Journal of Bwiness Finance &Accounting, 22(2), March 1995, 0306-686X

INTERNAL CASH FLOW, INSIDER OWNERSHIP,

AND CAPITAL EXPENDITURES: A TEST OF THE
PECKING ORDER AND MANAGERIAL HYPOTHESES
EMMETTH. GRINERAND LAWRENCE
A. GORDON*

INTRODUCTION

Corporate capital expenditures are of key importance for several reasons. At

the macroeconomic level, capital expenditures are an important part of
aggregate demand and gross national product, economic growth, and business
cycles (Dornbusch and Fisher, 1987). At the microeconomic level, capital
expenditures affect a firm’s production decisions (Nicholson, 1992) and strategic
plans (Bromiley, 1986). Capital expenditures also have been linked directly
to firm performance (McConnell and Muscarella, 1985).
Consequently, a large body of research has attempted to establish the factors
that determine the level of corporate capital expenditures. The classic readings
in this area include work by Kuh and Meyer (1957), Dusenberry (1958),
Jorgenson (1963), Kuh (1963), Jorgenson and Siebert (1968), Grabowski and
Mueller (1972), and Elliot (1973). Research concerning the determinants of
corporate capital expenditures has continued to the present day, largely because
of the importance of the issue and the mixed findings of the early studies. Works
by such individuals as Nair (1979), Berndt et al. (1980), Larcker (1983), Fazzari
and Athey (1987), Fazzari et al. (1988), Waegelein (1988), Madan and Prucha
(1989), and Gaver (1992) have contributed to our understanding of the
determinants of capital expenditure levels.
One unresolved issue in this area is the role of internal cash flow.* Although
previous studies have established that internal cash flow is an important
determinant of capital expenditures, there is disagreement as to why this is
the case. The two agency-based arguments that have been proposed are known
as the ‘pecking order’ and ‘managerial’ hypotheses. According to the pecking
order hypothesis set forth by Myers (1984) and Myers and Majluf (1984),
managers choose the level of capital expenditures that maximizes the wealth
of current shareholders, regardless of the managers’ ownership stake in the
firm. Managers are forced to rely on internal cash flow for financing due to
information asymmetries between themselves and potential new shareholders.

* The authors are respectively, Assistant Professor, Culverhouse School of Accountancy, University’
o f Alabama; and Ernst and Young Alumni Professor of Managerial Accounting, University of
Maryland. (Paper received December 1992, revised and accepted March 1993)
Address for correspondence: Lawrence A. Gordon, Ernst and Young Alumni Professor of
Managerial Accounting, College of Business and Management, University of Maryland, College
Park, Maryland 20742, USA.

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and 238 Main Street, Cambridge, MA 02142, USA.
180 GRINER AND GORDON

According to the managerial hypothesis, managers who have a small ownership

stake in the firm use internal cash flow to undertake a level of capital
expenditures higher than that which would maximize the wealth of other current
shareholders.
Both hypotheses agree that internal cash flow is an important determinant
of the level of capital expenditures, but differ sharply in their predictions of
the role of insider ownership. The pecking order hypothesis predicts no
association between capital expenditures and insider ownership, whereas the
managerial hypothesis predicts an inverse association. Recent studies of the
determinants of capital expenditures (Fazzari and Athey, 1987; and Fazzari
et al., 1988) interpreted the significance of internal cash flow in a pecking order
framework, but did not attempt to test this explanation against the managerial
alternative.
Accordingly, the purpose of this study is to empirically test the conflicting
predictions of the two hypotheses. The most important finding of the study
is that there is no association between capital expenditure levels and insider
ownership in any of the four years under study, after controlling for other
determinants of capital expenditures. This finding supports the pecking order
hypothesis and contradicts the managerial hypothesis. T h e managerial
hypothesis receives only limited support from the existence of an association
between capital expenditures and the interaction between internal cash flow
and insider ownership in two of the four years. The main conclusion is that
reliance on internal cash flow to finance capital expenditures is not caused by
conflicts of interest between managers and current shareholders, but rather
is a consequence of information asymmetries between managers and potential
new shareholders. The primary implication of the study is that shareholders
do not need to cede ownership to management in order to provide managers
with incentives when making capital expenditure decisions. Additional research
is needed to better understand why insider ownership does not affect capital
expenditure levels, despite the fact that it has been shown to influence a variety
of other management decisions.
The remainder of this paper is organized as follows. The next section develops
the conceptual argument underlying the empirical study. The third section
describes the models, hypotheses, and sample. The fourth section discusses
the results and implications of the study. The fifth and final section provides
a brief summary and statement of the conclusions of the paper.

CONCEPTUAL ARGUMENT

Internal Cash Flow (Liquidity) as a Determinant of Capital Expenditures

Jorgenson and Siebert (1968) conducted one of the first comprehensive
comparisons of the explanatory power of competing theories of the determinants

