Corporate investment and the role of expected profitability: a re-examination
Keywords: market efficiency
excess cash flow sensitivity
corporate investment

In the first chapter, we extend the empirical analysis in Cummins et al. (2006) to consider the significance of lagged cash flow in explaining the investment behaviour of the publicly-traded US companies, using their sample for years between 1982 and 1999. We find significant evidence of excess sensitivity of corporate investment to lagged cash flow, even con- trolling for their preferred measure of Tobin’s Q. This new measure uses securities analysts’ earnings forecasts rather than stock market valua- tions to capture the influence of expected future profitability on current investment decisions. Our results do suggest that capital market imper- fections should not be dismissed on the basis that corporate investment displays no sensitivity to indicators of the availability of internal funds.
The second chapter further explores the robustness of the Cummins et al. (2006) results by examining their subsamples of firms with and without bond ratings. We expand on the subsample results presented in Cum- mins et al. (2006) by introducing a lagged cash flow measure in both static and dynamic model specifications. As in the full sample, we find excess sensitivity to lagged cash flow for the rated firms subsample. These results are further strengthened once we use the two-step GMM estima- tors, with standard errors calculated using the finite sample correction proposed by Windmeijer (2005). We also provide evidence that selective reporting bias may be a source of the high predictive power of the alter- native measure of Tobin’s Q in the results presented in Cummins et al. (2006).
In the third chapter, we review the roles of expected profitability and cash flow in explaining investment rates for around 700 publicly-traded UK firms between the years 1987 and 2000. We do so by revisiting the dataset of Bond et al. (2004). We find that their main results, which are similar in spirit to those of Cummins et al. (2006), are not robust once we use additional valid instruments to estimate their models, and we use two-step GMM estimators with appropriate standard errors. We conclude that cash flow sensitivity, for this particular sample, cannot be dismissed, even when controlling for the novel measures of expected profitability, based on analysts’ earning forecasts, suggested by Bond et al. (2004).
In the fourth chapter, we follow closely the methods described in Bond et al. (2004) to recreate a dataset for publicly-traded UK firms cover- ing the period 1987 to 2000, using sources of data which are currently available. In particular, we use company accounts data from Worldscope, which provides less detail (although wider coverage of firms) than the older Datastream source used by Bond et al. (2004). Consequently our new dataset is not an exact replica of that constructed by Bond et al. (2004). A particular concern could be that we cannot replicate their mea- sure of the level of investment, which used information on the increase in net fixed assets due to acquisitions which is not available from World- scope. Nevertheless, after dropping observations on firms which were not covered by Datastream, we show that both descriptive statistics and the results of econometric models of investment are broadly comparable us- ing the two datasets. These results provide a bridge to the analysis in the final chapter, which studies the investment behaviour of publicly-traded UK firms in more recent years, using data obtained from the same cur- rently available sources.
In the last chapter, we extend our dataset for publicly traded UK firms through to 2016. We first confirm, using a larger sample of firms covered by Worldscope, that while the Bond et al. (2004) measure of expected profitability is an informative explanatory variable for corporate invest- ment rates, it does not eliminate the sensitivity of investment to cash flow over the time period 1987-2000. We then explore how the excess sen- sitivity of investment to cash flow evolved over time for our full sample of UK firms. We present evidence that cash flow sensitivity has dimin- ished for this sample, and we find no significant cash flow sensitivity for sample periods after the 2008 financial crisis. These findings echo similar results found previously for publicly-traded US firms. However, we also find interesting heterogeneity in the disappearance of cash flow sensitivity. We consider subsamples of firms which had relatively high and relatively low share price volatility over our sample period. We find significant and interesting differences between the results for these two subsamples. In particular, the decline in the sensitivity of investment to cash flow over this period reflects the behaviour of firms with less volatile stock market valuations. For the subsample of firms with more volatile stock market valuations, we find no significant excess sensitivity of investment to cash flow in any sub-period. For the subsample of firms with less volatile stock market valuations, we find significant cash flow sensitivity for periods up to 2007, but no significant cash flow sensitivity for periods after the 2008 financial crisis.