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

31 Pages Posted: 29 Oct 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)

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 sensitivity a result of agency problems when managers with high discretion over-invest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that investment-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.

Suggested Citation

Pawlina, Grzegorz and Renneboog, Luc, Is Investment-Cash Flow Sensitivity Caused by Agency Costs or Asymmetric Information? Evidence from the UK. European Financial Management, Vol. 11, No. 4, pp. 483-513, September 2005. Available at SSRN: https://ssrn.com/abstract=801908

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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