Finance, corporate value and credit market freedom in overinvesting US firms

• Date: 13 July 2020
• Published date: 13 July 2020
• DOI: https://doi.org/10.1108/CG-05-2020-0196
• Pages: 1053-1072
• Author: Alfonsina Iona,Marco Alberto De Benedetto,Dawit Zerihun Assefa,Michele Limosani
• Subject Matter: Strategy,Corporate governance

Finance, corporate value and credit

market freedom in overinvesting US firms

Alfonsina Iona, Marco Alberto De Benedetto, Dawit Zerihun Assefa and Michele Limosani

Abstract

Purpose –Using a sampleof US firms more likely to be affected by agency problems, the purposeof this

paper is to investigate the relationship between corporate value and financial policies and to study

whethercredit market freedom (CMF) affects thisrelationship.

Design/methodology/approach –The authors identify a sub-sample of non-financial US firms

potentially affected by agency problems using a joint criterion of over-investment and high cash-

holdings.A generalized method of moment econometricframework is then used to estimate the impactof

cash-holdingsand leverage policies on firm value for this sub-sample.This exercise is also performed by

takinginto account the level of CMF of the state wherethe firm operates.

Findings –The results showthat the relationship between cash-holdings –or leverage–and firm value is

‘‘U-shaped.’’In addition, when the authors focus on the role playedby the level of CMF, the authors find a

number of interesting facts: CMF facilitates the firms’ access to external finance, thereby relaxing the

need of internal fundsfor investing; the relationship between cash-holdingsand firm value is ‘‘U-shaped’’

only in states enjoyinghigh levels of CMF; the probability of observing firms morelikely to be affected by

agencyproblems is higher in states with high levelsof CMF.

Research limitations/implications –The empiricalfindings provide important insightsto policymakers,

shareholders and practitioners. To policymakers, the results suggest that providing institutional

environments with greater CMFcan enhance the firm access to external finance, the level of corporate

investment and the economicgrowth. To shareholders, the findings highlight thatthe conflicts of interest

between managers and shareholders may be more severe in states with higher CMF; therefore,

adequate financing policies and corporate governance mechanisms must be used to mitigate these

conflicts and maximize the firm value. Finally, to practitioners, the evidence suggests that, in valuing a

firm, they must takeinto consideration whether the economicenvironment provides managers with more

freedomto stockpile cash and invest sub-optimally.

Originality/value –The paper contributes to the corporate finance and governance literature in two

respects.First, it provides new evidence on the shapeof the relationship between cashholdings and firm

value for firms affectedby empire-building managers. Second, at the bestof the knowledge, it is the first

corporate finance study, which analyzes the role played by the CMF at the state level on the capital

structureand the level of investment of the firms.

Keywords Firm value, Leverage, Cash-holdings, Institutions

Paper type Research paper

1. Introduction

The effect of capital structure on firm value has been a subject of intense debate in the

finance literature. TheModigliani and Miller (1958) result of a capital structure irrelevance for

the firm value, under restrictive assumptions, caused economists to devote a lot of effort to

relax some of these assumptions.

On the one hand, the trade-off theory introduces corporation taxes to suppo rt the idea

that financial policy, debt, in particular, is relevant for the firm valu e. The basic idea

underlying this theory is that the value of the firm should increase by using debt, as

debt payments are excluded from income in computing corporate income tax

Alfonsina Iona is based at

the School of Economics

and Finance, Queen Mary

University of London,

London, UK.

Marco Alberto De

Benedetto, Dawit Zerihun

Assefa and Michele

Limosani are all based at

the Department of

Economics, Universita degli

Studi di Messina, Messina,

Italy.

JEL classification –C33,G30,

G32,G38,G39

Received 24 May 2020

Revised 7 June 2020

12 June 2020

Accepted 18 June 2020

DOI 10.1108/CG-05-2020-0196 VOL. 20 NO. 6 2020,pp. 1053-1072, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 1053

(Modigliani and Miller, 1963;Baxter, 1967). According to the trade-off theory, thus,

more profitable firms should have higher leverage ratios, a prediction that runs

counter to the empirical fact that these firms usually tend t o have lower levels of debt

(Abel, 2018). More specifically, Abel (2018) shows that, when the borrowing

constraint is not binding, the trade-off theory of debt holds and mor e profitable firms

have higher leverage ratios. However, contrary to the conventional interpretation but

consistent with empirical findings, it is possible that under the trade-off theory up ward

changes in current or future profitability also reduce the optimal leverage ratio. In light

of the arguments above, we should expect either a negative or a positive relationship

between leverage and firm value.

On the other hand, the pecking order theory and the agency theory focus on the role of

capital market imperfections, arising either from asymmetric information between the firm

and the outsider financiers or from agency problems between managers and shareholders,

to highlight that capital structure is relevant for the firm value. One important insight of this

strand of research is that information asymmetries (Greenwald et al.,1984;Myers and

Majluf, 1984) and agency problems (Jensen and Meckling, 1976;Stulz, 1990;Hart and

Moore, 1995) generate a wedge between the cost of internal and external finance. This

wedge makes capital structure relevant for a firm’s investment and value: companiesfacing

this wedge may pass up some profitable investment projects unless they can be financed

with retained earnings.

Some other studies underline the role of debt as a signalling device (Ross, 1977). They

argue that, if we relax the assumption according to which the market possesses full

information about the activitiesof firms and the quality of their investment projects, the value

of the firm will rise with leverage because, by boosting the leverage, managers can signal

that the firm is committed to pay debt service and has more taxable income to shield. This,

in turn, improves the corporate value by increasingthe stock prices.

Further progress on understanding capital structure has been done by adopting agency

and managerial discretion perspectives. Easterbrook (1984) and Jensen (1986) argue that

the self-interested managers value the financial flexibility that allows them to escape the

capital market discipline and in trading-off between current investment and cash retention

they give a larger relevance to the latter. The high-cash policy leads to an increase in the

managers’ discretion, and it is therefore likely to reduce the value of the firm (Iona and

Leonida, 2016;Iona et al., 2017). This happens as managers will always undertake new

investments, even when they are value decreasing if the management’s empire-building

tendencies are sufficiently strong (Jensen and Meckling, 1976;Jensen, 1986;Dittmar et al.,

2003;Ferreira and Vilela, 2004;Pinkowitz et al., 2006;Dittmar and Marth-Smith, 2007;

Kalcheva and Lins, 2007;McKnight and Weir, 2009;Kusnadi, 2011;Gao et al.,2013). As

the pioneer work by Jensen and Meckling (1976), most of the research in corporate finance

has focused on overinvestmenttendencies as a type of agency problem.

If this is the case, the issuance of debt may be beneficial to the firm value for several

reasons. First, it may allow managers to disgorge funds that may otherwise be wasted or

used to finance unprofitable investment projects. Second, the eventualthreat of bankruptcy

may improve the performance of managers lining up their interests with those of

shareholders (Hart and Moore, 1995). Finally, debt, by improving the managerial

performance, may increase the stock prices and makes the firm more valuable and more

costly to be taken over (Harris and Raviv, 1990).

Given these premises, we expect that alternate financing policies differently impact the

market valuation of firms potentially affected by incentive problems, in comparison to other

firms. The aim of the paper is, therefore, to investigate the relationship between corporate

value and alternate financing policies in corporations affected by overinvestment

tendencies which are likely to be driven by empire-building managers.

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