Investment Cashflow Sensitivity

Accounting and Finance 57 (2017) 165–197
Investment–cash flow sensitivity measures investment

thirst, but not financial constraint
Kebin Denga, Zhong Dinga, Yushu Zhub and Qing Zhoub

a
School of Accounting, Guangdong University of Foreign Studies, Guangdong, China
b
UQ Business School, University of Queensland, St. Lucia, QLD, Australia
Abstract
Literature streams disagree about the capacity of investment–cash flow

sensitivity (ICFS) to measure both investment thirst and financial constraint.
We argue that ICFS measures the former but not the latter. Therefore, we use
Fazzari et al.’s study (1988) to develop a model to test the relationship between
ICFS and financial constraint, but extend that model using Kornai (1979) to
include investment thirst. We demonstrate: because the ICFS–financial
constraint relationship varies, ICFS cannot measure financial constraint.
Conversely, using a natural experiment of China’s Four Trillion Stimulus
policy, we show ICFS significantly and positively correlates with investment
thirst after controlling for financial constraint.
Key words: Investment–cash flow sensitivity; Financial constraint; Investment

thirst; Overinvestment
JEL classification: G31, G32, C1
doi: 10.1111/acfi.12133
1. Introduction
The concept of soft budget constraint and investment thirst was first
introduced by Kornai (1979, 1980, 1986). The two concepts are closely linked
with investment–cash flow sensitivity (ICFS). Kornai suggests that investment
thirst leads to overinvestment, and this overinvestment syndrome is prominent
Kebin Deng would like to acknowledge the financial support from the National Social
Science Foundation of China (Grant No. 14BJY216).
[Correction added on 19 May 2015, after first online publication: The fourth author’s
first name has been changed from ‘Clara’ (English) to ‘Qing’ (Chinese).]
Received 3 March 2015; accepted 27 March 2015 by Kathy Walsh (Editor).
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166 K. Deng et al./Accounting and Finance 57 (2017) 165–197
in economies characterised by soft budget constraint. According to the

previous literature, a positive relationship between ICFS and overinvestment
can be pinned down.1 Thus, in this paper, we hypothesise a positive
relationship between ICFS and investment thirst. We focus on the intuition
and then develop a theory model to prove this positive relationship. Lastly, we
test this model empirically using a sample of firms in the Chinese economy that
are characterised by soft budget constraint.
ICFS was originally proposed as a measure of financial constraint in the
seminal work of Fazzari et al. (1988).2 Their suggestion of a positive
relationship between ICFS and investment has been supported by empirical
evidence such as D’Espallier and L opez-Iturriaga (2009). The positive
relationship, however, has been challenged by increasing evidence suggesting
that less financially constrained firms are associated with greater ICFS (see
Hoshi et al., 1991; Kaplan and Zingales, 1997; Beatty et al., 2007). Moreover,
some recent studies based on time series evidence in the U.S. markets have
found declining and disappearing trends in ICFS (see Allayannis and
Mozumdar, 2004; Agca and Mozumdar, 2008; Brown and Petersen, 2009;
Chen and Chen, 2012).3 These authors hence conclude that ICFS cannot be a
good measure of financial constraint.
Therefore, we disentangle the relationship between ICFS, investment thirst
and financial constraint under the framework of Fazzari et al. (1988) by
extending that model using Kornai (1979) so as to include investment thirst. In
Section 3, we show that the ICFS–financial constraint relationship varies. The
varying relationship supports the finding in recent studies that ICFS cannot be
a good measure of financial constraint. To ascertain the relationship between
ICFS and investment thirst, we develop in Section 4 a model and prove that a
hypothesised positive relation exists between them theoretically. In Section 5,
we design an empirical test using a natural experiment setting of China’s Four
Trillion Stimulus policy announced in 2008;4 this finds a significantly positive
relationship between ICFS and investment thirst after we control for financial
constraint (see Section 6). Further robustness tests such as subperiod regres-
sion, using GMM estimation method instead of OLS presented in Section 7,
suggest our results are robust. By taking these steps theoretically and
1
See discussions on the relationship between ICFS and overinvestment in Section 2.
2
An incomplete list of relevant studies includes Fazzari et al. (1988), Vogt (1994),
Kaplan and Zingales (1997), Kaplan and Zingales (2000), Moyen (2004), Chen and
Chen (2012), Sheu and Lee (2012), Chan et al. (2013), Chen et al. (2013), Poulsen et al.
(2013), D’Espallier et al. (2014), Tam (2014).
3
As a proxy for investment opportunities, the role of Tobin’s Q is also a focus in these
studies on ICFS.
4
The detailed effects of the ‘Four Trillion Stimulus’ investment are shown in Ouyang
and Peng (2015).
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K. Deng et al./Accounting and Finance 57 (2017) 165–197 167
empirically, we show that ICFS is a good firm-level measure of investment

thirst.
2. Background and literature review
2.1. Soft budget constraint
According to Kornai (1979, 1980, 1986), investment thirst is driven by soft

budget constraint. A soft budget constraint can occur for three reasons: first,
when investors lack the wherewithal to ensure an enterprise stays on budget;
second, when the investment plans proposed by the manager are ex-ante
efficient; and third, when the manager overinvests at his or her own volition.
The issue therefore with soft budget constraint is that it may motivate
managers to follow irresponsible incentives and thus risk enterprise finance
without adequate surveillance (Dewatripont and Maskin, 1995; Qian and
Roland, 1998). The soft budget-constraint problem is especially prominent in
transitional economies. Qian and Roland (1998) model the relationship
between soft budget constraint and federalism tailored for the China economy
to show that soft budget constraint significantly characterises Chinese firms.
This is also why we chose Chinese markets to test the relationship.
2.2. Investment thirst, free cash flow and overinvestment
Investment thirst, therefore, arises from two particular investment

approaches: first, when firms characterised by soft budget-constraint overin-
vest, and second, from managers’ investment impulsion for short-term gains.
The often-researched relationship between overinvestment and cash flows is
derived from Jensen (1986) theory paper on free cash flows (FCFs). FCFs are
considered cash flows beyond those required to fund all projects with positive
net-present values. Lang and Litzenberger (1989) find a significantly positive
relationship between the extent of managerial overinvestment and market
reaction. They conclude that overinvestment denotes that the situation firms
possessing high FCFs are investing in unprofitable projects.
Furthermore, Richardson (2006) creates a measure of overinvestment to
provide direct empirical evidence of a significantly positive relationship
between FCFs and overinvestment. Therefore, the positive relationship
between FCF and overinvestment is valid both theoretically and empirically.
Vogt (1994) investigates the over- and underinvestment effects of ICFS to find
that, for large firms of low dividends, ICFS signifies overinvestment, while
ICFS in small firms of low dividends, it indicates financial constraint. Such
evidence suggests a positive relationship between ICFS and overinvestment.
Although both streams of theories indicate a positive relationship between
ICFS and overinvestment, these theories vary in three ways: (i) the investment
thirst theory introduced by Kornai (1979, 1980, 1986) stresses the necessity of
© 2015 AFAANZ
soft budget constraint and expansion impulsion, while Jensen (1986) FCF
theory does not. Instead, Jensen attributes the main reason to the agency
problem induced by free cash flows. (ii) Soft budget constraint in a firm refer to
the situation whereby the manager violates his or her promises to investors
about using investment cash flows previously budgeted for (e.g. the original
investment plan would have been considered efficient by investors, while the
investment in violation ex post is not). This occurs because of a lack of
surveillance received by managers, whereas FCF is linked to investments after
the investment plan promised by the manager has been executed. (iii) While we
predict that investment thirst is closely related to ICFS, this is not necessarily
the case for FCFs. Investment thirst induces a firm to invest eagerly, resulting
in a higher level of ICFS. In contrast, FCFs without monitoring relax the
direction of investments and hence do not necessarily change the sensitivity of
investment–cash flows. Therefore, the point is that overinvestment caused by
investment thirst is closely related to ICFS, while overinvestment caused by
FCF may not be.
Our study differs from the existing literature in three significant ways. First,
almost all the existing finance studies explain the overinvestment problem
within the framework of the FCF theory developed by Jensen (1986).5
However, we find the investment thirst theory from the macroeconomics work
of Kornai (1979, 1980, 1986) better explains the overinvestment phenomenon
in transitional economies such as China.
Second, we discover that ICFS validly measures investment thirst at the firm
level. In existing macroeconomics studies (see Lee et al., 2012), the ratio of
incremental capital to output is commonly used to measure investment thirst at
the country level. However, no analogous index at the firm or industry level has
been offered. We propose that investment–cash flow sensitivity (hereafter
‘ICFS’) is a good firm-level measure of investment thirst.
Third, we find that the ICFS index combines the effects of financial
constraint and investment thirst on investment, whereas many of the existing
studies do not discern these two effects.6 In this paper, our empirical tests are
designed in a way such that the effects of investment thirst and financial
constraint on ICFS can be separated, and therefore, the relationship between
investment thirst and ICFS can be directly tested.
Correspondingly, our findings enrich the literature in three main ways. First,
we show the connection between ICFS and investment thirst theoretically. For
example, we propose that ICFS is more closely related to investment thirst than
financial constraint. Second, we present evidence to demonstrate that in a
transitional economy like China, in which firms face severe financial constraint
5
See Richardson (2006) for a detailed survey.
6
See Vogt (1994), Alti (2000), Almeida et al. (2004), Moyen (2004), Chen and Chen
(2012), Lee et al. (2012), Han and Pan (2015).
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and exhibit it concurrently with investment thirst, ICFS measures investment

thirst after financial constraint is controlled for. Third, using the natural
experiment setting we have chosen for this research offers two benefits: it makes
our empirical results less prone to endogeneity problems;7 second, the empirical
findings support our conjecture that ICFS is a good measure of investment
thirst.
3. The relationship between ICFS, investment thirst and financial constraint
According to Kornai (1979, 1980, 1986), investment thirst is driven by two

