In imperfect capital markets, financial flexibility, which means the ability to respond in a timely and value-maximizing manner to unexpected changes in cash flows and investment opportunities, is valuable. Consequently, in the presence of such imperfections, firms can be expected to choose financial policies that preserve the flexibility to respond to unexpected periods of insufficient resources.
Recent surveys of American and European CFOS suggest that the most important driver of firms' capital structure decisions is the desire to attain and preserve financial flexibility. According to A, Gamda and A. Triantis, 2008 financial flexibility represents the ability of a firm to access and restructure its financing at a low cost. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to readily fund investment when profitable opportunities arise. While a firm's financial flexibility depends on external financing costs that may reflect firm characteristics such as size, it is also a result of strategic decisions made by the firm related to capital structure, liquidity, and investment.
Empirical studies, as shown by S. Boyun 2007, in the capital structure find a positive relationship between firm size and leverage. Suggested explanations in the literature include: large firms tend to have more leverage perhaps because they are more transparent; have lower asset volatility; more diversified; naturally sell large enough debt issues so that the fixed costs of public borrowing are not prohibitive; have lower probability of default and less financial distress costs. On the other hand, small firms incur higher costs of issuing debt or equity since they are subject to severe asymmetric information problems and default risk, more likely to be growing firms with volatile cash flows and hence have less access to external funds than do large firms. Further, the costs of financial distress are likely to be particularly severe for small firms because much of their value comes from growth options whose value depreciates rapidly if the firm experiences financial distress. In addition, small firms have a large fraction of their assets that are firm specific or intangible, limiting their value as collateral. An alternative view is that cash holdings themselves are costly because of potential agency problems. This leads value-maximising firms to maintain relatively low cash balances and to preserve unused debt capacity that can be used in times of financial need. Dividends are kept relatively stable so as to allow the firm continued access to the capital market. Under this view, cash flow shortfalls are met primarily by new borrowings; reductions in cash balances are empirically less important and the maintenance of dividends is a first-order priority. This view has recently been developed more fully in DeAngelo and DeAngelo (2007).
In this essay it will be discussed and examined how financial flexibility and debt affect corporate governance and corporations. Also how firms manage with cash shortfalls and debt with the use of financial flexibility. The essay is divided in three main bodies the introduction the main section where a literature review is taking place and the different approaches firms use to overcome the debt by using financial flexibility. Finally in the third section the discussion and conclusion of how corporate firms could handle the debt with the use of financial flexibility.
2. Financial Flexibility and Debt
Financial flexibility represents the ability of a firm to access and restructure its financing at a low cost. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to readily fund investment when profitable opportunities arise. While a firm's financial flexibility depends on external financing costs that may reflect firm characteristics such as size, it is also a result of strategic decisions made by the firm related to capital structure, liquidity, and investment.
2.1 financial flexibility and investmet
In this chapter the role of financial flexibility and how it affects the debt will tried to be explained. Financial flexibility and the control of debt is explained in various literature. In presence of financial constraints, firms that anticipate valuable growth options in the future respond by accumulating reserves of borrowing power. Through a conservative leverage policy undertaken over a number of years, companies gain a degree of financial flexibility that allows them to have better access to the external market at time t, and to raise funds to supplement their internal funds, enabling them to invest more. Moreover according to M.T. Marchica et al 2007, findings indicate that, after a period of low leverage, financially flexible firms are able to invest significantly more in capital expenditures. It is shown that the impact of the flexibility factor is sizeable in economic terms.
2.2 Financial flexibility and stock listing
Research indicates that increased access to financial resources is one of the most important advantages of a stock listing. Specifically, because of the transparency linked to listing and the information production in public markets, asymmetric information problems and financial frictions should decrease with a stock listing. Stated in Beck et al., 2006 and Holod and Peek, 2007 the previous researchers expect that listed firms are less financially constrained.