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 181
of capital expenditures. Based on a time series analysis of fifteen large
manufacturing firms over twenty years, they ranked the models in the following
order: (1) neoclassical, (2) sales accelerator, (3) expectations, and (4) liquidity.
Elliot (1973) extended the work of Jorgenson and Siebert (1968) by conducting
cross-sectional and time series analyses using a sample of 184 manufacturing
and non-manufacturing firms. In Elliot’s study, the liquidity model ranked
first in both the cross-sectional and time series results. Nair (1979) showed that
the rankings of the various models were in part dependent on the accounting
techniques utilised. Grabowski and Mueller ( 1972) compared the explanatory
power of a neoclassical shareholder welfare model to that of a liquidity-based
managerial welfare model and concluded that the latter was ‘both conceptually
and statistically superior’ (Grabowski and Mueller, 1972, p. 23). More recently,
Fazzari and Athey (1987) and Fazzari et al. (1988) offered evidence that liquidity
adds significant explanatory power to a variety of capital expenditure models.
Although previous studies are generally in agreement that internal cash flow
is an important determinant of capital expenditure levels, there is substantial
disagreement as to why this is the case. Agency theorists have proposed two
conflicting explanations for the observed reliance on internal cash flow to finance
capital expenditures. These two explanations are known as the ‘pecking order’
and ‘managerial’ hypotheses.
The pecking order hypothesis does not acknowledge a conflict of interest
between managers and current shareholder^.^ According to the pecking order
hypothesis proposed by Myers (1984) and Myers and Majluf (1984), managers
are forced into reliance on internal cash flow because of information asymmetries
between themselves and potential new shareholders. When managers who are
seeking to maximize the wealth of current shareholders have information that
is not available to potential new shareholders, the new investors reduce the
price they are willing to pay for the new shares under the assumption that
managers will use the private information to act in the best interests of current
shareholders. If the private information is favorable, managers who wish to
use external finance are required to issue under-valued shares. Managers who
rely entirely on external financing will be denied funds for some of the capital
expenditures that would increase the wealth of current shareholders. According
to the pecking order hypothesis, the reliance on internal cash flow results from
managers seeking to avoid the under-valuation of shares imposed by imperfect
external capital markets, thereby maintaining the ability to undertake all capital
expenditures that would increase the wealth of current shareholders.
In contrast, the managerial hypothesis focuses on the conflicts of interest
between managers and current shareholders that arise from the separation of
ownership and control. Berle and Means (1932) were among the first to
acknowledge conflicts between managers and owners. Marris (1964) emphasized
internal cash flow and capital expenditures as focal points for this conflict by
arguing that managers tend to retain and re-invest a greater portion of earnings
than is in the best interest of shareholders. In a similar spirit, Grabowski and

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182 GRINER AND GORDON

Mueller (1972) argued that reliance on internal cash flow to finance capital
expenditures is a manifestation of managers acting in their own interest to the
detriment of shareholders. Jensen and Meckling (1976) framed the conflict
between managers and owners in terms of agency theory. More recently, Jensen
(1986) used an agency argument to conclude that ‘the problem is how to
motivate managers to disgorge the cash rather than invest it’ in capital
expenditures that do not serve the interests of shareholders Uensen, 1986,
p. 323). Several authors have argued that the agency conflicts are reduced (but
not eliminated) by a variety of market mechanisms Uensen and Meckling, 1976;
Fama, 1980; Jensen and Ruback, 1983; Hart, 1983; and Jensen, 1986).

Internal Cash Flow, Insider Ownership, and Capital Expenditures

Managerial theories hinge upon the separation of ownership and control.
According to Jensen and Meckling (1976), managers who own less than one-
hundred percent of the firm have incentives and opportunities to take actions
that do not benefit other owners. The incentive exists because managers enjoy
all of the non-pecuniary benefits of their actions without having to bear all of
the pecuniary costs. The opportunity arises as a result of the inability of owners
to costlessly observe all of the actions taken by management. The divergence
of preference between managers and owners, in conjunction with the
information asymmetries resulting from the separation of ownership and
control, has led to the use of mechanisms for aligning the interests of managers
and owners. Two such mechanisms are accounting-based compensation plans
and insider ownership of shares and options.
Larcker (1983) found that adoption of long-term performance plans was
associated with increases in capital expenditures and shareholder returns.
Waegelein (1988) obtained similar results for firms that adopted short-term
bonus plans. Newman (1989) found that the degree of capital intensity was
associated with the choice of after-tax versus pre-tax earnings measures in
managerial compensation plans. Gaver (1992) found that firms adopted long-
term performance plans in part to align management incentives and shareholder
interests in the presence of stagnant investment opportunities sets. Collectively,
this body of literature supports the argument that capital expenditure levels
are affected by agency considerations and that incentive-based compensation
plans are used to attempt to align the interests of managers and shareholder^.^
Little is known about the relation between insider ownership and capital
expenditures. However, there is a large body of research that investigates the
other effects of insider ownership. Analytical work by Haugen and Senbet (1981)
showed that insider ownership of options can provide managers with incentives
to make decisions that promote the interests of shareholders. Morck et al. (1988)
found an association between insider ownership and the financial performance
of the firm. Jensen et al. (1992) empirically established interdependencies among
insider ownership, debt levels, and dividend policies. Walkling and Long (1984),

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 183
Benston (1985), Agrawal and Mandelker (1987), and Sicherman and Pettway
(1987) offered evidence that insider ownership affects the level and nature of
merger and acquisition activity entered into by firms. As noted by Benston
(1985, p. 82):
. . . stock ownership is an important means by which the managers are induced to
act in the interests of shareholders.
T h e fact that several studies have found effects of insider ownership on a broad
range of decisions lends credence to the possibility that insider ownership
influences capital expenditure level^.^'^
According to the managerial hypothesis, internal cash flow provides the
opportunity for self-seeking managers to make capital expenditures, and low levels
of insider ownership provide the incentive for managers to choose a level of capital
expenditures higher than that preferred by other shareholders. According to
the pecking order hypothesis, reliance on internal cash flow is a consequence
of managers acting in the best interest of current shareholders, regardless of
the level of insider ownership. T h e purpose of this study is to test the conflicting
predictions of the pecking order and managerial hypotheses. T h e next section
describes the models, statistical hypotheses, a n d sample that are used in the
study.

