash Flow (OCF)
Funds from Operations
EBEXTRA
Preferred Dividends
Dividends
Payer
Definition
Payout Ratio
Effective Tax Rate
Dividends / Earnings
Taxes / Pre-tax Income
Leverage
Cash-to-assets
Z-score
Debt / Book value of assets
Cash / Book value of assets
Market-to-book
(Book assets – Book equity +
Market equity) / Book assets
Variable
CEO Delta (’000s)
Definition
Dollar change in CEO wealth for a 1% change in stock price, computed as in Core and
Guay (2002)
Dollar change in CEO wealth for a 1 point change in stock return volatilty, computed
as in Guay (1999)
Number of years of uninterrupted dividend payments.
OCFt −1 ⎞ 1 ⎛ OCFt −2
OCFt −3
OCFt −4 ⎞
1 ⎛ OCFt
⎜
⎟− ⎜
⎟ , where year t is
+
+
+
2 ⎜⎝ Assets t −1 Assetst −2 ⎟⎠ 3 ⎜⎝ Assetst −3 Assetst −4 Assetst −5 ⎟⎠
the year in which shortfall is computed. See Guay and Harford (2000).
OCFt + 2
OCFt +1 ⎞ 1 ⎛ OCFt −2
OCFt −3
OCFt −4 ⎞
1 ⎛ OCFt +3
⎜⎜
⎟⎟ − ⎜⎜
⎟ , where
+
+
+
+
3 ⎝ Assets t + 2 Assets t +1 Assetst ⎠ 3 ⎝ Assetst −3 Assetst −4 Assetst −5 ⎟⎠
CEO Vega ($)
Dividend History (years)
CF Shock
CF Permanence
Income before extra-ordinary items
Compustat data item#
data12
data6
data308
data110
data18
data19
data21
= 1 if data21 in prior year > 0
= 0 otherwise
data21 / (data18 – data19)
data16 / data170
= 0 if data16 / data170 ≤ 0
= 1 if data16 / data170 ≥ 1
(data9 + data34) / data6
data1 / data6
3.3×data178/data6 + 1.2×(data4–data5)/data6 +
data12/data6 +
0.6×data199×data25/(data9+data34) +
1.4×data36/data6
(data6 – data60 + data199×data25) / data6
year t is the year in which shortfall is computed. See Guay and Harford (2000).
26
A2. Statement of Cash Flows (SCF) when format code=7
Data Item #
Operating Activities: Net Cash Flow (OCF)
data308
Investing Activities
Capital Expenditures (CAPEX)
data128
Sale of Investments
data109
Increase in Investments
data113
Sale of Property, Plant, and Equipment
data107
Acquisitions
data129
Investing Activities – Other
data310
Short-term Investments – Change
Investing Activities: Net Cash Flow
(= – data128 + data109 – data113 + data107 –
data129 + data310 + data309 )
data309
data311
Financing Activities
Cash Dividends (includes, among others,
Stock dividend and preferred dividend)
data127
Sale of Common and Preferred Stock
data108
Purchase of Common and Preferred Stock
data115
Long-term Debt – Issuance
data111
Long-term Debt – Reduction
data114
Changes in Current Debt
data301
Financing Activities – Other
Financing Activities: Net Cash Flow
(= –data127 + data108 – data115 + data111 –
data114 + data301 + data312)
data312
data313
Exchange Rate Effect
data314
Change in Cash and Cash Equivalents
(= data308 + data311 + data313 + data314)
data274
27
A3. Variables derived from the SCF
Non-operating Cash: PPE (Divestitures)
data107
Non-operating Cash: PPE (Acquisitions)
data129
Non-operating Cash: PPE (Net)
data107 – data129
Non-operating Cash: Affiliates (Sale)
data109
Non-operating Cash: Affiliates (Investment)
data113
Non-operating Cash: Affiliates (Net)
data109 – data113
Non-operating Cash: Misc.
data310
Non-operating Cash =
Non-operating Cash: PPE (Net) +
Non-operating Cash: Affiliates (Net) +
Non-operating Cash: Misc.
