The Business Cycle, Investor Sentiment, and Costly External Finance

Abstract

The recent financial crisis shows that financial markets can impact the real economy. We investigate whether access to finance typically time-varies and, if so, what are the real effects. Consistent with time-varying external finance costs, both investment and employment are less sensitive to Tobin's q and more sensitive to cash flow during recessions and low investor sentiment periods. Share issuance plays a bigger role than debt issuance in causing these effects. Alternative tests that do not rely on q and cash flow sensitivities suggest that recessions and low sentiment increase external finance costs, thereby limiting investment and employment.

Financial Shocks and Corporate Investment in Emerging Markets

“…If so, cash flow could become informative to investment not only because of the presence of financial frictions but also because it may contain information about firm profitability that would not be fully captured by Q . However, as in McLean and Zhao (), our baseline results are unlikely to be affected by this critique because we focus on the change in the MPI before and after an external financial shock. Hence, unless the external shock can change the measurement errors in Q , the effects of measurement errors should cancel out when calculating the change in the MPI .…”

“…For each firm, we define firm‐level variables following the literature (e.g., Kaplan and Zingales , McLean and Zhao ). The investment ratio ( ι ) is capital expenditures (purchase of fix assets) within the year, normalized by capital stock (total net property, plant, and equipment) at the beginning of the year.…”

Cash Flows, Currency Risk, and the Cost of Capital

“…More specifically, cash flow is total earnings before extraordinary items, plus equity's share of depreciation, plus deferred taxes (if available). Following McLean and Zhao (), we standardize cash flows by total assets. For robustness, we also standardize cash flows by sales or do not standardize cash flows at all.…”

Investment, Tobin's Q, and Cash Flow Across Time and Frequencies

“…With regard to business cycle fluctuations, McLean and Zhao () find that investment is more sensitive to Q (cash flow) during business–cycle expansions (recessions), as well as during periods of high (low) investor sentiment.…”