EMPIRICAL PROCEDURES

T w o basic steps are followed to test the pecking order and managerial
hypotheses. First, we examine bivariate associations between capital
expenditures, internal cash flow, and insider ownership. Second, we propose
a benchmark equation to control for other factors that are known to influence
capital expenditure levels, and then extend the benchmark to include internal
cash flow, insider ownership, and their interaction. This section specifies the
regression equations, states the statistical hypotheses to be tested, defines the
variables, and describes the sample. T h e Appendix provides a listing of the
sample firms for each year.

Bivasiate Analysis
T h e pecking order and managerial hypotheses agree that internal cash flow
should have a n important influence on the level of capital expenditures. For
this reason, the first step in the analysis is to estimate the equation:’
Capexp(t) = BO + Bl*[Flow(t)].
Capexp(t) is the amount of expenditures on property, plant, and equipment
(Cornpustat item No. 30). We follow Lehn a n d Poulsen (1989) and Lang et
al. (1991) by defining Flow as:

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184 GRINER AND GORDON

FLOW = INC - TAX - INTEXP - PFDIV - COMDIV

where,
INC = operating income before depreciation (Compustat item No. 13);
TAX = total income taxes (Compustat item No. 16 minus the change
in the deferred taxes from the previous year to the current year
(change in Compustat item No. 35));
INTEXP = gross interest expense on short- and long-term debt (Compustat
item No. 15);
PFDIV = total amount of preferred dividend requirement on cumulative
preferred stock and dividends paid on noncumulative preferred
stock (Compustat item No. 19);
COMDIV = total dollar amount of dividends declared on common stock
(Compustat item No. 21).
Both the pecking order and managerial hypotheses predict that B1 will be
positive in each year. This test establishes the foundation for subsequent
discriminations between the competing hypotheses. Controls for firm size and
capital intensity are introduced in equation (4) below.
Under the managerial hypothesis, insider ownership is expected to reduce
the propensity of managers to over-invest in capital expenditures by forcing
them to bear more of the pecuniary consequences of their actions. Thus, an
inverse association between capital expenditures and insider ownership would
support the managerial hypothesis. The pecking order hypothesis assumes that
there is no conflict of interest between managers and current shareholders,
thereby implying no association between capital expenditures and insider
ownership. We take the predictions of the pecking order argument as the null
hypothesis and test it against the alternative of the inverse association implied
by the managerid hypothesis. We predict that capital expenditures will be linear
in the reciprocal of insider ownership,* leading to a regression equation of the
form:
Capexp(t) = BO + Bl*[l/IO(t)].
Insider Ownership (10) is defined as the percentage of votes corresponding
to shares and options owned by officers and directors as a group.g Under the
managerial hypothesis, B1 is predicted to be positive. Controls for firm size
and capital intensity are introduced in equation (4) below.

Multivariate Analysis
It is necessary to reinforce any finding of bivariate associations by showing
that the associations persist after controlling for other factors that are known
to influence the level of capital expenditures. Previous research has established
associations between capital expenditures and a broad range of variables.

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 185
However, there is not a consensus concerning which one of the various models
of the determinants of capital expenditures exhibits the greatest explanatory
power and/or strongest theoretical foundations. The analysis contained here
uses a benchmark regression equation that incorporates two key determinants
of capital expenditure levels. Specifically, the benchmark capital expenditure
equation is:"
Capexp(t) = BO + Bl*[Sales(t)] + B2*[Capint(t- l ) ] . (3)
Sales is defined as Compustat item No. 12. Capital intensity (Capint) is
defined as the ratio of net property, plant, and equipment (Compustat item
No. 8) to total assets (Compustat item No. 6).
Sales is included in the equation to control for size.'' Without this control,
any bivariate association between capital expenditures and internal cash flow
could be spurious, since both capital expenditures and internal cash flow are
likely to be positively associated with firm size. Also, any bivariate association
between capital expenditures and insider ownership could be spurious to the
extent that large firms tend to have a smaller percentage of votes concentrated
in the hands of officers and directors (Jensen et al., 1992). Allowing sales to
enter the equation removes effects attributable to size and permits an
examination of the incremental effects of internal cash flow and insider ownership.
Capital intensity is included in the equation to control for differences in the
need for property, plant, and equipment. Without this control, bivariate
associations could be spurious because firms with similar demands for property,
plant, and equipment may tend to be similar in cash flow patterns and
ownership structure.
B1 and B2 in equation (3) are predicted to be positive. Ultimately, the
appropriateness of equation (3) depends upon its explanatory power. High
explanatory power will serve as evidence that the equation captures the effects
it intends to capture and thus functions well as a benchmark against which
to assess the incremental explanatory power offered by the variables of interest
in this study.
The complete regression equation extends the benchmark by including
internal cash flow, insider ownership, and their interaction, as follows:'*
Capexp(t) = BO + Bl*[Sales(t)] + B2*[Capint(t- l)] + B3*[Flow(t)]
+ B4*[l/IO(t)] + B5*[Flow(t)/IO(t)] (4)
Table 1 summarizes the predictions of the pecking order and managerial
hypotheses for the coefficients in equation (4). Neither hypothesis makes any
prediction for the sign of the intercept term BO. Both hypotheses are consistent
with the prediction that B1, B2, and B3 are all positive. As explained earlier,
the managerial hypothesis implies an inverse association between capital
expenditures and insider ownership in which the level of capital expenditures
is positively associated with the reciprocal of insider ownership. The pecking