data107 – data129 +
data109 – data113 +
data310
External Cash: Equity (Issue)
data108
External Cash: Equity (Repurchase)
data115
External Cash: Equity (Net)
data108 – data115
External Cash: Debt (Issue)
data111 + Max(0,data301)
External Cash: Debt (Retire)
data114 – Min(0,data301)
External Cash: Debt (Net)
data111 – data114 + data301
External Cash: Misc.
data312 – (data127 – data19 – data21)
External Cash =
External Cash: Equity (Net) +
External Cash: Debt (Net) +
External Cash: Misc.
data108 – data115 +
data111 – data114 + data301 +
data312 – (data127 – data19 – data21)
Cash Drawdown
– data274 + data309 + data314
A4. Investment measures
CAPEX ($M)
Capital expenditure
data128
R&D ($M)
Max(0, data46)
Expected R&D ($M)
Research and Development expenditure
CAPEX + R&D × (1–T), where T is the effective
tax rate
Industry median ratio of CAPEX/lagged assets ×
Firm’s lagged assets
Industry median ratio of R&D/lagged assets ×
Firm’s lagged assets
Expected Investments ($M)
Expected CAPEX + Expected R&D × (1–T)
Investments ($M)
Expected CAPEX ($M)
28
Investments Cutback ($M)
Expected Investments – Investments
A5. Dividend measures
Dividends ($M)
Annual cash dividends to common stock holders
data21
Expected Dividends ($M)
Lagged common dividends
Lagged data21
Dividend Cutback ($M)
Expected Dividends – Dividends
A6. Financing Shortfall measures
Available Cash Flow ($M)
Shortfall ($M)
OCF + R&D×(1–T) – Preferred Dividends
= Expected Investments + Expected Dividends – Available Cash Flow
= Investment Cutback + Dividend Cutback + Non-operating Cash +
External Cash + Cash Drawdown
A6. Lintner (1956) model results
Following Fama (1974) and Grullon and Michaely (2002), for the sample of firms that paid
dividends both in the current year and the prior year, we regress the change in dividend
(Dividendst – Dividendst-1) on EBEXTRAt and Dividendst-1. Our regression results, with tstatistics (corrected for heteroskedasticity and firm-level clustering of standard errors) in
parentheses, are reproduced below.
Dividendst – Dividendst-1 = -1.509 + 0.031 EBEXTRAt + 0.001 Dividendst-1
(-3.5) (12.4)
(0.2)
Number of observations = 7952; R2 = 54%
The results above are not comparable with the results reported in the above studies because
of the different time periods and samples being considered.
29
A7. Expected investments: Alternative measure
We also estimate cutbacks in investments using a regression approach. To estimate the expected
investments, we first estimate separate regressions of CAPEXt/Assetst-1 and R&Dt/Assetst-1.
Exclude Available Cash Flow
CAPEXt /Assetst-1
R&Dt /Assetst-1
Vegat (× 10 )
-0.523
(0.1)
22.084***
(4.3)
Deltat (× 10-6)
0.037
(0.1)
-1.567*
(1.8)
-1.858*
(1.7)
3.097***
(2.9)
CEO Tenuret (× 10-3)
0.156
(1.2)
-0.531***
(4.4)
Log(Salest)
-0.000
(0.1)
-0.012***
(9.0)
Market-to-bookt-1
0.005***
(5.8)
0.008***
(10.0)
Market-to-bookt
0.001
(1.0)
0.004***
(4.2)
0.038***
(10.6)
0.020***
(6.0)
-0.007
(1.0)
-0.023***
(3.2)
-6
Cash Compensationt (× 10-6)
Available Cash Flowt-1 / Assetst-2
Available Cash Flowt /Assetst-1
Salest / Salest-1
Leveraget
***
-0.007
(5.4)
**
0.004
(2.6)
0.023
(3.3)
***
0.082
(9.3)
Year Dummies
Yes
Yes
2-digit SIC dummies
Yes
Yes
Observations
13960
13963
R-square
0.377
0.462
Fiscal stock returnt-1
0.007
(5.6)
Fiscal stock returnt
0.003
(2.3)
Constant
***
***
***
Expected CAPEXt is the predicted value of CAPEXt /Assetst-1 multiplied by the firm’s Assetst-1,
while Expected R&Dt is the predicted value of R&Dt /Assetst-1 multiplied by firm’s Assetst-1.
