Managerial Finance

Product market competition, cash flow and corporate investments

Hussein Ali Ahmad Abdoh, Oscar Varela,
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 Product Market Competition, Cash Flow and Corporate Investments

Abstract

Purpose This study examines the effects of product market competition on capital
spending (investments) financed by cash flow, and the role of financial constraints on
these effects.

Design/methodology/approach The Herfindahl-Hirschman index of concentration

measures competition. Earnings retention, working capital, the Kaplan and Zingales
(1997) index and cash flow shortfalls measure financial constraints. Regressions
relating capital spending to competition are performed for the full sample, as well as
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financially constrained and unconstrained, and growth and value firms’ sub-samples.
For robustness, large reductions in import tariffs are examined to exogenously measure
competition, with the impact of these on capital spending tested via the difference-in-
difference method.

Findings The results show that competition fosters valuable investments when firms
are financially unconstrained, especially for growth firms, and reduces these
investments when they are financially constrained, especially for value firms.

Practical implications – The role of policy-makers in alleviating financial constraints

should be focused toward growth firms that operate in competitive industries. As well,
increasing financial pressure on value firms in competitive industries can have desirable
effects, as it forces these firms to reduce investment inefficiency.

Originality/value – Many firm-specific and environmental factors drive the relation

between competition and investment. Khanna and Tice (2000) find profitable firms
increasing and highly levered firms decreasing investments in response to Wal-Mart's
entry into their markets. Jiang, Kim, Nofsinger and Zhu (2015) suggest that
environments with predictable growth drive a positive relation between competition and
investments. This study claims that another factor that affects this relation is the firm’s
level of financial constraints.
Keywords Product market competition, Financial constraints, Cash flow investment

1
 Paper type Research paper
1. Introduction
The role of product market competition and capital investments is nuanced. Competition
may promote investments by reducing managerial slack. Giroud and Mueller (2011)
conclude that competition substitutes for effective corporate governance and Hart
(1983) that competition reduces managerial slack. Competition may also reduce
investments because of the disciplinary effects that competitive pressures impose. Valta
(2012) finds that greater product market competition increases the cost of bank loans
for U.S. public manufacturing firms and Frésard and Valta (2012) that trade
liberalization (tariff reductions) leads U.S. firms to significantly reduce capital
investments and accumulate cash reserves.
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This paper, motivated by Valta (2012) and Frésard and Valta (2012), argues that the
relation between competition and capital investments is contingent on the level of
financial constraints. We focus specifically on cash flow investments, as agency cost of
cash flow – a major issue in corporate governance – argues that management can
within its discretion easily access cash with little scrutiny (Dittmar and Mahrt-Smith,
2007). We conclude that firms in more competitive industries are associated with
greater (less) capital expenditures if they are financially unconstrained (constrained).1
Our results also support the role of product market competition in reducing managerial
slack (Hart, 1983; Schmidt, 1997; Baggs and De Bettignies, 2007) and encouraging
corporate insiders to invest in value-enhancing projects; as well as the role of
competition in mitigating the overinvestment agency problem. Laksmana and Yang
(2015) find that competition disciplines management on its use of free cash flows in its
investments decisions. We find that financial constraints strengthen the negative
association between competition and cash flow overinvestments.
Our primary measure of product market competition is the Herfindahl–Hirschman Index
(HHI), with a high (low) value related to low (high) product market competition and/or
high (low) industry concentration. The HHI is a widely-used measure for market
concentration and a standard measure of product market competition (e.g., Akdoğu and
MacKay, 2008; Giroud and Mueller, 2011; Santalo and Becerra, 2008; Tirole, 1988). We
examine the moderating effect of financial constraints on the association between
product market competition and corporate capital expenditures, while controlling for

1
The link between competition and investments is multidimensional and not
straightforward. Higher product market competition can generate lower incentives to
invest due to lower post-entry rents. In contrast, it may motivate firms to invest and
innovate to escape or reduce the adverse effects of competition. This paper does not
address the wider debate on the relation between competition and total investments, but
rather seeks to understand how market concentration impacts cash flow investments
with respect to financial constraints.

2
 variables that prior research finds to be correlated with corporate investments. In
addition, firms are classified as financially unconstrained (constrained) when they have
low (high) earnings retention ratios, high (low) working capital, low (high) Kaplan and
Zingales (KZ) indexes, and/or low (high) cash flow shortfalls. We also follow Broussard,
Buchenroth and Pilotte (2004) in using Tobin’s Q and investment cash flow sensitivity to
measure levels of overinvestment and underinvestment. Huang, Jiang, Liu and Zhang
(2011) used the sensitivity of investments to cash flows to examine investment
distortions due to top executives' overconfidence.
We identify valuable (nonvaluable) investments as concentrated within growth (value)
firms. A positive (negative or no) investment sensitivity to cash flow within the value
(growth) firms is considered overinvestment (underinvestment) assuming these firms do
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not face financial constraints. Competition increases (decreases) the sensitivity of

