Do mispricing and financial constraints matter for investment decisions?

ABSTRACT

This study investigates how mispricing and financing constraints affect firms’ future capital investments. We find that when the financing constraints are high, overpriced (underpriced) firms invest more (less) subsequently under previous non-optimal investments. The overpriced (underpriced) firms with precautionary motives invest significantly less subsequently when they are financially constrained. The overall evidence suggests that share mispricing, financial constraints and precautionary motives play a critical role that enables investors to less effectively monitor managers’ real decisions, thus limiting firms’ capital investments.

KEYWORDS:

• Mispricing
• financing constraints
• capital investment
• precautionary motive
• information asymmetry

JEL CLASSIFICATION:

• G10
• G19
• G31
• M40

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ Gilchrist, Himmelberg, and Huberman (2005) indicate that information asymmetry encourages managers to use the proceeds of equity issuances to choose NPV projects, thus resulting in overinvestment.

² Campello et al. (2010, 2011, 2012) find that financially constrained firms, particularly for those without access to credit lines, are more likely to cut into their capital spending than other firms do. Duchin, Ozbas, and Sensoy (2010) reveal that corporate investments decrease considerably following crises faced by firms with low internal and external capital.

³ Biddle, Hilary, and Verdi (2009) suggest that if companies are likely to overinvest (underinvest) during a subsequent period, a negative (positive) correlation exists between the quality of financing reporting during the current period and the capex during the subsequent period. They find that the quality of financial reporting is correlated with real investment efficiency.

⁴ Cheng, Dhaliwal, and Zhang (2013) examine the causal relationship between the quality of financial reporting and investment efficiency and suggest that companies with financing constraints underinvest and those with no financing constraints overinvest (companies with financing constraints are defined as those with disclosed internal control weaknesses).

⁵ The liquidity preference theory from Keynes (1936) indicates that the three motives for people to hold currencies are transactional, precautionary and speculative.

⁶ Hovakimian and Titman (2006) measure financing constraints to segment two distinct investment regimes based on seven characteristic variables, namely firm size, firm age, financial leverage, market-to-book ratios, financial slack and dummy variables for dividend payout and bond rating.

⁷ Consistent with the precautionary motive, Opler et al. (1999) find that firms with riskier cash flows and more R&D spending hold more cash because adverse shocks and financial distress are more costly for them. Han and Qiu (2007) model the precautionary demand for cash and find that an increase in the volatility of cash flow increases cash holdings for firms that are financially constrained. Bates, Kahle, and Stulz (2009) use the cash flow volatility, R&D spending, and cash dividend to capture precautionary motive for cash holdings. They find that firms with greater cash flow volatility, greater R&D and more cash dividend hold more precautionary cash.

⁸ We detail the exact definitions for these variables in Appendices 1 and 2, respectively.

⁹ As a robustness test, we also consider total investment in the next two periods. The results (not tabulated) on total investment in the next two year are consistent with the results reported in Table 3. We also used investment efficiency, and the results (not reported) are unchanged.

Additional information

Funding

This work was supported by the Accounting Measurement Model, Reporting Mode and Integrated Reporting for Business Enterprises [16JJD790035].