MANAGERIAL INCENTIVES, CAPITAL EXPENDITURES AND CASH FLOW

Abstract

Misalignment in the incentives of a firm’s managers and shareholders is expected to increase the sensitivity of a firm’s capital expenditures to its cash flows. Managers, who have a greater propensity to act against the interests of the firm’s shareholders, are more likely to overinvest the firm’s free cash flows in unprofitable investments. Such managers are also more likely to display excessive conservatism in the financing decisions of their investments, due to a misguided perception of imperfect substitutability in internal and external funds, even when no significant differences in the cost of the two alternative financing sources exists. Thus, these managers have a greater propensity to prolong their firm’s investments until adequate cash balances have been accumulated. Investors in external capital markets are also less likely to be induced to invest their funds in firms with selfserving managers due to greater risk of misallocation of their funds by the managers. Consequently, such firms are expected to face more costly external financing in capital markets and correspondingly, be more reliant on their retained earnings to finance their investments. In this study, I find no evidence to support the notion that managerial incentives have an impact on a firm’s investmentcash flow sensitivity. Instead, I find that firms with managers who are more likely to act in the interests of the firms’ shareholders and that are correspondingly, more likely to be financially unconstrained, have higher investmentcash flow sensitivities. I interpret this finding as consistent with Kaplan and Zingales’ (1997) argument that the investmentcash flow sensitivity of a firm is not a reliable indicator of its financing constraints.