Asset Liquidity and the Cost of Capital
Hernán Ortiz-Molina
University of British Columbia
Gordon M. Phillips
University of Maryland & NBER
1
Motivation
• What determines a firm’s cost of capital?
– Corporate finance: affects investment, capital structure, etc.
– Asset pricing: the sources of risk that drive expected returns.
• Our basic insight: The liquidity of the market for a firm’s real
assets is an important determinant of its cost of capital.
• Reason: Asset liquidity gives a firm flexibility to react to changing
business conditions, especially in bad times:
– Allows the firm to redeploy unproductive assets to alternative
uses and to reduce fixed costs.
– Allows the firm to raise cash using asset sales.
• Examples:
– Constellation Energy needed cash and (after failed merger with
MidAmerican), was recently able to sell half of it nuclear-power
business for 4.5 billion (double the price offered by MidAmerican).
– Currently Quest wants to sell its struggling long-distance business, and
cash would also help pay down debt, but bids are at a 50% discount.
2
Conceptual Framework
• Main idea: Assets are often industry specific (Shleifer & Vishny
(1992)); asset sales in illiquid markets receive a large price discount
(Pulvino (1998)). Thus, asset liquidity determines whether a firm can
sell assets and which ones it will sell (Schlingeman et al. (2002)).
• Corporate finance: Asset liquidity increases a firm’s operating
flexibility, especially in bad times, because it allows the firm to exit
unprofitable businesses (cut costs) and to raise cash in an asset sale.
– Asset sales are key in firms’ restructurings (Maksimovic & Phillips (1998));
sellers are often poor performers or have high leverage (Lang et al.(1995)).
– Asset liquidity allows firms to maneuver in distress (Weiss & Wruck (1998)).
• Asset pricing: Costly reversibility of assets increases a firm’s equity
risk & cost of capital (Kogan (2004), Zhang (2005), Cooper (2006)).
– If reversing real investments is costly, firms will not scale down their
operations in bad times and will have high fixed costs.
– A larger covariance of a firm’s performance with the market during
economic downturns leads to higher required returns.
3
Hypothesis & Related Literature
• Main hypothesis: A more liquid market for a firm’s real assets
reduces its cost of capital by increasing its operating flexibility.
• Our study bridges two empirical literatures:
• 1. The literature on the importance of asset sales and asset liquidity
discussed before – asset liquidity increases operating flexibility.
• 2. The literature on operating flexibility and equity risk, which faces
the difficulty of measuring the costs of unwinding real assets:
– Mandelker & Rhee (1984) find a positive relation between
operating leverage and market beta.
– Gulen, Xing, and Zhang (2008) find that inflexibility (proxied by
FA/TA, recent disinvestment, financial and operating leverage)
increases the return spread between value and growth stocks.
• We use asset liquidity to measure operating flexibility ex-ante and
show that asset liquidity significantly reduces the cost of capital.
4
Specific Predictions
Predictions:
Time series:
• At the aggregate level, there should be an asset-liquidity discount
in the cost of capital that exhibits a counter-cyclical time-series
variation.
Cross-sectional:
• Firms with a more liquid market for their assets should have a
lower cost of capital.
• Inside asset liquidity should decrease a firm’s cost of capital more
than outside asset liquidity.
• Asset liquidity should reduce the cost of capital more for firms in
more competitive industries and for smaller firms.
• Asset liquidity should reduce the cost of capital more for firms
with less access to capital and for firms that are closer to default
and facing negative demand shocks.
5
Data & Measures of Key Variables
• Data: 6,858 firms operating in 327 different 3-digit SIC industries
(36,672 firm-year obs.) during the period 1984-2006. Sample
excludes financials & utilities, and firms not covered in IBES.
• 3 measures of asset liquidity:
• NoPotBuy: Number of potential buyers with investment grade
credit ratings.
• MnLev: - Mean leverage net of cash of rival firms.
– Capture the financial liquidity and purchasing power of rival firms a la
Shleifer and Vishny (1992(
• TotLiq (total asset liquidity) is that value of M&A involving
publicly traded targets in each 3-digit SIC industry, scaled by the
value of assets in the industry, and averaged over the past 5 years.
– The discounts that sellers must offer to attract buyers are smaller in
industries with a higher volume of transactions (Shleifer & Vishny (1992)).
– Schlingeman et al. (2002) show that this asset liquidity measure explains
how firm structure corporate divestitures.