investments to cash flow for growth firms if they are financially unconstrained
(constrained), suggesting that an unconstrained state promotes investment of cash flow
in valuable projects. Competition also reduces the sensitivity of value firms’ investments
to cash flow more significantly when firms are financially constrained, suggesting that a
constrained state inhibits or reduces cash flow overinvestment.
Finally, we examine the robustness of our results by using the annual 1989‐2005 tariff
data for U.S. manufacturing to identify industries that experienced an import tariff
reduction, tantamount to an exogenous change toward greater competition. The results
are robust and consistent with our earlier findings.
The remainder of this paper is organized as follows. Section 2 presents the literature
review and hypotheses development while Section 3 presents the sample selection and
variables, including descriptive statistics. Section 4 discusses the analysis and results,
and Section 5 presents the robustness test results from using tariff reductions as an
exogenous increase in competition. Section 6 presents the summary and conclusions.
2. Literature review and hypotheses development
Jensen and Meckling (1976) argue that agency conflicts arise because incentives to
search for profitable investment opportunities decrease when a manager's ownership
share decreases. Underinvestment may also be due to problems related to adverse
selection and debt overhang. Myers and Majluf (1984) develop an adverse selection
model where uninformed outside investors reduce bid prices for new shares believing
that managers are better informed about the value of the firm's assets and its growth
opportunities. Myers’s (1977) theory of debt overhang argues that outstanding debt can
lead to underinvestment, as the benefits of new investments in this case mostly accrue
to creditors instead of owners.
Other research suggests that overinvestment exists in firms. According to Jensen
(1986), managers have incentives to overinvest or otherwise misallocate free cash flow.
Richardson (2006) finds evidence that overinvestment is concentrated in firms with the

3
 highest levels of free cash flow. And Huang, Jiang, Liu and Zhang (2011) find that top
executives' overconfidence leads to increased investment.

Many studies suggest that the relation between product market competition and
corporate investment is conditioned on firm or environment specific factors. Giroud and
Mueller (2011) find that weak corporate governance firms in noncompetitive industries
make more value destroying acquisitions. On the other hand, Jiang, Kim, Nofsinger and
Zhu (2015) find a positive relation between product market competition and corporate
investment using a 1999–2010 sample of Chinese manufacturing firms. They postulate
that such positive relations are associated with environments with high, predictable
growth.
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We propose another factor in the relation between product market competition and cash
flow investments, with a positive relation when firms are financially unconstrained and
negative when financially constrained. The positive relation can be explained by the
agency role of competition. First, the likelihood of bankruptcy increases if competition
pushes down the price of output. Hart’s model (1983) proposes this idea wherein well-
managed rival firms may lower prices to capture more market share, such that firms
cannot afford to slack even in good times because industry prices are set competitively.
Second, strong competition in the product markets forces inefficient firms out (Fama
and Jensen (1983)). Third, competition increases the sensitivity of CEO turnover to firm
performance. DeFond and Park (1999) argue that CEO turnover is higher among firms
that operate in more competitive industries, because firm performance is easier to
gauge when many rivals exist.2
The agency role of competition, however, may not hold if firms are financially
constrained. In this alternative “financial constraints of competition” hypothesis, we
propose that competition may reduce investments in value enhancing projects because
of the difficulties of obtaining financing in competitive markets. First, product market
competition is positively associated with the firm’s idiosyncratic volatility (Gaspar and
Massa, 2006), which may be priced when investors cannot hold a well-diversified
portfolio. Second, the cost of borrowing is higher for firms operating in competitive
industries. Valta (2012) shows that one standard deviation increase in product market
competition raises financing costs by about 13 basis points for an average loan. This
increase in financing cost may force managers to invest less than optimum in order to
secure internal funds. Kim, Mauer, and Sherman (1998); Harford (1999); and Opler,
Pinkowitz, Stulz, and Williamson (1999) report that firms with greater difficulties in
obtaining external capital accumulate more cash, such that competition may drive firms
to underinvest cash flow even if there are valuable projects. This hypothesis also

2
Moral hazard regarding the manager’s performance may be lessened when
shareholders can compare the firm’s performance to a relative benchmark. Holmstrom
(1979, 1982) provides a detailed discussion about the moral hazard problem.

4
 implies that competition reduces overinvestment of cash flow more strongly when firms
are financially constrained. Luo (2011) argues that when firms have difficulty raising
external funds, empire-building managers of cash-rich firms should be less likely to
spend cash on negative NPV projects as compared to unconstrained managers.
3. Sample selection, variables and descriptive statistics
The sample consists of all Compustat firm-year observations over the period 1985–
2014, except that financial firms (SIC 6000–6999) and utilities (SIC 4900–4949) are
excluded owing to their regulatory footprints. Firm years with non-positive values for
total book assets, cash holdings and capital expenditures are also excluded. In addition,
firms must have at least two consecutive observations for all variables in order to
remain in the final sample.
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Regression equation (1) shows the main variables associated with investments,
measured as (I/K) i,t where I refers to investment, equal to capital expenditure, and K to
the beginning of period capital stock (net property, plant and equipment) for firm i in
year t.3
(I/K) i,t = a0 + a1(S/ K)i,t-1 + a2 Q i,t -1+ a3 (C/K) i,t-1 + a4 (CF/ K) i,t-1 + a5 ln(MV i,t-1)

+ a6 HHI i,t-1.(CF/ K) i,t-1 + a7 LV i,t-1 + a8 HHI i,t-1 + a9 FC i,t-1 + τt+ λi +εi,t (1)

Firms’ investment decisions (I) are expected to respond positively to sales (S). Our
firms' growth opportunities control variable is Tobin's Q (Q), i.e. the market value of
assets divided by book value of assets. Cash (C) is cash plus short-term investments.
Cash flow (CF) is calculated as income before extraordinary items plus depreciation and
amortization minus preferred and common dividends. Firm size is measured as the
natural logarithm of the market value of equity [ln(MV)]. Small firms have significantly
higher investment rates than large firms, even after controlling for standard empirical
proxies of firm real investment opportunities and financial status, including Tobin’s Q
and cash flow (Gala and Julio,2016). As shown in (1), I, S, C and CF are standardized
by K. Leverage (LV) is measured as total liabilities divided by total assets.
Four measures are used for financial constraints (FC), as there is no consensus on
which is best. These include the earnings retention ratio (RR), working capital ratio
(WK), Kaplan and Zingales index (KZ), and cash flow shortfalls (CS). Overall, firms that
are more financially constrained have higher RR, lower WK, higher KZ index or higher
CS.