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186 GRINER AND GORDON

Table 1
Predictions of the Pecking Order and Managerial Hypotheses

Predicted S i p
Coefficient Independent Variable Pecking Order Managerial
BO - No Prediction No Prediction
B1 Sales + +
B2 Capint + +
B3 Flow + +
B4 1/ I 0 0 +
B5 *
Flow (l/IO) 0 +

order hypothesis implies no such association. Thus, the managerial hypothesis

predicts that B4 should be positive, whereas the pecking order hypothesis
predicts that B4 should be zero. The coefficient of the interaction term (B5)
is also helpful in discriminating between the two theories. The managerial
hypothesis predicts that B5 will be positive. Under the managerial hypothesis,
internal cash flow provides the opportunity to make discretionary growth-
inducing capital expenditures without interference by current shareholders or
other capital market agents. A low level of insider ownership provides the
incentive to invest internal cash flow in capital expenditures rather than pay
it out to shareholders, because managers with a small ownership stake reap
the non-pecuniary benefits of growth without having to bear the full cost of
unprofitable growth. Over-investment will be most severe for firms where
managers have both the greatest opportunity and the greatest incentive. These
firms are those for which the interaction term corresponding to B5 will be largest
(i.e. where internal cash flow is large and insider ownership is small). Thus,
we again use the pecking order argument as the null hypothesis against the
alternative of a positive sign for B5.

Sample
The sample consists of a subset of the 1988 Fortune 500 that responded to a
mailed request for proxy statements for each year in the period 1985 through
1988. The Fortune 500 were chosen because of their dominant role in the US
economy, the industrial nature of the firms, and the precedent established by
previous studies. The year 1988 was chosen because it was the most recent
year for which complete data were available at the time the study was initiated.
The three years prior to 1988 were included to ensure that the findings were
not unique to any one year. One hundred and sixty firms provided one or more
useable responses, resulting in observations for each year as follows:

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 187
Year Number of Observations
1985 91
1986 99
1987 112
1988 73
A firm-year combination was deemed useable if two conditions were met:
(i) the company provided a proxy statement disclosing the insider ownership
information, and (ii) required financial statement data were available on
Compustat.

RESULTS AND DISCUSSION

Biuariate Results and Discussion

Table 2 shows the results of regressing capital expenditures against cash flow
for each year, as specified in equation (1). As predicted, the cash-flow coefficient
is positive and statistically significant in each year. This confirms the predictions
of both the pecking order and managerial hypotheses. In order to discriminate
between the two hypotheses, it is necessary to examine the association between
capital expenditures and insider ownership.
Table 3 provides descriptive statistics for the insider ownership data. As seen
in Table 3, the percentage of votes corresponding to shares and options owned
by management and directors as a group varies from less than one percent
to about 50 percent in each year. The data are extremely homogeneous across
time periods.

Table 2
Regression of Capital Expenditures Against Cash Flow:
Capexp = BO + B1 (Flow)

1985 I986 1987 I988

N = 91 N
= 99 N
= 112 N
= 73
R2 = 0.82 RZ = 0.73 R2 = 0.78 R2 = 0.57
B T B T B T B T
BO -13.92 -0.24 78.04 2.27' 90.32 2.21* 97.59 1.39
B1 1.74 20.03"' 1.02 16.57"* 1.09 19.98". 1.18 9.81'*'
Notes:
Significant at the 0.10 level.
* * Significant at the 0.01 level.
* * * Significant at the 0.001 level.

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188 GRINER AND GORDON

Table 3
Insider Ownership - Descriptive Statistics*

1985 I986 1987 I988

N = 91 N = 99 N = 112 N = 73

Mean 7.60 6.90 7.47 8.10

Standard Deviation 11.06 9.71 11.14 10.97
Minimum 0.11 0.20 0.09 0.13
Maximum 51.40 47.20 52.00 53.49
Nofe;
* Insider ownership is defined as the percentage of votes corresponding to shares held by
officers and directors as a group.

Table 4
Regression of Capital Expenditures Against the Reciprocal of Insider
Ownership:
Capexp = BO + B1 (1/IO)

I985 1986 1987 I988

N= 91 N
= 99 N = 112 N = 73
R2 = 0.31 RZ = 0.09 R' = 0.22 R2 = 0.12

B T B T B T B T
BO 160.09 1.40 201.61 2.88;. 201.67 2.49; 229.52 2.22.
B1 368.31 6.45*** 169.27 3.30" 206.77 5.71." 211.77 3.32;;
Notes:
* Significant at the 0.10 level.
* * Significant at the 0.01 level.
* * * Significant at the 0.001 level

Plots of capital expenditures against insider ownership (available from the

authors) revealed an inverse curvilinear association. Table 4 shows the results
of a formal test of the association specified in equation (2). As hypothesized,
there is a positive, statistically significant association between capital
expenditures and the reciprocal of insider ownership in each year. This finding
favors the managerial hypothesis by supporting the argument that reductions
in the degree of separation of ownership and control reduce the propensity of
managers to invest in capital expenditures.

