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Abstract:
We use the link between financial constraints and a firm's demand for liquidity to develop a new test of the effect of financial constraints on firm policies. The effect of financial constraints can be captured by a firm's propensity to save cash out of incremental cash inflows (the "cash flow sensitivity of cash"). While constrained firms should have a positive cash flow sensitivity of cash, unconstrained firms' cash savings should not be systematically related to cash flows. We estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971-2000 period and find that firms that are more likely to be financially constrained display a significantly positive cash flow sensitivity of cash, while unconstrained firms do not. Also consistent with our argument, we find that constrained firms' cash flow sensitivity of cash increases during recessions, while unconstrained firms' cash - cash flow sensitivity is unaffected by macroeconomic innovations. The use of cash flow sensitivities of cash appears to be a theoretically justified, empirically useful method to test for the importance of financial constraints.

Cash flow sensitivity of cash, financial constraints, cash policy, macroeconomic innovations

Abstract:
We use the link between financial constraints and a firm's demand for liquidity to develop a new test of the effect of financial constraints on firm policies. The effect of financial constraints can be captured by a firm's propensity to save cash out of incremental cash inflows (the "cash flow sensitivity of cash"). While constrained firms should have a positive cash flow sensitivity of cash, unconstrained firms' cash savings should not be systematically related to cash flows. We estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971-2000 period and find that firms that are more likely to be financially constrained display a significantly positive cash flow sensitivity of cash, while unconstrained firms do not. Also consistent with our argument, we find that constrained firms' cash flow sensitivity of cash increases during recessions, while unconstrained firms' cash--cash flow sensitivity is unaffected by macroeconomic innovations. The use of cash flow sensitivities of cash appears to be a theoretically justified, empirically useful method to test for the importance of financial constraints.

Cash flow sensitivity of cash, financial constraints, cash policy, macroeconomic innovations

Abstract:
We survey 1,050 CFOs in the U.S., Europe, and Asia to assess whether their firms are credit constrained during the global credit crisis of 2008. We study whether corporate spending plans differ conditional on this measure of financial constraint. Our evidence indicates that constrained firms planned deeper cuts in tech spending, employment, and capital spending. Constrained firms also burned through more cash, drew more heavily on lines of credit for fear banks would restrict access in the future, and sold more assets to fund their operations. We also find that the inability to borrow externally causes many firms to bypass attractive investment opportunities, with 86% of constrained U.S. CFOs saying their investment in attractive projects was restricted during the credit crisis of 2008. More than half of the respondents say they will cancel or postpone their planned investment. Our results also hold in Europe and Asia, and in many cases are stronger in those economies.

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Abstract:
The global credit crisis of 2008 provides a unique opportunity to study the effects of financing constraints on corporate behavior. Based on standard economic priors, we investigate whether this credit supply shock has a differential impact on the real and financial policies of credit constrained firms. In contrast to previous research, which has used proxies such as firm size and credit ratings to measure constraints, we survey 1,050 CFOs in the U.S., Europe, and Asia and directly assess whether their firms are credit constrained. Our evidence shows that the impact of the financial crisis is severe on credit constrained firms, leading to deeper cuts in planned R&D, employment, and capital spending. These firms also burn through more cash, draw more heavily on lines of credit for fear banks will restrict access in the future, and sell more assets to fund their operations. Using our direct measure of constraints, we also find that the inability to borrow externally causes many firms to bypass attractive investment projects, with 86% of constrained U.S. CFOs saying their investment in attractive projects has been restricted during the credit crisis of 2008 and more than half outright cancelling or postponing their investment plans. Our results also hold in Europe and Asia, and in many cases are stronger in those economies.

Financial crisis, financing constraints, investment spending, liquidity management, matching estimators

Abstract:
We survey 1,050 CFOs in the U.S., Europe, and Asia to directly assess whether their firms are credit constrained during the global financial crisis of 2008. We study whether corporate spending plans differ conditional on this survey-based measure of financial constraint. Our evidence indicates that constrained firms planned deeper cuts in tech spending, employment, and capital spending. Constrained firms also burned through more cash, drew more heavily on lines of credit for fear banks would restrict access in the future, and sold more assets to fund their operations. We also find that the inability to borrow externally caused many firms to bypass attractive investment opportunities, with 86% of constrained U.S. CFOs saying their investment in attractive projects was restricted during the credit crisis of 2008. More than half of the respondents said they canceled or postponed their planned investments. Our results also hold in Europe and Asia, and in many cases are stronger in those economies. Our analysis adds to the portfolio of approaches and knowledge about the impact of credit constraints on real firm behavior.

