RDP 9402: The Influence of Financial Factors on Corporate Investment 1. Introduction
May 1994
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In the past few years there has been a re-emergence of interest in the role that financial factors play in corporate investment decisions. This interest stems from the effect that financial factors such as asset prices, gearing and cash flow have had on shaping the most recent economic cycle. Recent theoretical developments have also shown that cash flows and the structure of a firm's balance sheet may have an important influence on investment.
The potential link between investment and finance implies that some of the changes in the structure of corporate balance sheets in the past decade could have significantly altered the dynamics of the economic cycle in Australia. During the 1980s, the indebtedness of the corporate sector increased sharply. This could have made firms more sensitive to the cycle. They may now adjust their expenditures more quickly in the face of a change in demand to meet their debt obligations.[1]
Establishing a link between cash flows, leverage and investment also provides insights into the way in which monetary policy and cyclical factors more generally influence the corporate sector. If cash flows are an important determinant of investment, changes in monetary policy (by changing some interest rates) will influence investment of indebted firms through a cash flow effect as well as through altering the rate at which the returns to investment are discounted. If this is the case, the higher leverage of the corporate sector implies, other things being equal, that monetary policy may have a larger impact on investment than in the past. Moreover, it implies that changes in monetary policy may not be transmitted evenly across the corporate sector. The cash flows of more highly geared firms will be more sensitive to changes in interest rates than cash flows of firms with minimal leverage.
Smaller firms are generally considered to be more sensitive to changes in financial conditions. External funding tends to be relatively more expensive for them because providers of finance have less information about their creditworthiness. Smaller firms also have limited access to securities or equity markets and are thus more reliant on intermediated funding as a source of external finance. Cash flows are a significant source of funding for them. Economic shocks that alter cash flows or change the lending behaviour of intermediaries are thus likely to have a more significant influence on the investment decisions of smaller firms.
This paper will explore the link between financial factors and investment in a sample of listed non-financial Australian firms.[2] First, it will attempt to see if these factors are important generally. Next, it will consider whether the importance varies across firms depending on their financial structure, size or dividend payout policies. The paper finds evidence that financial factors do have a significant influence on investment. Investment is positively related to cash flows and the stock of financial assets and negatively related to leverage. Moreover, it appears that investment of firms with higher leverage and smaller firms is more sensitive to financial factors than that of other firms. This implies that they could be more sensitive to economic conditions and changes in monetary policy than other firms.
The paper is organised as follows. Section 2 outlines the theoretical links between finance and investment. In Section 3 we present empirical results based on the estimation of a panel-data model. Section 4 concludes the paper.