Multivariate Results and Discussion

The bivariate analyses are revealing but not conclusive. The positive bivariate
association found between capital expenditures and cash flow is neutral with

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 189

Table 5
The Benchmark Regression Equation
Capexp = BO
+ B1 (Sales)
+ B2 (Capint)
I985 I986 1987 I988
N
= 91 N = 99 N = 112 N = 73
R2 = 0.94 R2 = 0.82 R2 = 0.88 R2 = 0.74
B T B T B T B T
~ ~~ ~ ~~ ~~ ~~ ~~

BO -328.59 -3.47** -100.24 -1.33 -136.07 -1.81' -284.33 -1.91*

B1 0.09 34.82*** 0.07 20.76*** 0.06 27.91*** 0.08 13.50***
B2 4.11 3.47*** 1.52 1.68* 2.26 2.56* 3.54 1.95.
Notes:
* Significant at the 0.10 level.
* * Significant at the 0.01 level.
* * * Significant at the 0.001 level.

respect to the pecking order and managerial hypotheses. The inverse bivariate
association between capital expenditures and insider ownership conforms to
the predictions of the managerial hypothesis and contradicts the pecking order
hypothesis. However, to fully discriminate between the two hypotheses, it is
necessary to introduce controls for other factors that are known to influence
capital expenditure levels. We employ the benchmark model in equation (3)
for this purpose.
Table 5 shows the results of estimating the benchmark model for each year.
As seen in Table 5 , every coeficient is statistically significant with the predicted
sign in each year. The high explanatory power of the model in each year
indicates that it is well suited to the purpose of controlling for the effects of
factors other than cash flow and insider ownership. In fact, this simple model
offers greater empirical explanatory power than many of the more sophisticated
models that have appeared in the literature.
Table 6 shows the results of estimating the complete regression equation
which includes sales, capital intensity, internal cash flow, insider ownership,
and the interaction between internal cash flow and insider ownership. The
results reported in Table 6 permit an examination of three pertinent questions.
First, does the positive association between capital expenditures and internal
cash flow persist after controlling for other factors that influence capital
expenditure levels? Second, does the inverse curvilinear association between
capital expenditures and insider ownership persist after controlling for other
factors that influence capital expenditure levels? Third, what is the interactive
effect of internal cash flow and insider ownership on capital expenditure levels?
Each of these questions is addressed below.

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Table 6
The Complete Regression Equation:
Capexp = BO
+ B1 (Sales)
+ B2 (Capint)
+ B3 (Flow)
+ B4 (1/IO)
+ B5 (Flow/IO)
1985 1986 1987 1988
N = 91 N
= 99 N = 112 N = 73
R2 = 0.96 R2 = 0.83 R2 = 0.90 R2 = 0.74
B T B T B ~~ ~
7- ~~ ~
B T
BO -205.24 -2.62' -16.32 -0.20 -94.63 -1.33 -334.3 -2.20'
B1 0.06 7.92'*' 0.05 6.09**' 0.05 10.53'" 0.07 6.20'"
B2 2.85 2.97'' 0.42 0.42 1.75 2.09' 3.63 2.00'
B3 0.33 2.86'. 0.42 2.40' 0.09 0.98 0.27 1.38
B4 21.28 1 . 1 7 1.52 0.05 15.57 0.89 63.96 1.55
B5 0.09 6.17'*' -0.04 -1.04 0.03 2.71" -0.06 - 1.03
Noles:
Significant at the 0.10 level.
* * Significant at the 0.01 level.
* * * Significant at the 0.001 level.

The results in Table 2 indicated the existence of a positive and statistically

significant association between capital expenditures and internal cash flow in
every year. The somewhat weaker results for B3 in Table 6 suggest that some
portion of the apparent influence of cash flow evident in Table 2 can be
attributed to firm size and capital intensity. However, it should be noted that
the internal cash flow coefficient is positive in every year and statistically
significant in two years. This confirms that internal cash flow is an important
determinant of capital expenditure levels even after controlling for firm size
and capital intensity. The significance of internal cash flow as a determinant
of capital expenditure levels is equally consistent with both the pecking order
and managerial hypotheses. In order to discriminate between these two
explanations, it is necessary to examine the effects of insider ownership.
Table 4 provided evidence of a statistically significant inverse curvilinear
association between capital expenditures and insider ownership in every year.
As seen in the results for B 4 in Table 6, the association disappears when other
determinants of capital expenditures are allowed to enter the equation. This
result supports the pecking order hypothesis and casts doubt on the managerial
hypothesis by contradicting the managerial prediction that capital expenditure
levels should be affected by the degree of separation of ownership and control.

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However, to fully understand the effects of insider ownership it is necessary
to consider the possibililty of a n interaction with internal cash flow.
Earlier, we justified the inclusion of an interaction term in the equation to
test the managerial hypothesis. High levels of internal cash flow provide
managers with the opportunity for over-investment in capital expenditures,
and low levels of insider ownership provide the incentive. Thus, the managerial
hypothesis predicts a positive sign for the coefficient for the interaction between
internal cash flow and the reciprocal of insider ownership. T h e results in Table
6 provide limited support for the managerial hypothesis in that B5 is positive
in the two years in which it is statistically significant.I3 T h e existence of a
positive association between capital expenditures and the interaction term,
coupled with the absence of any main effects for insider ownership, indicates
that incentives for over-investment (in the form of low insider ownership) will
not lead to higher capital expenditure levels unless managers also have the
opportunity to finance the expenditures through internal cash flow.
Overall, the results favor the pecking order hypothesis. Internal cash flow
is clearly an important determinant of capital expenditure levels, and insider
ownership is not. This finding contradicts the predictions of the managerial
hypothesis and confirms the view of Myers (1984) and Myers and Majluf (1984)
that reliance on internal cash flow does not reflect a conflict of interest between
managers and current shareholders. The evidence in this study does not suggest
reasons why ownership by officers and directors has no effect on capital
expenditure levels. O n e seemingly plausible conjecture is that capital
expenditure decisions tend to be made by division-level managers, not by officers
and directors. Investigation of this and other possibilities is needed to better
understand how the choice of capital expenditure levels differs from the large
number of managerial decisions that are affected by the ownership stake of
officers and directors.