Financial crisis, financing constraints, investment spending, liquidity management, matching estimators

Abstract:
A key assumption in the existing theoretical work on firm financial constraints is that these constraints translate entirely into higher costs of funds. This approach poses two types of difficulties to the research on that topic. First, it inadvertently narrows our understanding about financial constraints since, in practice, firms often face credit rationing. Second, it is a matter of debate whether such an approach can deliver unambiguous implications for corporate investment. The current paper develops a theory explaining the relationship between corporate investment and cash flow when firms face credit quantity constraints. We show that when firms' investments and use of external finance are endogenously related, investment-cash flow sensitivities increase as credit constraints are relaxed. From an empirical perspective, our analysis suggests a consistent way of identifying the impact of financial constraints on corporate investment. Our predictions, however, are markedly different from those examined in most empirical studies in this area.

investment, cash-flow, investment-cash flow sensitivities, financial constraints, credit rationing

Abstract:
Pledgeable assets support more borrowing, which allows for further investment in pledgeable assets. We use this credit multiplier to identify the impact of financing frictions on corporate investment. The multiplier suggests that investment cash flow sensitivities should be increasing in the tangibility of firms' assets (a proxy for pledgeability), but only if firms are financially constrained. Our empirical results confirm this theoretical prediction. Our approach is not subject to the Kaplan and Zingales () critique, and sidesteps problems stemming from unobservable variation in investment opportunities. Thus, our results strongly suggest that financing frictions affect investment decisions.

G31

Abstract:
When firms are able to pledge their assets as collateral, investment and borrowing become endogenous: pledgeable assets support more borrowings that in turn allow for further investment in pledgeable assets. We show that this credit multiplier has an important impact on investment when firms face credit constraints: investment-cash flow sensitivities are increasing in the degree of tangibility of constrained firms' assets. If firms are unconstrained, however, investment-cash flow sensitivities are unaffected by asset tangibility. Crucially, asset tangibility itself may determine whether a firm faces credit constraints - firms with more tangible assets may have greater access to external funds. This implies that the relationship between capital spending and cash flows is non-monotonic in the firm's asset tangibility. Our theory allows us to use a differences-in-differences approach to identify the effect of financing frictions on corporate investment: we compare the differential effect of asset tangibility on the sensitivity of investment to cash flow across different regimes of financial constraints. We implement this testing strategy on a large sample of manufacturing firms drawn from COMPUSTAT between 1985 and 2000. Our tests allow for the endogeneity of the firm's credit status, with asset tangibility influencing whether a firm is classified as credit constrained or unconstrained in a switching regression framework. The data strongly support our hypothesis about the role of asset tangibility on corporate investment under financial constraints.

Abstract:
When firms are able to pledge their assets as collateral, investment and borrowing become endogenous: pledgeable assets support more borrowings that in turn allow for further investment in pledgeable assets. We show that this credit multiplier has an important impact on investment when firms face credit constraints: investment-cash flow sensitivities are increasing in the degree of tangibility of constrained firms' assets. If firms are unconstrained, however, investment-cash flow sensitivities are unaffected by asset tangibility. Crucially, asset tangibility itself may determine whether a firm faces credit constraints - firms with more tangible assets may have greater access to external funds. This implies that the relationship between capital spending and cash flows is non-monotonic in the firm's asset tangibility. Our theory allows us to use a differences-in-differences approach to identify the effect of financing frictions on corporate investment: we compare the differential (marginal) effect of asset tangibility on the sensitivity of investment to cash flow across different regimes of financial constraints. We implement this testing strategy on a large sample of manufacturing firms drawn from COMPUSTAT between 1985 and 2000. Our tests allow for the endogeneity of the firm's credit status, with asset tangibility influencing whether a firm is classified as credit constrained or unconstrained in a switching regression framework. The data strongly support our hypothesis about the role of asset tangibility on corporate investment under financial constraints.

Investment-cash flow sensitivities, asset tangibility, financial constraints, credit multiplier, errors-in-variables, GMM

Abstract:
We construct firm-specific measures of expected equity returns using corporate bond yields, and replace standard ex postaverage returns with our expected-return measures in asset pricing tests. We find that the market beta is significantly priced in the cross section of expected returns. The expected size and value premiums are positive and countercyclical, but there is no evidence of positive expected momentum profits.

G12, E44

Abstract:
We use yield spreads to construct ex-ante returns on corporate securities, and then use the ex-ante returns in asset pricing assets. Differently from the standard approach, our tests do not use ex-post average returns as a proxy for expected returns. We find that the market beta plays a much more important role in the cross-section of expected returns than previously reported. The expected value premium is significantly positive and countercyclical. We find no evidence of ex-ante positive momentum profits.

Abstract:
We use corporate bond yield spreads to gauge investors' return expectations. We then replace standard ex-post, averaged measures of return with our ex-ante return measures in asset pricing assets. We find that the market beta plays a significant role in the cross-section of returns when expectations are measured ex-ante. The expected size and value premia are significantly positive and countercyclical, but there is no evidence of ex-ante positive momentum profits.

Expected Returns, Risk Factors, Systematic Risk, Yield Spreads

Abstract:
We show theoretically that while cash allows financially constrained firms to hedge future investment against income shortfalls, reducing current debt is a more effective way to boost investment in future high cash flow states. Thus, constrained firms prefer higher cash to lower debt if their hedging needs are high, but lower debt to higher cash if their hedging needs are low. We provide empirical evidence that supports our theory. Our analysis points to an important hedging motive behind cash and debt management policies. It suggests that cash should not be viewed as negative debt in the presence of financing frictions.

