Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

Hart, Oliver, and John Moore, “Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management,” The American Economic Review, Vol 85, No 3 (1995), 567-585.

  • Assume that managers will always invest in every project (due to empire-building, prestige, resumé-building, etc.)
    • If managers have too much cash flow, they will invest in bad (negative NPV) projects along with good ones.
    • Debt can fix the agency problem by forcing managers to pay out cash flows before investing.
  • The debt overhang problem
    • If managers have too little cash, they will have to forgo investing in good projects.
    • If managers have too much debt, they will not risk losing their job and, again, will forgo investing in good but risky projects.
  • Long-term debt can outperform complicated contracts in solving agency problems.
    • Contracts that attempt to align manager compensation with shareholders’ interests can’t address every agency problem.
    • Long-term debt restricts managers from borrowing against future cash flows to invest in bad projects.

Dynamic Agency and the q Theory of Investment

DeMarzo, Peter M., Michael J. Fishman, Zhiguo He, and Neng Wang, 2012, “Dynamic Agency and the q Theory of Investment,” The Journal of Finance, Vol. 67, No. 6 (2012), 2295-2340.

Purpose:  To introduce an agency problem into the standard q theory of investment; to show that cash flow is not the best predictor of investment.

Motivation:  A large body of literature uses cash flow to predict firm investment levels.  This paper argues that a better proxy is “financial slack,” which is directly related to the agency problem.


  • Productivity is a Brownian motion, and the agent controls the drift but not the volatility.
  • w = W/K is the agent’s total expected payoff per unit of capital, and must be high enough to incentivize the agent to maximize productivity.
  • The level of w depends on λ, σ, and historical firm profitability.
    • λ is a measure of the extent of the agency problem.
    • σ is the volatility of firm productivity.
    • Past productivity raises or lowers w, and the agent loses his job when w = 0.
    • A portion of w is deferred, giving the agent a stake in continued firm success.
  • Investor’s expected payoff per unit of capital, p(w), is a function of how much they pay the agent.
  • Average q is total firm value per unit of capital stock, or qa = p(w) + w.
  • Marginal q, or qm = p(w)wp’(w).
    • Firms invest when marginal q is less than 1, so investment is a function of w. It follows that investment depends upon λ, σ, and past firm performance.
  • “Financial slack” equals w/λ, and is the largest productivity shock the firm can suffer without changing agents.
  • The agent accumulates cash and available credit equal to the firm’s “financial slack,” then distributes excess income to shareholders.


  • Financial slack is a better predictor of investment than cash flow.
  • Average q is higher than marginal q because an increase in capital stock K reduces w, and hence reduces the agent’s [historically determined] incentives to maximize productivity.
  • Financial slack and profitability are substitutes in determining average q.
  • When the firm is profitable, w rises, the agent’s incentives grow, and return on investment increases.
    • Investment is serially correlated.
  • The cost of incentivizing the agent leads to underinvestment in every state of the world.

Why do U.S. Firms Hold So Much More Cash than They Used To?

Bates, Thomas W., Kathleen M. Kahle, and René M. Stulz, 2009, “Why Do U.S. Firms Hold So Much More Cash than They Used To?” Journal of Finance, Vol 64, No. 5 (2009), 1985-2021.

Purpose:  To document the increase in U.S. firms’ cash holdings from 1980-2006 and investigate its causes.

Motivation:  U.S. firms in 2006 hold twice as much cash (as a percentage of assets) than they did in 1980.  The average firm in 2006 has enough cash on hand to pay off all its debts.  This cash buildup has excited considerable popular attention.


  • Firms of all sizes have a much higher cash-to-asset ratio in 2006 than in 1980.
  • This also holds for firms with no foreign income, so repatriation taxes do not explain it.
  • Cash buildup is observed in firms that do not pay dividends, but not in dividend-payers.
  • Firms whose idiosyncratic risk increased saw more growth in cash holdings.
    • Firms in industries that grew riskier
    • Younger firms (with more recent IPOs)
  • As the increase in idiosyncratic risk has reversed in recent years, cash holdings have declined slightly.


  • Data is a sample of 13,599 U.S.-based, nonfinancial, non-utility firms with positive sales and positive assets, over the period 1980-2006 (from WRDS merged CRSP/Compustat database).
  • Look at descriptive statistics of the average cash ratios, with the data segmented by size, industry risk, year of IPO, dividends paid, and net income.
  • Ask whether firms’ cash demand curve shifted or whether firms moved along the curve.
    • Regress cash-to-assets ratio on several firm characteristics (R&D expenditures, size, etc).
  • Connect the rising cash levels to specific firm characteristics.
    • Use Fama-Macbeth regressions with 1980s data to predict cash holdings, based on several firm characteristics, in the 1990s and 2000s.
    • Compare prediction to actual holdings.
  • Examine whether increased cash holdings is due to agency problems.
    • Compare yearly average cash for quintiles based on the GIM index of management entrenchment.


