Political Regimes, Internal Funds and Investment Behaviour: An Empirical Analysis of Manufacturing Sector Firms in Pakistan

• Author: MUHAMMAD SAIM HASHMI, FAISAL MEHMOOD MIRZA AND NAJAM US SEHAR

Abstract

The prime objective of this study is to estimate the relationship between financial status and investment behaviour of the firms in manufacturing sector of Pakistan across different political regimes using data of 498 firms from 1973-2010. The study finds that cash flow is the most important factor affecting the firm's investment behaviour. Investigation of the possible effect of political regimes on the nexus between investment and cash flow of the firms confirms that changes in political regimes have affected the investment behaviour of firms in manufacturing sector of Pakistan. The estimates for the post 1990s era suggest that investment is positively related to both the internal cash flow and Tobin's Q. This indicates that governments should pursue liberal corporate policies in a deregulated environment to channelize internal funds of the firms into effective investment expenditures.

Keywords: Investment behaviour, Cash flow, Payout ratio, Political regimes, Pakistan

1. INTRODUCTION

   Investment and internal funds are vital factors in assessing the financial status of a firm. When a firm starts an investment project, it primarily relies on internal funds for financing these projects (Chay and Suh, 2008). Firms have various sources of internal funds like retained earnings, reserves and equity etc. When investors choose internally generated funds in the form of cash flows to finance their investment projects, they can quickly and independently implement their investment plans in the absence of any external constraints. Due to the use of internal funds, firms avoid different costs including flotation cost (i.e. government fees, printing cost and underwriting cost). Contrarily, when firms use external funds, they bear such type of costs by themselves.

   Internal funds are considered most important for investment as compared to the external funds (Chay and Suh, 2008). Park and Pincus (2000) describe that when firms have incomplete information about their investment plans, they choose internal funds for carrying out investment expenditures. If firms have complete information about investment plans, they use external funds. Pecking order theory states that due to asymmetric information, cost of financing increases and firms prefer internal funds instead of external funds for financing investment plans. When firms face high cost of external financing, internal funds show greater response to investment (Fazzari et al., 1988; Kaplan and Zingales, 2000; Cleary, 1999).

   Cleary (1999) establishes that investment decisions of a firm with high ability to repayment of debt are sensitive to accessibility of internal funds. The relationship between investment and internal funds of firms is very important because internal funds decide the status of the firm's behaviour regarding investment and investment further determines the overall financial status of the firm.

   There are very few studies available that explore the relationship between internal funds of the firms in the form of cash flow and their investment behaviour. Specifically, this topic lacks discussion for the case of manufacturing sector of Pakistan. To bridge the gap in literature for Pakistan, this study carries out firm level analysis of manufacturing sector of Pakistan1 by estimating relationship of firm's financial status and its investment behaviour.

   It is important to analyze the impact of non-financial events on the firm's investment behaviour as well. There are several aspects from which this issue can be explored. Pakistan has passed through different political cycles over the last 40 years (there are regular episodes of democratic and non-democratic eras). By considering these particular eras, this paper also tests whether changing political scenarios make any significant impact in firm's investment behaviour in manufacturing sector of Pakistan or not. The rest of the paper is organized as follows: Section II presents literature reviews, section III provides discussion on model and data description. Section IV reports discussion on results and study is concluded in section V.

2. LITERATURE REVIEW

   Literature provides dual pictures regarding sensitivity of firm's investment decisions to its cash flows. Cleary (1999) examines relationship between investment decisions of firms and their financial status in US and finds that investment of firms having high creditworthiness is more sensitive to availability of internal funds. Kaplan and Zingales (2000) provide both theoretical and empirical arguments that investment cash flow sensitivity is not proper indicator of financial constraints of firms. Fazzari et al. (2000) argue that literature on investment cash flow sensitivities does not have solid theoretical base and concludes that these sensitivities are useful measures of financial constraints.

   Allayannis and Mozumdar (2004) contribute in this debate by re- examining the arguments of Kaplan and Zingales (2000) and Cleary (1999) that cash flow sensitivity of investment is greater for the least constrained firms. They conclude that the results of Kaplan and Zingales (2000) are also influenced by a few outliers in their dataset. They also reveal that when these observations are excluded from the sample, the results are closer to the previous studies.

   Bhagat et al. (2005)...