Large Investments, Financial Constraint and Capital Structure

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Introduction Traditional financial theory dictates that firms partake in value-enhancing investment activity. Such actions are beneficial to both the firm and, more importantly, their shareholders. However, it could be suggested that such activity be curtailed in the face of financial constraint. Constraint increases barriers to capital resources, both internally and externally. Retaining internal capital accounts becomes a larger priority due to the necessity to mitigate future financial distress. Existing literature documents an increase in cash holdings as a result of increased financial constraint. External sources become more difficult to obtain and, if that hurdle is crossed, the costs of obtainment are typically at a premium. Thus, it is counterintuitive to think that firms would make abnormally large investments when they are financially constrained. However, Gatchev, Pulvino and Tarhan (2010) show that firms do not necessarily reduce their investment programs due to financial constraint. As an example, consider Immunogen Inc., a biopharmaceutical company with total assets of $82 million and no credit ratings as of March 2008. During the subsequent year, the firm incurred $17.6 million (which is equivalent to 21% of its assets and 43% of its cash stock) in capital expenditures for the first nine months of 2008, compared to only $1.4 million in the previous year. The capital outlays include $3.6 million for improved capabilities at its manufacturing plant in Norwood and $10.9 million for the building of its laboratory and office space in Waltham, both in Massachusetts. This work addresses two primary questions. First, how do constrained firms like Immunogen Inc. finance these large investments, presumably so as to not miss profitable opportunities? This provides a fertile environment to re-examine traditional capital structure theories and, more specifically, the influence of financial constraint on large project financing. Second, what is the impact on shareholders' value of such important financing decisions? Large investments would seem to require a large amount of external financing, a notion supported by Elsas, Flannery and Garfinkel (2012). This is a particularly important decision in the face of financial constraint, as theory suggests constraint forces firms to be more careful in their financing choice since incorrect capital budgeting decision would have harsher ramifications. Following Gatchev et al. (2009) and Elsas et al. (2012), we estimate a multi-equation system that allows decisions on the sources and uses of funds to be made simultaneously. Our analysis shows that constrained firms use approximately 65% external equity and 30% of debt to finance each dollar of large capital expenditures. The small remaining funding is arrived at through a combination of cash holding and negative share repurchases. In contrast, unconstrained firms use more internal cash and debt and rely less on equity to fund such projects. Traditional pecking theory suggests that higher financing costs and increased asymmetry associated with equity financing make it the least optimal funding source. However, equity may be used out of necessity since other funding options are unavailable or excessively expensive, especially in the event of financial distress. Pecking order theory does predict a negative relation between financial constraint and equity issuance (and a resulting positive relation between constraint and debt levels). However, our results suggest that constrained firms' equity use is a choice rather than a restriction imposed by market participants. This does seem to contradict the pecking order theory and provides a new conclusion to add to the evidence regarding funding choices. An alternative explanation often posed in the capital structure literature is the theory of market timing, which states that firms issue equity when market conditions are most favorable for them to do so. …