factors: the behaviour of short-term expansion in firms and soft budget
constraint. The former is related to the risk-seeking preference of managers,
while the latter relates to the misuse of investment funds by managers provoked
by a lack of surveillance from investors. For example, the manager may be
directing budgeted funds to unplanned investments that violate his/her ex-ante
promises to shareholders.
In this section, we illustrate the relationship between ICFS and investment
thirst figuratively, followed by a model in the next section to identify their
relationship in theory. We propose that a higher level of ICFS found in a firm
at least relates to one of the four following factors: (i) a manager with a higher
risk-seeking preference, (ii) more severe levels of agency problems caused by
soft budget constraint, (iii) more investment opportunities or (ii) higher levels
of financial constraint.
Following Fazzari et al. (1988), Figure 1a depicts the relationship between
the marginal cost of investment financing and the total amount of investment
financing. The difference between marginal cost of internal financing and
marginal cost of external financing, that is, the slope of the dashed line CI,
indicates the level of financial constraint. The solid line HI represents the
demand line of investment financing (as well as the marginal benefit from
investment for a firm). The ratio of DI/DW hence conveys ICFS, according to
Fazzari et al. (1988).
Figure 1b plots the effect of financial constraint on ICFS. When the firm
encounters a higher level of financial constraint, the line CI moves rightward to
C’I and becomes steeper. Moreover, if the HI line remains at the same position,
the ratio DI/DW (indicating ICFS) will rise, as discussed in Fazzari et al.
(1988).
However, in most situations, line HI would change with line CI rather than
maintaining its original position. In reality, higher levels of financial constraint
result in not only a higher valued slope of CI, but also higher uncertainty in CI.
Therefore, the increase in financial constraint is not just closely related to rising
external financing costs, but also shows that an increase in investment risk
7
See the discussion on the use of natural experiments in research confronted with
endogeneity problems in Gippel et al. (2015).
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(a)
Marginal
cost of
financing
HI
CI
External financing
Marginal
cost of
internal
financing
ƸW ƸI
Total investment financing
(b)
Marginal
cost of
financing
CI
HI
CI
External financing
Marginal
cost of
internal
financing
ƸW ƸI
(c)
Marginal
cost of
financing
C’I
HI
H’I
External financing
Marginal
cost of
internal
financing
ƸW
ƸI
Figure 1 (a) The relation between the marginal cost of financing and the total amount of
investment financing. (b) Investment-cash flow sensitivity and financial constraint. (c) Investment-
cash flow sensitivity, financial constraint and investment-demand. [Correction added on 19 May
2015, after first online publication: Figure 1 label captions have been removed from the images.]
© 2015 AFAANZ
would change the demand line, HI. Specifically, when managers encounter
higher levels of financial constraint, they will also change investment demand,
which makes HI steeper and move to the left; H’I is so depicted in Figure 1c.
Consequently, the ratio of DI/DW would shrink and thus not change given the
level of financial constraint.
To sum up, the value of ICFS depends on the comparative slope of HI to
CI. The slope of CI depends on the level of financial constraint, while the
slope of HI depends on three other factors besides financial constraint,
notably: (i) the short-term expansion behaviour determined by the risk
preference of managers: as indicated in Figure 1c, the higher the risk-seeking
preference of a manager, the flatter the HI line will be and will thus move
further to the rightward position; (ii) soft budget constraint can cause
investor infringement: soft budget constraint by nature occurs as a type of
agency problem between investors of a firm and the firm manager.
Therefore, higher levels of soft budget constraint correspond to a flatter
and more rightward position of HI;8 and (iii) investment opportunities: more
investment opportunities push HI further to the right-hand side and flatten
it. Because previous works on ICFS emphasise the impact of financial
constraint and investment opportunities but overlook the role of soft budget
constraint and managers’ risk-seeking preferences, this paper approaches this
research accordingly.
Soft budget constraint in a firm and the risk-seeking preference of its
manager are related to the characteristics of investment thirst (Kornai, 1979,
1980, 1986). As previous studies on ICFS focus mainly on investment
opportunities and financial constraint in explaining the level of ICFS, little
attention has been allocated to soft budget constraint and risk-seeking
preferences of a manager. In particular, research into soft budget constraint
after controlling for investment opportunities with measures, such as Tobin’s Q
and sales growth rates, has led those involved to debate the relationship
between ICFS and financial constraint acrimoniously.9 From what is shown
above, financial constraint, affects the slope of HI and CI simultaneously, thus
suggesting that the relationship between ICFS and financial constraint is
unclear. On the other hand, soft budget constraint and managers’ risk-seeking
preferences only affect HI, but not CI. Consequently, ICFS changes in the same
direction as investment thirst. Furthermore, even if financial constraint can
affect ICFS after controlling for the effect using reliable financial constraint
measures documented in the literature – we use the SA index and the WW
8
From Figures 1–3, as there is no clear monotonic relation between free cash flows and
ICFS, the increase of free cash flows might not raise the amount of W and I, nor the
slope of HI.
9
For example, Fazzari et al. (1988), Fazzari et al. (2000) believe ICFS can denote the
degree of financial constrains while Kaplan and Zingales (1997) do not support this
claim.
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index to control for financial constraint in the regression model used in

Section 4 – the effect of investment thirst on ICFS can be separated out and
tested directly.
4. The theory model
From the above research and our intuition, we rigorously establish our
theoretical model to draw the relationship between ICFS and investment thirst.
Based on Kaplan and Zingales (1997) model, we introduce two new variables (q
and b) to denote the levels of managers’ risk preferences and soft budget
constraint, respectively. The utility of a firm’s manager is defined as G in (1); in
Equation (2), H denotes the marginal output of investment as a function of
return on investment F ().
Y
G ¼ a½FðIð1 bÞÞ CðI WÞ I þ b I ðq; rðIÞÞ ð1Þ
Q
b
H ¼ FðIð1 bÞÞ I þ I ðq; rÞ ð2Þ
a a
a denotes the incentive payment from investment returns for the manager. I
stands for the amount of investment. b (0 < b < 1) represents the level of soft
budget constraint and the agency problem between the manager and investors.
bI denotes the private benefits to the manager exploited from investment I
which result from the problem of soft budget constraint in a firm. W denotes
the level of internal investment and operating cash flow, with I-W reflecting
external investment. C () is the cost of investment, which is determined by
external funding (I-W). q defines the level of risk-aversion of the manager. r ()
denotes the risk of investment, which is a monotone increasing function of I,
rI [ 0; rI;I [ 0. Π() represents the utility loss accounting for risk, which
involves a monotone increasing function of q and r.
Hence, from the derivation of implicit function in Equation (1), we obtain
the decision formula of ICFS as:10
dI 1 1
¼ Q ¼ H
ð3Þ
dW
FI;I ð1bÞ2 I;I 1 CI;II;I
1 CI;I
a
Consistent with the above figures, Equation (3) depicts that the value of
ICFS depends on the slopes of HI and CI. In detail, it is related to four factors:
(i) risk preference of the manager denoted by ΠI,I, (ii) level of soft budget
10
See Appendix I for details.
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constraint denoted by b, (iii) investment opportunities denoted by FI,I and (iv)

financial constraint denoted by CI,I. As the increase in CI,I usually enhances HI,I
by increasing r (), it is difficult to detect the level of financial constraint using
ICFS.
Thus, we can see:
d2 I d2 I
[ 0; Q \0 ð4Þ
dWdb dWd I;I
Q
d
In most cases, we have dqI;I [ 0,11 thus we can further derive:
d2 I
\0 ð5Þ
dWdq
Combining Equations (4) and (5), we have therefore shown that ICFS arises
from investment thirst, rather than financial constraint. ICFS can then be used
to detect investment thirst if the effect of financial constraint can be controlled
for.12 In the next two sections, we build our regression model and test this
theoretical hypothesis.
5. Empirical tests
5.1. The regression model
We build our regression model as:
It CFt St St1
¼ a0 þ a1 Tobin0 sQt1 þ a2 þ a3 þ a4 Tobin0 sQt1
Kt1 Kt1 St1
CFt
þ a5 FCt þ et
Kt1
ð6Þ
Where It/Kt1 represents the firm’s capital expenditure It scaled by beginning-

of-period total asset, Kt1; Tobin’s Qt1 is defined as the previous year’s Tobin’s
Q. (StSt1)/St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash
flow (net operating cash flow), with CFt deflated by its beginning-of-period
total asset, Kt1. We also introduce the interaction term Tobin’s Qt19CFt/Kt1
here according to Vogt (1994), of which the sign of the coefficient represents the
Q qr2
11
If we express Π by its certainty
Q equivalent value, we can easily obtain ¼ 2,
Q d
followed by I;I ¼ qrI;I , and dq ¼ rI;I [ 0:
I;I
12
We use the WW index developed by Whited and Wu (2006), Lin et al. (2011), and
Zeng and Lin (2014), and the SA index by Hadlock and Pierce (2010) as they are
regarded as more reliable financial constraint proxies than ICFS in recent literature.
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characteristics of ICFS.13 In detail, if the sign is negative, we can deduce that

