The aim of this study is to analyze the relationship between free cash flow and capital spending; evidence from the Automobile industry of Pakistan. Capital spending is strongly and positively associated to the level of free cash flow, and free cash flow’s influence on capital spending increases as firm size decreases and as insider ownership increases. Free cash flow is determined by integrating the cash receipt and disbursement items from the income statement with the change in each balance sheet item; the sum of the cash inflows equals the sum of the cash outflows. Capital spending is an amount a company spent buying or upgrading fixed assets, such as equipment, during the year and acquiring subsidiaries, minus government grants received. The free-cash-flow (FCF) hypothesis suggests that excess cash flow is wasted on value destroying capital spending because managers have a personal reason to raise the asset base of the firm rather than give out cash to shareholders. Free cash flow has always been somewhat of a puzzle in the literature on the determinants of investment. Cash flow does not belong in a capital spending equation, and yet practical studies dating back over 40 years almost invariably find that cash flow and capital spending are positively related. In this research regression analysis is used to find the relationship between FCF and capital spending. The results suggest a significant relationship between FCF and capital spending.
To Study the Impact of Free Cash Flow on Capital Spending
Vogt (1997) has explained Free cash flow as operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends. FCF is a coverage ratio representing the amount to which current period generated free cash flow (defined above) is sufficient to cover next period’s capital expenditures. (Vogt, 1997)
Vogt (1997) explains Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Negative free cash flow is not inevitably an indication of a bad company, however, since many young companies put a lot of their cash into capital spending, which diminishes their free cash flow. Although if a company is spending so much FCF, it should have a good grounds for doing so and it should be earning high rate of return on its investments. While free cash flow doesn’t receive as much attention as earnings do, it is considered by some experts to be a better indicator of a company’s financial health. (Vogt, 1997)
Poulsen (1989) FCF is a cash flow in hand for giving out among all the securities holders of an organization. Those include equity holders, debt holders, preferred stock holders, convertible security holders, and so on. (Poulsen, 1989)
Vogt (1997) explains FCF hypothesis as, it predicts that the capital market will react unfavorably to capital spending. The FCF hypothesis also explains that undistributed cash flow will be positively related to capital spending, but the significance of cash flow to capital spending will be positively related to firm size and negatively related to insider ownership. (Vogt, 1997)
Jensen (1986) suggests Free cash flow is a cash flow in surplus of that necessary to fund all projects that have positive net present value when discounted at the appropriate cost of capital. When FCF is present and shareholder monitoring is imperfect, the typical manager-shareholder agency problem arises. Managers have a tendency to overinvest (i.e., invest in negative-NPV projects) in order to capture the financial and non-financial benefits of increased firm size. (Jensen, 1986)
Jensen (1986) suggests free-cash-flow hypothesis as excess cash flow is wasted on value destroying capital spending because managers have a personal reason to raise the asset base of the firm rather than give out cash to shareholders. (Jensen, 1986)
The objective of this paper is to find the relationship between free cash flow and capital spending.
H1: Free Cash flow has a relationship with capital spending or investment.
REVIEW OF THE RELATED LITERATURE
The aim of this study is to observe whether free cash flow is important in the firm’s capital spending decision or not.