  • Firms whose cash holdings increased the most are newer, do not pay dividends, and are in industries that have become riskier since 1980.
  • Cash holdings rose because inventories fell, R&D expenses increased, capital expenditures fell, and cash flow risk increased.
  • Cash holdings did not increase more quickly for firms with entrenched management.

Do Acquisitions Relieve Target Firms’ Financial Constraints?

Erel, Isil, Yeejin Jang, and Michael S. Weisbach, “Do Acquisitions Relieve Target Firms’ Financial Constraints?” Journal of Finance, forthcoming as of Aug 2014

Purpose:  To ask whether a target company’s access to capital improves after an acquisition.

Motivation:  Managers often cite, as an argument for acquisition, the ability of the acquirer to finance the target company’s investment opportunities.  It is implicitly claimed that the target is financially constrained, but will be less constrained after the takeover.

Findings:  Takeover targets do seem to be financially constrained, and the constraints weaken after acquisition.  Cash holdings in the targets decline by 1.5%, investment levels increase, the sensitivity of cash to cash flow falls from 10.4% to zero, and cash flow sensitivity of investment also falls.  These effects are significant only for independent targets, which were more likely to be financially constrained than targets who were subsidiaries.  In a similar vein, the effects are strongest for the smallest tercile of target firms.

Data/Methods:  Post-acquisition financial data on U.S. companies is not publicly available, but most European countries require subsidiaries to publicly release such information.  The data comprises before-and-after data for 5,187 European companies who were acquired during the period 2001-2008.

  • Measure before-and-after cash policies of the target
    • Cash levels
    • Cash flow sensitivity of cash
    • Cash flow sensitivity of assets
  • Measure before-and-after investment policies of the target
    • Cash flow sensitivity of investments
  • Measure sensitivity of cash in [former] target to cash flows
    • In whole acquiring firm (including former target)
    • In all other departments of acquirer (not including former target)
  • Compare acquisition effects for targets of different size and sales growth, holding acquirer constant
  • Verify whether any effects are observed for firms very similar to the targets, but which were not acquired

Conclusions:  After firms are acquired, they tend to reduce cash holdings and increase investment, and their cash flow sensitivities of both cash and investment decline.  These changes in cash and investment policy are most notable in very small, independent targets and are much less significant for larger firms or subsidiary firms that are acquired.  There are no significant effects for firms that were not acquired, but were comparable to target firms.  These results suggest that financial constraints relax or disappear post-acquisition, especially for the firms most likely to be constrained.  It appears unlikely that this phenomenon is due to the other departments of the acquirer cross-subsidizing the former target’s investments; the easing of financial constraint is probably due to the target becoming part of a larger firm.

The Cash Flow Sensitivity of Cash

Almeida, Heitor, Murillo Campello, and Michael S. Weisbach, 2004, “The Cash Flow Sensitivity of Cash,” The Journal of Finance 59 (4), 1777-1804.

Purpose:  This paper develops a model of a firm’s demand for liquidity, and uses the model to obtain a new measurement of how important financial constraints are in affecting corporate policy.

Theory:  For financially constrained firms, or for firms that expect financial constraints in the future, higher cash flows should lead to more cash on the balance sheet.  For unconstrained firms that do not expect future constraints, the level of cash flows and the amount of cash on the balance sheet should be unrelated.  If this “cash flow sensitivity of cash” can be shown to be correlated with proxies for financial constraint, it will be a useful indicator of the influence of such constraints on firm behavior.

Motivation:  The effects of financial constraints on firm behavior and firms’ financial management are two topics usually studied separately, though they are closely linked.  Most previous literature regarding this link discusses the connection between financial constraints and firm investment demand.  There is a robust debate around this, with no clear consensus on what the empirical evidence means.  One complication with the literature is that current investment demand is correlated with future investment demand (since current investments impact cash flow).  Cash balances are not inherently linked to cash flows, and so are unrelated to future investment demand.  Therefore, the link between cash balances and financial constraints is less problematic to measure.

Empirical Evidence:  Using a large sample of manufacturing firms from 1971-2000, divide firms into subgroups on proxies for financial constraint.  Measure the cash flow sensitivity of cash for each group.


  • Firms exhibiting proxies for financial constraint hold 15% of assets as cash, compared to only 8-9% for firms that are not under [proxied] financial constraint
  • For 4 of the 5 financial constraint proxies, the firms expected to be constrained have the higher cash sensitivity to cash flows
  • Cash flow sensitivity of cash is a useful method for identifying financially constrained firms