3
The terms 'capital expenditures’, “capital spending” and ‘investments’ are used
interchangeably. We note that this study does not consider research and development
investment because otherwise the observations would be significantly reduced,
whereas a large number is necessary given the significant correlations between some
of the independent variables (see Table II).

5
 The first financial constraint measure (RR) uses the annual payout ratio, i.e. earnings
retention, as suggested by Fazzari et al. (1988) who argue that unconstrained
(constrained) firms are more likely to have higher (lower) payout ratios [or lower (higher)
earnings retention ratios]. The firm-year observations with earnings retention ratios
below (above) the sample median are financially unconstrained (constrained).
The second measure (WK) uses working capital. A higher working capital enables firms
to meet their financial needs or raise external finance. Fazzari and Petersen (1993)
demonstrate the role of working capital in smoothing investments. Ding, Guariglia, and
Knight (2013) explore the role played by working capital management to explain why
Chinese firms invest at very high rates despite significant financing constraints. Firms
with working capital above (below) the sample median are classified as financially
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unconstrained (constrained).
The third measure (KZ) uses the Kaplan and Zingales (1997) index to measure the
likelihood that a firm faces financial constraints. Following Lamont, Polk and Saaá-
Requejo (2001), we construct the index by applying the following linearization to the
data.
KZ = −1.001909*(Cash Flow/K) + 0.2826389*Tobin’s Q + 3.139193*(Debt/Total Capital)
− 39.3678*(Dividends/K) − 1.314759*(Cash/K) (2)
Companies with a higher KZ-Index scores are more likely to experience difficulties
financing their ongoing operations. Firms with KZ indexes above (below) the sample
median are considered financially constrained (unconstrained).
The fourth measure (CS) uses the cash flow shortfall as another variable to measure
financial constraints. Like Daniel, Denis and Naveen (2008), we estimate the firm’s cash
flow shortfall as expected investment plus expected dividends less available cash flow.4
Firms with cash flow shortfall above (below) the sample median are considered
financially constrained (unconstrained).
The Herfindahl-Hirschman index of concentration (HHI) is measured as the sum of the
squared market shares. We measure a firm’s market share as the ratio of the firm’s
sales to the sum of sales of all firms in the industry, using its sales data from
COMPUSTAT. The range for HHI is from 0 to 1, indicating a competitively large number
of very small firms when equal to 0 to a monopolistic firm when equal to 1. Our HHI
measure of product market competition uses different specifications based on two, three
and four-digit Standard Industrial Classifications (SIC). Only the results for the two-digit

4
Details on the calculation of the firm’s cash flow are provided within the definition of
cash flow shortfalls (CS) in the appendix.

6
 SIC are presented for brevity, although similar results apply for the three or four-digit
SICs.5
The parameter τt is a year fixed effect, λi is a firm fixed effect and εi,t is the error term.
The firm and year fixed effects capture differences in capital spending across firms and
years that are not captured by the independent variables. All independent variables are
lagged by one year to mitigate the possibility of simultaneous or reverse causality bias.
The control variables we include in equation (1) are consistent with those used in prior
studies.
Our variable of interest is HHI, the proxy of product market competition, and more
importantly, its interaction with CF/ K. If the coefficient estimate of HHI is statistically
significant and negative (positive), we can conclude that product market competition is
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positively (negatively) associated with capital spending (investments). If the coefficient

estimate of HHI.(CF/ K) is statistically significant and negative (positive), we can
conclude that product market competition is positively (negatively) associated with
capital spending (investments) that is sensitive to cash flow increases.
Table I reports descriptive statistics for the full, concentrated and competitive samples,
and test results for significant differences between the latter two. The concentrated
(competitive) sample includes industries with Herfindahl- Hirschman Index (HHI) above
(below) the median. Descriptive statistics for the full sample are in table I, column 1. The
mean (median) HHI of the full sample is 0.075 (0.056) indicating that the average firm
operates in a competitive industry. The mean (median) Tobin’s Q of 1.675 (1.347) is
higher than one, indicating that the average firm has valuable investment opportunities.
The mean (median) capital expenditures (I/K) equaled 21.4 (18.8) percent of beginning
capital, and the mean (median) holdings of cash and marketable securities relative to
total capital (C/K) equaled 68.2 (19.5) percent, indicating that the latter was quite
skewed to the right.
Descriptive statistics for the competitive and concentrated samples are in table I,
columns 2 and 3, respectively. Firms in the competitive sample are quite different from
those in the concentrated sample, as most differences are statistically significant. For

5
The Herfindahl-Hirschman index is calculated as HHI = ∑

 S , where Si is the
market share of firm i in its industry and N is the number of firms in the industry. The
use of HHI as a measure of industry concentration is not without criticism. For example,
HHI is incapable of capturing collusion between firms. The COMPUSTAT data as well
does not include private firms such that their absence in the data could lead to an
inaccurate measure of concentration. However, as larger firms are usually publicly
owned and these firms significantly determine the value of HHI, the bias due to the
exclusion of private, and usually small, firms may be minimal (Laksmana and Yang,
2015).