30
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34
Table 1
Sample Description
The sample comprises all firms on Execucomp for the period 1992-2005. A firm is defined as a Payer in a given
year if it paid cash dividends in the prior year (regardless of whether the firm paid common dividends in the current
year). Dividends is the annual cash dividend paid in $M. Expected Dividends is the annual cash dividend paid in the
prior year, and is zero for non-payers. CAPEX is the capital expenditures in $M. R&D is the research &
development expenditures in $M. Investments equals CAPEX + R&D×(1–t), where t is the effective tax rate. t is set
to zero if less than zero and is set to 1 if greater than 1. Expected CAPEX is the capital expenditures that the firm
should spend in $M. Expected CAPEX equals industry median CAPEX/lagged assets × Firm’s lagged assets, where
the industry median is computed using data on all firms (both payers and non-payers included) at the 2-digit SIC
level for each year. Similarly, Expected R&D equals industry median R&D/lagged assets × Firm’s lagged assets.
Expected Investments equals Expected CAPEX + Expected R&D×(1–T). OCF is the net cash flow from operating
activities as given in the Statement of Cash Flows. Available Cash Flow equals OCF + R&D×(1–T) – preferred
dividends. Shortfall equals Expected Investments + Expected Dividends – Available Cash Flow. ∆ Expected
Investments is the change in expected investments. ∆ Available Cash Flow is the change in available cash flow.
Expected
Investment
Expected
Dividends
Available
Cash Flow
Shortfall
N
∆ Expected
Investment
∆ Available
Cash Flow
A. Shortfall > 0
All firms
Payers
Non-payers
5,279
2,693
2,586
243
382
98
40
78
0
176
306
41
100
142
56
12
18
6
-33
-42
-23
B. Shortfall ≤ 0
All firms
Payers
Non-payers
11,227
5,514
5,713
218
346
95
55
112
0
511
795
236
-218
-303
-135
11
14
8
70
96
45
35
Table 2
A Closer Look at Firms with Positive Cash Flow Shortfalls
The sample comprises all firms on Execucomp for the period 1992-2005. A firm is defined as a Payer in a given
year if it paid cash dividends in the prior year (regardless of whether the firm paid common dividends in the current
year). Dividends is the annual cash dividend paid in $M. Expected Dividends is the annual cash dividend paid in the
prior year, and is zero for non-payers. CAPEX is the capital expenditures in $M. R&D is the research &
development expenditures in $M. Investments equals CAPEX + R&D×(1–t), where t is the effective tax rate. t is set
to zero if less than zero and is set to 1 if greater than 1. Expected CAPEX is the capital expenditures that the firm
should spend in $M. Expected CAPEX equals industry median CAPEX/lagged assets × Firm’s lagged assets, where
the industry median is computed using data on all firms (both payers and non-payers included) at the 2-digit SIC
level for each year. Similarly, Expected R&D equals industry median R&D/lagged assets × Firm’s lagged assets.
Expected Investments equals Expected CAPEX + Expected R&D×(1–T). OCF is the net cash flow from operating
activities as given in the Statement of Cash Flows. Available Cash Flow equals OCF + R&D×(1–T) – preferred
dividends. Shortfall equals Expected Investments + Expected Dividends – Available Cash Flow.
A. All Firms
Level
Shortfall as a %
of level
% of firms that
could fund 100%
of shortfall.
B. Payers
Level
Shortfall as a %
of level
% of firms that
could fund 100%
of shortfall.
C. Non-payers
Level
Shortfall as a %
of level
% of firms that
could fund 100%
of shortfall.
Shortfall
Expected
Investment
Expected
Dividend
Casht-1
Dividend t-1 +
Cash t-1
100
NA
243
41.2%
40
250%
163
61.3%
205
48.8%
NA
75%
14%
56%
62%
142
NA
382
37.2%
78
182.1%
203
70.0%
286
49.7%
NA
80%
28%
50%
63%
56
NA
98
57.1%
0
NA
121
46.3%
121
46.3%
NA
70%
0%
61%
61%
36
Table 3
How do firms resolve cash shortfalls?