ICFS rises while investment opportunities decline, and that ICFS should be
correlated with soft budget constraint, firm risk-seeking behaviour and
overinvestment.14 Hence, introducing the interaction term here can help
identify the relationship between ICFS and investment thirst. We also include
year- and industry-fixed effects.
5.2. Data and sample selection
To determine the relationship between ICFS and investment thirst, we select

a sample of Chinese publicly listed firms for a number of reasons. First,
according to Kornai (1979, 1980, 1986) and Qian and Roland (1998), the
problem of investment thirst usually arises from transitional economies
characterised by soft budget constraint. Indeed, China is the largest emerging
and transitional economy in the world. Second, Chinese firms might be facing
severe investment thirst and financial constraint problems at the same time,
which could provide benefits in testing wherein ICFS can be a good proxy for
investment thirst. For example, an International Monetary Fund (IMF) report
entitled ‘Is China Over-Investing and Does it Matter?’ suggests that China has
experienced prominent overinvestment problems over the last decade; this
conclusion draws on the evidence of comparing the incremental capital–output
ratio among a large numbers of countries (Lee et al., 2012). Meanwhile,
according to a series of surveys conducted by the Development Research
Center of State Council in China, 2007 to 2012, more than 90 percentage of
managers in Chinese firms believe they are facing serious financial constraint.15
These two pieces of evidence indicate that financial constraint and investment
thirst co-exist in Chinese firms.
Although the sample for our research was set to be derived over 2001 to 2012,
the regression model was narrowed to a sample period of 11 years from 2002 to
2012, after we took into account that some variables are 1-year lagged. We also
eliminated observations from the finance industries as well as those missing
values in the variables used in the study. Our final sample hence consists of
15,576 firm-year observations from 2297 firms in 30 provinces of China. We
obtained all accounting data from the China Stock Market and the Accounting
Research (CSMAR) database, which is widely used in China-related research.
13
This regression model is based on the framework of Fazzari et al. (1988) while we are
aware that the results may suffer from the latent spurious ratio problem due to scaling
which is discussed in Zhu (2012).
14
Flow cash flows might also be related to investor infringements whereby, as
mentioned above, the kind of investor infringement has no relation to the value of ICFS.
15
Find more discussion about financial constraint in Chinese firms in Chang et al.
(2014).
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5.3. Summary statistics
We split the sample into four groups according to the quartile values of financial
constraint in each year. In Panels A and B of Table 1, we present summary statistics
of each subsample based on the WW index of Whited and Wu (2006) and the SA
index developed by Hadlock and Pierce (2010) to denote the degree of financial
constraint for each.16 The two studies suggest that the WW index is supposed to be
positively related to the level of financial constraint, whereas the SA index has a
reverse relation to financial constraint. In Panel A, while we observe Tobin’s Qt1
increases with a rising value in WW index and financial constraint, Sizet and
(StSt1)/St1 decrease with the augment of the WW index, It/Kt1 and CFt/Kt1
do not show any obvious relationship with the WW index. In Panel B, we observe
that the coefficient of Tobin’s Qt1 is decreasing with the value of SA index goes up
(and augment of financial constraint), and It/Kt1, Sizet, CFt/Kt1, and (StSt1)/
St1 increase when the value in SA index goes up (and decreasing financial
constraint). The results on the SA index are more persistent than those of using the
WW index, which indicate the SA index provides a better measure of financial
constraint than the WW index in this study. Moreover, in Panel B of Table 1, the
value of Tobin’s Qt1 in groups with less financial constraint (Groups 3 and 4) is
lower than 1, which coincides with the definition of ‘bad firms’ in Lang and Stulz
(1994) and the definition of ‘overinvestment companies’ in Lang and Litzenberger
(1989).
We hereby identify the relationship between ICFS and investment thirst in
three steps: first, we need to disentangle the relationship between ICFS,
financial constraint and overinvestment. By doing this, we can show that ICFS
is more closely related to overinvestment than to financial constraint. Second,
we offer direct evidence of the positive relationship between ICFS and a firm’s
risk-seeking preferences. Third, we present empirical results to show that the
value of ICFS is related to soft budget -constraint and investor infringements.
In particular, using the exogenous setting of a natural experiment of the ‘Four
Trillion Stimulus’ policy in China, we provide valid evidence on the explanatory
power of ICFS on investment thirst.
6. Empirical results
6.1. ICFS, financial constraint and overinvestment
We first divide the sample into four groups according to their degree of
financial constraint (the WW index and the SA index, see Table 1). Group 1
consists of firms with the least financial constraint, while Group 4 consists of
firms with the most financial constraint. In Panel A of Table 2, the sample is
sorted by the value of the WW index using the regression model without the
16
See Appendix II for the details in computing the WW index and SA index.
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Table 1
Summary statistics: four portfolios sorted on financial constraint indexes
Panel A: four portfolios sorted on Whited and Wu (2006)’s WW index
Smallest WW (Least FC) Biggest WW (Largest FC)?
Group 1 Group 2 Group 3 Group 4
Tobin’sQt1 1.535 1.675 1.761 1.755

It/Kt1 0.056 0.069 0.065 0.062
CFt/Kt1 0.059 0.041 0.043 0.045
(StSt1)/St1 4.207 1.451 0.601 0.539
Sizet 22.174 21.422 21.225 21.401
SA index 4.540 3.673 3.433 3.619
WW index 16.365 13.485 11.607 7.057
Obs. 3893 3897 3897 3889
Panel B: four portfolios sorted on Hadlock and Pierce (2010)’s SA index
Smallest SA (Largest FC) Biggest SA (Least FC)?
Group 1 Group 2 Group 3 Group 4
Tobin’sQt1 2.343 1.660 0.064 0.060

It/Kt1 0.051 0.062 0.064 0.074
CFt/Kt1 0.036 0.047 0.047 0.058
(StSt1)/St1 0.648 0.254 1.341 4.566
Sizet 20.274 21.098 21.766 23.074
SA index 2.358 3.289 4.007 5.570
WW index 11.516 11.708 12.185 13.096
Obs. 3893 3896 3898 3883
This table presents the means of the main variables in this paper in quartile groups on behalf
of different levels of financial constraint (WW index or SA index). The WW index is
calculated following Whited and Wu (2006), Lin et al. (2011), and Zeng and Lin (2014); the
SA index is computed as in Hadlock and Pierce (2010). More detail on both indexes is given
in Appendix II. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. It/Kt1 represents the
firm’s capital expenditure. It is deflated by its beginning-of-period total assets, Kt1
(StSt1)/St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash flow (net
operating cash flow), with CFt deflated by its beginning-of-period total assets, Kt1. sizet
indicates the log of inflation-adjusted total book-assets.
The inflation rate is obtained from the website of China’s National Bureau of Statistics
(http://www.stats.gov.cn/).
interaction term Tobin’s Qt1 9 CFt/Kt1 and the WW index (results displayed
in the left-hand side of Panel A of Table 2).17 No definite pattern is observed in
17
Models like this have been used in the literature on ICFS. For examples, see Fazzari
et al. (1988) and Chen and Chen (2012).
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Table 2
The estimators of investment–cash flow sensitivities on different level of financial constraint
Group 1 Group 2 Group 3 Group 4 Group 1 Group 2 Group 3 Group 4
(Least FC) (Largest FC) (Least FC) (Largest FC)
Panel A: four portfolios sorted by Whited and Wu (2006)’s WW index
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Tobin’s Qt1 0.0026** (0.001) 0.0007* (0.000) 0.0035*** (0.001) 0.0026*** (0.001) 0.0002 (0.002) 0.0003 (0.000) 0.0031** (0.001) 0.0027*** (0.001)
CFt/Kt1 0.1169*** (0.014) 0.1324*** (0.014) 0.1066*** (0.014) 0.1185*** (0.015) 0.1555*** (0.022) 0.1499*** (0.016) 0.1236*** (0.023) 0.1328*** (0.018)
(StSt1)/St1 0.0018 (0.002) 0.0061*** (0.002) 0.0025 (0.002) 0.0089*** (0.002) 0.0017 (0.002) 0.0061*** (0.002) 0.0026 (0.002) 0.0090*** (0.002)
Tobin’s 0.0234** (0.010) 0.0086** (0.004) 0.0084 (0.010) 0.0075 (0.006)
Qt1 9 CFt/Kt1
WW indext 0.0001 (0.000) 0.0078** (0.003) 0.0038*** (0.001) 0.0003 (0.001)
Obs. 3837 3833 3830 3813 3837 3833 3830 3813
R2 0.1412 0.1075 0.1026 0.1043 0.1430 0.1104 0.1060 0.1047
Panel B: four portfolios sorted on Hadlock and Pierce (2010)’s SA index
Tobin’s Qt1 0.0005 (0.001) 0.0013 (0.001) 0.0029* (0.002) 0.0009* (0.000) 0.0002 (0.001) 0.0054*** (0.002) 0.0034* (0.002) 0.0002 (0.000)
CFt/Kt1 0.1419*** (0.018) 0.1148*** (0.014) 0.0427*** (0.012) 0.0806*** (0.012) 0.1488*** (0.024) 0.1810*** (0.022) 0.1400*** (0.029) 0.0845*** (0.013)
(StSt1)/St1 0.0008 (0.002) 0.0029 (0.002) 0.0074*** (0.002) 0.0041*** (0.002) 0.0011 (0.002) 0.0025 (0.002) 0.0087*** (0.002) 0.0042*** (0.002)
Tobin’s 0.0061 (0.011) 0.0416*** (0.010) 0.0269* (0.016) 0.0050* (0.003)
Qt1 9 CFt/Kt1
SA indext 0.0025* (0.001) 0.0065 (0.004) 0.0003 (0.005) 0.0161*** (0.002)
Obs. 3814 3829 3842 3822 3814 3829 3842 3822
R2 0.1657 0.1051 0.0694 0.1675 0.1087 0.0884 0.0895
This table presents ICFS in quartile groups on behalf of different levels of financial constraint (WW index or SA index). The ICFS are calculated from the OLS estimators of the model:
It 0 CFt St St1 0 CFt
Kt1 ¼ a0 þ a1 Tobin sQt1 þ a2 Kt1 þ a3 St1 þ a4 Tobin sQt1 Kt1 þ a5 FCt þ et . It/Kt1 represents the firm’s capital expenditure. It is deflated by its beginning-of-period total asset,
K. Deng et al./Accounting and Finance 57 (2017) 165–197
Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash flow (net operating cash flow), with CFt, deflated
by its beginning-of-period total asset, Kt1. We also introduce the interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994), of which the negative sign of the coefficient
represents the characteristic of investor infringement of ICFS. FCt is the level of financial constraint, denoted by the WW index or SA index. The WW index is calculated as in Whited and
Wu (2006), Lin et al. (2011) and Zeng and Lin (2014); the SA index is computed as Hadlock and Pierce (2010); both are shown in Appendix II in more detail. Industry- and year-fixed
effects are included but unreported. Standard errors are heteroskedasticity consistent and clustered at the firm level. The sample includes firms of all industries with the exception of the
financial industry in the CSMAR from 2002 to 2012. ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
177
the relationship between the financial constraint and the coefficient of CFt/Kt1.
Nevertheless, after introducing the interaction term Tobin’s Qt1 9 CFt/Kt1
and the WW index term, we observe that the coefficients of CFt/Kt1 in Groups
1 and 2 are larger than those in Groups 3 and 4 (results displayed in the right-
hand side of Panel A of Table 2) showing that all the coefficient estimates are
significant at a 1 percentage level.
Panel B of Table 2 shows the regression results of the sample sorted on the
value of the SA index. In the regression model without the interaction term
Tobin’s Qt1 9 CFt/Kt1 and the SA index term, the coefficients of CFt/Kt1 in
Groups 1 and 2 are larger than those in Groups 3 and 4. After introducing the
interaction term Tobin’s Qt1 9 CFt/Kt1 and the SA index term, the results
only change slightly. Notably, in Panels A and B of Table 2, a significantly
positive coefficient of CFt/Kt1 is accompanied by a negative coefficient of
Tobin’s Qt1 9 CFt/Kt1,18 which implies that, in China, ICFS is significantly
correlated with soft budget constraint and investor infringements.
Panel A of Table 2 shows that most of the coefficients of Tobin’s Qt1 are
negative and that the pattern does not change even after introducing the WW
index term. On the contrary, Panel B of Table 2 shows that, after introducing
the SA index term, the coefficients of Tobin’s Qt1 become larger and most
become positive. Thus, we hereby argue that the ability of the SA index in
discerning the effect of financial constraint and the effect of investment
opportunities (e.g. Tobin’s Q) is greater than that of the WW index in our
sample.
Following Richardson (2006), we next sort our firms based on the quartile
values of overinvestment each year.19 Each sample firm falls into one of the
four exclusive groups: Groups 1 and 2 represent firms of underinvestment,
while Groups 3 and 4 represent firms of overinvestment. Table 3 shows ICFS
levels in each of these four groups. In Panel A of Table 3, with the sample
sorted on the value of the WW index using the regression model without the
interaction term Tobin’s Qt1 9 CFt/Kt1 and the WW index, we observe a
significantly positive relationship between the level of investment and CFt/Kt1.
Furthermore, after introducing the interaction term Tobin’s Qt1 9 CFt/Kt1,
the significant positive relationship between the level of investment and CFt/
Kt1 is unchanged. This consistency implies that ICFS is closely related to
overinvestment. Furthermore, the largest coefficient of CFt/Kt1 in Group 4 is
accompanied by a significantly negative coefficient of CFt/Kt1.
Panel B of Table 3 shows more evidence of the relationship between ICFS and
overinvestment after adding the interaction term Tobin’s Qt1 9 CFt/Kt1 and
the financial constraint index term. When using the WW index as the proxy for
18
We use SUEST and then a t-test to identify the difference in ICFS between Group 1
and Group 4, and find it is significant at the 1 percent confidence level.
19
See Appendix III for the computing details of overinvestment.
© 2015 AFAANZ
Table 3
The estimators of investment–cash flow sensitivities on different levels of investment
Underinvestment Overinvestment Underinvestment Overinvestment
Group 1 Group 2 Group 3 Group 4 Group 1 Group 2 Group 3 Group 4
© 2015 AFAANZ
Panel A: without the financial constraint index term
Tobin’s Qt1 0.0015*** (0.000) 0.0008 (0.001) 0.0028*** (0.001) 0.0002 (0.001) 0.0016*** (0.000) 0.0009* (0.001) 0.0029*** (0.001) 0.0010 (0.001)
CFt/Kt1 0.0621*** (0.007) 0.0650*** (0.006) 0.0752*** (0.008) 0.0964*** (0.016) 0.0582*** (0.010) 0.0584*** (0.008) 0.0730*** (0.013) 0.1423*** (0.024)
(StSt1)/St1 0.0043*** (0.001) 0.0010 (0.001) 0.0001 (0.001) 0.0037 (0.003) 0.0043*** (0.001) 0.0010 (0.001) 0.0001 (0.001) 0.0039 (0.003)
Tobin’s Qt1 0.0020 (0.004) 0.0036 (0.003) 0.0012 (0.005) 0.0235*** (0.009)
9 CFt/Kt1
Obs. 3196 3198 3199 3192 3196 3198 3199 3192
R2 0.0658 0.0829 0.1219 0.0523 0.0659 0.0833 0.1220 0.0545
Panel B: introducing the financial constraint index
Tobin’s Qt1 0.0017*** (0.000) 0.0009* (0.001) 0.0029*** (0.001) 0.0010 (0.001) 0.0001 (0.000) 0.0020*** (0.001) 0.0026*** (0.001) 0.0042*** (0.001)
CFt/Kt1 0.0578*** (0.010) 0.0579*** (0.008) 0.0731*** (0.013) 0.1422*** (0.024) 0.0579*** (0.010) 0.0529*** (0.008) 0.0713*** (0.013) 0.1247*** (0.025)
(StSt1)/St1 0.0043*** (0.001) 0.0010 (0.001) 0.0001 (0.001) 0.0039 (0.003) 0.0029*** (0.001) 0.0009 (0.001) 0.0020** (0.001) 0.0022 (0.003)
Tobin’s Qt1 0.0025 (0.004) 0.0038 (0.003) 0.0012 (0.005) 0.0235*** (0.009) 0.0002 (0.004) 0.0033 (0.003) 0.0079 (0.006) 0.0233** (0.010)
9 CFt/K 1
WW indext 0.0003* (0.000) 0.0001** (0.000) 0.0000 (0.000) 0.0000 (0.000)