According to F. Schoubben and C. Van Hulle, 2009 financially unconstrained firms set the optimal investment policy independently from current income. This means that, investment decisions focus purely on value creation, such as positive Net Present Value (NPV). Since these firms face no credit constraints when raising funds for positive NPV projects, their spending remains insensitive to cash flow shocks. Financially constraint firms prefer using internal over external funds. Higher internal cash flows will trigger a decline in the use of external financing, thus a lower internal cash flow will increase the use of external financing. When firms face financing frictions then, the substitution effect between internal and external financing will be much smaller. Investment spending will then have to change in order to accommodate for cash flow shocks. If the cash flow shock is positive, constrained firms will optimally channel at least part of the income surplus into additional investment spending as, due to capital constraints, these firms likely have under invested in the past. Consequently, financially constrained firms' use of external funding tends to decline by less than the decline for unconstrained firms experiencing similar income windfalls. Likewise, if the cash flow shock is negative, financially constrained firms are not able to fully compensate its impact on investments by way of raising external funds. Therefore, external financing increases by less than the increase for unconstrained firms experiencing a similar income shock. Put differently, as financing constraints increase, adjustments in investment spending partially absorb cash flow shocks and reduce the substitution between cash flow and external financing. Since unlisted firms face more financing frictions in comparison to listed firms, the main hypothesis for unlisted firms is that they show little substitutability between internally generated funds and debt financing. So we could say that listed firm's show a strong substitution effect between internal and external financing because they face less financing frictions.
2.3 Are Internal funds are costless form of financial flexibility?
In corporate firms managers select the firm's financial policies at each date in an infinite horizon world so that, at every decision node, managers must be mindful of the consequences of today's decisions on the feasible set of decisions at each future date. Financial policy decisions include all of the variables of the basic finance model such as investment in real assets, investment in financial assets like cash balances. Moreover capital infusions from the issuance of debt and equity, distributions such as interest, principal, dividends, stock repurchases, and recapitalisations. At any given date, managers and outside investors face uncertainty about the future cash flow consequences of prior and current investment decisions, and about the investment opportunities and market prices of debt and equity securities that will manifest at future dates. Uncertainty about earnings, investment opportunities, and future security prices give managers incentives to select financial policies that provide the flexibility to respond to unanticipated shocks to these factors. Managers have an informational advantage over outside investors with respect to the firm's investment opportunities and the cash flow consequences of alternative managerial decisions. This asymmetry cannot be eliminated, although over time investors observe managerial decisions and thereby improve their estimates of the consequences of those decisions. According to H. DeAngelo and L. DeAngelo, 2007 asymmetric information permits potentially large and persistent gaps between market prices and managers' assessments of intrinsic values, and these security valuation problems raise firms' costs of external (equity and risky debt) financing, and that internal funds entail costs of their own. Moreover it is stated in their analysis that cash balances both entail agency costs and confers flexibility benefits, thus cash accumulation is no longer uniformly beneficial and investors will pressure firms to limit cash balances to mitigate agency costs while also encouraging managers to maintain a cash cushion that is sufficient to fund moderate unanticipated capital needs that may arise.
2.4 How Firms deal with financial flexibility, growth opportunities and debt
In the vast literature about financial flexibility and specifically according to N. D. Daniel et al, 2008, on average, firms with cash shortfalls treat the maintenance of dividends as a priority and resolve the shortfall primarily with a combination of investment reductions and external debt financing. Nonetheless, as stated in N.D. Daniel et al, 2008 analysis potentially mask important heterogeneity in the manner in which firms resolve cash shortfalls. In their hypothesis they expect that firms with better growth opportunities are less likely to cut investment and more likely to cover the shortfall with external financing and dividend reductions. To proxy for growth opportunities, they compute the ratio of the firm's market value (market value of equity + book value of total assets - book value of equity) to the book value of its assets and sort all payers with a positive shortfall into two groups based on the lagged value of this variable. They concluded that firms with a higher market-to book ratio cover a lower percentage of the shortfall with investment cutbacks than do firms with lower market-to-book ratios (48% versus 70%). Nonetheless, these firms still finance nearly half of the shortfall via reductions in investment relative to expected levels.