The table reports the magnitude of the cut in investment expenditures and the amount of cash raised from other sources in response to a cash shortfall facing
dividend payers. The sample comprises all dividend payers from Execucomp for the period 1992-2005. A firm is defined as a Payer in a given year if it paid cash
dividends in the prior year (regardless of whether the firm paid common dividends in the current year). Dividends is the annual cash dividend paid in $M.
Expected Dividends is the annual cash dividend paid in the prior year, and hence zero for non-payers. CAPEX is the capital expenditures in $M. R&D is the
research & development expenditures in $M. Investments equals CAPEX + R&D×(1–t), where t is the effective tax rate. t is set to zero if less than zero and is set
to 1 if greater than 1. Expected CAPEX is the capital expenditures that the firm should spend in $M. Expected CAPEX equals industry median CAPEX/lagged
assets × Firm’s lagged assets, where the industry median is computed using data on all firms (both payers and non-payers included) at the 2-digit SIC level for
each year. Similarly, Expected R&D equals industry median R&D/lagged assets × Firm’s lagged assets. Expected Investments equals Expected CAPEX +
Expected R&D×(1–T). OCF is the net cash flow from operating activities as given in the Statement of Cash Flows. Available Cash Flow equals OCF +
R&D×(1–T) – preferred dividends. Shortfall equals Expected Investments + Expected Dividends – Available Cash Flow. Investment Cutback equals Expected
Investments – Investments. Dividend Cutback equals Expected Dividends – Dividends. Non-operating Cash is net cash flow from investing activities as given in
the Statement of Cash Flows but does not include CAPEX and change in short-term investments. External Cash is net cash flow from financing activities as
given in the Statement of Cash Flows but does not include common dividends and preferred dividends. Cash Drawdown is the drawdown in cash and short-term
investments. All variables are winsorized at the 1st and 99th percentile levels to remove the effect of outliers. Hence, shortfall will not equal expected investments
plus expected dividends minus available cash flow. Also, the sum of the five sources (the last 5 columns in the table below) will not equal the shortfall (for
example, -1+74+53+5-9 = 122 ≠ 142). To compute what % of Shortfall is financed by each of these five sources (second row of table), we divide the average
value of each source by the sum of the average value of all 5 sources. For example, for ‘investment cutback,’ we divide the average investment cutback (=74) by
the sum of the five sources (=122) instead of the shortfall (=142). This ensures that the percentages add up to 100. A positive number is interpreted as a source of
cash for the firm, while a negative number is interpreted as a use of cash. % of Positive (% of Negative) indicate the percentage of shortfall (surplus) firm-years
that have positive (negative) values for each of the five sources.
