In recent years, a number of studies report increase cash balance or extremely low debt ratios (Bates et al. 2009; Strebulaev and Yang 2013). This trend is the results of firms’ preference of financial flexibility. Although the exact definition of fin ...
In recent years, a number of studies report increase cash balance or extremely low debt ratios (Bates et al. 2009; Strebulaev and Yang 2013). This trend is the results of firms’ preference of financial flexibility. Although the exact definition of financial flexibility varies from document to document, the economic nature that each definition explains is largely the same (DeAngelo and DeAngelo 2007; Denis 2011; Gamba and Triantis 2008). Financial flexibility is a concept that is in contrast to financial constraints. As financing flexibility increases, firms are more likely to invest and operate without external financing. Financial flexibility is a concept that covers all related financial procurement methods, without specifying specific assets, financing methods, etc. However, this study focuses on the usefulness of financial statements in evaluating corporate value. Therefore, among the various financial flexibility measures, only those measures that are easy to be found on the financial statements are used for analysis.
Several studies report that financial flexibility leaves an operational or financial impact on a firm (Brown and Petersen 2011; Harford 1999; Faleye 2004). However, the impact of financial flexibility on the information environment and valuation of firms have not been studied much yet. This study investigates the effects of financial flexibility on corporate information asymmetry and revision of stock price using Korean data.
Several studies point out that firms' financing decisions affect information asymmetry between insiders and outsiders of the firm. For example, a firm that needs external financing increases financial disclosure to lower its cost of capital (Botosan 1997; Botosan and Plumlee 2002). Watts (2003) argues that one of the roles of conservatism in accounting is to promote efficient contracts between capital providers and firms. While these documents focus largely on external financing of firms and disclosure, the effects of financial flexibility on information environment of the firm has not been studied much. This study focuses on this void in the literature.
This study focuses on the proxies of financial flexibility that can be easily found in financial statement because financial statements are the easiest and most reliable ways to obtain information for firm valuation. This study focus on cash holdings and debt ratio as the proxies for financial flexibility, which are easily obtained from financial statements and are also widely used in practice. Prior studies indirectly investigate the relation between these proxies and information environment. For example, Faleye (2004) argue that the holding of cash assets can strengthen the entrenchment of agents (Faleye 2004). Although entrenchment does not have direct relation with information environment, it is unlikely to improve information environment. Shleifer and Vishny (1997), and several studies after this study, generally accept that creditors can play a role of governance and lower information asymmetry. However, few study directly address and test the view that measures of financial flexibility affect information environment. Regarding the use of debt, the literature reviewing the relationship between capital cost and debt ratio covers topics close to the topic that is mentioned here. However, previous research has mainly focused on the risk of bankruptcy of debt and does not seriously consider the aspect of information asymmetry of individual firms.
Our study covers the influence of financial flexibility and stock price crash in relation with investment activities because of following two reasons. First, the goal of financial flexibility is to maintain the ability to invest in positive net present value (NPV) projects without being affected by the friction of external financing, thus the concept, financial flexibility is associated with investment by nature. Second, investment activities have inherent uncertainties about the future. Managers know their investment better than capital market participants. Therefore, investment provides a good setting for studying the issues related to firm opacity.
This study focuses on research and development (R&D) investment, for the following reasons. First, R&D investment has the greatest uncertainty among various types of investments. Unlike investments in real assets or investment in affiliated firms, On the same day when the Hyundai Motor Group bided on the KEPCO site in Samsung-dong, the press released an evaluation of the investment. It is easy to evaluate the investment accordingly. ( http://www.koreatimes.co.kr/www/news/biz/2014/09/123_164839.html )
the results of R&D investment cannot be easily observed by outsiders because R&D creates intangible assets. Therefore, the information of the results of R&D investment are easy to hide from investors than the information about other types of investments. Second, R&D related assets have large adjustment costs, Hall (2002) points out that biggest portion of R&D expenditure is salaries and wages for highly-educated employees. Prior studies generally accept that these types of expenditures have high adjustment cost (Banker et al. 2013).
so managers cannot easily reduce R&D investment unless there is serious damage in expected future cash flows. In addition, assets formed as a result of R&D investment are largely intangible assets that have firm-specific characteristics, The asset here is an economic asset, but not an asset that meets the definition of an accounting standards.
which do not contribute to capital raising through collateralized borrowing because they have low collateral value. Therefore, R&D investments rely on financial flexibility, especially cash holdings (Himmelberg and Petersen 1994; Brown and Petersen 2011). Because of the reasons above, R&D investment provides a powerful setting that is most suitable for this study.
