Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK

G. Pawlina, L.D.R. Renneboog

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Abstract

We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive.Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium?We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow.The magnitude of the relationship depends on insider ownership in a nonmonotonic way.Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring.Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets.We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages50
Volume2005-23
Publication statusPublished - 2005

Publication series

NameCentER Discussion Paper
Volume2005-23

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Agency costs
Asymmetric information
Investment-cash flow sensitivity
Cash flow
Managers
Financial institutions
Blockholders
Equity
Insider ownership
Market demand
Power indices
Capital markets
Efficient frontier
Monitoring
Agency problems
Informational asymmetry
Investment policy
Risk premium
Government
Free cash flow

Keywords

  • investment-cash flow sensitivity
  • ownership and control
  • asymmetric information
  • liquidity constraints
  • agency costs of free cash flow
  • large shareholder monitoring
  • Shapley values

Cite this

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title = "Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK",
abstract = "We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive.Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium?We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow.The magnitude of the relationship depends on insider ownership in a nonmonotonic way.Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring.Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets.We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.",
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Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK. / Pawlina, G.; Renneboog, L.D.R.

Tilburg : Finance, 2005. (CentER Discussion Paper; Vol. 2005-23).

Research output: Working paperDiscussion paperOther research output

TY - UNPB

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AU - Renneboog, L.D.R.

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AB - We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive.Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium?We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow.The magnitude of the relationship depends on insider ownership in a nonmonotonic way.Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring.Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets.We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.

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KW - ownership and control

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KW - liquidity constraints

KW - agency costs of free cash flow

KW - large shareholder monitoring

KW - Shapley values

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