CFA Institute Journal Review June 2015 Volume 45 Issue 6
The Value of Financial Flexibility and Corporate Financial Policy (Digest Summary)
Journal of Corporate Finance
A new method is proposed to measure the value of financial flexibility (VOFF) as perceived by shareholders. This method uses market-based and forward-looking factors that are not directly influenced by past financial decisions. The VOFF plays a central role in corporate finance. A higher VOFF usually results in lower dividend payouts, a preference for share repurchases over dividends, lower leverage ratios, and a greater accumulation of cash.
Financial flexibility is defined by Gamba and Triantis (Journal of Finance 2008) as “the ability of a firm to access and restructure its financing at a low cost.” Flexibility lessens the underinvestment problems if access to capital is limited and helps to avoid financial distress. Using the Gamba and Triantis model, the authors develop empirical proxies for the five factors found to explain the value of financial flexibility (VOFF) from a shareholder perspective—growth opportunities, profitability, the effective cost of holding cash, the cost of external financing, and the reversibility of capital.
How Is This Research Useful to Practitioners?
Unlike other proxies used to study corporate finance, the VOFF provides a market-linked and forward-looking value that an investor might assign to a firm. In addition, the VOFF measure is less exposed to endogeneity issues because the five factors reflect the environment in which the firm operates and are not influenced by current corporate financial policies. The authors expand on previous literature by examining all three dimensions of corporate financial policies: payout decisions, capital structure decisions, and the previously studied cash accumulation decisions. This information allows academics, policymakers, and research analysts to gain a more thorough understanding of the link between the value of financial flexibility and corporate financial decisions.
One way the authors test the methodology is by analyzing stock market returns around the default of Lehman Brothers and the resulting credit crunch. They show that firms with a higher VOFF had lower abnormal returns than those with a lower VOFF. The VOFF may also prove useful in analyzing other financial decisions, such as mergers and acquisitions.
How Did the Authors Conduct This Research?
The authors examine US-listed equities from 1988 to 2010 using data from Compustat (accounting data) and CRSP (capital market data). They remove outlier stocks and convert the data into real values in 2005 dollars using a consumer price index obtained from the OECD.
For the sample, the authors identify empirical proxies for the five factors: annual sales growth for the firm’s growth opportunities, the ratio of change in earnings to lagged market capitalization for profitability, the effective tax rate for both the firm and the investor for the effective cost of holding cash, the bid–ask spread of the stock for the cost of external financing, and the tangibility of assets for the reversibility of capital. Regressing unexpected changes in market capitalization on the five factors for unexpected changes in cash, the authors use the coefficients from those regressions as weights to create a single VOFF for each firm-year.
The authors then examine whether financial flexibility considerations help explain corporate financial policies. They find that firms with a higher VOFF are more likely to have lower dividends, a greater tendency to omit dividends, and a preference to repurchase shares. They also tend to use less leverage and accumulate more cash to maintain their debt capacity.
In 2003, the Jobs and Growth Tax Relief Reconciliation Act lowered the tax rate for dividends to the rate for long-term capital gains. The authors find that firms with a higher VOFF increased their dividend payouts less than firms with a lower VOFF, which suggests that causality runs from the VOFF to the financial policy decision and not vice versa.
The idea of decomposing the premium in a stock value by identifying the value of financial flexibility offers new perspectives. It would also be worthwhile to note that this phenomenon does not differentiate between considerations from institutional investors and retail shareholders. Furthermore, it would be interesting to analyze the international stock markets and identify the existence of country factors.
About the Author(s)
Biharilal Deora is a director at Abakkus Asset Manager LLP, an India-focused asset management company. His investment expertise spans a broad array of asset classes. Prior to joining Abakkus, Mr. Deora was managing corporate, family office, and university clients. He began his career as a financial analyst at leading financial services firms, such as Credit Suisse and Fidelity Investments. Mr. Deora holds a master’s degree in commerce from Veer Narmad South Gujarat University.
He is a top-ranking chartered accountant and a certified financial planner. Mr. Deora serves as a director on the board of CFA Society India and is a visiting faculty member for advanced finance programs.