$M
Shortfall>0 % of Shortfall
Expected
dividends
Expected
investment
Available
cash flow
Shortfall
78
382
306
142
% positive
Shortfall≤0
$M
% of Shortfall
112
346
795
-303
% negative
37
Dividend
cutback
Investment
cutback
External
cash
Non-operating
cash
Cash
drawdown
-1
-1%
74
61%
53
44%
5
4%
-9
-7%
6%
68%
60%
52%
53%
-10
4%
-56
20%
-65
24%
-97
35%
-47
17%
43%
57%
63%
64%
61%
Table 4
Alternative Measures of Expected Investment
The table replicates Table 3 for various measures of expected investment. The table reports the magnitude of the reduction in investment expenditures and the
amount of cash raised from other sources in response to a cash shortfall facing dividend payers. The sample comprises all dividend payers from Execucomp for
the period 1992-2005. A firm is defined as a Payer in a given year if it paid cash dividends in the prior year (regardless of whether the firm paid common
dividends in the current year). Dividends is the annual cash dividend paid in $M. Expected Dividends is the annual cash dividend paid in the prior year, and hence
zero for non-payers. CAPEX is the capital expenditures in $M. R&D is the research & development expenditures in $M. Investments equals CAPEX + R&D×(1–
t), where t is the effective tax rate. t is set to zero if less than zero and is set to 1 if greater than 1. Expected CAPEX is the capital expenditures that the firm should
spend in $M. Expected CAPEX equals industry median CAPEX/lagged assets × Firm’s lagged assets, where the industry median is computed using data on all
firms (both payers and non-payers included) at the 2-digit SIC level for each year. Similarly, Expected R&D equals industry median R&D/lagged assets × Firm’s
lagged assets. Expected Investments equals Expected CAPEX + Expected R&D×(1–t). OCF is the net cash flow from operating activities as given in the
Statement of Cash Flows. Available Cash Flow equals OCF + R&D×(1–t) – preferred dividends. Shortfall equals Expected Investments + Expected Dividends –
Available Cash Flow. Investment Cutback equals Expected Investments – Investments. Dividend Cutback equals Expected Dividends – Dividends. Nonoperating Cash is net cash flow from investing activities as given in the Statement of Cash Flows but does not include CAPEX and change in short-term
investments. External Cash is net cash flow from financing activities as given in the Statement of Cash Flows but does not include common dividends and
preferred dividends. Cash Drawdown is the drawdown in cash and short-term investments. All variables are winsorized at the 1st and 99th percentile levels to
remove the effect of outliers. Hence, shortfall will not equal expected investments plus expected dividends minus available cash flow. Also, the sum of the five
sources (the last 5 columns in the table below) will not equal the shortfall (for example, -1+74+53+5-9 = 122 ≠ 142). To compute what % of Shortfall is financed
by each of these five sources (second row of table), we divide the average value of each source by the sum of the average value of all 5 sources. For example, for
‘investment cutback,’ we divide the average investment cutback (=74) by the sum of the five sources (=122) instead of the shortfall (=142). This ensures that the
percentages add up to 100. A positive number is interpreted as a source of cash for the firm, while a negative number is interpreted as a use of cash. % of Positive
(% of Negative) indicate the percentage of shortfall (surplus) firm-years that have positive (negative) values for each of the five sources.
38
Panel A: Expected Investment = Firm’s prior years investment scaled by assets
Dividend
cutback
Investment
cutback
External
cash
Non-operating
cash
Cash
drawdown
-3
-2%
64
45%
74
52%
15
11%
-9
-6%
6%
65%
65%
53%
53%
-10
-2
-76
-102
-47
% of Shortfall
4%
1%
32%
43%
20%
% negative
43%
55%
65%
64%
61%
$M
Shortfall>0 % of Shortfall
Expected
dividends
Expected
investments
Available
cash flow
Shortfall
86
468
401
161
% positive
Shortfall≤0
$M
109
368
756
-257
Panel B: Expected Investment = Industry median investment ratio + Firm’s deviation from median investment ratio in prior year
$M
Shortfall>0 % of Shortfall
Expected
dividends
Expected
investments
Available
cash flow
Shortfall
85
448
386
154
% positive
Shortfall≤0
$M
% of Shortfall
112
346
795
-303
% negative
Dividend
cutback
Investment
cutback
External
cash
Non-operating
cash
Cash
drawdown
-2
-2%
53
39%
84
62%
8
6%
-8
-5%
5%
63%
66%
53%
54%
-10
4%
-56
6%
-65
32%
-97
39%
-47
19%
43%
58%
65%
64%
61%
Panel C: Expected Investment = Predicted value from OLS regression of investment ratio
$M
Shortfall>0 % of Shortfall
Expected
dividends
Expected
investments
Available
cash flow
Shortfall
Dividend
