Abstract

This paper investigates whether investment spending of firms is sensitive to the availability of internal funds. Imperfect capital markets create a hierarchy for the different sources of funds such that investment and financial decisions are not independent. The relation between corporate investment and free cash flow is investigated using the Bond and Meghir (1994a) Euler-equation model for a panel of 240 companies listed on the London Stock Exchange over a 6-year period. This method allows for a direct test of the first-order condition of an intertemporal maximisation problem. It does not require the use of Tobin's q, which is subject to mis-measurement problems. Apart from past investment levels and generated cash flow, the model also includes a leverage factor which captures potential bankruptcy costs and the tax advantages of debt. More importantly, we investigate whether ownership concentration by class of shareholder creates or mitigates liquidity constraints.

Control is expected to influence the investment financing relation for two reasons. First, due to asymmetric information, the link between liquidity and investment could be a symptom of underinvestment. Firms pass up some projects with positive net present values because of the inflated cost of external funds. Second, from an agency perspective, external funds may not be too expensive but internal funds (free cash flow) may be too inexpensive from the manager's perspective. Whereas high insider ownership concentration reduces the liquidity constraints induced by agency costs, high insider shareholding concentration increases the liquidity constraints in the case of asymmetric information. It is expected that the induced liquidity constraints due to insider ownership are substantially reduced when outside investors control a substantial share stake and have therefore an increased propensity to monitor management. When industrial companies control large shareholdings, there is evidence of increased overinvestment. This suggests that industrial companies are able to influence investment spending. In contrast, large institutional holdings reduce the positive link between investment spending and cash flow relation and hence suboptimal investing. Whereas there is no evidence of over- or underinvesting at low levels of insider shareholding, a high concentration of control in the hands of executive directors creates a positive investment-cash flow relation.