Financial Constraints and Investment Choice: Evidence from Pakistani Firms

ABSTRACT

The main purpose of this study is to investigate that what types of financial constraints a firm faces in the process of investment moreover, this study also measured the impact of Internal Financial constraints (IFC) and External Financial Constraints (EFC) on investment choice among Pakistani firms. This study consist of secondary data and research design is explanatory. Following purposive sampling, 52 listed companies (listed at Pakistan Stock Exchange) is sampled, these firms are chosen from 9 major economic groups which are currently producing output in Pakistan, these are categorized as Chemicals, Telecommunication, Textile, Pharmaceutical, Metal and Mining, Tobacco, Fuel and Energy, Cement industry and Sugar. The study includes five years data throughout 2013-2017. The findings reveal a positive association between the size of firm and investment.  Furthermore, a negative relationship is investigated between the age of firm and investment. Moreover, another negative relationship is observed between the dividend payout ratio and investment. The findings are crucial for managerial practices in anticipation of appropriate investment choice. The outcomes reveal that if the size of firm increases at that time firms would take part in investment choice, contrary the negative relationships expresses that when the firms get matured, then they tend to invest less in the expansion of the business. The financial constraints and investment choice are hardly studied specifically in the context of Pakistan. This study provides a prospect for financial managers to invest in right time along with an appropriate choice of investment for generating returns and minimizing risk.

Keywords: Financial Constraints, Investment Choice, Dividend Payout

INTRODUCTION

It is always the question for financial managers that how they would choose an optimal line of cash flows by which they would have the accessibility of funds to finance the firm’s operations. Though this is the case of dependency of investment, or it refers to financial constraint. Moreover, the investment of the firm depends on external and internal financing. Therefore, Managers analyze the issues to choose the best fitting line for investment. The research findings of Fazzari, Hubbard and Petersen (1988) refer to financial constraints. According to them if the firm has no choice to finance the firm from external sources (External financial constraint) so the firm would be dependent on the internal funds, and it would be riskier for the financially constrained firm to use internal funds. Therefore, it is necessary for financial managers to make sure themselves in making an appropriate ground for investment.

Furthermore, most of the risk-averse firm also choose internal financing. However, these firms have smooth accessibility to get funds from external sources but owing to the risk-averse landscape of financial managers they give preference to internal funds; simply, this financial constraint may be created by financial managers on their own. In case of immediate need of funds, these types of financial constraint firms keep some amount of reserve in shape of “Cash” to meet the requirements of business operations.

The firms having an unambiguous stream of cash flows will tend to use more external funds, (Almeida, Campello & Weisbach, 2004). Moreover, Almeida and Campello (2007) depicts that secured cash flows refer to less volatility in factors which can affect the investment, though, a better certain condition of financial manager emphases the firm’s financial behavior on the external side.

Precisely, Almeida, Campello and Weisbach (2004) and Almeida and Campello (2007) investigated the “Cash” value for high financial constraint and less financial constraint firms. It seems to be the relation that less financial constraint firms may have priority in external financings, so they have easy access to collect funds externally. Contrary, financial constraint firms must have needed to maintain the cash reserve for the immediate operations. We found the empirical evidence in several countries like China, Malaysia, and the United Kingdoms. This study focused on 9 main economic groups which are currently giving the output in Pakistan; these groups are categorized as Chemicals, Telecommunication, Textile, Pharmaceutical, Metal and Mining, Tobacco, Fuel and Energy, Cement industry and Sugar. Every economic group wants to be better in their investments. However, this is the only matter of discussion that what factors effects their investments and what financial constraints these firms are facing in the territory of Pakistan. This study is divided into two proportions. The first proportion of this study simply gives the identification of the relationship between External Financial Constraints (EFC) and Internal Financial Constraints (IFC) and investment.

Moreover, the second proportion examines the effects of these constraints on investment in several economic groups of Pakistan which are currently giving the output. This paper is organized in five distinct sections; the sequence of rest of the paper is as follows except section I (Introduction). Section II refers to a detailed literature review; it consists of a brief overview of various empirical studies related to financial constraints and investment alternatives. Furthermore, Section III  is based on a study model and  Section IV describes research data and methodology which we applied to prove the study hypotheses and Section V gives a brief view of study results. Finally, Part 6 refers to the conclusion of the study.