cutback
Investment
cutback
External
cash
Non-operating
cash
Cash
drawdown
67
320
255
112
-2
53
45
3
-1
% positive
Shortfall≤0
$M
% of Shortfall
129
426
914
-339
% negative
39
-2%
54%
46%
3%
-1%
5%
74%
59%
50%
53%
-11
4%
-60
19%
-72
24%
-103
34%
-59
19%
43%
50%
64%
63%
62%
Table 5
A closer look into how firms manage cash shortfalls
The table reports the magnitude of the cut in investment expenditures and the amount of cash raised from other sources in
response to a cash shortfall facing dividend payers. The sample comprises all dividend payers from Execucomp for the
period 1992-2005. A firm is defined as a Payer in a given year if it paid cash dividends in the prior year (regardless of
whether the firm paid common dividends in the current year). Dividends is the annual cash dividend paid in $M. Expected
Dividends is the annual cash dividend paid in the prior year, and hence zero for non-payers. CAPEX is the capital
expenditures in $M. R&D is the research & development expenditures in $M. Investments equals CAPEX + R&D×(1–t),
where t is the effective tax rate. t is set to zero if less than zero and is set to 1 if greater than 1. Expected CAPEX is the
capital expenditures that the firm should spend in $M. Expected CAPEX equals industry median CAPEX/lagged assets ×
Firm’s lagged assets, where the industry median is computed using data on all firms (both payers and non-payers
included) at the 2-digit SIC level for each year. Similarly, Expected R&D equals industry median R&D/lagged assets ×
Firm’s lagged assets. Expected Investments equals Expected CAPEX + Expected R&D×(1–T). OCF is the net cash flow
from operating activities as given in the Statement of Cash Flows. Available Cash Flow equals OCF + R&D×(1–T) –
preferred dividends. Shortfall equals Expected Investments + Expected Dividends – Available Cash Flow. A positive
shortfall indicates that the firm will have to either cut back on expected investment or raise additional cash to meet
expected dividends. CAPEX Cutback equals Expected CAPEX – CAPEX. R&D Cutback equals Expected R&D – R&D.
Non-operating Cash is net cash flow from investing activities as given in the Statement of Cash Flows but does not
include CAPEX and change in short-term investments. External Cash is net cash flow from financing activities as given
in the Statement of Cash Flows but does not include common dividends and preferred dividends. Cash Drawdown is the
drawdown in cash and short-term investments. A positive number for these five “sources” of funds indicates that this
avenue has been used to fund the shortfall. Firms with a positive shortfall are sorted into five groups each year based on
the level of shortfall. All variables are defined in the Appendix. All variables are winsorized at the 1st and 99th percentile
levels to remove the effect of outliers. Since we winsorize the variables, the average (dollar) shortfall will not equal the
sum of the average (dollar) values of dividend cutback, investment cutback, external cash, non-operating cash, and cash
drawdown. Thus, to compute what % of Shortfall (Panel A) is financed by each of these five sources, we divide the
average dollar value of each source by the sum of the average dollar value of all five sources (instead of dividing by the
average shortfall). This ensures that the percentages add up to 100. Panel B gives the percentage of shortfall firm-years
that have positive values for each of the five sources. That is, the numbers indicate the percentage of shortfall firm-years
that raise money from that source.
Panel A: % of shortfall funded by each source
Dividend Investment External Non-operating
Cash
Shortfall groups Shortfall
cutback
cutback
cash
cash
drawdown
Low = 1
5
4%
86%
287%
-257%
-21%
2
20
0%
102%
91%
-82%
-11%
3
51
-1%
45%
98%
-35%
-8%
4
131
-2%
58%
50%
-9%
1%
High = 5
508
-1%
61%
32%
18%
-9%
Panel B: % of firms that raised money from a given source
Dividend Investment External Non-operating
Cash
Shortfall groups Shortfall
cutback
cutback
cash
cash
drawdown
Low = 1
5
5%
60%
52%
46%
52%
2
20
6%
65%
61%
49%
56%
3
51
6%
68%
63%
50%
56%
4
131
6%
70%
62%
52%
53%
High = 5
508
8%
78%
62%
62%
48%
40
Table 6
A disaggregated analysis of external financing, investment cuts, and asset sales
The table reports the magnitude of the cut in investment expenditures and the amount of cash raised from other sources in
response to a cash shortfall facing dividend payers. The sample comprises all dividend payers from Execucomp for the
period 1992-2005. A firm is defined as a Payer in a given year if it paid cash dividends in the prior year (regardless of
whether the firm paid common dividends in the current year). Dividends is the annual cash dividend paid in $M.