6
Measures of Cost of Capital
• ICC (the implied cost of capital of Gebhardt et al. (2001)), is the
discount rate that makes the present value of expected future cash
flow equal to the current stock price.
– Address Elton’s critique of using realized returns in asset pricing tests.
– ICC is a good proxy for a stock’s expected return (Pástor et al. (2008)).
– Tests using ICC detect the risk-return tradeoff (Pástor et al. (2008) and a
positive effect of distress risk on expected returns (Chava & Purn.
(2008)).
• FFCC: Fama French Expected Cost of Capital
– linear projection of returns based on the market, size, and value factors.
– Estimate actor loadings, for each stock j in year t (between 1984 and
2006), we estimate the following time-series regression using monthly
data from year t-4MKT
to t (we requireHML
a minimum of
36 months of data):
SMB
r j  r f   j   j (rM  r f )   j HML   j SMB   j
– Project forward using long-term risk premiums:
FFCC j ,t  r f  ˆ jMKT
(rM  r f )  ˆ jHML
HML  ˆ jSMB
,t
,t
,t SMB
7
Asset Liquidity for Selected Industries
A: Highest Asset Liquidity Industries
SIC3
808
265
737
483
781
Industry Description
Home health care services
Paperboard containers & boxes
Computer programming & data processing
Radio & television broadcasting stations
Motion picture production & allied
services
Avg. 84-06
9.87%
8.83%
8.69%
8.45%
8.44%
1984
1995
2006
2.35% 10.62% 7.98%
9.51% 5.67% 2.24%
5.11% 7.83% 6.10%
4.51% 6.28% 1.58%
9.51%
7.22%
8.79%
B: Lowest Asset Liquidity Industries
SIC3
371
375
321
533
211
Industry Description
Avg. 84-06
Motor vehicles & motor vehicle equipment
0.38%
Motorcycles, bicycles, & parts
0.38%
Flat glass
0.20%
Variety stores
0.10%
Cigarettes
0.09%
1984
0.16%
0.00%
0.00%
0.12%
0.00%
1995
0.12%
0.30%
0.00%
0.01%
0.45%
2006
0.26%
0.84%
0.78%
0.02%
0.01%
8
Initial Evidence
• Our main hypothesis has two broad implications that should hold at
the aggregate level (prediction 1):
– There should be an asset-liquidity discount in firms’ cost of capital.
– This discount should be counter-cyclical.
A: Sort firms into quintile portfolios based on TotLiq.
Tot:Liq Quintile:
Q1
Q2
Q3
0.43%
1.68%
2.98%
4.90% 9.35%
8.92%
0.000
EW ICC
12.53% 11.25% 10.36%
10.27% 8.46%
-4.07%
0.000
VW ICC
10.82%
9.15% 6.90%
-3.92%
0.000
Avg. TotLiq
9.56%
8.92%
Q4
Q5
Q5 – Q1 p-value
B: Regress the asset-liquidity discount (-) on business-cycle indicators.
GDP Gr. Capacity. Util. Inflation
Coef.
T-stat
0.007
(5.45)
0.004
(5.45)
0.010
(3.95)
T-Bill Rate Default Spr. Market Ret.
0.009
(9.81)
-0.027
(4.21)
0.038
(3.21)
9
Multivariate Evidence
At the firm level and industry level, there should be a negative
association between TotLiq and ICC (prediction 2).
ICC/FFCC = α + βTotLiq + γControls + ε ; cluster std. errors by 3digit SIC.
Controls: size; leverage; ROE; volatility of ROE; fixed assets/total
assets; R&D expenses; age; dividend payer; sales growth.
(1)
(2)
(3)
(4)
(5)
(6)
TotLiq
-0.338
(5.27)
-0.380
(9.54)
-0.120
(2.50)
-0.240
(5.25)
-0.218
(3.01)
-0.109
(2.29)
All Controls
Year Dummies
SIC3 Dummies
Aggregation
Estimation
Yes
Yes
No
Firm
OLS
Yes
No
No
Firm
Between
Yes
Yes
Yes
Firm
OLS
Yes
Yes
No
Industry
WLS
Yes
No
No
Industry
Between
Yes
Yes
Yes
Industry
WLS
Observations
R2
36672
0.30
6845
0.31
36672
0.52
5070
0.58
327
0.53
5070
0.84
10
Inside vs. Outside Asset Liquidity
“Inside” asset liquidity should decrease a firm’s cost of capital by
more than “outside” asset liquidity (prediction 3).
