The Effects of Future Capital Investment and R&D Expenditures on Firms' Liquidity

• Author: Oleksandr Talavera,Christopher F. Baum,Mustafa Caglayan
• DOI: http://doi.org/10.1111/roie.12048
• Date: 01 August 2013
• Published date: 01 August 2013

The Effects of Future Capital Investment and R&D

Expenditures on Firms’ Liquidity

Christopher F. Baum, Mustafa Caglayan, and Oleksandr Talavera*

Abstract

The paper explores factors that lead to accumulation or decumulation of firms’ cash reserves.In particular,

the paper empirically examines whether additional future fixed capital and R&D investment expenditures

induce firms to change their liquidity ratio while considering the role of market imperfections. Implement-

ing a dynamic framework on a panel of US, UK, and German firms, it is found that firms in all three coun-

tries make larger adjustments to cash holdings when they plan additional future R&D rather than fixed

capital investment expenditures.This behavior is particularly prevalent among financially constrained firms.

1. Introduction

It is important to understand why firms hold substantial amounts of cash, which earns

little or no interest, rather than channeling those funds towards capital investment

projects or as dividends to shareholders. In an environment with no market imperfec-

tions, firms can tap into financial markets costlessly and need not hold cash (Keynes,

1936) as cash has a zero net present investment value (Modigliani and Miller, 1958).

However, in the presence of financial frictions, firms do not undertake all positive net

present value projects, but rather choose to save funds for transactions or precaution-

ary motives. In that sense, firms facing market imperfections must choose their level of

liquidity at each point in time while taking into account current and future business

opportunities.

In this paper, we empirically examine the changes in firms’ cash holdings, focusing

on the effects of future investment expenditures on the accumulation or decumulation

of firms’ cash reserves. Although we are not the first to investigate how firms’ invest-

ment expenditures affect their cash holding behavior, our study differs from the rest

of the literature on several grounds. An inspection of the literature shows that

researchers have recognized the significance of current and future investment plans

for liquidity management, yet there seems to be little consensus on how to capture

those effects. For instance, some researchers use current investment expenditures or

reported investment plans, while others use Tobin’s Qto proxy future investment

opportunities of the firm. However, all of these strategies have their drawbacks, as we

later discuss. In this paper, we examine the effect of one-period-ahead additional

investment expenditures on firms’ liquidity management behavior. We reason that a

rational manager who plans to expand her firm’s investment in the next period would

take measures to improve the liquid assets of the company so that the project could

be realized despite the potential effects of external or internal financial constraints. In

such circumstances we should observe that firm’s cash holdings will increase.

* Baum: Department of Economics, Boston College, Chestnut Hill, MA 02467, USA. Tel:+1-617-552-3673;

Fax:+1-617-552-2308; E-mail: baum@bc.edu. Also at DIW Berlin,Mohrenstraße 58, 10117 Berlin, Germany.

Caglayan: Department of Economics, University of Sheffield, Sheffield S1 4DT, UK. Talavera: Durham

Business School, Durham University,Durham DH1 3LB, UK.

Review of International Economics, 21(3), 459–474, 2013

DOI:10.1111/roie.12048

© 2013 JohnWiley & Sons Ltd

Our second objective is to examine which type of future investment, fixed capital vs

R&D expenditures, would lead to a higher accumulation of cash buffer stocks. We

conjecture that an increase in future R&D expenditures will require firms to increase

their cash holdings by more than that of fixed capital expenditures. Our reasoning,

similar to that of the earlier literature including Brown and Petersen (2011), Hall and

Lerner (2009), Bates et al. (2009), and Opler and Titman (1994), can be explained as

follows. In contrast to fixed capital investment, R&D investment contributes to the

stock of intangible capital and cannot be used as collateral. Thus, firms undergoing

large R&D expenditures do not have the financial flexibility of firms that mainly

invest in physical capital, as the latter firms may pledge their fixed investment as col-

lateral. As most of a firm’s R&D capital stock is represented by human capital, it

would be much more difficult to temporarily reduce R&D expenditures without

losing much of the specialized human capital to other companies.1Therefore, compa-

nies that have carried out sizable R&D activities are more likely to face greater obsta-

cles in accessing external financing in comparison with those firms that have largely

invested in pledgeable physical or financial assets. In the presence of financial fric-

tions, this will require firms to hoard more cash should they plan to increase their

R&D expenditures. Another reason linking expansion in R&D activities to those

firms’ increase in cash holdings is the fact that R&D expenditures have a lengthy and

highly uncertain payback.

Some studies in the literature have considered the impact of R&D and fixed invest-

ment expenditures along with several potential firm-specific variables which may also

affect firms’ cash holding behavior. In particular,Bates et al. (2009) examine why cash

holdings of US firms increased. They suggest that the precautionary demand for cash

can plausibly explain the secular increase in cash holdings, and show that firms whose

R&D expenditures increase hold more cash, while cash is generally negatively

correlated with fixed capital investment. An earlier, influential study by Opler et al.

(1999) also implies that firms’ cash holdings increase significantly as their capital

expenditures-to-assets ratio as well as their R&D-to-sales ratio increases. In contrast

to these studies’ findings, Brown and Petersen (2011) investigate the factors that affect

firms’ R&D expenditures and show that in order to smooth their R&D activities, firms

build up their cash reserves when cash flow is available while drawing them down

when cash flow is reduced.2In this context, our study is closer to those of Bates et al.

(2009) and Opler et al. (1999). However, we investigate firms’ cash holding behavior

in a dynamic setting as we evaluate the impact of firms’ future investment activities on

this process, and we deal with issues of endogeneity that are not addressed in those

studies. Hence, our work complements the prior literature,as we show that accumula-

tion of cash holdings is related to firms’ future investment activities, but is most sensi-

tive to planned R&D activities. These implications are forthcoming from the

analytical findings of Almeida et al. (2011), who present several propositions for firms’

choice of liquid vs illiquid investments, and safe vs risky assets in the context of future

financing constraints.

To test the hypothesis that future fixed capital and R&D investment expenditures

have an impact on firms’ cash holdings, we use large panels of quoted manufacturing

firms obtained from Global COMPUSTAT for the USA, UK, and Germany over the

1989–2007 period. We employ the dynamic panel data system-GMM (generalized

method of moments) estimator of Blundell and Bond (1998) to allow for the possible

endogeneity of the explanatory variables. Our approach considers how changes in

future investment expenditures may lead to changes in firms’ current cash holdings.3

In estimating our models, we take into account firm-level fixed effects and time effects

460 Christopher F. Baum, Mustafa Caglayan,and Oleksandr Talavera

© 2013 JohnWiley & Sons Ltd