SA indext 0.0037*** (0.001) 0.0059*** (0.001) 0.0084*** (0.001) 0.0070*** (0.001)
Obs. 3196 3198 3199 3192 3196 3198 3199 3192
R2 0.0680 0.0845 0.1220 0.0545 0.0885 0.1506 0.2120 0.0778
This table presents ICFS in quartile groups on different levels of investment. The four portfolios are sorted using Richardson (2006)’s method of measuring levels of investment. The ICFS
t t t1 t
þ a5 FCt þ et . It/Kt1 represents the firm’s capital expenditure.
are calculated from the OLS estimators of the model: KIt1 ¼ a0 þ a1 Tobin0 sQt1 þ a2 KCF
t1
þ a3 StSS
t1
þ a4 Tobin0 sQt1 KCF
t1
It is deflated by its beginning-of-period total asset, Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash
flow (net operating cash flow), CFt is deflated by its beginning-of-period total asset, Kt1. We also introduce the interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994), of
which the negative sign of coefficient represents the characteristic of investor infringement of ICFS. FCt is the level of financial constraint, denoted by the WW index or SA index. The WW
index is calculated as in Whited and Wu (2006), Lin et al. (2011) and Zeng and Lin (2014); SA index is computed as in Hadlock and Pierce (2010); both are shown in more detail in
Appendix II. Industry- and year-fixed effects are included but unreported. Standard errors are heteroskedasticity consistent and clustered at the firm level. The sample includes firms of all
industries with the exception of the financial industry in CSMAR from 2002 to 2012. ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
179
financial constraint, the regression results are almost the same as for the results in
the right-hand side of Panel A of Table 3. The coefficient of Tobin’s Qt1 remains
negative, and most coefficients of the WW index are positive, both of which
illustrate that, using the WW index, it is hard to separate the effect of financial
constraint and that of Tobin’s Q in our sample. However, when the SA index
instead of the WW index is used as the proxy for financial constraint, the
regression results are different to those in Panel A of Table 3. Most of the
coefficients of Tobin’s Qt1 become positive, and the coefficients of the SA index
are significantly positive. Therefore, this again demonstrates that the capability
of the SA index to discern both the effect of financial constraint and the effect of
Tobin’s Q on investment is better than the WW index for our sample.
6.2. ICFS and risk-seeking preferences
In the second step, we discuss the relationship between ICFS and risk-seeking
preferences. We sort our firms based on the quartile values of relative
idiosyncratic risk in each year20 and clarify all observations into four groups
from the lowest risk (Group 1) to the highest risk (Group 4).21
However, it is difficult to determine the effect of risk-seeking preference on
ICFS by computing ICFS directly in each group, because of its close
association with soft budget constraint and investor-infringement effects. To
account for the possible confounding effects, we have to manage our sample
more carefully. Therefore, we construct a sample consisting of observations
with low soft budget constraint only. We examine our results in Table 3 and
find that the coefficient of Tobin’s Qt1 9 CFt/Kt1 in Group 2 is the largest;
this suggests that firms in this group could, on average, afford the lowest soft
budget constraint. However, even when we include firms in Group 2 of Table 3
in the sample, we cannot rule out the effect that firms with high soft budget
constraint tend to have lower levels of soft budget constraint together, which
can also lead to a high coefficient of Tobin’s Qt1 9 CFt/Kt1. To mitigate such
effects as much as possible, we further examine the results in Table 2 and
identify that the coefficient of Tobin’s Qt1 9 CFt/Kt1 in Group 4 is the
largest. Consequently, we select the observations existing in both Group 4 of
20
The risk is calculated based on the three-factors model of Fama and French (1992).
The regular expression is logðr2f =r2m Þ, where r2f denotes the absolute idiosyncratic risk,
and r2m denotes the systematic idiosyncratic risk. A number of studies show that r2f has a
closely positive relation with r2m (such as Chun et al., 2008; Han and Lesmond, 2011;
Panousi and Papanikolaou, 2012), thus we use relative idiosyncratic risk here instead of
absolute idiosyncratic risk. For robustness, we also present similar results in Section 6.3.
(Table 8) based on the relative idiosyncratic risk estimated through CAPM.
21
An incomplete list of studies on investment and idiosyncratic risk in different
countries include Chan et al. (2011); Nartea et al. (2011), Bugeja and Sinelnikov (2012);
Jian and Xu (2012); Routledge and Morrison (2012); Nguyen and Rahman (2014).
© 2015 AFAANZ
Table 2 and Group 2 of Table 3 simultaneously and divide them into four
groups by their quartile values of relative idiosyncratic risk.
Table 4 presents the results of the relationship between ICFS and risk. We
find the coefficients of CFt/Kt1 in Groups 3 and 4 are commonly larger than
those in Groups 1 and 2. However, as this is an obviously exceptional case, the
largest coefficient of CFt/Kt1 emerges in Column 1 of Panel B, although, at the
same time, the only significant negative coefficients of CFt/Kt1 are also shown
here. Therefore, the abnormal coefficient of CFt/Kt1 in Column 1 of Panel B
not only represents the effect of risk-seeking preference, but also includes the
effect of soft budget constraint and investor infringements. In short, our
evidence shows a positive relationship between ICFS and risk-seeking
preferences, although it is difficult to remove the effect of soft budget
constraint from that of risk seeking.
Similar to Table 3, when using the WW index to denote financial constraint
in Table 4, we still observe the coefficient estimate of Tobin’s Qt1 being
negative, whereas most of the coefficient estimates of the WW index are
positive. This means that, with the WW index, separating the effect of financial
constraint and that of Tobin’s Q in our sample is again difficult. Additionally,
when we use the SA index as the proxy for financial constraint, the sign of
Tobin’s Qt1 in most cases becomes positive, and the coefficients of the SA
index are significantly positive. Again, we find the ability of the SA index in
discerning the financially constrained effect and Tobin’s Q effect on investment
is better than the WW index in our sample.
6.3. ICFS, soft budget constraint and Investor infringements
Table 5 presents the regression results of ICFS in each year from 2002 to 2012.
Panel A shows both the results for ICFS from the regression model without the
interaction term of Tobin’s Qt1 9 CFt/Kt1 and the financial constraint proxy.
We do not find any obvious pattern in the value of ICFS coefficient estimates.
After introducing the interaction term Tobin’s Qt1 9 CFt/Kt1, we find that the
coefficients of CFt/Kt1 are significant and increasing in the three periods of 2002–
2004, 2007–2008 and 2009–2012. We note that they are insignificant in 2005 and
2006 based on the results shown in Panel B of Table 5. Furthermore, most of the
significant coefficient estimates on CFt/Kt1 are accompanied by negative
coefficient estimates on Tobin’s Qt1 9 CFt/Kt1, which implies ICFS, soft
budgets and investor infringements are closely correlated.
To separate the effect of financial constraint on ICFS from that of investment
thirst, Panels C and D introduce the WW index and SA index, respectively. Similar
to Tables 3 and 4, in which we used the WW index to denote financial constraint, in
Panel C of Table 5, we still observe that the signs of coefficient estimates on Tobin’s
Qt1 are negative in most cases. Nevertheless, these signs are positive in the WW
index coefficient estimates in most cases, both indicating that, for the WW index, it
is hard to separate the effect of financial constraint and that of Tobin’s Q.
© 2015 AFAANZ
Table 4
182
The estimators of investment–cash flow sensitivities on investment level and then relative idiosyncratic risk (calculated by Fama and French (1992) three-
factors model)
Financial constraint denoted by Whited and Wu (2006)’s WW Financial constraint denoted by Hadlock and Pierce (2010)’s SA
index index
© 2015 AFAANZ
Risk-lowest Risk- 2 Risk-3 Risk-largest Risk-lowest Risk- 2 Risk-3 Risk-largest
Panel A: three-factors model
Tobin’s Qt1 0.0039*** (0.001) 0.0050 (0.003) 0.0013** (0.001) 0.0020 (0.002) 0.0036** (0.002) 0.0019 (0.002) 0.0010 (0.001) 0.0002 (0.001)
CFt/Kt1 0.0432* (0.023) 0.0421* (0.024) 0.0561*** (0.019) 0.0568* (0.029) 0.0283 (0.017) 0.0292 (0.019) 0.0527*** (0.016) 0.0316** (0.015)
(StSt1)/St1 0.0036 (0.004) 0.0070* (0.004) 0.0007 (0.002) 0.0057 (0.004) 0.0045 (0.004) 0.0001 (0.004) 0.0005 (0.002) 0.0010 (0.003)
Obs. 228 176 191 206 230 201 178 211
R2 0.2115 0.2151 0.3310 0.2818 0.1728 0.1391 0.2080 0.2111
Panel B: five factors model
Tobin’s Qt1 0.0038** (0.002) 0.0053 (0.003) 0.0025 (0.002) 0.0033** (0.001) 0.0017 (0.002) 0.0008 (0.001) 0.0016 (0.002) 0.0015 (0.001)
CFt/Kt1 0.0843** (0.033) 0.0156 (0.070) 0.0680*** (0.024) 0.0109 (0.054) 0.0115 (0.026) 0.0004 (0.026) 0.0386 (0.025) 0.0613* (0.033)
(StSt1)/St1 0.0036 (0.004) 0.0073* (0.004) 0.0008 (0.002) 0.0053 (0.004) 0.0032 (0.003) 0.0001 (0.003) 0.0001 (0.003) 0.0000 (0.003)
Tobin’s Qt1 0.0262* (0.014) 0.0178 (0.049) 0.0067 (0.009) 0.0337 (0.027) 0.0105 (0.013) 0.0136** (0.007) 0.0066 (0.010) 0.0130 (0.010)
9 CFt/Kt1
WW indext 0.0001 (0.001) 0.0000 (0.001) 0.0000 (0.001) 0.0006 (0.001)
SA indext 0.0099*** (0.003) 0.0169*** (0.004) 0.0103*** (0.003) 0.0103*** (0.002)
Obs. 228 176 191 206 230 201 178 211
R2 0.2180 0.2161 0.3327 0.2945 0.2201 0.2361 0.2503 0.2836
This table presents ICFS in quartile groups at different levels of relative idiosyncratic risk. The ICFS are calculated from the OLS estimators of the model:
It 0 CFt St St1 0 CFt
Kt1 ¼ a0 þ a1 Tobin sQt1 þ a2 Kt1 þ a3 St1 þ a4 Tobin sQt1 Kt1 þ a5 FCt þ et . It/Kt1 represents the firm’s capital expenditure. It is deflated by its beginning-of-period total asset,
Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash flow (net operating cash flow), with CFt deflated by its
beginning-of-period total asset, Kt1. We also introduce the interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994), of which the negative sign of the coefficient represents the
characteristic of investor infringement of ICFS. FCt is the level of financial constraint, denoted by the WW index or SA index. The WW index is calculated as in Whited and Wu (2006), Lin et al.
(2011) and Zeng and Lin (2014); the SA index is computed as in Hadlock and Pierce (2010); and both are shown in Appendix II in more detail. Industry and year fixed effects are included but
unreported. Standard errors are heteroskedasticity consistent and clustered at the firm level. We select the observations existing in both Group 4 of Table 2 and Group 2 of Table 3 simultaneously,
and divide them into four groups by their quartile value of relative idiosyncratic risk. ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
Table 5
Estimation of investment–cash flow sensitivities by year
Variables 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Panel A: three-factors model
© 2015 AFAANZ
Tobin’s Qt1 0.0000 0.0037 0.0027 0.0104 0.0058 0.0015 0.0019 0.0032 0.0044*** 0.0036*** 0.0004
(0.003) (0.004) (0.005) (0.007) (0.007) (0.001) (0.001) (0.002) (0.001) (0.001) (0.000)