Firms with high ratio of debt to assets are presumably more likely to have spare debt capacity, thereby allowing them to borrow funds and avoid large reductions in investment. Similarly, firms with high cash holdings can draw down on these balances without having to resort to extensive investment cutbacks.
Overall, there are some significant cross-sectional differences in how firms resolve cash shortfalls. Consistent with intuition, firms with greater growth opportunities and more financial flexibility finance a greater percentage of the cash shortfall with external financing and a lower percentage with investment cuts than are firms with poorer growth options and less financial flexibility. Reductions in cash balances rarely finance a significant portion of the shortfall, but are larger in firms with higher beginning cash balances.
2.5 Financial flexibility and how to alter the debt by using the choice between dividends and stock repurchases.
One of the most significant trends in corporate finance is the increasing popularity of open market stock repurchase programs. According to M. Jagannathan et al, 1999 repurchases are noticeably more volatile than dividends. They appear to vary procyclically: they were high during the rising markets of the late 1980s, dropped in the recession of the early 1990s and increased during the boom of the mid-1990s. Repurchases are responsible for a disproportionately large fraction of the variation in total payouts. The smoothness of the dividend series combined with the volatility of the repurchase series are consistent with the view that dividends are paid out of sustainable cash flows while repurchases are paid out of temporary cash flows. Repurchases do not appear to be replacing dividends; rather they seem to serve the complementary role of paying out short-term cash flows. Firms with higher operating cash flows are more likely to increase dividends, while firms with higher non-operating cash flows are more likely to increase repurchases. Firms with a higher standard deviation of cash flows are more likely to use repurchases. Subsequent to the payout increase, cash flows of repurchasing firms continue to be lower than those of dividend-increasing firms. Moreover Even though repurchases have not replaced dividends, they have become an important source of payouts.
3. Discussion and conclusions
According to the literature review and research there is evidence provided on the primary sources of financial flexibility. In the face of significant cash flow shortfalls, firms virtually never cut their dividend and finance only a trivial portion of the shortfall via reductions in cash reserves. Instead, these firms rely primarily on external debt financing to resolve the shortfall. As stated in the bibliography It is assumed that faced with a shortfall, firms will temporarily draw down these cash balances so as to avoid costly external financing. Our findings suggest that firms in a liquidity crunch finance only a modest portion of the shortfall by drawing down cash reserves, but do access the external capital market if they appear to have debt capacity. This suggests that financial flexibility in the form of debt capacity has a significant impact on the costs of external finance and that agency costs of cash holdings are economically important.
Firms are reluctant to cut dividends is certainly not new, it is typically assumed that this is a byproduct of dividend policies that are set so that it is unlikely that the firm's cash flow would ever necessitate a reduction in the dividend. In the event of such a liquidity crunch, the presumption is that firms would treat investment policy as being of first order importance and treat dividends as the residual. The findings from the literature review strongly contradict this presumption in that firms behave as if the maintenance of dividends is of first-order importance and appear to treat investment policy as more of a residual.
The literature on the interaction of financing and investment decisions commonly assumes that dividend payers are less financially constrained than are non-payers. This assumption is based on the view that faced with a cash shortfall; dividend payers can always cut their dividend to meet investment needs rather than using costly external financing. This view appears to be flawed in the sense that once firms pay dividends, they appear to be more likely to cut investment than to cut dividends.
Debt capacity represents the primary source of financial flexibility. As such, they have implications for corporate capital structure dynamics. A transitory role for debt financing such that debt ratios increase in response to cash shortfalls, then evolve in subsequent period according to the evolution of the firm's cash flow stream.