The main research question of this study is whether a firm’s opacity increases in financial flexibility when the firm invests n R&D activities. We predict as follows: Financially flexible firms are less influenced by capital providers’ monitoring and disciplines, thus they are less likely to provide information to the market participants voluntarily. In addition, because R&D investment has high opacity by nature, firms that invest in R&D are expected to have high opacity. Since the firm is opaque and less likely to be influenced by external financing, market monitoring and discipline against R&D firms that have high financial flexibility would be week. Consequently, financial flexibility of R&D firms would increase the likelihood of overinvestment. Overinvestment in inefficient investment projects would damage future cash flows. However, managers of financially flexible firms have few reasons to release such negative news in a timely manner because those firms are not dependent to external financing. Furthermore, manager compensation is generally tied to equity value, managers have motivation to hide the news from investors, especially when the news is negative. On the other hand, non-R&D firms are harder to hide negative information regardless of financial flexibility, since market participants can evaluate the firm’s investment activities more accurately and easily. Therefore, the accumulation of negative news and the relationship of cash assets are likely to be weak in non-R&D firms.
In the empirical analysis of this study, accumulation of negative news is measured using the stock price crash. Under information asymmetry, managers have incentives to delay the disclosure of negative information. When bad news is accumulated to the point that that cannot be hidden, the news would be revealed at once, which cause revision of stock price. According to prior studies, this sudden revision of stock price is the cause of crash (Jin and Myers 2006; Hutton et al. 2009).
The empirical analyses of this study use the ratio of cash holdings to total assets as the proxy for financial flexibility. Cash holdings are the most convenient sources of funds with little restriction, therefore, the best measure for financial flexibility. In addition, the total debt ratio was also used as auxiliary proxy for financial flexibility. Debts do not measure financial flexibility as directly as cash holdings because of the interactions between a firm and their creditors in debt issuance and retention. Despite that limitation, debt ratio is one of most widely used measure of financial flexibility (Graham and Harvey 2001), therefore, this study also adopts debt ratio as the measure of financial flexibility. To address the influence of detailed characteristics of debts, we further divide debt ratio into private/public debt ratios or short-term/long-term debt ratios, according to the types of the debts or maturity.
The empirical analyses of this study shows the following results. R&D firms tend to suffer a plunge in stock prices as cash holdings increase. However, non-R&D firms’ crashes are not influenced by their cash holdings. The results show that the increase in financial flexibility enhance accumulation of negative news in R&D firms, as we expected.
The first additional analysis of this study find that the relation between cash holdings and crash exist only in low-profitability firms, which supports that overinvestment is the cause of the correlation between cash holdings and stock price crash. In the second additional test, we find that the positive association between cash holdings and stock price crash is found only in firms do not pay dividends. Since dividend payout decreases the possibility of overinvestment, this result also supports that overinvestment is the cause of our main finding. Finally, a positive association between cash holdings and stock price crash has been observed only in companies that do not have a commercial paper rating, indicating that our main finding occurs in companies that have a poor information environment so that accumulation of negative news is convenient.
This study has several contributions to the literature. This paper examines the effect of financial characteristics on firm’s opacity and firm valuation from the perspective of investment. In the literature related to financial flexibility, to the best of our knowledge, no study directly addresses the fact that financial flexibility has a real impact on firm’s opacity through investment.
In addition, this study provides empirical evidences that financial flexibility and investment activities jointly affect firm opacity and corporate valuations. The traditional valuation theory distinguishes financing from investment (or operation), and firm value is determined by investment (Feltham and Ohlson 1995). However, in actual capital markets, unlike the perfect capital market, no economic entity can separate investment and/or operation from financing because of the market friction of external financing (Denis 2011). Some of recent studies address the interaction between financing and investing in several contexts. This study contributes to the literature by adding empirical result of the valuation effect of financing.
Third, active research is underway on stock price crash. Previous studies point out that agency problems and the overconfidence of managers as the potential causes of stock price crash. However, no study investigated the inherent uncertainty of investment and/or financial characteristics as the cause of stock price crash. This study contributes to the literature by filling the void of prior studies.