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We exploit a change in bankruptcy law in 1978 in the U.S. as an exogenous shock that increased the cost of external funds for public companies. In a quasi-natural experiment setting, we investigate the impact of an increased cost of debt on the investment-cash flow sensitivity of firms. Our results show that the sensitivity of investment to cash flow increased by one third after 1978, and for a sample of firms likely to be more financially constrained the effect was as high as 80%. Our findings suggest the market value of a dollar in cash holdings increased by 12 cents after the change in law, with a larger effect for financially constrained firms.
We exploit the Bankruptcy Reform Act of 1978 in the U.S. as an exogenous shock that increased the cost of external funds for public companies. In a quasi-natural experiment setting, we find that the investment-cash flow sensitivity of firms increased after the reform. The BRA introduced the possibility of strategic default by debtors, as well granted shareholders more bargaining power in the reorganization process of firms under Chapter 11 which resulted in more frequent and larger deviations from Absolute Priority Rule in bankruptcy. Acharya and Krishnamurthy (2009) note the BRA made the U.S. bankruptcy code more debtor–friendly that other developed economies at the time. Given this exogenous increase in risk to creditors, firms faced a shift in their cost of external funds. For the typical firm in our sample, the investment sensitivity to internally generated cash flow increased by one third after the BRA, though the effect is much stronger for firms likely to be more financially constrained. Firms in the bottom tercile of tangibility – relatively lacking assets they can pledge as collateral for debt – increase their sensitivity by over 80%. Moreover, the value assigned by shareholders to cash holdings of firms also increased after the BRA. Faulkender and Wang (2006) argue cash reserves allow companies to fund future projects without the need for external funds and protects them from financial distress by allowing them to better absorb negative shocks. Since the BRA turned internal funds more important for investment projects, and at the same time it made financial distress more expensive by imposing larger expected loses on creditors, we investigate if the value of cash increased after the BRA. Using the methodology of Faulkender and Wang (2006), we find that shareholders value one dollar of cash holdings 12 cents higher after the BRA, and for firms likely to be more financially constrained the effect is over 20 cents higher. Our study contributes to the literature by showing that investment-cash flow sensitivities do respond to financing constraints. The quasi-natural experiment setup suggests our findings have a causal interpretation and allows us to steer clear of common shortcomings of empirical studies of corporate investment.