CFt/Kt1 0.1645*** 0.1179*** 0.1878*** 0.1600*** 0.1536*** 0.1150*** 0.1312*** 0.0481*** 0.0911*** 0.0890*** 0.1001***
(0.024) (0.023) (0.022) (0.023) (0.022) (0.019) (0.019) (0.017) (0.017) (0.019) (0.017)
(StSt1)/St1 0.0058* 0.0050 0.0006 0.0074* 0.0051 0.0021 0.0096*** 0.0031 0.0051** 0.0103*** 0.0031
(0.003) (0.003) (0.003) (0.004) (0.003) (0.002) (0.003) (0.003) (0.003) (0.003) (0.002)
Obs. 1081 1135 1183 1246 1240 1316 1431 1461 1514 1720 1989
R2 0.1023 0.1012 0.1405 0.1437 0.1234 0.1099 0.1238 0.1000 0.1125 0.1023 0.0869
Panel B: four factor model (including interaction term)
Tobin’s Qt1 0.0002 0.0021 0.0025 0.0058 0.0048 0.0016 0.0010 0.0048** 0.0043*** 0.0036*** 0.0002
(0.004) (0.005) (0.005) (0.009) (0.009) (0.005) (0.001) (0.002) (0.001) (0.001) (0.000)
CFt/Kt1 0.1582** 0.1636** 0.1926*** 0.0842 0.1332 0.1145*** 0.1846*** 0.0937*** 0.0991*** 0.1138*** 0.1506***
(0.067) (0.067) (0.067) (0.099) (0.105) (0.030) (0.032) (0.029) (0.028) (0.026) (0.029)
(StSt1)/St1 0.0058* 0.0049 0.0006 0.0072* 0.0051 0.0021 0.0099*** 0.0032 0.0052** 0.0104*** 0.0031
(0.003) (0.004) (0.003) (0.004) (0.003) (0.002) (0.003) (0.003) (0.003) (0.003) (0.002)
Tobin’s Qt1 0.0037 0.0301 0.0036 0.0642 0.0183 0.0004 0.0205** 0.0286** 0.0031 0.0081 0.0253**
9 CFt/K 1 (0.036) (0.042) (0.048) (0.081) (0.092) (0.018) (0.010) (0.015) (0.009) (0.006) (0.012)
Obs. 1081 1135 1183 1246 1240 1316 1431 1461 1514 1720 1989
R2 0.1023 0.1016 0.1405 0.1441 0.1234 0.1099 0.1265 0.1024 0.1126 0.1033 0.0889
Panel C: five factors model (financial constraint denoted by Whited and Wu (2006)’s WW index)
Tobin’s Qt1 0.0008 0.0036 0.0026 0.0060 0.0046 0.0018 0.0009 0.0048** 0.0043*** 0.0041*** 0.0002
(0.004) 0.005) (0.005) (0.009) (0.009) (0.005) (0.001) (0.002) (0.001) (0.001) (0.000)
CFt/Kt1 0.1603** 0.1609** 0.1931*** 0.0832 0.1327 0.1136*** 0.1845*** 0.0937*** 0.0994*** 0.1043*** 0.1505***
(0.067) (0.067) (0.067) (0.099) (0.106) (0.030) (0.032) (0.029) (0.028) (0.025) (0.029)
(StSt1)/St1 0.0059* 0.0047 0.0006 0.0072* 0.0051 0.0021 0.0097*** 0.0033 0.0052** 0.0095*** 0.0031
(0.003) (0.003) (0.003) (0.004) (0.003) (0.002) (0.003) (0.003) (0.003) (0.003) (0.002)
(continued)
183
Table 5 (continued)
184
Variables 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Tobin’s Qt1 0.0041 0.0270 0.0037 0.0646 0.0194 0.0009 0.0210** 0.0285* 0.0032 0.0068 0.0253**
9 CFt/Kt1 (0.036) (0.042) (0.048) (0.082) (0.092) (0.018) (0.010) (0.015) (0.009) (0.006) (0.012)
WW indext 0.0014 0.0011* 0.0001 0.0001 0.0002 0.0008* 0.0006 0.0001 0.0001 0.0015*** 0.0000
(0.002) (0.001) (0.001) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
© 2015 AFAANZ
Obs. 1081 1135 1183 1246 1240 1316 1431 1461 1514 1720 1989
R2 0.1026 0.1043 0.1405 0.1442 0.1235 0.1122 0.1277 0.1024 0.1126 0.1218 0.0889
Panel D: five factors model (financial constraint denoted by Hadlock and Pierce (2010)’s SA index)
Tobin’s Qt1 0.0078* 0.0056 0.0148*** 0.0336*** 0.0267*** 0.0063 0.0021 0.0098*** 0.0034*** 0.0035*** 0.0002
(0.004) (0.005) (0.006) (0.009) (0.009) (0.005) (0.001) (0.002) (0.001) (0.001) (0.000)
CFt/Kt1 0.1203* 0.1367** 0.0956 0.0679 0.0793 0.1439*** 0.1757*** 0.0954*** 0.0993*** 0.1130*** 0.1505***
(0.068) (0.068) (0.066) (0.096) (0.104) (0.029) (0.031) (0.028) (0.028) (0.026) (0.029)
(StSt1)/St1 0.0052 0.0035 0.0007 0.0039 0.0020 0.0001 0.0060* 0.0019 0.0043 0.0101*** 0.0031
(0.003) (0.004) (0.003) (0.004) (0.003) (0.002) (0.003) (0.003) (0.003) (0.003) (0.002)
Tobin’s Qt1 0.0191 0.0203 0.0493 0.0526 0.0452 0.0269 0.0220** 0.0325** 0.0039 0.0081 0.0253**
9 CFt/Kt1 (0.036) (0.042) (0.047) (0.079) (0.091) (0.018) (0.010) (0.014) (0.009) (0.006) (0.012)
SA indext 0.0080*** 0.0067*** 0.0141*** 0.0137*** 0.0108*** 0.0091*** 0.0089*** 0.0069*** 0.0024** 0.0006 0.0000
(0.002) (0.002) (0.002) (0.002) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
Obs. 1081 1135 1183 1246 1240 1316 1431 1461 1514 1720 1989
R2 0.1112 0.1091 0.1817 0.1892 0.1596 0.1456 0.1602 0.1289 0.1157 0.1035 0.0889
The table presents coefficients from the OLS estimators of investment for 2002 to 2012 from the model as:
It t t1 t
Kt1 ¼ a0 þ a1 Tobin0 sQt1 þ a2 KCF
t1
þ a3 StSS
t1
t1
þ a5 FCt þ et . It/Kt1 represents the firm’s capital expenditure. It is deflated
by its beginning-of-period total asset, Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate. CFt/
Kt1 is the firm’s internal cash flow (net operating cash flow), with CFt deflated by its beginning-of-period total asset, Kt1. We also introduce the
interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994), of which the negative sign of the coefficient represents the characteristic
of investor infringement of ICFS. FCt is the level of financial constraint, denoted by the WW index or SA index. WW index is calculated as in
Whited and Wu (2006), Lin et al. (2011) and Zeng and Lin(2014), the SA index is computed following Hadlock and Pierce (2010), and both are
shown in more detail in Appendix II. Industry-fixed effects are included but unreported. Standard errors are heteroskedasticity consistent and
clustered at the firm level. The sample includes firms of all industries with the exception of the financial industry in CSMAR from 2002 to 2012.
***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
Next, we use the SA index (instead of the WW index) as the proxy for
financial constraint, which shows that most of the coefficients of Tobin’s
Qt1 become positive, and a number of the coefficients of the SA index are
significantly positive. The result of this comparison again shows the ability
of the SA index to discern the effect of financial constraint and the effect of
Tobin’s Q on investment, as well as its relative efficiency compared to the
WW index. Consequently, the results in Panel C are almost identical to
those in Panel B, while the results in Panel D differ somewhat. In particular,
the coefficient estimates of CFt/Kt1 are significant in that they increase in
the three periods of 2002 to 2003, 2007 to 2008 and 2009 to 2012, while
being insignificant between 2004 and 2006.
6.4. ICFS and incremental capital–output ratio
In this section, we discuss the third step used in our empirical work and test
the explanatory power of ICFS on investment thirst. Existing studies in
macroeconomics typically employ the incremental capital-to-output ratio to
detect investment thirst and overinvestment in China (e.g. Lee et al., 2012).22 If
ICFS is a good measure of investment thirst as we suggest, it should coincide
with the incremental capital-to-output ratio.
In a typical transitional environment such as China, where investment
thirst tends to connect with government policy (Kornai, 1980; Stiglitz, 1996),
we test the effect of ICFS on investment thirst using a natural experiment of
a typical government policy that occurred during the sample period. The
Four Trillion Stimulus investment policy, announced in December 2008, is
regarded as the most important policy adopted by the Chinese government.
Thus, we use this event to analyse the relationship between ICFS and
investment thirst as follows.
Figure 2a,b compare the changing trends of ICFS with that of incremental
capital-to-output ratios from 2002 to 2012. The values of ICFS in Figure 2a are
sourced from Panel D of Table 5, and the values of incremental capital-to-
output ratios in Figure 2b are calculated using the data from investment on
fixed assets and gross domestic product (GDP) during 2000 to 2013.23 We
observe that the changes in ICFS (firm-level measure of investment thirst)
accurately mirror the changes in incremental capital-to-output ratios (country-
level measure of investment thirst) changes over the sample period.
22
In a typical transitional environment such as China, according to Kornai (1980) and
Stiglitz (1996), because of a lack of surveillance of managers’ behavior, firms’ over-
investment is connected with the government’s investment policy and result in
investment thirst rather than free cash flows.
23
Downloaded from the website of China’s National Bureau of statistics (http://
www.stats.gov.cn/).
© 2015 AFAANZ
(a) (b)
Figure 2 (a) Investment sensitivities of cash flow ratios between 2002 and 2012. (b) Incremental
capital-output ratios between 2001 and 2013. [Correction added on 19 May 2015, after first online
publication: Figure 2 label captions have been removed from the images.]
Note:
The figures plot the changing trend of ICFS and that of incremental capital-to-output ratios
from 2002 to 2012. In (a), We calculate the coefficients from the OLS estimators of investment
using the model:
It CFt St St1
¼ a0 þ a1 Tobin0 sQt1 þ a2 þ a3 þ a4 Tobin0 sQt1
Kt1 Kt1 St1
CFt
þ a5 FCt þ et :
Kt1
It/Kt1 represents the firm’s capital expenditure. It is deflated by its beginning-of-period total asset,
Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate.
CFt/Kt1 is the firm’s internal cash flow (net operating cash flow), CFt, deflated by its beginning-of-
period total asset, Kt1. We also introduce the interaction term Tobin’ s Qt1 9 CFt/Kt1 here
according to Vogt (1994), of which the negative sign of coefficient represents the characteristic of
investor infringement of ICFS. FCt represents the level of financial constraint, denoted by SA index
computed as Hadlock and Pierce (2010). The values of incremental capital-to-output in (a and b) are
calculated by two datasets from 2001 to 2013 downloaded from the website of China’s national bureau
of statistics (http://www.stats.gov.cn/), including the investment on fixed asset, and gross domestic
products (GDP). The 4 sub-sample periods are given based on (a and b). Industry and year fixed effects
are included but unreported. Standard errors are heteroskedasticity consistent and clustered at the
firm level. The sample includes firms of all industries but financial industry in CSMAR from 2002 to
2012.
7. Further robustness tests
In this section, we show both that ICFS coincides with incremental capital–
output ratios in different economic cycles, and that the GMM estimate of ICFS
is also correlated to investment thirst.
7.1. Subperiod regressions
We find similar trends in both ICFS over time and the incremental capital-to-
output ratios, which further confirms the significant relationship between ICFS
© 2015 AFAANZ
and investment thirst. Moreover, the ICFS captures the effect of the Four
Trillion Stimulus investment policy of 2008 accurately, whereas the incremental
capital-to-output ratios exhibit a 1-year lag. Indeed, while the policy was
announced in 2008, most of the investment activities occurred in 2009, which
explains the 1-year-lagged macrodata. This difference also suggests that ICFS is
more efficient than incremental capital-to-output ratios in detecting investment
thirst.
We further split the sample period into four subperiods according to the
trends of incremental capital-to-output ratios in Figure 2b, so as to present the
ICFS of each subperiod displayed in Table 6. The results of ICFS are 0.1112,
0.0529, 0.1186 and 0.1061 in the using the data from 2002 to 2006 (considering
1-year lag, we are left with 4 years panel), respectively. A similar pattern is
observed in the changes of the incremental capital-to-output ratios. Again, we
show that the changes in firm-level investment thirst measure (ICFS) are
consistent with the county-level measure results.
7.2. GMM results
To address the concern that the measurement errors in Tobin’s Q might