Risk management, financing frictions, investment, cash policy, debt capacity

Abstract:
We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows financially constrained firms to hedge against future income shortfalls, reducing debt - "saving borrowing capacity" - is a more effective way of securing future investment in high cash flow states. This trade-off implies that constrained firms will allocate excess cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). However, constrained firms will use excess cash flows to reduce current debt if their hedging needs are low. The empirical examination of cash and debt policies of a large sample of constrained and unconstrained firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows, while showing no propensity to reduce outstanding debt. In contrast, constrained firms with low hedging needs systematically channel free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.

Abstract:
We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows constrained firms to hedge against future cash flow shortfalls, reducing current debt - 'saving borrowing capacity' - is a more effective way of securing investment in high cash flow states. This trade-off implies that constrained firms will allocate cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). Those same firms, however, will use free cash flows to reduce current debt if their hedging needs are low. The empirical examination of debt and cash policies of a large sample of firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows while leaving their debt positions unchanged. In contrast, constrained firms with low hedging needs direct most of their free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.

Cash holdings, debt policies, hedging, financing constraints, risk management

Abstract:
We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows financially constrained firms to hedge future investment against income shortfalls, reducing current debt (saving debt capacity) is a more effective way to boost investment in future high cash flow states. This tradeoff implies that constrained firms will prefer cash to debt capacity if their hedging needs are high (i.e., if the correlation between operating income and investment opportunities is low), but will prefer debt capacity to cash if their hedging needs are low. The empirical examination of cash and debt policies of a large sample of constrained and unconstrained firms reveals evidence that is consistent with our theory. In particular, financially constrained firms with high hedging needs show a strong propensity to save cash out of cash flows, while displaying no propensity to reduce debt. In contrast, constrained firms with low hedging needs systematically channel cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt in the presence of financing frictions.

Risk management, financing frictions, investment, cash savings, debt capacity

Abstract:
This paper provides firm- and industry-level evidence on the effects of capital structure on product market outcomes for a large cross-section of industries. The analysis uses shocks to aggregate demand as surrogates for exogenous changes in the product market environment, dealing with concerns about the endogenous nature of the relation between financial structure and competitive performance. I find that debt financing has a negative impact on firm (relative-to-industry) sales growth in industries where rivals are relatively unlevered during recessions, but not during booms. In contrast, no such effects are observed for firms competing in high-debt industries. At the industry level, I find that markups are more countercyclical when industry debt is high. The cyclical dynamics I find for firm sales growth and for industry markups are consistent with Chevalier and Scharfstein's (1996) prediction that firms that rely more heavily on external financing are more prone to boost short-term profits at the expense of future sales in response to negative shocks to demand, and that the competitive outcomes resulting from such actions depend on the financial structures of their industry rivals.

Abstract:
This paper provides firm- and industry-level evidence on the effects of capital structure on product market outcomes for a large cross-section of industries. The analysis uses shocks to aggregate demand as surrogates for exogenous changes in the product market environment, dealing with concerns about the endogenous nature of the relation between financial structure and competitive performance. I find that debt financing has a negative impact on firm (relative-to-industry) sales growth in industries where rivals are relatively unlevered during recessions, but not during booms. In contrast, no such effects are observed for firms competing in high-debt industries. At the industry level, I find that markups are more countercyclical when industry debt is high. The cyclical dynamics I find for firm sales growth and for industry markups are consistent with Chevalier and Scharfstein's (1996) prediction that firms that rely more heavily on external financing are more prone to boost short-term profits at the expense of future sales in response to negative shocks to demand, and that the competitive outcomes resulting from such actions depend on the financial structures of their industry rivals.

Abstract:
This paper develops a test for herding in forecasts by professional financial analysts that is robust to (a) correlated information amongst analysts; (b) common unforecasted industry-wide earnings shocks; (c) information arrival over the forecasting cycle; (d) the possibility that the earnings that analysts forecast differ from what the econometrician observes; and (e) systematic optimism or pessimism among analysts. We find that forecasts are biased, but that analysts do not herd. Instead, analysts anti-herd: Analysts systematically issue biased contrarian forecasts that overshoot the publicly-available consensus forecast in the direction of their private information.

Earnings forecasting, Financial analysts, Herding, Econometric test, Contrarian behavior

Abstract:
This paper develops a test for forecast bias that is robust to (a) correlated information amongst analysts; (b) common unforecasted industry-wide earnings shocks; (c) information arrival at different points of the forecast horizon; and (d) the possibility that the measure of earnings that analysts forecast differs from that which the econometrician observes. We find no empirical support for herding. On the contrary, analysts systematically issue biased contrarian forecasts that overshoot the publicly-available consensus forecast in the direction of their private information. We find that the forecast bias is economically large and declines with the amount of information at an analyst's disposal. The magnitude of the bias, its systematic variation with analyst following, and the pattern of bias in forecast revisions indicate that the bias is strategically chosen. In particular, the data cannot be explained by analyst myopia or analyst overconfidence.

