Corporate Efficiency, Financial Constraints and the Role of Internal Finance: A Study of Capital Market Imperfection

Drawing on insights from the corporate finance and industrial economics literatures, this thesis combines different empirical strategies and econometric techniques to study the role of capital-market imperfections on the financial and operational activities of firms. The thesis is mainly composed of three different but interlinked empirical chapters as summarized below using an unbalanced panel data on 1122 UK firms listed on the London Stock Exchange during the period 1981 to 2009. Stochastic Frontier Analysis to Corporate Efficiency : Using the stochastic frontier analysis (SFA), long run and short run corporate efficiencies are predicted in this chapter focusing on value and profit maximization approach respectively. The estimation results reveal that, an average firm in the sample achieves 74.5% of it's best performing peer's market value and 86.6% of it's best performing peer's profit and both of them are highly significant in the analysis. The inverse of these serve as proxies of agency costs and significantly related to the chosen explanatory variables. The general conception that larger firms are more efficient remains valid in this study. The long run market value efficiency supports the agency cost of outside equity and the short run profit efficiency supports the agency cost of outside debt hypothesis. Also there is a positive rank correlation between these two efficiencies which confirms that an average firm in the UK suffers from inefficiency or agency conflicts to a certain extent, no matter whether the firm is driven by short run or long run growth perspectives. Corporate Efficiency, Credit Status and Investment : The endogenous switching regression models (SRM) incorporating the predicted corporate efficiencies are estimated in this chapter in an effort to clarify the role of cash flow in examining the impact of capital-market imperfections. It is revealed that a financially constrained firm is more likely to be smaller, younger, deficient in capturing better investment opportunities, reserves higher safety stock, pays low dividends, has less collaterizable assets and less external debt. Moreover, a firm's constrained credit status changes with the improvement of it's efficiency. The results further reveal that financially constrained firm's investment is comparatively more sensitive to cash flow, but this sensitivity is negatively and significantly related with corporate efficiency. These results point to the fact that high investment sensitivity to cash flow may not be solely driven by measurement error in investment opportunity, but may still be interpreted as a consequence of imperfect substitutability between internal and external financing arising from the capital market imperfections. Financial constraints and the dynamics of firm size and growth : Differential quantitative effects of cash flow on growth among firms facing different degrees of financial constraints are found in this chapter using the generalized methods of moments (GMM) estimations and the results are consistent with financial constraints arising from capital market imperfections. The results in general reject Gibrat's "Law of Proportionate Effects" and smaller and younger firms are found to grow faster. The estimated results indicate a substantially greater sensitivity of growth to cash flow for firm years facing the most binding financial constraints on their growth. Furthermore, these firms can actually expand their size more than the extent of increase in cash flow they may have supporting the leverage effect hypothesis. The estimated impact decreases monotonically thereafter as financial constraints become less binding allowing the firms to finance successively bigger portion of their growth through external financing.