SUMMARY AND CONCLUSIONS

Although several studies have established that internal cash flow (liquidity) is
an important determinant of the level of corporate capital expenditures, there
is disagreement as to why this is the case. According to the pecking order
hypothesis, managers rely on internal cash flow in a n effort to undertake all
capital expenditures that serve the best interest of current shareholders.
According to the managerial hypothesis, managers rely on internal cash flow
in a n effort to undertake capital expenditures in a n amount greater than that
which serves the best interest of shareholders. T h e two hypotheses agree that
capital expenditures should be positively associated with internal cash flow but
differ sharply in their predictions concerning the effects of insider ownership.
This study used subsets of the Fortune 500 in each of the years 1985 through
1988 to test the pecking order and managerial hypotheses. The bivariate analysis

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192 GRINER AND GORDON

of capital expenditures and internal cash flow confirmed the prediction of both
theories that internal cash flow is an important determinant of capital
expenditure levels. The bivariate analysis also revealed an inverse curvilinear
association between capital expenditures and insider ownership. The purpose
of the multivariate analysis was to see if the bivariate results persisted after
controlling for other factors that influence capital expenditure levels. The
multivariate analysis confirmed that internal cash flow is an important
determinant of capital expenditure levels. However, the most important finding
was that there was no association between capital expenditure levels and insider
ownership in any of the four years, after controlling for other determinants
of capital expenditures. The conclusion is that reliance on internal cash flow
to finance capital expenditures is not caused by conflicts of interest between
managers and existing shareholders, but rather is a consequence of information
asymmetries between managers and potential new shareholders. The
implication of the study is that shareholders do not need to cede ownership
to management in order to provide managers with incentives when making
capital expenditure decisions. Additional research is needed to better understand
why insider ownership influences a broad range of management decisions but
does not affect capital expenditure levels.

APPENDIX

Sample Firms - By Year

1985 1986 1987 1988

1. Abbott Laboratories X X
2. Affiliated Publications X
3. Allied Signal X X
4. Amax Inc. X X
5. American Greetings X X X
6. Ametek X X X
7. Amoco X X X
8. AMP X X X
9. Ashland Oil X X X X
10. Avery International X X X
11. Avon Products X
12. Baker-Hughes Inc. X X
13. Bard (C.R.) Inc. X X X
14. Bemis Co. X X X
15. Boise Cascade X X
16. Briggs & Stratton X X X
17. Brunswick Corp. X
18. Calmat Co. X X
19. Caterpillar X X X
20. Chevron X X
21. Chrysler X
22. Clark Equipment Co. X X
23. Clorox Co. X

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 193

1985 I986 1987 1988

24. Coastal Corp. X
25. Coca-Cola X X
26. Cooper Industries X X X
27. Cooper Tire & Rubber X X X
28. Corning Inc. X
29. CPC International X
30. Crane X
3 1. Crown Cork & Seal X X X
32. Dana Corp. X
33. Data General Corp. X X X
34. Dean Foods X X
35. Dennison Manufacturing X X X
36. Donnelley (R.R.) & Sons X X X
37. Dow Jones & c o . X X X
38. Dupont X X X X
39. E-Systems Inc. X X X X
40. Eagle-Picher Industries X X X X
41. Eaatman Kodak Co. X X
42. Eaton Corp. X X
43. Emerson Electric X X
44. Englehard Corp. X X X
45. Ethyl Corp. X X X X
46. Exxon Corp. X X X
47. Federal Paper Board X X X
48. Federal-Mogul Corp X X
49. FMC Corp. X X
50. Ford Motor Co. X X
5 I . Fuqua Industries X X X X
52. Gannett Co. X X
53. Gencorp Inc. X
54. General Dynamics X
55. General Electric X X X
56. General Mills Inc. X
57. Georgia-Pacific X X X
58. Gerber Products X X X
59. Gillette Co. X X
60. Goodrich (B.F.) Co. X
61. Great Northern Nekoosa Co. X
62. Handy & Harman X X X
63. Harris Corp. X X X
64. Harsco Corp. X X X
65. Hercules Inc. X X
66. Hershey Foods Corp. X X X
67. Hillenbrand Industries X X
68. Ingersoll-Rand c o . X X X
69. Inland Steel Industries X X X
70. Inspiration Resources X
71. James River Corp. Of Virginia X X X
72. Johnson Controls X X X
73. Kerr-McGee Corp. X X X
74. Kimberley-Clark X X X
75. Knight-Ridder Inc. X
76. Lafarge Corp. X
77. Leggett & Platt X X X
78. Loral Corp. X
79. Louisiana Land & Exploration X X X X
80. Louisiana-Pacific X