Abstract:
This paper investigates whether firms manage analyst forecasts to generate positive earnings surprises and the consequences of such forecast management. We first document that firms "talk down" forecasts. Forecasts of quarterly earnings issued later in the forecasting horizon grow increasingly pessimistic on average. More importantly, the exact timing of changes in earnings forecasts turn out to be a key determinant of whether a firm indeed succeeds at generating positive earnings surprises. In particular, (i) changes in consensus early in the forecast horizon have no effect on the probability that earnings will exceed the consensus, (ii) late forecasts that raise the consensus sharply reduce the probability of a positive earnings surprise, and (iii) late forecasts that lower the consensus sharply raise the probability of a positive earnings surprise. These last two findings are the opposite of what would be predicted if deviations of late forecasts from the consensus were due to new information arrival. We then find evidence that investors are systematically "misled" by late arriving forecasts. In particular, downward revisions in the consensus lead to large positive cumulative abnormal returns following the earnings announcement. Finally, while the finding that investors reward firms that successfully manage forecasts down might seem to provide a rationale for downward forecast management, this is not so. Specifically, controlling for the extant earnings-consensus forecast differential, the negative impact of downward forecast revisions on stock price dominates the stock price appreciation following the earnings announcement. This begs the question: Firms manage analyst forecasts (down), but why?

Analysts consensus, forecast errors, earnings management

Abstract:
Much of corporate finance is concerned with the impact of financing constraints on firms. However, the literature on financing constraints largely ignores the intertemporal implications of those constraints; in particular, how future financing constraints affect current investment decisions. We present a model in which future financing constraints lead firms to have a current preference for investments with shorter payback periods, investments with less risk, and investments that utilize more liquid/pledgeable assets. The model has a host of implications in different areas of corporate finance, including firms' capital budgeting rules, risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. We show how a number of patterns reported in the empirical literature can be reconciled and interpreted in light of the intertemporal optimization problem firms solve when they face costly external financing. For example, contrary to Jensen and Meckling (1976), we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to distort the risk profile of their most liquid investments.

Abstract:
We study a model in which future financing constraints leas firms to have a preference for investments with sorter payback periods, investments with less risk, and investments that utilize more pledgeable assets. The model also shows how investment distortions towards more liquid, safer assets vary with the marginal cost of external financing and with firm internal cash flows. Our theory helps reconcile and interpret a number of patterns reported in the empirical literature, in areas such as risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. For example, contrary to Jensen and Meckling (1976), we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to decrease the risk of their most liquid investments.

financial constraints, types of investment, capital budgeting, risk shifting

Abstract:
Research on capital structure-product market interactions has traditionally sought to establish whether debt financing either hurts or boosts firm performance. This paper proposes that both of these competitive outcomes are likely to emerge in an industry setting: debt can hurt and boost a firm's product market performance. To motivate this case, I analyze a simple model implying a non-monotonic relation between a firm's use of external (debt-like) financing and its competitive conduct. I then empirically examine the within-industry relation between corporate debt and sales performance using firm-level data from a panel of 115 industries over 30 years. The testing strategy I implement allows for the marginal effect of debt policies on product market outcomes to vary according to the level of firm/rival indebtedness. Crucially, it addresses concerns with the endogeneity of financing decisions in a novel fashion: I use creditors' valuation of firms' assets in liquidation to identify financial leverage in an empirical model of product market performance. My evidence suggests that moderate (relative-to-industry) firm debt taking is, on the margin, associated with sales gains that obtain at the expense of industry rivals. After some point, however, higher relative indebtedness leads to significant sales underperformance. I also investigate whether financing-performance linkages vary with industry concentration and with firm leadership (market share size). I find that leader (follower) firms in concentrated industries underperform (outperform) their rivals when those firms' leverage ratios exceed the industry norm. In contrast, less leveraged leaders in those same industries observe positive sales-debt sensitivities. Firm debt and leadership positions are less relevant for competitive outcomes in less concentrated markets.

Capital structure, product market competition, industry concentration, endogeneity, GMM

Abstract:
In a recent paper, Bernhardt et al. (2004) developed a non-parametric test for bias in forecasts by professional financial analysts that is robust to correlated information amongst analysts and information arrival over the forecasting cycle. The tests show that analysts anti-herd: Analysts systematically issue biased contrarian forecasts that overshoot the publicly-available consensus forecast in the direction of their private information. In this campanion paper, we show that for those analysts that report later in the forecast-horizon, a reward scheme that is convex in relative performance may shed some light on this strategic behavior. The pattern and magnitude of the forecast bias in the last forecast are identical to the results in Bernhardt et al., and slightly higher in some sub-samples. An analysis of daily returns around the date of earnings announcement reveals that investors do not fully unravel the bias in late forecasts.