7
 example, the mean of cash to fixed capital (C/K) in the competitive sample is 86.8
percent, significantly higher than the concentrated sample’s 50.8. The earnings
retention ratio (RR) of 3.498 percent for firms in the competitive sample is significantly
lower than the 3.751 percent for firms in the concentrated sample. This difference could
be explained by the disciplinary forces of competition which induce managers to payout
excess cash. Grullon and Michaely (2007) find that firms in more competitive industries
have significantly higher payout ratios than firms in less competitive industries.
[Place Table I Here]
Table II presents the correlation coefficients between selected variables. The table
shows that investment (I/K) is significantly and positively correlated with sales, Tobin’s
Q, cash, working capital and cash flow. Sales are also significantly and positively
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correlated with cash flow and cash. There is a negative correlation between investment
and leverage indicating that debt overhang could distort the firm’s incentive to invest.
Aivazian, Ge and Qiu (2005) show that leverage is negatively related to investment and
that this negative effect is significantly stronger for firms with low growth opportunities
than those with high growth opportunities.
[Place Table II Here]
4. Analysis and results
The model (equation 1) is estimated for the full sample, and the two sub-samples
comprising growth and value firms, respectively. Firms with Tobin’s Q greater (less)
than one are classified as growth (value) firms because they are more (less) likely to
have valuable investment opportunities. The underinvestment problem is expected to be
more prevalent with growth firms, and the overinvestment problem more prevalent with
value firms.
Table III shows the regression results using the full, growth and value samples. The full
and growth sample regression indicates that capital spending (I/K) is significantly
positively related to sales (S/K) but not to Tobin’s Q. In contrast, the value sample
regression indicates that I/K is significantly negatively related to S/K and significantly
positively related to Q. Thus, capital spending appears to increase with product demand
but not with the profitability of investments for the full and growth samples. Capital
spending (I/K) is also significantly positively related to cash flow to capital spending
(CF/K), and cash to capital spending (C/K) for all samples The coefficient of leverage
(LV) is negative and significant only in the value sample, supporting Lang, Ofek and
Stulz’s (1996) view that leverage reduces investments for firms with low Tobin Q’s.
The interaction between competition and cash flow (HHI*CF/K) is a main variable of
interest, measuring the influence of competition on cash flow investing. The results
show a negative coefficient for the full sample (-0.269, significant at 1%) and growth
sample (-0.284, significant at 1%), indicating that the sensitivity of capital spending to
cash flow increases with higher competition for the full sample, and specially for growth

8
 firms. There are two explanations for a negative value for the interaction term
HHI*CF/K. First, competition creates financial constraints that raise the capital spending
sensitivity to cash flow (the financial constraints of competition hypothesis). Second,
competition is a disciplinary force on managers to increase the capital spending in value
enhancing projects. Since the average Tobin’s Q is greater than one, the latter
explanation is plausible. In order to examine the agency role of competition, we need to
isolate the impact of financial constraints on the relation between competition and
capital spending. To achieve this, we divide the growth and value samples into
financially constrained and unconstrained sub-samples.
[Place Table III Here]
Tables IV to VII reports the results for the growth and value samples, when further
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divided into financially constrained and unconstrained sub-samples, for our four
measures of constraints, respectively. Each table’s columns show the results for growth
and value firms that are financially constrained and unconstrained, respectively, labelled
as growth/constrained, growth/unconstrained, value/constrained, and
value/unconstrained.
Table IV reports the growth and value sample results when the earnings retention ratio
serves as the criteria for differentiating between constrained and unconstrained firms.
The coefficient of the interaction term HHI* CF/K for the growth/unconstrained sample is
-0.0666 (significant at 1%), suggesting increased capital spending in valuable projects
for financially unconstrained growth firms. In contrast, the coefficient for the
growth/constrained sample of 0.284 (significant at 1%) suggests that competition
reduces capital spending when firms are constrained. The coefficients for the
value/constrained sample of 0.179 (significant at 1%) and value/unconstrained sample
of 0.007 (significant at 5%) suggests that competition in value firms decreases capital
spending, even if firms are financially unconstrained, possibly because of its agency
role.
[Place Table IV Here]
Tables V and VI report the results when working capital (Table V) and the Kaplan-
Zingales (KZ) index (Table VI) serves as the criteria for measuring financial constraints.
The results are consistent with the evidence that competition reduces (increases) the
sensitivity of capital spending for growth firms that are financially constrained
(unconstrained). The coefficients of (HHI*CF/K) for the growth/constrained firms are
0.069 (significant at 10%) for the working capital measure and 0.229 (significant at 1%)
for the KZ measure. In contrast, the growth/unconstrained results are -1.824 (significant
at 1%) for working capital and -0.709 (significant at 1%) for KZ. Financial constraints
also play a role in reducing capital spending in non-valuable projects. Using the working
capital measure of financial constraint, the coefficient (HHI*CF/K) of 0.480 (significant at
1%) for the value/constrained firms is higher than the coefficient of 0.032 (significant at
1%) for the value/unconstrained firms, such that the impact of competition in reducing

9
 cash overinvestment is higher when firms are financially constrained. When using the
KZ measure, competition significantly reduces capital spending for the
value/constrained firms as well, but not for the value/unconstrained firms.
[Place Tables V and VI Here]
Table VII report the results when cash flow shortfalls serve as the measure of financial
constraints. Consistent with our earlier findings, the negative impact of competition on
capital spending is concentrated in growth and value financially constrained firms, with
the growth/unconstrained firms the only ones to show a positive result from competition
to cash flow investing.
[Place Table VII Here]
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Overall, the results suggest that competition encourages capital spending in valuable
investment opportunities when firms are not financially constrained, especially for
growth firms. And that financial constraints reduce capital spending, especially for non-
valuable projects, and especially for value firms. Our results should be interpreted with
concerns about the possibility of an endogenously determined concentration measure
(HHI). More precisely, market shares could be determined in equilibrium by firms’ capital
spending and investment decisions. We address this endogeneity concern by using
reduction in tariffs as an exogenous factor that increases competition.
5.Tariff reductions as an exogenous increase in competition – a robustness test
Large reductions in import tariff rates promote more competition, such that such
changes can be studied for further evidence on the relation between product market
competition and capital spending. Changes in import tariffs leads to exogenous changes
in product market structure, where a reduction (negative change) reflects lower barriers
to entry and increases in imports. Valta (2012) shows that when tariff rates decrease
from 3% to below 1.5%, import penetration significantly increases from 19.5% to 24.1%.
Tariff duties data are available at the four-digit SIC (Standard Industry Classification)
level for U.S. manufacturing (SIC 2000–3999) from 1990 to 2005.6 Ad valorem tariff
rates are computed as the ratio of duties collected at U.S. customs divided by the Free-
On-Board custom value of imports for each four- digit SIC industry and each year in our
data set. Following Fre´sard and Valta (2016), a large tariff reduction is identified if it is
at least three times larger than the average annual (absolute) change in tariff rate
across all years. To estimate the effect of the tariff reductions on capital spending, we
use a difference-in-difference approach. In particular, if a firm operates in an industry
that experiences a large tariff reduction (a “treated” firm), we compute the difference in
investment after and before the tariff reduction. We then compare this difference with
the corresponding difference for a “control” firm. Each treated firm is matched to a