The internally generated cash flow on financing capital spending is well recognized. Modigliani and Miller’s (1958) insignificance suggestion asserts firms to carry out all positive net present value (NPV) investments regardless of the financing source. (Modigliani & Miller, 1958)
Jensen (1986) explains Free cash flow as a cash in surplus of that necessary to fund all positive net present value projects. Free cash flow tempts managers to expand the scope of operations and the size of the firm, thus increasing managers’ control and personal compensation, by investing free resources in projects that have zero or negative net present values. These unprofitable spending is an aspect of the basic conflict of interest between owners and managers. Free cash flow is inconsistent with the goal of owner wealth maximization. Expansions wasted by administration instead could have been distributed to the owners of stock holders as cash dividends or to the policyholders of mutual or stock firms in the form of lower premiums, higher policy dividends, or higher investment returns. The existence of free cash flow provides managers with an opportunity to waste cash on unprofitable capital spending. These unprofitable capital spending represents an incremental cost of the owner-manager conflict. (Jensen, 1986)
Jensen (1986) suggests that the majority of existing evidence on the free cash flow hypothesis focuses on changes in financial structure. Jensen suggests that leveraged buyout activities are one way of controlling free cash flow because the debt incurred in such transactions forces managers to pour out excess cash. It examines the cross-sectional relation between free cash flow and ownership structure and finds some evidence that organizational forms specific to the oil industry (corporations, master limited partnerships, and royalty trusts) have different agency costs of free cash flow. Specifically, the Capital spending of free cash flow is lower in royalty trusts and master limited partnerships than in corporations. (Jensen, 1986)
Jensen (1986) studies test for differences in free cash flow between Capital spending automobile insurance industry. The purpose is to examine whether organizational form affects managerial behavior with respect to the holding of free cash flow rather distributing or investing. (Jensen, 1986)
Jensen’s (1986) theory predicts that Capital spending of equity is partly driven by free cash flow. Previous research indicates that the agency problems between owners and managers are greater in mutual organizations than in stock organizations, which leads to the expectation that the free cash flow problem will be greater in mutual insurers than in stock insurers. (Jensen, 1986)
James A. Gentry (1990) analyzed capital spending with total cash outflow and found out that the percentage of cash outflows going to capital investment (NI/TCF) ranged from an outflow of 60 per cent or more. The giant companies invested a higher percentage of their total outflow in plant and equipment than companies in the other size categories. The small companies invested the lowest percentage of their total outflows in capital. (James A. Gentry, 1990)
Research was applied to agricultural firms by Farrell E. Jensen, (1993) which showed that results are consistent with previous studies for nonagricultural firms which show that internal cash flow variables are important in explaining investment. Result indicate that internal cash flow variables are important and that the addition of internal cash flow variables can improve the explanatory power of agricultural investment models. In terms of elasticity, investment was more responsive to internal cash flow variables. (Farrell E. Jensen, 1993)
Vogt’s (1994) explains the relationship of cash flow and capital spending by analyzing the free cash flow theory of Jensen’s (1986) and find outs that, since monitoring is costly, and managers can benefit from over investment, cash flow will significantly influence capital spending after controlling for the cost of capital. Capital spending of firms not paying dividend will be more influenced by cash flow than investment spending of firms that pay dividends. This follows because no-dividend firms are able to retain all cash flow and still not reach the retention constraint. (Vogt S. , 1994)
Worthington (1995) has found that cash flow measures enter industry level investment equations positively and significantly, even after investment opportunities are proxied by capacity utilization variables. The effect of cash flow is greater in durable goods industries than in nondurable goods industries. (Worthington, 1995)
Klaus Gugler, Dennis C. Mueller, and B. Burcin Yurtoglu in 2004 tested the following hypothesis first asymmetric information (AI) hypothesis which predicted that firms underinvest and have returns on investment greater than their costs of capital, and second the managerial discretion (MD) hypothesis which predicts overinvestment and returns on investment less than the costs of capital, using the ratio of returns on investment to costs of capital for each firm is a natural way to make this identification. (Klaus Gugler, 2004)
Nathalie Moyen in 2004 explained the fact that the cash flow sensitivity of firms described by the constrained model is lower than the cash flow sensitivity of firms described by the unconstrained model can be easily explained. In both models, cash flow is highly correlated with investment opportunities. With more favorable opportunities, both constrained and unconstrained firms invest more. (Moyen, 2004)
Raj Aggarwal in 2005 started a study on four controlling for the investment opportunity set, and he concluded investment levels are significantly positively influenced by levels of internal cash flows. The strength of this association generally increases with the level of financial constraints faced by firms. Overall, these findings seem strong to the nature of the financial system and indicate that most firms operate in financially incomplete and imperfect markets and find external finance to be less attractive than internal finance. (Raj Aggarwal, 2005)