Abstract:
This paper shows novel evidence on the mechanism through which financial constraints amplify fluctuations in asset prices and credit. It does so using contractual features of housing finance. Among agents whose housing demand is constrained by the availability of collateral, those who can borrow against a larger fraction of their housing value (achieve a higher loan-to-value, or LTV, ratio) have more procyclical debt capacity. This procyclicality underlies the financial accelerator mechanism described by Stein (1995) and Bernanke et al. (1996). Our study uses international variation in maximum LTV ratios over three decades to test whether (a) housing prices and (b) demand for new mortgage borrowings are more sensitive to income shocks in countries where households can achieve higher LTV ratios. The results we obtain are consistent with the dynamics of a collateral-based financial accelerator in housing markets.

financial accelerator, housing prices, collateral constraint, income constraint, credit multiplier

Abstract:
This paper investigates internal capital markets in financial conglomerates by studying the responses of small banks to changes in monetary policy. I find that if a small bank operates on a stand-alone basis, then that bank's loan growth becomes significantly more dependent on its own cash flows as monetary policy is tightened. In contrast, if a small bank operates under a multi-bank holding company with another bank with easy access to nonreservable funds, then the small bank's loan growth does not become more sensitive to its own cash flows in periods of tight money. My evidence shows that internal capital markets in financial conglomerates relax the constraints faced by affiliates unable to raise funds via liabilities that bear credit risk. Further analysis indicates that internal capital markets have the potential of lessening the impact of Fed policies on bank lending activity. The paper also examines the role of internal capital markets in influencing the investment allocation process of conglomerates. In a sample of constrained (unconstrained) multi-bank holding companies, comparisons across bank affiliates of the same conglomerate show that the funding of new loans becomes less (more) sensitive to affiliate-level cash flows for the worst affiliates relative to the best affiliates following a tightening. My findings suggest that frictions between conglomerate headquarters and external capital markets are at the root of investment inefficiencies generated by internal capital markets.

Internal Capital Markets, Financial Constraints, Financial Institutions, Monetary Policy

Abstract:
This paper investigates internal capital markets in financial conglomerates by studying the responses of small banks to changes in monetary policy. I find that if a small bank operates on a stand-alone basis, then that bank's loan growth becomes significantly more dependent on its own cash flows as monetary policy is tightened. In contrast, if a small bank operates under a multi-bank holding company with another bank with easy access to nonreservable funds, then the small bank's loan growth does not become more sensitive to its own cash flows in periods of tight money. My evidence shows that internal capital markets in financial conglomerates relax the constraints faced by affiliates unable to raise funds via liabilities that bear credit risk. Further analysis indicates that internal capital markets have the potential of lessening the impact of Fed policies on bank lending activity. The paper also examines the role of internal capital markets in influencing the investment allocation process of conglomerates. In a sample of constrained (unconstrained) multi-bank holding companies, comparisons across bank affiliates of the same conglomerate show that the funding of new loans becomes less (more) sensitive to affiliate-level cash flows for the worst affiliates relative to the best affiliates following a tightening. My findings suggest that frictions between conglomerate headquarters and external capital markets are at the root of investment inefficiencies generated by internal capital markets.

Internal Capital Markets, Financial Constraints, Financial Institutions, Monetary Policy

Abstract:
This paper examines the real and financial implications of credit market imperfections. It does so using detailed firm-level data. Under alternative measures of financing constraints, we first show that financially constrained firms' business fundamentals (e.g., operating earnings and capital expenditures) are systematically more sensitive to aggregate economic movements than unconstrained firms' fundamentals. We then show that financial constraint "factors" have significant explanatory power over equity returns. Crucially, those return factors covary with macroeconomic movements exactly as suggested by the theory: the difference between the stock returns of financially constrained and unconstrained firms widens precisely when financial constraints are more likely to bind (when aggregate credit conditions are tight). Because a firm's stocks and bonds are claims written on the same real production process, we also look for evidence on financial constraints in the pricing of debt securities. We find that financially constrained firms' bonds command higher ex ante risk premia in virtually every month of the last three decades. Moreover, these ex ante risk premia, too, covary with macroeconomic movements in a fashion that is consistent with the effect of financial constraints on real firm behavior: the constraint risk premia are counter-cyclical. The evidence we gather from firm fundamentals, stocks, and bonds indicate that financial constraint is a systematic, priced risk.

Financial constraints, equity returns, credit spreads, systematic risk, macroeconomic shocks

Abstract:
There is ample empirical evidence of a negative relation between internal funds (profitability) and the demand for external funds (debt issuance). This negative relation has been interpreted as evidence for external financing costs arising from capital market frictions such as asymmetric information (e.g., the pecking order theory). We show, however, that the negative effect of internal funds on the demand for external financing is concentrated among firms that are \QTR{em}{least likely} to face high costs of external finance (firms that distribute large amounts of dividends, that are large, and whose bonds and commercial papers are rated). For firms in the other end of the spectrum (low payout, small, and unrated), external financing is insensitive to innovations to internal funds. These cross-firm differences hold separately for debt and outside equity financing, and are magnified in the aftermath of macroeconomic movements that tighten financial constraints. We argue that the greater degree of complementarity between internal funds and external finance for constrained firms is a consequence of the interdependence of their financing and investment decisions. Our findings suggest that the negative relation between internal funds and external financing should not be interpreted as evidence for external financing costs.