LITERATURE REVIEW

Literature of finance gives the evidence that the topic “Financial constraints and investment” is broadly examined in the last decade. Numerous studies are being conducted from different perspectives. A significant study had investigated in Spain by (Hernando & Tiomo 2002). They empirically found a significant relationship between financial constraints and investment in favor of the Spanish firm. The finding proposes that excess of investment leads to non-payment of dividends which means that the firms are financially constrained because they have not enough stream of cash inflows from the invested amount, so it results in a deficiency of dividend payouts.

Furthermore, the insignificant relationship between the volatility of investment and financial constraints is investigated in the USA. Huang (2002) had sampled the non-financial sector which was listed in the US stock market. Moreover, a time series analyses were investigated for UK firms. Financial behavior of UK firms consists of several ranges of investment volatility and financial constraints (Guariglia, 2008). The time series had shown a linear relationship from 1993 to 2003. Whited (2006) reported time value of the investment. He stated that external financial constraint might be possible when the financial market turns to downward. He depicts that firms are more likely to expand business projects from the money of outsider (borrowings) but if the financial market does not perform well, so it creates an external financial constraint in the investment process. Hence, he supported financial constrained of the firm by the time value.

Firms are different; therefore, the changing pattern of firms affect the stream of cash flows (Investment), and that effect could not be identical for every firm, and it leads to different intensities of financial constraints firm by firm (Chen, 2007). This investigation was conducted with a sample of 815 firms which are listed in China for 6 years (1998-2004). China is world famous country in the industrialization concept, Chen (2007) investigated the financial constraints of Chinese firms on two dimensions, the first dimension refers to those firms which are under the government control and the second dimension directs without state intervention. They investigated that under the Regional development policy of China, industries are divided into three poles, eastern pole, central pole and western pole. The findings suggest that firms situated in eastern and central poles have strong more financial constraints compared to the western pole.

Furthermore, the stated that government-controlled firms’ investment behavior is different from without state-controlled firms. The investing behavior of state-controlled firms does not depend on the availability of cash. Therefore, the large-scale firms are under government control. Whereas non-state-controlled firms have a dependency on cash flows in investment. Hence the volatility of investment makes some sort of financial constraints for them. Another study was conducted in USA based manufacturing firms to analyze the impact of efficient financial markets and financial constraints on the investment and cash flow volatility. “If the markets are not efficient (Non-Disclosure) which is subjected the problems of undervaluation and overvaluation issues in financial securities which may be lead to the financial manager on the mispricing of security” (Chang, Tam, Tan & Wong 2007). They investigated that financially constrained firms have high volatility in investment cash flow when financial markets are not efficient compared to unconstrained firms. Moreover, they stated that investment could be secured when markets are undervalued and could be less secured in overvaluation.

Furthermore, another study is conducted on the relationship of financial constraints, tangibility, and investment. The finds suggest that firms which have more tangibility have easy access to collect funds on the collateral to their assets, they face less financial constraints (Almeida & Campello, 2007). Moreover, the study investigated that strong tangibility leads to a fine confidence level of an outsider (lender) to realize funds and firms also have investment alternatives to roll over the best investment opportunity which can give some suitable future returns. It enhances the risk-bearing level in investment behavior (Almeida & Campello, 2007). Contrary, some of the firms are weak intangibility (Fixed Assets) so they face external financial constraints, and they depend only on the internal cash flows. Size of the firm is also being discussed in several studies. The size of the firm is positively correlated with the investment. Simply, the size of the firm shows a positive relationship to investment, bigger size of firm leads to large investment and vice versa. They used natural logarithm of sales as the measure of firm’s size. More of the sales increase the strength of the firm to invest from the internal sources which are sometimes better for the firm but not in all times. If a firm invested in a project from an internal source, it decreases the free cash flow of firm.

Meanwhile, it affects the dividend payouts. Knight, Ding and Guariglia (2010) conducted a time series analyses of Chinese firms from the period of 2000 to 2007 along with sample size of 12000 firms from non-financial sector listed in Chinese stock market. They cited the significant positive relationship between financial constraint and investment, and working capital. Working capital is simply a process in which a firm decides on short-term investments. The study found that how firms adjust their short-term needs of funds in financial constraints with investment variations. They draw a framework in which firms categorized by their age; they linked the age of the firm on investment behavior. It refers that the firms which are older or large they have less financial constraints and less volatility in cash flows so that they can meet requirements of working capital with no trouble. On the opposite side, newly started firms face complications in internal financing and external financing as well (Financial constraints), hence their investment cash flows have much volatility, so it is tricky for them to adjust the working capital requirements from the running operations. Age of firm is directly proportionate to the growth of the firm (Bottazzi & secchi, 2006). They investigated the Italian firms that the age of firm has a significant relationship to the investment of firms and financial constraints.