Expected Dividends is the annual cash dividend paid in the prior year, and hence zero for non-payers. CAPEX is the
capital expenditures in $M. R&D is the research & development expenditures in $M. Investments equals CAPEX +
R&D×(1–t), where t is the effective tax rate. t is set to zero if less than zero and is set to 1 if greater than 1. Expected
CAPEX is the capital expenditures that the firm should spend in $M. Expected CAPEX equals industry median
CAPEX/lagged assets × Firm’s lagged assets, where the industry median is computed using data on all firms (both payers
and non-payers included) at the 2-digit SIC level for each year. Similarly, Expected R&D equals industry median
R&D/lagged assets × Firm’s lagged assets. Expected Investments equals Expected CAPEX + Expected R&D×(1–T).
OCF is the net cash flow from operating activities as given in the Statement of Cash Flows. Available Cash Flow equals
OCF + R&D×(1–T) – preferred dividends. Shortfall equals Expected Investments + Expected Dividends – Available
Cash Flow. A positive shortfall indicates that the firm will have to either cut back on expected investment or raise
additional cash to meet expected dividends. CAPEX cutback equals Expected CAPEX – CAPEX. R&D cutback equals
Expected R&D – R&D. External cash is net cash flow from financing activities as given in the Statement of Cash Flows
but does not include common dividends and preferred dividends. External cash: Stock is the net cash from issue and
repurchase of stock. External cash: Debt is the net cash from issue and retirement of debt. External cash: Misc. is the net
cash from sale of miscellaneous financing activities. ∆Debt/Assets is the ratio of change in total debt scaled by lagged
assets. Non-operating cash is net cash flow from investing activities as given in the Statement of Cash Flows but does not
include CAPEX and change in short-term investments. Non-operating cash: Affiliates is the net cash from sale and
purchase of investments in affiliates. Non-operating cash: PPE is the net cash from divestitures and acquisitions. Nonoperating cash: Misc. is the net cash from sale of miscellaneous investing activities. Cash drawdown is the drawdown in
cash and short-term investments. Shortfall equals the sum of investment cutback, dividend cutback, non-operating cash,
external cash, and cash drawdown. A positive number for these five “sources” of funds indicates that this avenue has been
used to fund the shortfall. Firms with a positive shortfall are sorted into five groups each year based on the level of
shortfall. All variables are defined in the Appendix. All variables are winsorized at the 1st and 99th percentile levels to
remove the effect of outliers. Hence, the average will not add up to the sum of the parts. For example, external cash: debt
will not equal the issue of debt less repurchase of debt.
41
Panel A: Breakup of External Cash
Shortfall groups Shortfall
Stock
Repurchase
2
Δ TD/TA
Net
3 = 1–2
Issue
4
Debt
Retire
5
Misc.
Issue
1
Net
6 = 4–5
7
8
Low = 1
5
9
11
-2
91
71
15
0
3.8%
2
20
12
21
-9
129
103
25
0
5.2%
3
51
20
29
-9
249
193
57
1
5.1%
4
131
33
53
-21
437
341
80
4
4.6%
High = 5
508
72
144
-73
1,000
808
208
7
2.2%
All shortfall firms
142
29
51
-23
379
302
76
2
4.2%
All surplus firms
-303
44
141
-97
333
293
40
-1
2.7%
Panel B: Breakup of Investment Cutback
Shortfall groups Shortfall
Expected Investment cutback Expected CAPEX Cutback Expected R&D Cutback
investment Expected investment CAPEX Expected CAPEX
R&D
Expected R&D
Low = 1
5
70
5%
59
-1%
17
25%
2
20
104
17%
84
13%
29
38%
3
51
195
11%
159
4%
48
44%
4
131
359
19%
303
15%
81
42%
High = 5
508
1,198
22%
996
22%
267
25%
All shortfall firms
142
382
19%
318
17%
88
31%
All surplus firms
-303
345
-16%
269
-12%
106
-27%
Panel C: Breakup of Non-operating Cash
Shortfall groups Shortfall
Sale
1
Affiliates
Purchase
2
Net
3 = 1–2
PPE
Divestitures Acquisitions
4
5
Net
6 = 4–5
7
Nonoperating
cash
8 = 3+6+7
Misc.