Bo Becker, and Jagadeesh Sivadasan in 2006 concluded for their research paper that in frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, results indicate that firms invest more on average when they have higher cash flow. Contribution to the literature is being made by testing formally if the coefficient on internal resources (cash flow) is related to a country’s financial development. Comparing countries, it is further discovered the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. ( (Bo Becker, 2006)
Vogt S. (1994) explains the case of capital spending, the observed results tend to support the free cash flow description of the cash flow/capital spending relationship. Actions that supports the FCF assumption, however, it is found in small firms paying low dividends. In the case of R&D spending, results are more reliable with the FCF assumption. These results together suggest that the effect that cash flow-financed investment has on firm value depends on asset size, dividend behavior, and the type of capitalspending. (Vogt S. , 1994)
Vogt S (1994) explains FCF assumption that cash flow should influence capital spending. The firms not paying dividends should demonstrate the strongest relationship between cash flow and capital spending, while those paying high dividends should show the weakest relationship. (Vogt S. , 1994)
Vogt S. (1994) gives an explaination on Free cash flow, however, is still an significant variable in the capital spending behavior of small, low-payout firms. The constraint predicts, less than those associated with the larger firms in the low-payout group, is still highly significant. Consequently, the asymmetric information induced FCF assumption explanation cannot be dismissed. The most reasonable argument is that both free cash flow and asymmetric information are important factors contributing to the influence of cash flow on capital spending. (Vogt S. , 1994)
Vogt S. (1994) explains different incentives that R & D and capital spending may generate for managers over time R&D represents an expenditure on intangible assets whose impact on the asset size and future cash flows of the firm is (1) extremely uncertain and (2) no likely to be realized in the near future. Fixed plant and equipment spending is likely to produce more certain cash flows in the near future (in part because of accelerate depreciation allowances) as well as increase the tangible asset base of the firm. The effect of plant and equipment spending is to generate free cash flow that can be used in the next period. Consequently, capital spending may be more susceptible to free cash flow problems than research and development spending. (Vogt S. , 1994)
Vogt S. (1994) suggests that cash flow-financed capital spending is marginally inefficient and provides primary evidence in support of the FCF hypothesis. The negative relationship found in the aggregate data isconcentrated in firms paying low dividends over the sample period, in large firms, and most strongly in large firms paying low dividends. (Vogt S. , 1994)
Vogt S. (1994) explains important implications for both investors and managers. While the study shows that cash flow-financed capital spending is marginally unproductive for some firms, the potential sources of this inefficiency have also been identified. Cash flow-financed growth by large, low-dividend firms tends to be value-destroying, while cash flow-financed growth is value-creating for small, low-dividend firms. The importance of dividends as a method of mitigating agency costs of free cash flow, moreover, is confirmed. Managers of cash flow-rich companies may consider increasing dividend payouts as a method of increasing the efficiency of their capital spending decisions. A continued high-dividend-payout policy may also signal to shareholders that additional and costly monitoring of capital spending decisions is unnecessary. (Vogt S. , 1994)
Mizen (2005) explains the relationship between cash low and investment in all but a few papers are based on sample-splitting between constrained and unconstrained firms taken from a single country. This paper seeks to explain why the the degree of sensitivity appears to be greater. It extends the literature by examining from a number of perspectives the behaviour of firms. The research article proposes a number of hypotheses that are explored in turn. A first possible reason is that firms in market-oriented financial systems show greater sensitivity to cash flow because borrowers and lenders operate at arms length compared to those in relationship-oriented systems. A second possible cause for differences in response to cash flow across countries is that the samples of firms taken from each country might differ in composition with respect to particular characteristics, for instance size. Equally, the industrial type may be an important determinant of investment sensitivity to cash flow since industries differ considerably in terms of the size of firms, capital-intensity, borrowing capacity, openness and the durability of their output. (Mizen, 2005)
Vogt S. (1997) explains the strong influence that free cash flow has on capital spending is well documented. On the free-cash-flow hypothesis of Jensen (1986) as explanations for the importance of free cash flow on capital spending. Initial results expose relations similar to those uncovered in previous studies. Capital spending is associated with positive and statistically significant with free cash flow. Firms with favorable investment opportunities are responsible for much of the positive, excess returns. Also, for firms announcing spending increases, the level of announced capital spending is positively and strongly related to the level of cash flow. The power of this relation increases for firms with profitable capital spending opportunities, as firm size declines, and as the proportion of insider ownership increases. Further analysis suggests that considerable diversity exists in the capital market’s response to cash-flow-financed capital spending. (Vogt, 1997)