6
The tariff data are available on Peter Schott’s website, referenced as:
http://www.som.yale.edu/faculty/pks4/sub_international.htm
10
 control firm on the basis of industry and firm-level characteristics using the following
procedure.
First, we match each treated firm to control firms based on a two-digit industry
classification. This approach balances two concerns. On the one hand, the industry
partition based on broad industry classification includes a larger potential of control
firms that share similar firm-level characteristics with the treated firm. On the other
hand, since the tariff rates are based on the four-digit industry level, matching with
control firms at the two-digit level is feasible because the control firm will have different
tariff rate changes from that for the treated firm.
Second, out of the remaining control firm candidates, we select the nearest neighbor on
the basis of five firm-level characteristics: Investment, cash holdings, cash flow,
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leverage, and size, computed in the year prior to the tariff reduction. To be considered
in our final sample, treated and control firms need to have no missing observations on
any matching variable. The control firm is also required to have a yearly tariff rate
change with an absolute value that is not greater than three times the absolute value of
the average tariff change during the sample period. This ensures that the control firm is
not significantly affected by the treatment. The nearest neighbor is the control firm with
the lowest Mahalanobis distance to the treated firm across the five matching variables.7
The matching based on pretreatment values ensures that the results are not driven by
the treated firm’s characteristics.
For each treated firm and for each control firm, we compute the difference between the
firm’s capital spending (I/K) following the tariff reduction and the firm’s capital spending
in the year preceding the tariff reduction. Then, we regress the difference in the change
in I/K between the treated and control firms on the difference in their Tobin’s Q market-
to-book ratios (Q) and financial constraints’ measures (FC).

∆(I/K) i-j = a0+ a1 Q i-j +a2 FC i-j+a3 Q i-j×FC i-j +εi,j (4)

where ∆(I/K) i-j: is the difference in the change in I/K between the treated firm (i) and
control firm (j), Q i-j: is he difference in Q between the treated and control firms in the
year prior to the tariff reduction, and FC i-j: is the difference in the FC between the
treated and control firms in the year prior to the tariff reduction, with the measures the
same as used in our earlier tests.

The difference in Q between the treated and control firms is expected to increase the
difference between their I/K following the tariff reductions as the treated firm has more
valuable growth opportunities, as proxied by the market-to-book ratio, than the control
firm.

7
The Mahalanobis distance between treated firm i and candidate firm j is given by =
[(Xi −Xj)’  −1 (Xi −Xj)]1⁄2, where X is a (5 × 1) vector containing the five matching
variables and  is the (5 × 5) covariance matrix of these five variables.
11
 Table VIII reports the results for regression equation (4). The coefficient for Q i-j is
positive and significant in all financial constraints’ specifications, suggesting that the
effect of competition, such as that from a reduction in import tariff rates, on capital
expenditures is increasing when firms have future growth opportunities. The interaction
coefficient for Q i-j×FC i-j indicates how financial constraints impact the relation between
the market-to-book ratio and investments. In most specifications, except for the
retention ratio’s (RR) insignificance, the interaction term shows that the relation between
market-to-book and investments is stronger when treated firms are less financially
constrained than control firms. The coefficient for the interaction term when using
working capital (WK) as a measure of financial constraint is positive (.003) and
significant (at one percent). This indicates that treated firms with less financing
constraints when WK is higher and with higher market-to-book ratios than their control
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firms invest more after tariff reductions. The coefficient for the interaction term when
using the Kaplan and Zingales (KZ) or cash flow shortfalls (CS) measures of financial
constraint are negative (-.0002 for KZ and -.0005 for CS) and significant (at one
percent). This indicates that treated firms with less financing constraints when KZ and
CS are lower and with higher market-to-book ratios than their control firms invest more
after tariff reductions.
[Place Table VIII Here]
6. Summary and conclusions

The overarching objective of this paper is to study the relation between the competitive
environment that a firm operates in and its cash flow capital investments, contingent on
its level of financial constraints. Competition may by acting as a disciplinary force on
management promote (valuable) investments by reducing managerial slack. It may also
reduce (non-valuable) investments by promoting investment efficiency.
This study contributes to a literature where scholars have long argued that competitive
pressures from product markets play an important role in inducing managers to carry
out a sound investment policy. Recent evidence, however, shows that competition
increases financial constraints, which may prevent firms from using cash flow for
undertaking valuable investments.
Product market competition is identified with the Herfindahl–Hirschman Index, as lower
values indicate more competitiveness in an industry. It is also identified with annual
1989‐2005 tariff data for U.S. manufacturing, as industries experiencing import tariff
reduction are subject to more competitiveness. The latter, an exogenous change toward
greater competition, serves as a robustness check for the initial results. Also, firms with
low (high) earnings retention ratios, high (low) working capital, low (high) Kaplan and
Zingales (KZ) indexes, and/or low (high) cash flow shortfalls are classified as financially
unconstrained (constrained); and firms with Tobin’s Q high greater (less) than one are
classified as growth (value) firms.