Low = 1
5
17
21
-1
3
19
-16
10
-10
2
20
18
19
-2
5
28
-23
12
-14
3
51
41
51
-8
9
40
-31
24
-16
4
131
102
117
-18
13
73
-59
74
-10
High = 5
508
291
349
-51
27
122
-91
208
75
All shortfall firms
142
93
110
-16
11
56
-44
65
5
All surplus firms
-303
123
153
-20
10
101
-89
25
-97
42
Table 7
The impact of firm characteristics on how firms resolve cash shortfalls
The table reports the average dividend cutback, investment cutback, external cash, non-operating cash, and cash
drawdowns as a percentage of Shortfall The sample is limited to firms with a positive shortfall. It includes all dividend
payers from Execucomp for the period 1992-2005, except for the payer-non-payer subsample for which we consider all
firms. A firm is defined as a Payer in a given year if it paid cash dividends in the prior year (regardless of whether the firm
paid common dividends in the current year). We sort firms with a positive shortfall into two equal groups (High and Low)
based on the median level of various firm characteristics. Market-to-book is the ratio of market value of assets to the book
value of assets. Leverage is the lagged value of total debt-to-assets ratio. Cash holdings is the lagged value of cash-toassets ratio. Z-score is computed as in Altman (1968). Dividend history is the number of uninterrupted years over which
the firm has paid dividends. Expected Dividends is the annual cash dividend paid in the prior year, and hence zero for
non-payers. CAPEX is the capital expenditures in $M. R&D is the research & development expenditures in $M.
Investments equals CAPEX + R&D×(1–t), where t is the effective tax rate. t is set to zero if less than zero and is set to 1 if
greater than 1. Expected capital expenditures (CAPEX) equals industry median CAPEX/lagged assets × Firm’s lagged
assets, where the industry median is computed using data on all firms (both payers and non-payers included) at the 2-digit
SIC level for each year. Similarly, Expected R&D equals industry median R&D/lagged assets × Firm’s lagged assets.
Expected Investment equals Expected CAPEX + Expected R&D×(1–T). OCF is the net cash flow from operating
activities as given in the Statement of Cash Flows. Available Cash Flow equals OCF + R&D×(1–T) – preferred
dividends. Shortfall equals Expected Investment + Expected Dividends – Available Cash Flow. Investment Cutback
equals Expected Investment – Investment. Dividend Cutback equals Expected Dividends – Dividends. Non-operating
Cash is net cash flow from investing activities as given in the Statement of Cash Flows but does not include CAPEX and
change in short-term investments. External Cash is net cash flow from financing activities as given in the Statement of
Cash Flows but does not include common dividends and preferred dividends. Cash Drawdown is the drawdown in cash
and short-term investments. All variables are winsorized at the 1st and 99th percentile levels to remove the effect of
outliers.
Shortfall
Dividend
cutback
Low
High
159
125
0%
-3%
70%
48%
14%
85%
21%
-20%
-5%
-10%
Leverage
Low
High
103
181
-2%
-1%
38%
72%
69%
31%
-5%
9%
0%
-11%
Cash holdings
Low
High
163
121
-1%
-1%
66%
53%
48%
37%
5%
1%
-18%
10%
Z-score
Low
High
177
97
0%
-3%
67%
33%
13%
84%
33%
-19%
-13%
5%
Dividend history (yrs)
Low
High
114
175
-1%
-2%
50%
69%
40%
44%
10%
0%
1%
-11%
Payout ratio
Low
High
132
153
-1%
-1%
59%
62%
46%
42%
5%
3%
-9%
-6%
Non-Payers
Payers
56
142
-1%
-1%
32%
60%
67%
44%
-8%
4%
10%
-7%
Characteristic
Investment External Non-operating
cutback
cash
cash
Cash
drawdown
Growth Opportunities
Market-to-book
Financial Flexibility
Payout Policy
Payers vs. Non-payers
43