Capital structure, external financing, pecking order, financial constraints, investment, GMM, business cycles

Abstract:
The focus of the current credit crisis is on the immediate implications, such as reduced profits and increased unemployment. In contrast, we show that there are worrisome long-term economic consequences of the crisis through its effect on financially constrained firms. Using a survey of over 1,000 CFOs in the United States, Europe and Asia, we show that firms are cutting back or canceling projects that they know add to firm value. The elimination of profitable projects is especially acute for firms that face financial constraints. One of the basic tenets of finance is that projects that enhance firm value should be pursued. Financial constraints potentially prevent the funding of these projects. The current credit crisis is an ideal setting to measure the impact of constraints on value creation. Turning down or canceling profitable projects is a lesser known cost of the current financial crisis. Our evidence suggests that in the scramble for short-term cash flow, firms are sacrificing long-term value. This implies lower future growth opportunities and lower future employment growth.

Financial crisis, financing constraints, investment spending, liquidity management, matching estimators

Abstract:
We study the effect of asset liquidity (tangibility) on firm policies in the presence of financing constraints. We do so in a real options framework that allows for the simultaneous determination of investment and financing. In the presence of financing imperfections, firms that operate more tangible assets have larger credit capacity. By expanding the firm's capital base, the investment process engenders a feedback effect in which investment (in tangible assets) helps relax financing constraints, which in turn allows for additional investment, easing financing further, and so on. Our model formalizes the endogenous mechanism through which asset tangibility amplifies the impact of shocks to the firm's opportunity set onto the firm's investment and financing across time - a firm-level credit multiplier. Examining a large sample of manufacturing firms over the 1971-2005 period, we find support for our model's prediction that asset tangibility boosts investment spending when firms face financing constraints. We also verify that this result is driven by firms' debt issuance activities. Consistent with our identification strategy, the credit multiplier is absent from samples of financially unconstrained firms and samples of financially constrained firms with low incremental (asset-based) debt capacity.

Credit Multiplier, Financing Constraints, Investment, Capital Structure, Real Options, GMM, Switching Regressions

Abstract:
As liquidity became scarce and internal profits plunged, many firms were forced to rely on bank lines of credit during the 2008-9 financial crisis. Surprisingly, little is known about these credit facilities in general, let alone about their importance during a crisis. This paper investigates a unique dataset that describes how public and private firms in the U.S. and abroad use lines of credit during early 2009. Our analysis emphasizes the interaction between internal funds, external funds, and real decisions such as corporate investment and employment. Among other things, we find that firms that are "credit constrained" (small, private, non-investment grade, and unprofitable) have larger credit lines (as a proportion of assets) than their large, public, investment-grade, profitable counterparts both before and during the crisis. Constrained firms draw more funds from their credit lines and are more likely to face difficulties in renewing or initiating new lines during the crisis. The terms of credit line facilities changed significantly with the crisis: maturities declined; and commitment fees and interest spreads went up for all firms, but particularly for constrained firms. Our evidence suggests that while being profitable helps firms establish credit lines, it does not monotonically lead to increased use. Instead, lines of credit are used when internal funds (cash stocks and cash flows) decline. Looking at real-side decisions, our estimates suggest that lines of credit provide the liquidity "edge" firms need to invest during the crisis.

Financial crisis, investment, liquidity management, lines of credit

Abstract:
Exploring the functioning of internal capital markets in financial conglomerates, this paper conducts a novel test of the credit channel of monetary policy. We look at differences in the response of lending to monetary policy shocks across small banks that are affiliated with the same bank holding company but that operate in different geographical areas. These banks tap into the same pool of funds but face different pools of borrowers. Because small subsidiary banks concentrate their lending with small local businesses (whose fortunes are tied to their local economies), we can exploit cross-sectional differences in local economic conditions at the time of a monetary policy shock to study whether the strength of borrowers' balance sheets influences the response of bank lending to policy. We find evidence that the negative response of bank loan growth to a monetary contraction is significantly more (less) pronounced when borrowers are more likely to have weak (strong) balance sheets. On the flip side, borrowers with weak balance sheets obtain more new bank credit than other borrowers in monetary expansions. Our results are consistent with the operation of a demand-driven transmission mechanism that works independently of the bank-supply (lending) channel. In fact, our estimates suggest that borrowers' balance sheet strength accounts for a significant fraction of the broad credit channel of monetary policy.

Firm Financial Constraints, Monetary Policy, Balance Sheet Channel, Financial Conglomerates, Internal Capital Markets

Abstract:
We model the interaction of product market competition and firms' financing decision when firms face capital market imperfections and consumers face switching costs. In our model, consumers anticipate that capital market frictions may drive their supplier out of business and account for welfare losses that firm bankruptcy imposes upon them. Likewise, managers, when investing in long-term market share building, take into account the possibility of business failure and the residual value they may capture from the firm's liquidation process. Our theory yields four central implications. In response to a negative shock to demand: (1) more leveraged firms will experience significant market share losses; (2) the market share losses of more leveraged firms will be more pronounced in industries where low debt usage is the norm; (3) the market share losses of more leveraged firms will be more pronounced in industries where consumers face higher switching costs; and (4) the market share losses of more leveraged firms will be magnified in industries where asset liquidation is less efficient. Using detailed firm- and industry-level data from U.S. manufacturers over the 1990-91 recession, we present empirical evidence supporting our model's predictions. We later expand our empirical analysis, studying a large panel of firms over the various phases of the full business cycles contained in the 1976-96 period. Results from these broader tests provide additional evidence in support of our theory.