Vogt (1997) research’s result indicate a positive and significant excess returns found in the sample announcing increases is concentrated in the smallest of the sample firms, in firms with low cash flow relative to capital spending, and, to a lesser extent, in firms with high levels of insider stock ownership. Tests elaborating the cross-sectional variation in returns disclose that excess returns for medium and small firms in the sample are positively associated with unexpected increases in planned spending. These tests also recommend that the market reacts more favorably to announced capital spending by small firms when the planned spending is more dependent on free cash flow. Conversely, excess returns for the largest firms in the sample are negative, though not statistically significant. Cross-sectional regressions specify that large firms have, excess returns and are negatively related to the extent that undistributed free cash flow is available to finance planned capital spending, and positively related to their capital spending opportunities. These results are consistent with the hypothesis that small firms follow a FCF model like that described by Myers (1984) and Myers and Majluf (1984). Because small firms and high-ownership firms are the most likely to face the liquidity constraints associated with asymmetric information, they are also the most likely to forgo profitable investment spending in times of cash-flow shortages. As free cash flow rises, the set of profitable capital spending projects the firm can undertake also increases. Consequently, capital spending is met with positive shareholder reactions, particularly when spending is dependent on cash flow. (Vogt, 1997)
Vogt (1997) finds some indication that is reliable with the free- cash-flow hypothesis. Excess returns are negatively related to large firm’s ability to cover capital spending with cash flow. This is consistent with the FCF hypotheses. This apparent diversity in the market’s response to capital spending decisions suggests different capital-spending financing policies for firms that seek to enhance shareholder value. Small firms with sizeable insider ownership and firms that are generally cash-flow constrained appear to be enhanced, on average, by financing capital spending with free cash flow. These firms might consider policies of conserving undistributed cash flow through low payout and leverage policies, thus encouraging new capital spending from internally generated funds. No evidence that free cash flow financed capital spending improves these firms’ market values, on average. Furthermore, limited indication exists that such a financing strategy could reduce market value for large, low insider owned, and cash flow rich firms. (Vogt, 1997)
Alti (2003) research paper analyzes the sensitivity of investment to cash flow in the benchmark case where financing is frictionless. Overall, the results indicate that the frictionless benchmark is able to account for the observed magnitudes of the investment-cash flow sensitivity, and the patterns it exhibits. Investment is sensitive to cash flow, even after controlling for its link to profitability by conditioning market. Furthermore, the sensitivity is substantially higher for young, small firms with high growth rates and low dividend payout ratios, as it is in the data. The uncertainty these firms face about their growth prospects amplifies the investment-cash flow sensitivity in two ways. First, the uncertainty is resolved in time as cash flow realizations provide new information about investment opportunities. This makes capital spending highly sensitive to free cash flow surprises. (Alti, 2003)
James A. Gentry (1990) tells about Free cash flow analysis shows that the financial health of a company depends upon its ability to generate net operating cash flows that are sufficient to cover a hierarchy of cash outflows. The profiles generated from a large sample of companies show that relative cash flow components vary across company size and across industry groups. The researcher hopes that these profiles will serve as benchmarks for comparing cash flow components and encourage financial analysts to use cash flow analysis. (James A. Gentry, 1990)
Bo Becker (2006) research explains that in frictionless financial markets, investment does not depend on internal cash flows. In a large European data set, the researcher finds that firms invest more on average when they have higher cash flow. The researcher contributes to the literature by testing formally if the coefficient on internal resources (cash flow) is related to a country’s financial development. Comparing countries, the researcher finds that the cash flow effect is indeed stronger in countries with weaker financial development. This suggests that financial constraints are strongest when financial development is low. The effect is weaker inside conglomerates and is probably not driven by the East-West difference. This is consistent with the idea that conglomerates ease internal financial constraints. Industries with few low liquid assets may experience bigger benefits of financial development (i.e. the cash flow coefficient is reduced more by financial development in low liquidity industries). However, the proof for this is diverse. Our findings suggest that financial frictions operate in Europe. They suggest that financial development is beneficial because it reduces financial constraints at the firm level and therefore relaxes the correlation between internal resources and investment. (Bo Becker, 2006)
The research aims to find the relationship between Free Cash Flow and Capital Spending; evidence from Automobile sector of Pakistan. The linear regression analysis used to find out whether Net Capital Spending is depended on Free Cash Flow or not.
H1: Free Cash flow has a relationship with capital spending or investment.
Dependent Variable = Independent Variable
Change in Fixed Assets = Free Cash Flow
Sample size used by the researcher is taken from the year 1999 to 2008 or Musharaf Era.
The variables are as follows:
Independent Variable = Free Cash Flow (FCF)
Dependent Variable = Net Capital Spending
Free Cash Flow
Free cash flow, is explained as operating income before depreciation, less interest expense on debt, less income taxes, less preferred and common dividends. FCF is a coverage ratio representing the amount to which current period generated free cash flow (defined above) is sufficient to cover next period’s capital expenditures. (Vogt, 1997)
Free cash flow is determined by integrating the cash receipt and disbursement items from the income statement with the change in each balance sheet item; the sum of the cash inflows equals the sum of the cash outflows.
FCF = Operating Income + Depreciation – Interest Expense – Income Taxes – Dividends
Net Capital Spending
Capital spending is an amount a company spent buying or upgrading fixed assets, such as equipment, during the year and acquiring subsidiaries.