12
 This study finds evidence for the influence of financial constraints on the relation
between competition and cash flow investments. Overall, the results suggest that
competition encourages capital spending in valuable investment opportunities when
firms are not financially constrained, especially for growth firms. And that financial
constraints reduce capital spending, especially for non-valuable projects, and especially
for value firms. The results show that the relation between competition and investment
is moderated by the level of financial constraints.
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13
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16
 Appendix. Definitions for selected variables
Variable Definition
I Investment, i.e. capital expenditures, (item #30)
K Fixed capital, i.e. net property, plant and equipment, (item #8)
S Sales (item #12)

Q Tobin's Q, i.e. market value of assets divided by book value of assets.

Market value of assets is measured as total assets (item #6) minus book equity plus market
value of common stocks
Book equity is defined as total asset minus total liabilities (item # 181) minus
preferred Stock (item # 10) plus deferred taxes (item # 74)
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C Cash and short-term investments (item #1)

CF Cash Flow, i.e. income before extraordinary items (item #18) plus depreciation and
amortization (item #14) minus preferred dividends (item # 19)
minus common dividend (item # 21)
LV Leverage, i.e. total liabilities (item # 181) divided by total assets (item # 6)

HHI The Herfindahl-Hirschman index, i.e. sum of the squared market shares (firm sales divided
by total industry sales) of firms in the industry.
RR Earnings retention ratio, i.e. Income before Extraordinary Items (item # 18) divided by the
amount of ordinary dividends (item # 21).
MV Market Value of Equity

WK WK is measured as the firms’ net current assets minus current liabilities

Kaplan and Zingales index,

KZ
i.e. equals−1.001909*CashFlow/K+0.2826389*Tobin’sQ+3.139193*Debt/TotalCapital
−39.3678*Dividends/K − 1.314759*Cash/K

CS Cash Flow Shortfalls = expected investment + expected dividends – available cash flow
Cash Flow = net cash flow from operations (item # 308) + R&D (item # 46) × (1–T) –
preferred dividends (item # 19), where R&D is Research
and Development expenditures and T is the effective tax rate (the ratio of total taxes paid to
pre-tax income). Note that R&D is already deducted as a pre-tax expense in the income
statement; therefore, the after tax R&D is added back to Cash Flow from Operations,
which itself is already on an after-tax basis.
R&D is Research and Development expenditure. T is the effective tax rate calculated as the
ratio of total taxes paid to pre-tax income (item #16 /item #170).
Expected investment = expected capital expenditure (CAPEX) + expected R&D × (1–T).
Note that the post-tax value of R&D is added to CAPEX because
R&D is expensed in the income statement whereas CAPEX is not.
Expected CAPEX = (Industry median ratio of CAPEX/lagged assets) × Firm’s lagged
assets. Expected R&D = (Industry median ratio of R&D/lagged assets) × Firm’s lagged
assets. Expected dividends are the annual cash dividend (item # 21) paid in the prior year,
and is zero for non-payers
Note: Item number, i.e. “item #”, refers to COMPUSTAT annual data iItems.

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Table I. Descriptive statistics for the full sample, and competitive and concentrated sub-samples,
and test results for differences between the competitive and concentrated sub-samples
Variable (1) Full sample (2) Competitive (3) Concentrated (4) Mean Diff (2-3) (5) Median Diff (2-3)
HHI, Herfindahl-Hirschman 0.075 0.038 0.118 -0.08*** -0.049***
Index (0.056) (0.038) (0.087)
I/K, Investment/Fixed Capital 0.214 0.214 0.213 0.0004 0.004
(0.188) (0.182) (0.178)
MV, Market Value Equity 6766.76 7806.59 5728.37 2078.22*** 292.113***
(711.584) (1509.689) (1217.576)
LV, Leverage 0.510 0.509 0.512 -0.004 0.006
(0.523) (0.527) (0.521)
C/K, Cash/Fixed Capital 0.682 0.868 0.508 0.360*** 0.077***
(0.195) (0.253) (0.175)
Q, Tobin’s Q 1.675 1.769 1.583 0.186*** 0.127***
(1.347) (1.502) (1.376)
S/K, Sales/Fixed Capital 6.202 6.187 6.168 0.019 0.454***
(4.161) (4.354) (3.901)
RR, Retention Ratio 3.613 3.498 3.751 -0.252*** -0.222***
(2.627) (2.679) (2.901)
WK, Working Capital 1.207 1.408 0.996 0.412*** 0.264***
(0.571) (0.711) (0.447)
KZ, The KZ Index -5.008 -6.526 -3.325 -3.201*** -1.446***
(-1.61) (-2.342) (-.896)
CS, Cash Flow Shortfalls 105.785 116.871 93.501 23.369 -4.012
(1.702) (0.119) (4.131)
Observations 22,315 11,691 10,541
Notes: The concentrated sample (competitive sample) includes industries with Herfindahl-Hirschman Index (HHI) above the median (below the
median). The HHI is equal to the sum of the squared market shares of all firms in an industry. The numbers in columns 1, 2 and 3 denote mean
and median (in parentheses) values, with the variable definitions available in the appendix. The parametric t-test (column 4) and nonparametric
Wilcoxon signed-rank test (column 5) are to evaluate differences in means and medians, respectively, between the competitive and concentrated
sub-samples. Observations are winsorized at 99% and 1% to control for extreme observations or data recording errors. The symbols *, **, and ***
indicate that the test statistics are significant at the 10%, 5%, and 1% levels, respectively.

