Financial flexibility is the ability of an organisation or a firm to respond to unexpected changes in cash flows and investment opportunities.
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.
Empirical studies, as shown by S. Boyun 2007, in the capital structure find a positive relationship between firm size and leverage. Small firms gain most of their value from growth so it is they loose really easily their value when a small firm is experiencing a financial distress. A different point of view suggests that cash holdings in different countries could be particularly costly for the reason of agency problems. So the trick for value - maximising organisations is to maintain short cash flow balances in order to safeguard unused debt ability in a period of financial crisis and need. Moreover these firms and organisations keep stable dividend income rates so they could keep on having entry to the capital market. All these treatments used by firms, contribute that cash flow shortfalls could be remedied by 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
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 are explained in various literature sources. 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.
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, firms with net cash decreasing focus their effort to protect the dividends of the firm as a main concern and find the solution of the problem in external funding. Nonetheless, as stated in N.D. Daniel et al, 2008 Firms with high ratio of debt to assets are hypothetically more possible to have additional debt capacity, so these firms are more flexible in adding more funds to their budget and dodge the decrease in investments. Similarly, firms with high cash holdings can draw down on these balances without having to resort to extensive investment cutbacks.
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
This study was a research about the financial flexibility of firms and organisations and how they manage the equity and debt when they endure financial shortfalls. The firs section was an introduction about the meaning of financial flexibility and the way firm decrease or increase debt in order to overcome finance difficulties and the role of equity in this matter. The second section is the literature review of the vast bibliography about financial flexibility. This section is divided in subsections about financial flexibility and investment, financial flexibility and stock listing, financial flexibility and stock funds, financial flexibility and debt and financial flexibility and debt handling by reducing dividends and equity.
According to the literature review and research there is evidence provided on the primary sources of financial flexibility; debt capacity represents the primary source of financial flexibility. As noticed in the literature review when organisations and corporate firms have lack of net cash, they never decrease their dividends but they overcome the financial problem by supporting a portion of the shortfall by reductions in cash reserves. Moreover these firms rely primarily on external debt financing to resolve the shortfall.
Nevertheless firms in a liquidity crisis do not reduce their dividends but they finance a small portion of the shortfall using any available cash reserves, also firms and organisations tend to find cash resources in the open market if they have the ability of a high debt capacity. So concluding this study there is evidence that financial flexibility in the structure of debt capacity has a great blow on the costs of external finance.