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194 GRINER AND GORDON

I985 I986 1987 I988

81. LTV Corp. X

82. Lubrizol Corp. X X X
83. Mapco Inc. X X X
84. Marion Labs X X X X
85. Martin Marietta X X X X
86. Maytag Corp. X X
87. McDonnell Douglas X
88. Mead Corp. X X X X
89. Media General X X
90. Medtronic Inc. X
91. Merck & Co. X X
92. Minnesota Mining and Manufacturing X
93. Mobil Corp. X X X
94. Monsanto X
95. Motorola Inc. X X X X
96. Murphy Oil X X
97. Nacco Industries X
98. Nalco Chemical Co. X X X
99. National Service Industries X X X X
100. Newell Companies X
101. Norton Co. X X X
102. Nucor Corp. X
103 Olin Corp. X X X X
104 Oxford Industries X X
105 Parker-Hannilin X X X
106 Pennzoil Co. X X X X
I07 Pepsico Inc. X X X X
I08 Phelps Dodge Corp. X X X
109 Phillips Petroleum X X X
110 Pittway Corp. X
1 1 1 Polaroid Corp. X
112 Pope & Talbot Inc. X X X X
113 Potlatch Corp. X X X
114 PPG Industries Inc. X
115. Quaker Oats X X
116. Quaker State Corp. X X X
1 17. Raytheon X X X
118. Reynolds & Reynolds X X
119. Robertson (H.H.)Co. X
120. Rockwell International X X X
121. Rohm & Haas X X
122. Rubbermaid Inc. X X X
123. Russell Corp. X X X X
124. Schering-Plough X X X
125. Scott Paper Co. X X X
126. Shaw Industries X X
127. Sherwin-Williams X X X X
128. Smith (A.O.) Corp. X X
129. Southdown Inc. X X X
130. Springs Industries X X
131. Standard Products X
132. Stanley Works X X X X
133. Stone Container X
134. Sun Co. Inc. X X X
135. Sundstrand Corp. X X
136. Tambrands Inc. X
137. Tecumseh Products X

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 195
1985 1986 1987 1988
138. Teleflex Inc. X X
139. Tenneco Inc. X X X
140. Texaco Inc. X X X
141. Texas Instruments X X X X
142. Thomas & Betts X
143. Tosco Corp. X X
144. T R W Inc. X X
145. Tyler Corp. X X X
146. Union Camp Corp. X X
147. United Technologies X
148. Universal Foods X X
149. Unocal Corp. X X X
150. Upjohn Co. X X
151. Valero Energy X X X
152. Vulcan Materials Co. X X X
153. Wang Laboratories X X X
154. Warner-Lambert Co. X
155. Westvaco Corp. X X
156. Weyerhauser Co. X
157. Whirlpool Corp. X
158. Wrigley (Wm. Jr.) X X
159. Xerox Corp. X X
160. Zenith Electronics X
Number of Observations by Year 91 99 I12 73

NOTES
1 I t should be noted that there is a large body of literature addressing related capital expenditure
issues. For example, the strengths and weaknesses of various decision rules for selecting specific
capital projects have received much attention (e.g., Klammer, 1972,and 1973;Sundem 1974;
Schall et al., 1978;Schall and Sundem, 1980;Haka et al., 1985;Copeland and Weston, 1988;
and Gordon, 1989).
2 The liquidity measure used in this study is described as ‘internal’ cash flow rather than ‘free’
cash flow, although its operational definition is identical to that of the free cash flow measure
employed by Lehn and Poulsen (1989)and Lang et al. (1991).Free cash flow has been defined
as the ‘cash flow left after the firm has invested in all positive NPV projects’ (Lang et al. 1991,
p. 319). Under this definition, measurement of free cash flow requires observation of the
investment opportunity set for each sample firm. Because investment opportunity sets are not
observable, proxies must be employed. Lehn and Poulsen (1989)used sales growth rates for
this purpose, and Lang et al. (1991)used Tobin’s 9. Acknowledging the limitations in any
numerical measure of firms’ opportunity sets, Gaver (1992)conducted a content analysis of
the reports in Value Line to assess the degree to which investment portfolios were expanding
or contracting. Because of the broad array of conceptual and empirical difficulties known to
be associated with Tobin’s q , and the subjectivity inherent in Gaver’s approach, we followed
Lehn and Poulsen (1989)and allowed sales growth to enter our final regression equation. Due
to the fact that sales growth did not add statistically significant explanatory power in any year,
we dropped the sales growth terms from the equation. Although all of our sample firms are
large, mature, industrial corporations that are likely to face similar opportunities, the inherent
unobservability of investment opportunity sets leads us to refrain from use of the term ‘free
cash flow’.
3 Interpreted broadly, the term ‘pecking order’ refers to the empirically established preference
for internal over external financing and for debt over equity when external financing is used.
Myers (1984)and Myers and Majluf (1984)dismissed the notion that the use of a pecking
order necessarily goes against shareholder interests. They also objected on both conceptual and