Capital spending is a payment by a business for basic assets such as property, fixtures, or machinery, but not for day-to-day operations such as payroll, inventory, maintenance and advertising. Capital spending is supposedly increase the value of company assets and is usually intended to improve productivity.
Net Capital Spending = (Current Year – Previous Year)
Log of Net Capital Spending is taken to control the variability of the data.
Log of Net Capital Spending = LN (Net Capital Spending)
Sources of Information
The research work is done on Automobile sector of Pakistan. All the required data is extracted from financial reports of the companies which are available on their website and hardcopies of financial reports are also available. All the values of variables are on annual basis.
The technique used by the researcher is Multiple Regression. Multiple linear regression analysis is a statistical tool that can be used to analyze the association between a dependent variable and several independent variables. The objective of multiple linear regression analysis is to use the independent variables whose values are known to forecast the single dependent value selected by the researcher. (Hair, 2006)
Multiple Linear Regression estimates the coefficients of the linear equation, involving one or more independent variables that best predict the value of the dependent variable. For e.g., you can try to predict a salesperson’s total yearly sales (the dependent variable) from independent variables such as age, education, and years of experience.
Predictors: (Constant), Free Cash Flow in Millions
Dependent Variable: Log Net FA
SPSS is used by the researcher to run regression analysis on the variables. Total variation explained by the regression model as indicated by R square is 0.273 or 27.3 %. So the variation explained by the independent variable FCF is positive but it is very low. (Hair, 2006)
The change in the R Square statistic that is produced by adding or deleting an independent variable. If the R Square change associated with a variable is large, that means that the variable is a good predictor of the dependent variable. (Hair, 2006)
The F test for the regression model is significant which indicates that regression model is best fit. (Hair, 2006)
Regression model result is pointing out that FCF has a positive impact on Net Capital Spending. (Hair, 2006)
FCF in Millions
Dependent Variable: Log Net FA
Unstandardized Equation: Log Net FA = 3.186 + .002 FCF in Millions
Standardized Equation: Log Net FA = 0.523 FCF in Millions
That means if FCF will change by 1 million, Log of Net Capital Spending will change by 0.002, which means Net Capital Spending will increase by 1.002002 Million. (Hair, 2006)
The regression coefficient represents the amount of change in the dependent variable for a one unit change in the independent variable. (Hair, 2006)
The coefficient plus the constant both are significant at 0.05 level. (Hair, 2006)
This model explains 27.3 % of variation of the dependent variable. (Hair, 2006)
The purpose is to examine whether organizational form affects managerial behavior with respect to the holding of free cash flow rather distributing or investing.
Some researchers have important implications for both investors and managers. While the study shows that cash flow-financed capital spending is marginally unproductive for some firms, the potential sources of this inefficiency have also been identified. Cash flow-financed growth by large, low-dividend firms tends to be value-destroying, while cash flow-financed growth is value-creating for small, low-dividend firms. The importance of dividends as a method of mitigating agency costs of free cash flow, moreover, is confirmed. Managers of cash flow-rich companies may consider increasing dividend payouts as a method of increasing the efficiency of their capital spending decisions. A continued high-dividend-payout policy may also signal to shareholders that additional and costly monitoring of capital spending decisions is unnecessary.
This study will help mangers to make a good dividend payout policy and it will be useful for capital spending decisions also.
For the Automobile industry of Pakistan the period 1999 to 2008 a unique research has been done to test the cause of the well-documented relationship between free cash flow and Capital spending. The free cash flow (FCF) hypothesis, which assumes managers overinvest free cash flow in unprofitable investment projects. Results from several empirical specifications indicate that the influence of free cash flow on capital spending is weaker for firms belonging to Automobile sector of Pakistan. This result suggests that free cash flow doesn’t effects capital spending in the automobile sector of Pakistan.
As the previous studies showed this study also proves that there is a significant relationship between free cash flow on capital spending.
Free cash Flow is likely to result in managers relaxing the profitability criteria necessary to justify a specific project but such profitability criteria are still useful in ranking projects.
FCF cannot be observed directly. Instead, scarce profitable investment opportunities; considerable, steady cash flow; low financial leverage; and high levels of diversification are identified as indicators of free cash flow.
The results predict that Capital spending of equity is partly driven by free cash flow. Capital spending from free cash flow is lower in royalty trusts and master limited partnerships than in corporations.
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