The effect of intra‐group loans on the cash flow sensitivity of cash: Evidence from Chile

• Published date: 01 June 2021
• Author: Mauricio Jara‐Bertín,Cristian Pinto‐Gutiérrez,Carlos Pombo
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/irfi.12276

ORIGINAL ARTICLE

The effect of intra-group loans on the cash flow

sensitivity of cash: Evidence from Chile

Mauricio Jara-Bertín

1

| Cristian Pinto-Gutiérrez

2

| Carlos Pombo

3

1

School of Economics and Business, Business

Department, Universidad de Chile, Santiago,

Chile

2

Department of Management, Universidad

Católica del Norte, Antofagasta, Chile

3

School of Management, Finance

Department, Universidad de los Andes,

Bogotá, Colombia

Correspondence

Cristian Pinto-Gutiérrez, Department of

Management, Universidad Católica del Norte,

0610 Avenida Angamos, Antofagasta, Chile.

Email: cristian.pinto@ucn.cl

Abstract

We examine the effects of internal capital markets on the

propensity of firms to save cash from cash flows. We argue

that firms that are providers of funds to related parties must

maintain a higher cash flow sensitivity of cash to prevent

high levels of pressure on their cash holdings in contrast to

receivers of intra-holding funds. Based on a sample of Chil-

ean firms, we confirm that firms with high levels of loans to

related companies have higher cash flow sensitivities of

cash. This relationship is strongest for firms affiliated with

business groups and financially constrained firms. We do

not find conclusive evidence of loss to the minority share-

holders (tunneling) from intra-group loans.

KEYWORDS

business groups, cash flow sensitivity of cash, financial

constraints, internal capital markets, pyramidal structure

JEL CLASSIFICATION

G3

1|INTRODUCTION

Internal capital markets have a significant impact on the cash policies of firms. In this paper, we analyze the direct

effects that the underlying intra-group flows of capital among related companies have on the propensity of these

companies to save cash from operating cash flows. Two contrasting arguments predict the relationship between

intra-group loans and cash holdings. On the one hand, the bright side view of internal capital markets suggests that

business group affiliates should hold less cash than nonaffiliated firms. Internal capital markets mitigate problems of

information and contract enforcement typically associated with external financing. Consequently, smaller informa-

tion asymmetries decrease financial constraints and also allow affiliates to keep lower cash reserves because these

Received: 19 July 2018 Revised: 22 February 2019 Accepted: 10 May 2019

DOI: 10.1111/irfi.12276

© 2019 International Review of Finance Ltd. 2019

374 International Review of Finance. 2021;21:374–403.wileyonlinelibrary.com/journal/irfi

firms can access the internal capital market of the group (Deloof, 2001; Locorotondo, Dewaelheyns, & Van Hulle,

2014; Pinkowitz & Williamson, 2001). Affiliation to business groups and access to internal capital markets can also

improve access to external credit as the assets of one group member can serve as collateral for other affiliates

(Chang & Hong, 2000; Ghatak & Kali, 2001; Verschueren & Deloof, 2006).

On the other hand, the dark side view of internal capital markets suggests that business group membership could

lead members to increase their cash levels to reduce costs of financial distress and overall default risk (Ferreira &

Vilela, 2004; García-Teruel & Martínez-Solano, 2008). This adverse effect appears as potential group-wide financial

distress puts all affiliated firms under pressure to meet contractual obligations, pressing managers to accumulate cash

balances and increase the amount of liquid assets under their control in times of financial trouble, and when external

financial constraints are tightened (e.g., Buchuk, Larrain, Prem, & Urzúa, 2017).

The role of operating cash flow in firm cash policies is also a point of contention in the literature regarding

financial constraints. For instance, Almeida, Campello, and Weisbach (2004) find that financially constrained

firms have a positive cash flow sensitivity of cash holdings for precautionary savings reasons. Follow-up studies

verify this argument and find that the cash flow sensitivity of cash is indeed higher in subsamples that are more

likely to suffer from financing constraints, such as smaller firms, low dividend paying c ompanies, and firms with-

out bond or commercial paper ratings (Khurana, Martin, & Pereira, 2006; Han & Qiu, 2007; Lin, 2007;

Sufi, 2009).

In contrast, Riddick and Whited (2009) re-examine this argument with a different theoretical and empirical

modelspecificationandfindtherelation between changes in cash holdings and cash flow is actually negative.

They argue that a firm's cash flow sensitivity of cash is driven by fluctuations and uncertainty of income rather

than by the emergence of binding external financing constraints. Furthermore, Bao, Chan, and Zhang (2012)

determine that the cash flow sensitivity of cash exhibits asymmetrical cash sensitivity when facing positive or

negative cash flows. This asymmetry may be due to several factors including binding project contracts, withhold-

ing of bad news, and agency costs. Overall, the literature provides no consensus on the sign and determinants of

the cash flow sensitivity of cash.

This paper explores the internal capital markets among related companies as another explanation for the propen-

sity of companies to save cash from operating cash flows. In particular, using a sample of Chilean firms listed on the

Santiago Stock Exchange, we examine the effects of internal capital markets on the propensity of firms to save cash

from cash flows (i.e., the cash flow sensitivity of cash). To the best of our knowledge, no prior study has directly

examined the effects of internal capital markets on the cash holding policy of firms. In this paper, we show that there

is a relationship among intra-group loans, cash holdings, and cash savings from operating cash flows. Previous stud-

ies, including Bertrand, Mehta, and Mullainathan (2002) and Almeida and Wolfenzon (2006a, 2006b) suggest that

group affiliated firms can eliminate the potential effect of operating cash flows on cash savings. However, none of

these papers directly examine the effects that the underlying flows of money of internal capital markets of business

groups have on the cash flow sensitivity of cash.

Chile provides an especially suitable corporate framework to test the effect of internal capital markets on cash

holding policies. Regulations of Chile's internal capital markets require every listed firm to report a line called “notes

and accounts payable from related companies”on both the liability and the asset side of the balance sheet.

1

These

accounts allow us to precisely measure the use of internal capital markets by these firms in Chile. Intra-group lending

data taken from the financial statements of Chilean companies has been previously used by Buchuk, Larrain, Muñoz,

and Urzúa (2014) to test whether intra-group lending can be motivated by tunneling or by a financing advantage.

They find that the activity of internal capital markets is better explained by the financing advantage. They also dem-

onstrate that firms that borrow internally have higher investments, leverage, and return on equity than other firms.

However, Buchuk et al. (2014) do not address the question of whether the levels of intra-group lending affect firms'

cash holdings or the cash flow sensitivities of cash. Thus, our paper extends the literature on firm financial con-

straints and document a new side of internal capital markets by establishing a direct link between inter-corporate

loans and the propensity of firms to save cash from cash flows.

JARA-BERTÍN ET AL.375