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Table II. Correlation coefficients for selected variables

Variable I/K S/K Q C/K CF/ K ln(MV) HHI* CF/ K LV HHI RR KZ CS

I/K 1
S/K 0.033*** 1
Q 0.003 0.006** 1
C/K 0.072*** 0.259*** 0.002 1
CF/K 0.018*** 0.061*** -0.08*** -0.312*** 1
ln(MV) -0.012*** -0.052*** -0.015*** -0.014*** 0.035*** 1
HHI* CF/ K -0.001 0.303*** -0.010*** 0.038*** 0.155*** 0.008*** 1
LV 0.005** 0.007*** 0.552*** -0.002 -0.224*** -0.031*** -0.047*** 1
HHI -0.001 0.003 -0.002 -0.003 0.0031 -0.007*** -0.012*** -0.002 1
RR 0.00001 0.001 -0.002 -0.0004 0.003 0.007 0.0008 -0.021*** 0.0005 1
KZ -0.012*** -0.314*** 0.033*** -0.334*** -0.0404*** -0.003 -0.027*** 0.035*** 0.0009 0.0002 1
CS -0.001 -0.009*** -0.003 -0.006** -0.0006 0.091*** -0.0006 -0.0006 -0.004 -0.009* 0.002 1

WK 0.021*** 0.132*** -0.112*** 0.555*** 0.142*** 0.023*** 0.062*** -0.309*** 0.0004 0.00005 -0.172*** -0.002
Notes: Variable definitions are available in the appendix. The symbols *, **, and *** indicate that the correlations are significant at the 10%, 5%,
and 1% levels, respectively.

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Table III. Regressions for capital expenditures (I/K) for the full sample, and the growth and value sub-samples
Variable Full sample Growth sample Value sample
HHIi,t-1.CF/K i,t-1 -0.269*** -0.284*** 0.037 ***
(0.0196) (0.024) (0.013)
(CF/ K)i,t-1 .00304*** 0.022*** 0.003 **
(0.0002) (0.0015) (0.001)
HHI i,t-1 1.412 2.501 -0.288
(2.269) (3.163) (0.538)
Q i,t -1 0.003 0.0036 0.778***
(0.003) (0.004) (0.194)
(S/ K)i,t-1 0.003*** 0.003*** -.0005**
(0.0008) (0.001) (0.0002)
(C/K) i,t-1 0.028*** 0.031*** 0.009***
(0.001) (0.001) (0.0005)
Ln(MV i,t-1) -0.306** -0.47*** -.1629 ***
(0.078) (0.109) (0.029)
LV i,t-1 -0.001 -0.005 -.873 ***
(0.016) (0.018) (0.191)
No. of obs. 151,821 119,242 32,579
Year Indicators YES YES YES
Firm level Indicators YES YES YES
Notes: The dependent variable (I/K) is capital expenditures (I) in year t scaled by fixed capital (K). Variable definitions are available in the
appendix. The symbols *, **, and *** indicate that the coefficients are significant at the 10%, 5%, and 1% levels, respectively. Standard errors of
the coefficients are in parentheses.

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Table IV: Regressions for capital expenditures (I/K) for the growth and value sub-samples
of constrained and unconstrained firms, using the earnings retention ratio measure of financial constraint

Variable Growth/Constrained Growth/Unconstrained Value/Constrained Value/Unconstrained

HHIi,t-1.CF/K i,t-1 0.284*** -.0666 *** 0.179*** 0.007**
(0.051) (0.006) (0.07) (0.004)
(CF/ K)i,t-1 0.024*** -0.004 0.103 -.0048***
(0.005) (0.0003) (0.01) (0.0009)
HHI i,t-1 -0.1005 -.3115* 0.024 -0.128
(0.081) (0.173) (0.134) (0.086)
Q i,t -1 .0143*** 0.008** -0.0019 0.208***
(0.002) (0.003) (0.064) (0.035)
(S/ K)i,t-1 .0029*** .004*** -0.004 -0.000007
(0.0002) (0.0003) (0.0007) (0.00008)
(C/K) i,t-1 0.003*** -.0021*** 0.036*** -.002***
(0.001) (0.0003) (0.002) (0.0003)
Ln(MV i,t-1) -0.007 0.0006 -.0266** -0.007
(0.006) (0.012) (0.013) (0.006)
LV i,t-1 -.1098*** -.139 *** -.1599*** -.329***
(0.028) (0.048) (0.062) (0.037)
RR i,t-1 0.000004 0.00002 -0.00005 -0.000002
(0.00002) (0.00003) (0.00008) (0.00001)
No. of obs. 17,983 17,950 4,555 4,094
Year Indicators YES YES YES YES
Firm level Indicators YES YES YES YES
Notes: Financially constrained (unconstrained) firms are those with earning retention ratios above (below) the median. The dependent variable
(I/K) is capital expenditures (I) in year t scaled by fixed capital (K). The appendix provides detailed description of the variables. The *, ** and ***
indicate that the coefficients are significant at the 10%, 5% and 1% levels, respectively. Standard errors of the coefficients are in parentheses.