contaminate the OLS regression results in Section 5, we use high-order moment
estimators of Erickson and Whited (2000). Based on the overidentification J-
test results, we use the third up to the six order moments in our regression.24
Following EW, we first partial out the perfectly measured regressors (all other
regressors except Tobin’s q, it is assumed that Tobin’s q is the only mismeasured
variable and EW’s approach is specifically used to address the measurement
problem of Tobin’s q.)
Our model is specified as follows,
yi ¼ zi a þ Xi b þ ui
xi ¼ c þ Xi þ ei
In which, zi denotes all other regressors except Tobin’s q, and these regressors
are assumed perfectly measured. Xi denotes the mismeasured regressor: Tobin’s
q. ui is the regression disturbance; and ei is the measurement error. a, b, c are
coefficients. In EW’s work, they partial out the perfectly measured regressors to
obtain:
yi zi uy ¼ qi b þ ui
xi zi ux ¼ qi þ ei
24
In their study, the third order moments through to the seventh moments are
suggested.
© 2015 AFAANZ
188
Table 6
Investment–cash flow sensitivities in four periods
© 2015 AFAANZ
Variables 2002–2003 2004–2006 2007–2009 2010–2012
Tobin’s Qt1 0.0063* (0.003) 0.0202*** (0.004) 0.0035*** (0.001) 0.0009 (0.001)
CFt/Kt1 0.1112* (0.057) 0.0529 (0.049) 0.1186*** (0.014) 0.1061*** (0.016)
(StSt1)/St1 0.0045* (0.002) 0.0014 (0.002) 0.0023 (0.002) 0.0047** (0.002)
Tobin’s 0.0091 (0.035) 0.0728* (0.040) 0.0167*** (0.005) 0.0073 (0.005)
Qt19CFt/Kt1
SA index 0.0074*** (0.002) 0.0125*** (0.001) 0.0081*** (0.001) 0.0015** (0.001)
Obs. 2216 3669 4208 5223
R2 0.1053 0.1724 0.1400 0.0944
The table presents coefficients from the OLS estimators of investment on the model:
It t St St1 0 CFt
Kt1 ¼ a0 þ a1 Tobin0 sQt1 þ a2 KCF
t1
þ a3 St1 þ a 4 Tobin sQ t1 Kt1 þ a 5 FC t þ et . It/K t1 represents the firm’s capital expenditure. It deflated
by its beginning-of-period total asset, Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales growth rate. CFt/
Kt1 is the firm’s internal cash flow (net operating cash flow), CFt, deflated by its beginning-of-period total asset, Kt1. We also introduce the
interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994) – of which the negative sign of coefficient represents the characteristic of
investor infringement of ICFS. FCt represents the level of financial constraint, denoted by WW index or SA index. WW index is calculated as
Whited and Wu (2006), Lin et al. (2011) and Zeng and Lin (2015); SA index is computed as Hadlock and Pierce (2010); both are shown in
Appendix II in detail. The four subsample periods are given based on the Figure 2a. Industry- and year-fixed effects are included but unreported.
Standard errors are heteroskedasticity consistent and clustered at the firm level. The sample includes firms of all industries but financial industry
in CSMAR from 2002 to 2012. ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
where
h i
ux ¼ E ðzi z0i Þ1 ðzi xi Þ
h i
uy ¼ E ðzi z0i Þ1 ðzi yi Þ
qi ¼ Xi zi ux
Therefore, the six order moment (GMM6) equations are shown as follows.
6r
r X
X
r 6r
r
E½ðyi zi uy Þ ðxi zi ux Þ 6r
¼ brj Eðuji ÞEðeli ÞEðq6jl
i Þ
j¼0 l¼0 j l
Table 7 presents the test results implementing the EW’s GMM method.
Given that our previous tests showed that the SA index is found to be better
than the WW index in measuring financial constraint, we therefore use the
SA index to proxy for financial constraint. The same concern of measure-
ment errors can apply to the interaction term used in the models, as
exemplified by the interaction terms containing Tobin’s Q. To address this
problem, we introduce a dummy variable to replace Tobin’s Q and create a
new interaction term, I-Dummyt 9 CFt/Kt1, to detect investor infringement.
The dummy variable I-Dummy is defined in the condition: if the sustainable
growth rate is larger than the real growth rate, (StSt1)/St1, then I-
Dummy equals to 1, otherwise 0. In general, if the sustainable growth rate is
larger than the real growth rate, managers would invest more, causing an
increase in ICFS. If the sustainable growth rate is below the real growth rate,
investment detriments can be found and a negative sign of the coefficient of
I-Dummyt 9 CFt/Kt1 is expected.
Table 7 reports the GMM estimation results showing that the trend in the
ICFS GMM estimators is similar to its OLS estimators in Table 5. We
conclude that ICFS is a good measure of investment thirst and thus that our
results in Section 5 are robust.
7.3. Relative idiosyncratic risk calculated through CAPM
Table 8 presents some robust tests for the results of the relationship between
ICFS and risk. Here, we use the CAPM model instead of Fama and French
(1992) method to compute idiosyncratic risk. We find that the coefficients of
CFt/Kt1 in Groups 3 and 4 are commonly larger than those in Groups 1 and 2,
which is similar to the results in Table 4. Therefore, our evidence in Table 8
also implies a positive relationship between ICFS and risk-seeking preferences.
© 2015 AFAANZ
190
Table 7
GMM estimation of investment–cash flow sensitivities by year
© 2015 AFAANZ
Variables 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Tobin’s Qt1 0.2403** 0.5236** 0.0031 0.4411*** 0.6088*** 0.0001*** 0.0009 0.0253*** 0.0036*** 0.0027*** 0.0000
(0.093) (0.236) (0.026) (0.151) (0.220) (0.000) (0.000) (0.002) (0.001) (0.003) (0.000)
CFt/Kt1 0.1854*** 0.2552*** 0.2440*** 0.0385 0.0289 0.2188*** 0.2561*** 0.0768** 0.1195*** 0.1281*** 0.1154***
(0.066) (0.097) (0.029) (0.094) (0.1196) (0.031) (0.031) (0.034) (0.020) (0.025) (0.028)
(StSt1)/St1 0.0222* 0.0618* 0.0019 0.0123 0.0345 0.0010 0.0041 0.0035 0.0030 0.0010 0.0010
(0.012) (0.032) (0.003) (0.010) (0.022) (0.003) (0.003) (0.003) (0.004) (0.004) (0.003)
I-Dummyt 0.1010 0.0792 0.1620*** 0.1427 0.0521 0.1369*** 0.1437*** 0.0339 0.0441 0.0802** 0.0064
9 CFt/Kt1 (0.091) (0.195) (0.043) (0.110) (0.104) (0.036) (0.035) (0.036) (0.030) (0.036) (0.032)
SA index 0.0765** 0.1249** 0.0123*** 0.0563*** 0.0549*** 0.0091*** 0.0088*** 0.0106*** 0.0057*** 0.0032*** 0.0002
(0.032) (0.059) (0.004) (0.015) (0.016) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
Obs. 1989 1135 1183 1246 1240 1316 1431 1461 1514 1720 1989
The table presents the coefficients from the Erickson and Whited (2000) GMM6 (utilising the third up to the six moments) estimators of
t t t1 t
investment on the model: KIt1 ¼ a0 þ a1 Tobin0 sQt1 þ a2 KCF
t1
þ a3 StSS
t1
þ a4 I Dummyt KCF
t1
þ a5 FCt þ et . It/Kt1 represents the firm’s
capital expenditure. It is deflated by its beginning-of-period total asset, Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/
St1 is the sales growth rate. CFt/Kt1 is the firm’s internal cash flow (net operating cash flow), CFt is deflated by its beginning-of-period total
asset, Kt1. We also introduce the interaction term I-Dummyt 9 CFt/Kt1 here, of which the negative sign of coefficient represents the
characteristic of investor infringement of ICFS. If the sustainable growth rate is larger than real growth rate, (StSt1)/St1, the dummy
variable I-Dummy equal to 1, otherwise it equals to 0. FCt represents the level of financial constraint, denoted by SA index, computed as in
Hadlock and Pierce (2010); details about constructing the SA index are shown in Appendix II. Industry-fixed effects are included but unreported.
The sample includes firms of all industries with the exception of the financial industry in CSMAR from 2002 to 2012. ***, **, and * denote
significance at the level of 1%, 5%, and 10% level, respectively.
Table 8
The estimators of investment–cash flow sensitivities on investment level and then relative idiosyncratic risk (calculated by CAPM)
© 2015 AFAANZ
Risk-lowest Risk-2 Risk-3 Risk-largest
Tobin’s Qt1 0.0014 (0.002) 0.0021* (0.001) 0.0024* (0.001) 0.0020* (0.001)
CFt/Kt1 0.0070 (0.027) 0.0304* (0.016) 0.0363 (0.027) 0.0380 (0.030)
(StSt1)/St1 0.0148** (0.006) 0.0013 (0.002) 0.0036 (0.003) 0.0002 (0.002)
Tobin’s Qt1 0.0307*** (0.010) 0.0053 (0.005) 0.0095 (0.010) 0.0088 (0.009)
9 CFt/Kt1
SA indext 0.0150*** (0.003) 0.0124*** (0.003) 0.0083*** (0.002) 0.0071*** (0.002)
Obs. 206 242 211 163
R2 0.2744 0.2423 0.2088 0.3295
This table presents ICFS in quartile groups at different levels of relative idiosyncratic risk. The ICFS are calculated from the OLS estimators of
t t t1 t
the model: KIt1 ¼ a0 þ a1 Tobin0 sQt1 þ a2 KCF
t1
þ a3 StSS
t1
t1
þ a5 FCt þ et . It/Kt1 represents the firm’s capital expenditure.
It is deflated by its beginning-of-period total asset, Kt1. Tobin’s Qt1 is defined as the previous year’s Tobin’s Q. (StSt1)/St1 is the sales
growth rate. CFt/Kt1 is the firm’s internal cash flow (net operating cash flow), with CFt deflated by its beginning-of-period total asset, Kt1. We
also introduce the interaction term Tobin’s Qt1 9 CFt/Kt1 here according to Vogt (1994), of which the negative sign of the coefficient represents
the characteristic of investor infringement of ICFS. FCt is the level of financial constraint, denoted by the WW index or SA index. the SA index is
computed as in Hadlock and Pierce (2010); and both are shown in Appendix II in more detail. Industry- and year-fixed effects are included but
unreported. Standard errors are heteroskedasticity consistent and clustered at the firm level. We select the observations existing in both Group 4
of Table 2 and Group 2 of Table 3 simultaneously, and divide them into four groups by their quartile value of relative idiosyncratic risk. ***, **,
and * denote significance at the 1%, 5%, and 10% level, respectively.
191
8. Conclusion
In the existing theories of ICFS, doubts have arisen as to whether ICFS