Leverage, product market competition, switching costs, asset liquidation, endogeneity, business cycles

Abstract:
We model the interplay between corporate liquidity and asset reallocation opportunities. Our model implies that financially distressed firms may be acquired by liquid firms in their industries even when there are no operational synergies associated with the merger. We call these transactions "liquidity mergers," since their main purpose is to reallocate liquidity to firms that might be otherwise inefficiently terminated. We show that liquidity mergers are more likely to occur when industry-level asset specificity is high (i.e., industry-specific rents are high) and firm-level asset specificity is low (industry counterparts can efficiently operate the distressed firms' assets). We also provide a detailed analysis of firms' optimal liquidity policies as a function of real asset reallocation. We show that firms are more likely to use credit lines relative to cash if they anticipate liquidity-merger activity in their industry. The model makes a number of predictions that have not been examined in the literature. Using a large sample of mergers, we verify the model's prediction that liquidity-driven acquisitions are more likely to occur in industries with specific, but transferable assets. Using alternative data sources for credit lines, we also confirm the model's prediction that firms are more likely to use credit lines (relative to cash) when they operate in industries in which liquidity mergers are more frequent.

Mergers and acquisitions, credit lines, cash, asset specificity, financial distress

Abstract:
Do firms issue stock when prices seem irrationally high? Do they invest or save the proceeds from the sale of overvalued stocks? Is value created or destroyed in the process? This paper uses a novel identification strategy to tackle these questions. We examine the capital investment, stock issuance, and cash savings behavior of financially constrained and unconstrained non-tech manufacturers (old economy firms) around the 1990's technology bubble. Our results suggest that, because they relax financing constraints, high stock prices affect corporate policies. In particular, during the bubble, constrained non-tech firms issued equity in response to mispricing and used the proceeds to invest. They also saved part of those funds in their cash accounts. We do not find similar patterns for unconstrained non-tech firms, neither for tech firms. Our findings do not support the notion that managers systematically issue overvalued stocks and invest in ways that transfer wealth from new to old shareholders, destroying economic value. Rather, our evidence implies that what appears to be overvaluation in one sector of the economy may have welfare-increasing effects across other sectors.

Abstract:
Do firms issue stock when prices seem irrationally high? Do they invest or save the proceeds from the sale of overvalued stocks? Is value created or destroyed in the process? This paper uses a novel identification strategy to tackle these questions. We examine the capital investment, stock issuance, and cash savings behavior of financially constrained and unconstrained non-tech manufacturers ("old economy firms") around the 1990's technology bubble. Our results suggest that, because they relax financing constraints, high stock prices affect corporate policies. In particular, during the bubble, constrained non-tech firms issued equity in response to mispricing and used the proceeds to invest. They also saved part of those funds in their cash accounts. We do not find similar patterns for unconstrained non-tech firms, nor for tech firms. Our findings do not support the notion that managers systematically issue overvalued stocks and invest in ways that transfer wealth from new to old shareholders, destroying economic value. Rather, our evidence implies that what appears to be overvaluation in one sector of the economy may have welfare-increasing effects across other sectors.

Stock markets, real investment, bubbles, financial constraints, endogeneity

Abstract:
I examine the impact of contract enforceability on corporate performance. My tests sidestep the issue of endogeneity between contracting and economic outcomes using "asset tangibility" (i.e., the resale value or ease of redeployment of corporate assets) as an instrument. Because asset tangibility changes over time for reasons that are outside of the control of firms and financiers (e.g., industry demand for second-hand assets), it can be used to identify a causal link between financing and performance. The identification works along the lines of a moral hazard argument: when asset tangibility is high managers have heightened incentives to perform since firm liquidation/reorganization becomes a more credible threat. I find evidence that the ex post resale value and redeployability of corporate assets drive the relative performance of firms that rely more heavily on external financing for their investment. Specifically, I show that the component of investment that is explained by external financing is associated with superior (inferior) relative-to-rival product market performance, capital market valuation, and accounting returns when asset tangibility turns out to be high (low) after the firm raises financing. Crucially, these sorts of tangibility-driven dynamics are not observed for internally-funded investment (when contract enforceability is irrelevant), and obtain despite the fact that asset tangibility does not unconditionally forecast firm performance. The effect of asset tangibility on investment performance under external financing is magnified when firms are near distress.