 

  INVESTMENT
  DIVIDEND PAYOUT    
  FIRM’s AGE  

 

 

 

 

 

                       

  FIRM’s SIZE

 

 

 

 

 

 

 

 

Figure 1: Theoretical Framework

METHODOLOGY

The current study examines the impact of financial constraint on the investment choices of companies operating in Pakistan. In the observation of variables, we have taken some main economic groups of Pakistan which are listed in Pakistan Stock Exchange (PSX) with the time series for the period of 2013 to 2017. This study focused on 9 main economic groups which are currently giving the output in Pakistan; these groups are categorized as Chemicals, Telecommunication, Textile, Pharmaceutical, Metal and Mining, Tobacco, Fuel and Energy, Cement industry and Sugar. From these economic groups, the data of 52 listed companies (listed in the Pakistan Stock Exchange) have been taken from 2013 to 2017 yearly (Calendar/Fiscal).

The Hypothesis of the Study

Following are the hypothesis of this study

H1: IFC has a significant impact on investment.

H2: EFC has a significant impact on investment.

This study refers to investment as the dependent variable and Dividend payout ratio, the age of the firm, firm’s size as independent variables while to investigate the relationship between financial constraints and investment. Moreover, we have used multiple regression analyses Following is the regression model of the study.

INV= ₀ + ₁DVP + ₂AG + ₃SZ + µ

Where:

₀        = Constant Value

INV     = Natural Logarithm of Tangible Assets

DVP    = Dividend Payout Ratio

AG      = Firm’s Age

SZ       = Firm’s Size

DATA ANALYSES

We have described the data more precisely through descriptive statistics. Descriptive statistics help out to understand the ranges of the observed data. We have used minimum, maximum, mean and standard deviation columns in following Table 1.

Table1: Descriptive Statistics

Variables N Minimum Maximum Mean Std.Deviation
Investment 193 -4.13 8.81 4.18 1.75
Dividend Payout Ratio 193 4.27 12.01 7.48 1.36
Firm’s Age 193 -4.72 7.61 3.51 1.51
Firm’s Size 193 0.58 3.66 2.98 0.56

The above Table 1 refers to descriptive statistics. The first column shows the list of all variables (Dependent and Independent) which we have taken in this study. Furthermore, the above table shows the “N” column which refers to the number of observations in this study; we took the sample of 193 firms from the main economic groups which are currently giving the output in Pakistan from 2013 to 2017. Moreover, the other columns like minimum, maximum, mean and std. Deviation made simple to understand the data for Investment (Dependent Variable) and Dividend payout ratio, Firm’s age, Firm’s Size (Independent Variables). It is observed in the above table that the there is less deviation to mean values in all the variables. We have also applied a well-known test “Durban-Watson Test” to analyze the presence of autocorrelation in the residuals named after James Durbin & Geoffrey Watson, 1950.

Table 2: Autocorrect Test (D-W)

1 2 3 4 5 6
DW 1.21* 1.37* 1.72 2.19 2.15 1.79
Pr<DW (0.00) (0.00) (0.12) (0.69) (0.59) (0.27)
Pr>DW (1.00) (0.99) (0.87) (0.30) (0.40) (0.72)

In the above Table-2, we can observe the presence of autocorrelation in the data set till 2nd order. The statisticians Cochrane and Orcutt, (1949) have given a method from which we can remove the autocorrelation error. Therefore, we have applied this method to adjust and remove the error of autocorrelation. The following Table 3 shows 36 lags in the columns in which there is no autocorrelation.

Table 3: Adjusted Autocorrect (Cochrane-Orcutt Method)

6 12 18 24 30 36
ϰ² 3.56 7.44 16.70 21.90 30.12 42.55
p-value (0.49) (0.53) (0.31) (0.32) (0.37) (0.11)
Df 4 10 16 22 28 34

The following Table 4 is showing the results of Multiple regression analyses. Moreover, we have used ordinary least square (OLS) approach. After the elimination of autocorrelation error, we have used a regression model to analyze the goodness of fit and significance level. The table-3 consist Beta values (coefficients), t-stat, and probability column. In the bottom of the table-3, we have stated Adj: R square, F-Statistics and confidence interval to understand the relationship between dependent variable (Investment) and independent variables (Dividend Payout Ratio, Firm’s Age, Firm’s Size).