serves as a valid measure of financial constraint in a firm. Indeed, it is not
clear what ICFS truly captures, particular after conflicting the literature’s
evidence on the relationship between ICFS, financial constraint and
overinvestment, which brings the research about ICFS to be even more
challenging.
To address these doubts, we extend the framework of Fazzari et al. (1988)
to find that the ICFS level is determined by managers’ risk preferences and
overinvestments owing to soft budget constraint, investment opportunities
and financial constraint. When the first two factors are combined, the result
coincides with the concept ‘investment thirst’ introduced by Kornai (1979,
1980, 1986), while the latter two are correspond with the work of Fazzari
et al. (1988). After controlling for the effects of investment opportunity and
financial constraint, we show that ICFS measures the level of investment
thirst in a firm.
We use a sample of China’s listed firms from 2002 to 2012 to determine
the capacity of ICFS to measure investment thirst, because investment thirst
and financial constraint may co-exist insofar as China is a transitional
economy. After using reliable proxies [e.g. we use the WW index of Whited
and Wu (2006) and the SA index Hadlock and Pierce (2010)] to control for
financial constraint, we find that the ICFS can be used to detect investment
thirst. This finding about ICFS at the firm level is highly consistent with
that using country-level measures (e.g. the index of incremental capital–
output ratios). In addition, using a natural experiment of China’s Four
Trillion Stimulus policy announced in December 2008, we provide robust
evidence showing that ICFS is a good measure of investment thirst at the
firm level.
While our results are consistent with most of the existing literature, it
newly explains some anomalies about ICFS as well. For example, Vogt
(1994) argues that, in firms of large size and low dividends, ICFS might
denote overinvestment, while ICFS can also proxy for financial constraint in
firms of small size and low dividends. Our evidence, however, shows that, if
we do not control for the effect of financial constraint, the ‘financial
constraint’ effect and ‘investment thirst’ effect on ICFS can exist in the same
firm. Moreover, in firms of small size and low dividends, the effect of
financial constraint dominates the effect of investment thirst, while for large,
low-dividends firms, the opposite is found.
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Appendix I
Proof of Equation (3)
From Equation (1) we can easily get:

Y
GI ¼ a ½ð1 bÞ FI CI 1 þ b I
By implicit differentiation of the above equation, we derive:
dI aCI;I
¼ Q 2
I;I þaCI;I aFI;I ð1 bÞ
dW
Rearrange the terms, we obtain:
dI 1
¼ Q ðA 1Þ
dW
FI;I ð1bÞ2 I;I
1 CI;I
a
Rewriting Equation (2), we have:
b P
H ¼ FðIð1 bÞÞ I þ I ðq; rÞ
a a
Hence, we can easily derive:
Q
2 I;I
HI;I ¼ ð1 bÞ FI;I ðA 2Þ
a
Combining Equations (A-1) and (A-2), we obtain:
© 2015 AFAANZ
dI 1 1
¼ Q ¼ H
dW
FI;I ð1bÞ2 I;I 1 CI;II;I
1 CI;I
a
Q.E.D.
Appendix II
Calculating financial constraint indices
According to Whited and Wu (2006), Lin et al. (2011), Deng and Zeng (2014),
Zeng and Lin (2014), the WW index of each firm in our sample is given by:
WWit ¼ 2:817 LongDebtit 0:29 Dividumit 0:636

Logassetit 0:085 IndSAlegrowit 4:43
CashRatioit þ 5:214 IndDebtit þ 0:947 Control private
þ 0:373 ðDiverRatioÞit
The variables in the above equation are defined as follows:
LongDebt: long-term debt, scaled by total assets.

Logasset: log value of total assets.
IndSAlegrow: average sales growth ratio of each industry, calculated by the
asset-weighted average value of each firm’s sales growth ratio in one
industry. The industries are categorised by the SIC criterion of China’s
Securities Regulatory Commission (two digits).
Cash Ratio: cash-holding ratio, defined as cash plus short-term investment,
scaled by total assets.
IndDebt:industrial mean long-term debt ratio weighted by firm total assets.
Control_private: an indicator equalling to 1 for firms ultimately controlled
by private firms and 0 otherwise.
Diver Ratio: control-ownership wedge, defined as the difference between
control rights and cash-flow rights for the ultimate controlling shareholder.
Control rights and cash flow rights for the ultimate controlling shareholder
are both defined following La Porta et al. (1999). The WW index is positively
related to financial constraint, that is, the larger the index is associated with a
higher degree of financial constraint.
Following Hadlock and Pierce (2010) and Li (2011), the SA index is given by:
SAit ¼ absð0:737 sizeit þ 0:043 size2it 0:040 Ageit Þ
© 2015 AFAANZ
Where size indicates the log of inflation-adjusted total-book-assets, and Age

is the number between the current year and the listed year of the firm.
According to Hadlock and Pierce, 2010, the SA index is a reverse index of
financial constraint, that is, the larger the index, the lower degree of financial
constraint.
For robustness, in our unreported results, we have replaced the value of size
with the total-book-assets without inflation-adjustment. These results are
similar with the reported results in this paper.
Appendix III
Definition of the level of investment
Based on Richardson (2006), we derive the amount of overinvestment from

the following regression model:
It =Kt1 ¼ a þ b1 Tobin0 sQ þ b2 Leveraget1 þ b3 Casht1

þ b4 Aget1 þ b5 Sizet1 þ b6 StockReturnt1
X
þ b7 It1 =Kt2 þ b8 Industry Indicator þ et
The variables in the model are explained as follows:
I/K: the firm’s capital expenditure, I is deflated by its beginning-of -period

total asset, K.
Tobin’s Q: a normal measure of growth opportunities.
Leverage: the sum of the book value of debt deflated by the sum of the book
value of assets.
Cash: the balance of cash and short term investments deflated by total assets
measured at the start of the year.
Age: the log of the number of years the firm has been listed on China’s Stock
Market.
Size: the log of the book value of total assets.
Stock Return: the stock return for the year prior to the investment year. It is
measured as the change in market value of the firm over that prior year.
Industry Indicators: a vector of indicator variables to capture industry fixed
effects. Note that there are 13 industry indicator variables (one digit SIC) in
this regression.
As a result, we obtain e for each firm in every year, and divide the sample into
four groups according their value of e. The observations in Groups 3 and 4,
with larger values, are defined as firms of overinvestment, while the observa-
tions in Groups 1 and 2, with smaller values, are defined as firms of under-
investment.
© 2015 AFAANZ

Investment Cashflow Sensitivity

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Investment Cashflow Sensitivity

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Accounting and Finance 57 (2017) 165–197

Investment–cash ﬂow sensitivity measures investment

Kebin Denga, Zhong Dinga, Yushu Zhub and Qing Zhoub

Literature streams disagree about the capacity of investment–cash ﬂow

Key words: Investment–cash ﬂow sensitivity; Financial constraint; Investment

JEL classification: G31, G32, C1

in economies characterised by soft budget constraint. According to the

empirically, we show that ICFS is a good ﬁrm-level measure of investment

2. Background and literature review

2.1. Soft budget constraint

According to Kornai (1979, 1980, 1986), investment thirst is driven by soft

2.2. Investment thirst, free cash flow and overinvestment

Investment thirst, therefore, arises from two particular investment

and exhibit it concurrently with investment thirst, ICFS measures investment

3. The relationship between ICFS, investment thirst and financial constraint

According to Kornai (1979, 1980, 1986), investment thirst is driven by two

index to control for ﬁnancial constraint in the regression model used in

4. The theory model

constraint denoted by b, (iii) investment opportunities denoted by FI,I and (iv)

5.1. The regression model

We build our regression model as:

Where It/Kt1 represents the ﬁrm’s capital expenditure It scaled by beginning-

characteristics of ICFS.13 In detail, if the sign is negative, we can deduce that

5.2. Data and sample selection

To determine the relationship between ICFS and investment thirst, we select

5.3. Summary statistics

6.1. ICFS, financial constraint and overinvestment

Panel A: four portfolios sorted on Whited and Wu (2006)’s WW index

Smallest WW (Least FC) Biggest WW (Largest FC)?

Group 1 Group 2 Group 3 Group 4

Tobin’sQt1 1.535 1.675 1.761 1.755

Panel B: four portfolios sorted on Hadlock and Pierce (2010)’s SA index

Smallest SA (Largest FC) Biggest SA (Least FC)?

Group 1 Group 2 Group 3 Group 4

Tobin’sQt1 2.343 1.660 0.064 0.060

Panel A: four portfolios sorted by Whited and Wu (2006)’s WW index

Panel B: four portfolios sorted on Hadlock and Pierce (2010)’s SA index

Underinvestment Overinvestment Underinvestment Overinvestment

Group 1 Group 2 Group 3 Group 4 Group 1 Group 2 Group 3 Group 4

Panel B: introducing the ﬁnancial constraint index

WW indext 0.0003* (0.000) 0.0001** (0.000) 0.0000 (0.000) 0.0000 (0.000)

6.2. ICFS and risk-seeking preferences

6.3. ICFS, soft budget constraint and Investor infringements

Panel A: three-factors model

Panel B: ﬁve factors model

Panel A: three-factors model

Panel B: four factor model (including interaction term)

6.4. ICFS and incremental capital–output ratio

7. Further robustness tests

7.1. Subperiod regressions

7.2. GMM results

To address the concern that the measurement errors in Tobin’s Q might

7.3. Relative idiosyncratic risk calculated through CAPM

In the existing theories of ICFS, doubts have arisen as to whether ICFS

Stiglitz, J. E., 1996, Wither Socialism? (MIT Press, Cambridge, MA).

From Equation (1) we can easily get:

By implicit diﬀerentiation of the above equation, we derive:

Rearrange the terms, we obtain:

Rewriting Equation (2), we have:

Combining Equations (A-1) and (A-2), we obtain:

WWit ¼ 2:817  LongDebtit 0:29  Dividumit 0:636

The variables in the above equation are deﬁned as follows:

LongDebt: long-term debt, scaled by total assets.

SAit ¼ absð0:737  sizeit þ 0:043  size2it 0:040  Ageit Þ

WWit ¼ 2:817 LongDebtit 0:29 Dividumit 0:636

SAit ¼ absð0:737 sizeit þ 0:043 size2it 0:040 Ageit Þ