Organizational Capital and Investment‐Cash Flow Sensitivity: The Effect of Management Quality Practices

Abstract

This paper examines the influence of organizational capital, as evident in management quality practices, on the response of firm investment to internal cash flows. We provide novel and strong evidence that investment sensitivity to internal cash flows decreases in the presence of superior management practices. We also find that superior management practices reduce the firm's financing frictions, evident in lower capital constraints. Our results are robust to numerous tests. Overall, our findings suggest that intangible organizational capital is important for investment decisions and that superior management practices contribute to value‐maximizing behavior.

Organization capital and firm life cycle

“…Prior studies extensively document the view that organization capital enables the firm to achieve efficient production, stable business operation and transactions, and that this leads to higher productivity (Black and Lynch 2005) and better firm performance (Attig and Cleary 2014; Evenson and Westphal 1995;Lev et al 2009). Recent studies in finance and accounting also acknowledge the implication of organization capital in explaining stock return (Eisfeldt and Papanikolaou 2013), investment cash flow sensitivity (Attig and Cleary 2014), corporate social responsibility (Attig and Cleary 2015) and employee turnover and diversity in skill and wages (Carlin et al 2012). Eisfeldt and Papanikolaou (2013) show that firms with more organization capital are more productive, have higher Tobin's Q and higher risk-adjusted returns, and display a higher level of executive compensation.…”

“…We, so far, take a 'static view' to link organization capital with firm life cycle stages. However, extant studies indicate that organization capital integrates the human skills and physical capital that enable the firm to achieve efficient production and a stable business operation, both of which then lead to higher productivity (Black and Lynch 2005) and better future firm performance (Attig and Cleary 2014;Evenson and Westphal 1995;Lev et al 2009). The foreseeable future benefits stemming from organization capital have the potential to cause firms to move to other favourable life cycle stages progressively: the 'dynamic view' of organization capital.…”

Corporate Financial Constraints and Internal Capital Markets: Evidence from Emerging Countries

“…Most of these constraints ,resulting from capital market imperfections, have drawn attention to the importance of availability of internal financing for firms' investments.The research on capital investment determinants is generally based on Tobin's Q investment models , and mostly use investment sensitivity of cash flows (ICFS) as an indicator of financial constraints (Fazzari et al, 2000;Fisman & Love, 2003;Carpenter & Guaraglia, 2008;Ozbas & Scharfstein, 2009;Attig & Cleary, 2014;Magud & Sosa, 2015). Numerous studies find that more financially constrained firms display higher ICFS than less constrained firms (Fazarri et al, 1988;Almeida & Campello, 2007;Beatty et al, 2010).…”

“…Investment cash flow sensitivity has been widely used as a measure of financial constraint despite the criticisms expressed in the finance literature by Kaplan and Zingales (1997), Gomes (2001), Abel and Eberly (2011) and Cleary (1999) and different measures of financial constraints developed such as KZ index (Kaplan & Zingales, 1997), WWindex (Whited & Wu, 2006) and SA index (Hadlock & Pierce, 2010). Several studies have attempted to resolve the contradictory results by employing other variables that affect the relation between ICFS and investment outlays including the marginal cost of capital (Cleary, 1999), foreign direct investment flows (Magud & Sosa, 2015) and management quality practices (Attig & Cleary, 2014 that they change over time (Allayannis & Mozumdar, 2004;Agca & Mozumdar, 2008;Brown & Petersen, 2009;Chen & Chen, 2012). The sensitivity of investment to cash flows is particularly strong for smaller firms (Fazzari et al, 1988;Carpenter & Guariglia, 2008) and for firms in less financially developed economies (Fisman & Love, 2003).…”

“…Numerous studies find that the more financially constrained firms display higher ICFS than less constrained firms (Fazarri et al, 1988;Almeida & Campello, 2007;Beatty et al, 2010). Some studies have incorporated proxies that affect the relationship between ICFS and investment outlays such as the marginal cost of capital (Cleary et al, 2007), management quality practices (Attig & Cleary, 2014) and FDI (Magud & Sosa, 2015) so as to resolve the contradictory views on the use of ICFS as an indicator of financial constraint.Evidence from developed countries reveals that the internal capital markets of conglomerates may enable subsidiaries to fund profitable investments that the external capital market would not be able to finance because of information asymmetries and agency costs that make external financing costly (Williamson, 1975;Gertner et al, 1994;Stein, 1997;Fluck & Lynch, 1999;Maksimovic & Phillips, 2013).…”