Table 4:  Regression Model Summary

Variables Beta t-stat Probability VIF
Investment -0.03 -0.03 (0.86)
Dividend Payout Ratio -0.79* 9.68 (0.00) 1.02
Firm’s Age -0.11** -1.68 (0.06) 1.01
Firm’s Size 0.37* -2.13 (0.01) 1.01
Adjusted R-Square 0.71 F-Statistic 3.11 0.00
* Significant at level 0.05 ** Significant at level 0.01

The above Table-4, the results show that the first independent variable, dividend pay-out has a negative relationship to investment and this relationship is significant. This result simply defines the financial constraint of firms; it means that the firms having dividend decision reduces the amount of investment for further expansion as we know that when firms compute the earnings available for common stockholders at that time firms decide whether to pay dividends or not. Once if they decide to pay a dividend, so it reduces the retained earnings which leads to a financial constraint while investment. This result of study matches the findings of Huang (2002). Furthermore, it is investigated that firm’s Age also has a negative relationship to investment which means that a firm’s age can also be a financial constraint. The reason is when the firm is newly started it consists many opportunities to expand the business for better future growth, but with time when the firms get older, they ignore to invest further in the expansion. It shows the maturity stage of the firm in which most of the firms do not want to expand the business projects. This study investigated the stated behavior of firms in Pakistan regarding the firm’s age. Finally, the firm’s size shows a positive relationship to investment. It simply states that larger the firm’s size greater the investment could be. The finds suggest that large firms have more capacity to invest in long-term projects compared to small firms. Moreover, large firms face less financial constraints because they have a strong position in their tangibility. However, it helps the large firms to borrow from external sources more frequently. Contrary, small firms have a nominal range of assets face external financial constraints due to less confidence level of external investor. Therefore, they may not invest sufficiently compared to large firms. Moreover, that firm’s Age has also a negative relationship to investment which means that firm’s age can also be a financial constraint. The reason is when the firm is newly started it consists many opportunities to expand the business for better future growth, but with time when the firms get older, they the ignore to invest further in the expansion.

CONCLUSION AND RECOMMENDATIONS

This study investigated the relationship of dividend payout, firm’s age, firm’s size towards investment. We have taken these variables to observe the financial constraints of Pakistani firms over investment. This study focused on 9 main economic groups which are currently giving the output in Pakistan; these groups are categorized as Chemicals, Telecommunication, Textile, Pharmaceutical, Metal and Mining, Tobacco, Fuel and Energy, Cement industry and Sugar. From these economic groups, the data of 52 listed companies (listed in the Pakistan Stock Exchange) have been taken for the period 2013 to 2017 yearly (Calendar/Fiscal). The results show that the dividend payout has a negative relationship to investment and this relationship is significant. This result simply defines the internal financial constraint of firms; it means that the firms having dividend decision reduces the amount of investment for further expansion as we know that when firms compute the earnings available for common stockholders at that time firms decide whether to pay dividends or not. Therefore, once if they decide to pay a dividend, so it reduces the retained earnings which leads to a financial constraint while investment. This result of study matches the findings of (Zhangkai Huang, 2002). Lastly, the firm’s size shows a positive relationship to investment. It simply states that larger the firm’s size greater the investment could be. The finds suggest that large firms have more capacity to invest in long-term projects compared to small firms. Moreover, large firms face less financial constraints because they have a strong position in their tangibility. However, it helps the large firms to borrow from external sources more frequently. Contrary, small firms have a nominal range of assets face external financial constraints due to less confidence level of external investor. Therefore, they may not invest sufficiently compared to large firms. For future research, it would be better to analyze dividends into two categorical formats, (Non-Dividend firms and Dividend Firms). It separates those firms which are consecutively paying dividends from the non-paying firms. Moreover, future studies in Pakistan regarding financial constraints may be studied with some more variables like the Institutional setting of Pakistan, Low savings ratio in commercial banks, etc.

REFERENCES

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Cochrane, D., & Orcutt, G. H. (1949). Application of least squares regression to relationships containing auto-correlated error terms. Journal of the American Statistical Sssociation44(245), 32-61.

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