– Inside buyers can better redeploy the asset to a productive use and are
willing to pay higher prices (Shleifer & Vishny (1997).
– Outside buyers are willing to pay lower prices due to less synergies and
lack of experience in operating the asset.
– Firms forced to sell to industry outsiders obtain lower prices than if
they were able to sell to insiders (e.g., Pulvino (1998).
InsLiq
OutLiq
All Controls
Year Dummies
SIC3 Dummies
Aggregation
Estimation
(1)
-0.590
(5.74)
(2)
-0.206
(2.39)
(3)
-0.187
(2.12)
Yes
Yes
No
Firm
OLS
Yes
Yes
Yes
Firm
OLS
Yes
Yes
Yes
Industry
WLS
(4)
(5)
(6)
-0.241
(2.16)
-0.076
(1.73)
-0.072
(1.68)
Yes
Yes
No
Firm
OLS
Yes
Yes
Yes
Firm
OLS
Yes
Yes
Yes
Industry
WLS
11
Industry Structure & Industry Position
Asset liquidity should reduce the cost of capital more for firms in
more competitive industries (prediction 4.a).
– Bankruptcy risk is higher in more competitive industries due to lower
barriers to entry (Hou & Robinson (2006)).
Asset liquidity should reduce the cost of capital more for the smallest
firms in the industry due to their higher default risk (prediction 4.b).
– weaker industry positions (e.g., less customer loyalty).
– they account for majority of exits in industry restructurings.
– small stocks have higher distress risk (Chan & Chen (1991)).
TotLiq
All Controls
Year Dummies
3-Dig SIC Dummies
Clustering by SIC3
High HHI
-0.033
(0.66)
Low HHI
-0.166
(2.13)
Leaders
-0.029
(1.19)
Followers
-0.136
(2.45)
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
12
Financial Situation & Business Environment
• Asset sales allow the firm to raise cash to fund existing or new
operations, and to maneuver in financial distress. Thus, asset liquidity
is also valuable because it increases a firm’s financial flexibility.
• Asset liquidity should reduce the cost of capital more for firms with
less access to capital (prediction 5.a).
• Asset liquidity should reduce the cost of capital more for firms that
are closer to default (prediction 5.b).
• Asset liquidity should reduce the cost of capital more for firms with
lower valuations (prediction 5.c).
• Asset liquidity should reduce the cost of capital more for firms facing
negative demand shocks (prediction 5.d).
13
Financial Situation & Business Environment
A: Access to debt financing and default risk.
Unrated Debt Rated Debt
TotLiq
All controls
Year Dummies
SIC3 Dummies
High Def. Prob. Low Def. Prob.
-0.103
(2.12)
-0.062
(1.59)
-0.178
(3.12)
-0.049
(1.20)
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
B: Market valuations and demand shocks.
Low V/A High V/A Low Sal. Gr. High Sal. Gr. Downtur
n
TotLiq
All Controls
Year Dum.
SIC3 Dum.
Norma
l
-0.159
(2.68)
-0.102
(2.09)
-0.147
(2.66)
-0.100
(1.87)
-0.615
(5.03)
-0.320
(5.37)
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
No
14
Further Investigation
• Issue 1: Are our results driven by the variation in industry valuations?
– We run pure cross-sectional regressions using the time-series
averages of the variables. We get similar results.
– We control for the industry’s valuation and the industry’s valuation
relative to historical values. We get similar results.
• Issue 2: Role of cash holdings
– Are our results driven by the omission of cash holdings?
– Do cash reserves diminish the importance of real asset liquidity?
– The effect of TotLiq on ICC holds if we control for cash/assets,
and is similar for firms with low and high cash holdings.
• Issue 3: Are we picking up a financial leverage effect?
– We control for financial leverage throughout.
– We run tests using unlevered cost of capital, but results are similar.
15
Summary & Conclusions
• We argue that asset liquidity increases a firm’s operating flexibility
and thus it reduces the risk of its equity and its cost of capital.
• We find that asset liquidity significantly reduces firms’ cost of
capital, and that this effect varies across firms and over time in ways
that are consistent with the operating flexibility channel.
• Asset liquidity has value! It allows firms to unwind investment
decisions and raise capital to adapt to new environments.
– In the cross section this benefits small firms, firms with a high
probability of default, firms without access to debt markets, and
firms with many potential buyers.
– In the time series the largest benefit for firms is in recessions.
• More generally, the results suggests that operating inflexibility is an
economically important source of risk.
16