Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK

54 Pages Posted: 10 Feb 2005

See all articles by Grzegorz Pawlina

Grzegorz Pawlina

Lancaster University - Department of Accounting and Finance

Luc Renneboog

Tilburg University - Department of Finance; European Corporate Governance Institute (ECGI); Tilburg Law and Economics Center (TILEC)

Date Written: February 2005

Abstract

We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive. Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow. The magnitude of the relationship depends on insider ownership in a non-monotonic way. Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring. Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets. We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.

Keywords: investment-cash flow sensitivity, ownership and control, asymmetric information, liquidity constraints, agency costs of free cash flow, large shareholder monitoring, Shapley values

JEL Classification: D92, G31, G32

Suggested Citation

Pawlina, Grzegorz and Renneboog, Luc, Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK (February 2005). ECGI - Finance Working Paper No. 69/2005; CentER Discussion Paper No. 2005-23; TILEC Discussion Paper 2005-001. Available at SSRN: https://ssrn.com/abstract=664981 or http://dx.doi.org/10.2139/ssrn.664981

Grzegorz Pawlina (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+ 44 1524 592834 (Phone)
+ 44 1524 847321 (Fax)

Luc Renneboog

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Warandelaan 2
5000 LE Tilburg
Netherlands
+13 31 466 8210 (Phone)
+13 31 466 2875 (Fax)

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Tilburg Law and Economics Center (TILEC)

Warandelaan 2
Tilburg, 5000 LE
Netherlands

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