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196 GRINER AND GORDON

empirical grounds to the so-called ‘static trade-off theory, according to which firms establish
and move toward target debt-to-value ratios. They proposed a modified pecking order hypothesis
that incorporates the elements of the static trade-off theory that have been shown to have empirical
support. The modified pecking order hypothesis is built upon an agency-based rationale that
explains why managers’ financing preferences do not reflect conflicts of interests between
managers and current shareholders. For brevity and clarity in this study, we use the term ‘pecking
order hypothesis’ to mean the agency-based rationale offered by Myers (1984) and Myers and
Majluf (1984) as an alternative to the view that reliance on internal finance is contrary to the
interests of shareholders.
4 Most previous studies focused on the effects of adopting an incentive-based compensation plan
for the first time. Gaver et al. (1992) identifed several difficulties associated with studies of
performance plan adoption. Also, in the time period examined in this study (1985-1988) virtually
all large industrial firms, including the ones in our sample, had at least one incentive-based
compensation plan in place. For these reasons, we have not attempted to incorporate
compensation plans into this study.
5 While suggestive, the evidence concerning the effects of insider ownership on merger and
acquisition activity cannot be generalized to all capital expenditures due to the fact that mergers
and acquisitions often substantially change the ordinary course of business for the firms involved.
Shareholders frequently have the right to vote on mergers and acquisitions proposed by
management, but do not have the right to vote on capital expenditures made in the ordinary
course of business. Also, extensive press coverage exposes mergers and acquisitions to greater
scrutiny than ordinary capital expenditures not requiring a business combination.
6 Insider ownership also has been shown to help align the interests of managers and shareholders
regarding sell-off decisions (Hirschey and Zaima, 1989). However, as with merger and acquisition
decisions, sell-off decisions are substantially different from capital expenditure decisions.
7 Neither the pecking order hypothesis nor the managerial hypothesis makes any predictions
concerning the intercept term in equations (1) through (4). Accordingly, we report each intercept,
f-value, and significance level, but we do not attempt to offer interpretations.
8 The conjecture that capital expenditure levels are linear in the reciprocal of insider ownership
is motivated by the notion of diminishing marginal returns. A priori, we believe that a given
aboslute increase in the level of insider ownership will decrease capital expenditures more at
low levels of insider ownership than at high levels. Prior to estimating equation (Z), the insider
ownership data were plotted against capital expenditures to confirm the reasonableness of the
functional form specified.
9 The measures of insider ownership employed in previous studies have focused on the dollar
value of insider holdings (Benston, 1985; and Agrawal and Mandelker, 1987) or the percentage
of shares owned by insiders (Agrawal and Mandelker, 1987; Morck et al., 1988; and Jensen
et al., 1992). In this study, the term ‘ownership’ is defined to mean the right to vote on corporate
matters. Because different classes of stock sometimes have different numbers of votes per share,
we introduce a new measure by defining insider ownership as the percentage of votes
corresponding to shares and options owned by officers and directors as a group. The necessary
data were obtained from proxy statements.
10 There is considerable intuitive appeal to the notion that capital expenditure levels should be
inversely associated with the firm-specific cost of capital. This possibility was formally
incorporated into the neoclassical capital expenditure model developed by Jorgenson (1963)
and tested in Jorgenson and Sieben (1968), Grabowski and Mueller (1972), Elliot (1973), Fazzari
and Athey (1987) and Fazzari et al. (1988). There are three reasons why we have not incorporated
a cost-of-capital variable in equation (3). First, the objective of equation (3) is to empirically
control for determinants of capital expenditures other than internal cash flow and insider
ownership, not to provide a fully specified analytic model of capital expenditure behavior. For
the purposes of this study, the relevant test of equation (3) is its explanatory power. The results
in Table 5 indicate that the criterion of explanatory power has been met. Second, there is a
broad range of limitations inherent in measures of the cost of capital that have been employed
in previous studies. Jorgenson and Siebert (1968) and Elliot (1973) used an accounting-based
rate of return to proxy for the firm’s equilibrium return. Grabowski and Mueller (1972) used
measures of the cost of equity based upon the CAPM and upon firm-specific risk, but did not
consider the cost of debt. More recently, Fazzari and Athey (1987) incorporated debt into the
calculations by conjecturing various values for firms’ debt betas, whereas Fazzari et al. (1988)

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 CASH FLOW, INSIDER OWNERSHIP, CAPITAL EXPENDITURES 197
resorted to the assumption that all firms earn the Baa bond yield. Each of these approaches
is fraught with shortcomings. Third, we improved upon previous measures by employing a
firm-specific weighted average cost-of-capital based upon the CAPM for the cost of equity and
the ratio of interest expense to book value of long-term debt for the cost of debt. We found
no association with capital expenditures and decided to drop the cost of capital variable from
equation (3).
1 1 Several studies of the determinants of capital expenditures have controlled for size by using
financial ratios with sales or fixed assets in the denominator (for example, Larcker, 1983; Fazzari
et al., 1988; and Newman, 1989). Similarly, Lehn and Poulsen (1989) normalized their cash
flow measure by dividing by the market value of common equity, whereas Lang et al. (1991)
used the book value of equity. Lev and Sunder (1979) argued that ‘control for size by the ratio
method is adequate only under very restrictive conditions’ and recommended instead that
researchers define a ‘structural relationship between the investigated variable and size variable’
(Lev and Sunder, 1979, p. 188). In developing the accelerator theory of capital expenditures,
Eisner (1967) specified a structural relation between capital expenditure levels and sales by
showing that capital expenditures should be proportional to output. Although some accelerator
models have used the change in sales as the independent variable, we simply use sales, as
recommended by Abel and Blanchard (1986) and Fazzari et al. (1988).
12 An argument might be made that a simultaneous equations model is needed due to the fact
that capital expenditures cannot be studied in isolation from other phenomena, such as dividends.
Grabowski and Mueller (1972) used a simultaneous equations model incorporating capital
expenditures, dividends, and research and development expenditures. They interpreted the
results as confirming ‘the findings of single equation studies of these variables’ (Grabowski
and Mueller, 1972). Single equation models of capital expenditures continue to dominate the
literature. For these reasons, we employ a single equation model.
13 Although we do not have a specific explanation as to why the interaction term is significant
in only two years, we can offer two plausible conjectures. The first possibility is that the difference
across years results from our use of different sample firms in each year. A second possibility
suggested by Uri (1982) is that capital expenditure functions are unstable over time. We believe
that both factors are at work in the four annual cross-sections in this study.

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