Product markets, asset tangibility, external financing, moral hazard, endogeneity

Abstract:
We construct firm-specific measures of expected equity returns using corporate bond yields, and replace standard ex-post average returns with our expected-return measures in asset pricing tests. We find that the market beta is significantly priced in the cross-section of expected returns. The expected size and value premia are positive and countercyclical, but there is no evidence of positive expected momentum profits.

Expected returns, risk factors, systematic risk, yield spreads

Abstract:
We use the 2007 credit crisis to assess the effect of financial contracting on real corporate behavior. We identify heterogeneity in financial contracting at the onset of the crisis by exploring ex-ante variation in long-term debt maturity. Our empirical methodology uses an experiment-like design in which we control for observed and unobserved firm heterogeneity via a differences-in-differences matching estimator. We study whether firms with large portions of their long-term debt maturing right at the time of the crisis observe more pronounced outcomes than otherwise similar firms that need not refinance their debt during the crisis. Firms whose long-term debt was largely maturing right after the third quarter of 2007 reduced investment by 2.5% more (on a quarterly basis) than otherwise similar firms whose debt was scheduled to mature well after 2008. This relative decline in investment is statistically significant and economically large, representing approximately one-third of pre-crisis investment levels. A number of falsification and placebo tests confirm our inferences about the effect of credit supply shocks on corporate policies. For example, in the absence of a credit shock (normal times), the maturity composition of long-term debt has no effect on investment outcomes. Likewise, maturity composition has no impact on investment when long-term debt is not a major source of funding for the firm.

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Abstract:
We use the 2007 credit crisis to assess the effect of financial contracting on real corporate behavior. We identify heterogeneity in financial contracting at the onset of the crisis by exploring ex-ante variation in long-term debt maturity. Our empirical methodology uses an experiment-like design in which we control for observed and unobserved firm heterogeneity via a differences-in-differences matching estimator. We study whether firms with large portions of their long-term debt maturing right at the time of the crisis observe more pronounced outcomes than otherwise similar firms that need not refinance their debt during the crisis. Firms whose long-term debt was largely maturing right after the third quarter of 2007 reduced investment by 2.5% more (on a quarterly basis) than otherwise similar firms whose debt was scheduled to mature well after 2008. This relative decline in investment is statistically significant and economically large, representing approximately one-third of pre-crisis investment levels. A number of falsification and placebo tests confirm our inferences about the effect of credit supply shocks on corporate policies. For example, in the absence of a credit shock ("normal times"), the maturity composition of long-term debt has no effect on investment outcomes. Likewise, that maturity composition has no impact on investment when long-term debt is not a major source of funding for the firm.

Financial crisis, debt maturity, matching estimators, investment spending, financing constraints

Abstract:
Does hedging affect corporate outcomes? This paper looks at the consequences of hedging for firm financing and investment. It does so using detailed, hand-collected data on hedging and loan contracts. Hedging can reduce the odds of negative profit realizations, reducing the expected costs of financial distress. In theory, this should ease a firm's access to credit. Using a tax-based instrumental variables approach, we find that hedgers pay lower interest spreads and are less likely to have capital expenditure restrictions in their loan agreements. These favorable financing terms, in turn, allow hedgers to invest more. Our results identify two channels (cost of borrowing and investment restrictions) through which hedging affects firm outcomes. The study provides new evidence on the real consequences of financial contracting.

Hedging, risk management, financing terms, investment spending, instrumental variables

Abstract:
Building on recent evidence concerning the functioning of internal capital markets in financial conglomerates, we conduct a novel test of the balance-sheet channel of monetary policy. Specifically, we investigate how the response of lending to monetary policy differs across small banks that are affiliated with the same bank holding company but operate in different geographical areas. These banks face similar constraints in accessing internal and external sources of funds, but have different pools of borrowers. Because they typically concentrate their lending with small local businesses, we can exploit cross-sectional differences in local economic indicators at the time of a policy shock to study whether the strength of borrowers' balance sheets affects the response of bank lending. We find evidence that the negative response of bank loan growth to a monetary contraction is significantly stronger when borrowers have weaker balance sheets.

balance sheet channel, internal capital markets

Abstract:
This paper proposes a theory of corporate liquidity demand and provides new evidence on corporate cash policies. Firms have access to valuable investment opportunities, but potentially cannot fund them with the use of external finance. Firms that are financially unconstrained can undertake all positive NPV projects regardless of their cash position, so their cash positions are irrelevant. In contrast, firms facing financial constraints have an optimal cash position determined by the value of today's investments relative to the expected value of future investments. The model predicts that constrained firms will save a positive fraction of incremental cash flows, while unconstrained firms will not. We also consider the impact of Jensen (1986) style overinvestment on the model's equilibrium, and derive conditions under which overinvestment affects corporate cash policies. We test the model's implications on a large sample of publicly-traded manufacturing firms over the 1981-2000 period, and find that firms classified as financially constrained save a positive fraction of their cash flows, while firms classified as unconstrained do not. Moreover, constrained firms save a higher fraction of cash inflows during recessions. These results are robust to the use of alternative proxies for financial constraints, and to several changes in the empirical specification. We also find weak evidence consistent with our agency-based model of corporate liquidity.