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Table V: Regressions for capital expenditures (I/K) for the growth and value sub-samples
of constrained and unconstrained firms, using the working capital measure of financial constraint
Variable Growth/Constrained Growth/Unconstrained Value/Constrained Value/Unconstrained
HHIi,t-1.CF/K i,t-1 0.069* -1.824*** 0.480*** 0.032***
(0.041) -0.073 -0.018 -0.007
(CF/ K)i,t-1 -0.001 0.15*** 0.008*** -0.002**
(0.002) (0.003) (0.002) (0.0008)
HHI i,t-1 6.988 2.107 -.391* -0.097
(6.069) (3.623) (0.201) (0.341)
Q i,t -1 0.004 0.039 0.524*** 1.068***
(0.005) (0.024) (0.056) (0.133)
(S/K)i,t-1 0.027*** -0.026*** -.004*** 0.001***
(0.002) (0.001) (0.0007) (0.0002)
(C/K) i,t-1 - 0.124*** -0.151*** -.0217*** 0.002***
(0.015) (0.004) (0.003) (0.0004)
Ln(MV i,t-1) -0.816*** 0.069 -.0454*** -0.199***
(0.188) (0.148) (0.008) (0.023)
LV i,t-1 -0.091*** 2.243*** -.792*** -1.157***
(0.022) (0.535) (0.06) (0.139)
WK i,t-1 -0.024*** 0.274*** -.278*** -0.0008**
(0.002) (0.004) (0.0011) (0.0003)
No. of obs. 58,389 58,524 14,263 17,160
Year Indicators YES YES YES YES
Firm level Indicators YES YES YES YES
Notes: Financially constrained (unconstrained) firms are those with working capital ratios below (above) the median. The dependent variable (I/K)
is capital expenditures (I) in year t scaled by fixed capital (K). The appendix provides detailed description of the variables. The *, ** and *** indicate
that the coefficients are significant at the 10%, 5% and 1% levels, respectively. Standard errors of the coefficients are in parentheses.

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Table VI: Regressions for capital expenditures (I/K) for the growth and value sub-samples
of constrained and unconstrained firms, using the Kaplan and Zingales measure of financial constraint
Variable Growth/Constrained Growth/Unconstrained Value/Constrained Value/Unconstrained
HHI i,t-1*CF/K i,t-1 0.229*** -0.709*** 0.127*** 0.029
(0.050) (0.038) (0.017) (0.022)
CF i,t -1 -0.023*** 0.094*** -0.007 -0.001
(0.003) (0.002) (0.002) (0.002)
HHI i,t-1 5.94 4.885 -0.240 -0.866
(5.788) (4.338) (0.172) (1.21)
Q i,t -1 0.002 0.078** 0.509 1.142***
(0.005) (0.036) (0.072) (0.391)
(S/K)i,t-1 0.047*** -0.031*** 0.006 0.0003
(0.003) (0.001) (0.0002) (0.0004)
(C/K) i,t-1 0.005 0.074*** 0.0009 0.003***
(0.012) (0.002) (0.0008) (0.0007)
Ln(MV i,t-1) -0.838*** -0.065 -0.059 -0.252***
(0.187) (0.167) (0.009) (0.076)
LV i,t-1 -0.018 -0.189 -0.689 -0.600
(0.023) (0.121) (0.073) (0.464)
KZ i,t-1 -0.00003 0.001*** 0.001 -0.0001
(0.0002) (0.0001) (0.001) (0.0002)
No. of obs. 57,935 58,050 15,759 15,566
Year Indicators Yes Yes Yes Yes
Firm level Indicators Yes Yes Yes Yes
Notes: Financially constrained (unconstrained) firms are those with Kaplan and Zingales indexes above (below) the median. The dependent
variable (I/K) is capital expenditures (I) in year t scaled by fixed capital (K). The appendix provides detailed description of the variables. The *, **
and *** indicate that the coefficients are significant at the 10%, 5% and 1% levels, respectively. Standard errors of the coefficients are in
parentheses.

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Table VII: Regressions for capital expenditures (I/K) for the growth and value sub-samples
of constrained and unconstrained firms, using the cash flow shortfalls measure of financial constraint
Variable Growth/Constrained Growth/Unconstrained Value/Constrained Value/Unconstrained
HHIi,t-1.CF/K i,t-1 1.717 *** -1.871 *** 0.132*** 0.105
(0.465) (0.175) (0.033) (0.118)
(CF/ K)i,t-1 0.0009 -0.069*** 0.0002 .0033***
(0.0009) (0.005) (0.0002) (0.0013)
HHI i,t-1 3.178 -0.770 -0.138 -0.383
(16.16) (25.495) (0.384) (1.542)
Q i,t -1 0.018** -.0184 * 0.286*** 0.812***
(0.008) (0.010) (0.031) (0.163)
(S/ K)i,t-1 .0338*** .0155 *** 0.003*** 0.0012***
(0.001) (0.002) (0.0001) (0.0002)
(C/K) i,t-1 0.018*** -.0141*** 0.0006*** .002***
(0.001) (0.004) (0.0002) (0.0003)
Ln(MV i,t-1) -0.219*** -0.717*** -.0136** -0.176***
(0.078) (0.220) (0.004) (0.029)
LV i,t-1 -0.015 -0.013 -.395*** -1.112***
(0.018) (0.0358) (0.032) (0.161)
CS i,t-1 0.00003 0.00006 -0.00000002 0.000004
(0.00007) (0.0004) (0.00002) (0.00002)
No. of obs. 55,931 55,262 14,997 15,451
Year Indicators YES YES YES YES
Firm level Indicators YES YES YES YES
Notes: Financially constrained (unconstrained) firms are those with cash flow shortfalls above (below) the median. The dependent variable (I/K) is
capital expenditures (I) in year t scaled by fixed capital (K). The appendix provides detailed description of the variables. The *, ** and *** indicate
that the coefficients are significant at the 10%, 5% and 1% levels, respectively. Standard errors of the coefficients are in parentheses.

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Table VIII: Regressions for difference between capital expenditures (I/K) for treated firms based on tariff reductions and control firms,
given differences in their market-to-book ratios and financial constraint measures
Variable FC is KZ index FC is WK FC is CS FC is RR
Q i-j .037*** 0.121*** .184*** .0203*
(0.006) (.007) (.007) (.01)
FC i-j .004*** 0.00003 .0003*** -.0001
(.00046) (.002) (.00008) (.0003)
Q i-j× FC i-j -.0002*** .003*** -.0005*** 0.0002
(.00004) (.0002) (.00004) (.0004)
No. of obs. 4,257 4,681 4,269 954
Notes: This table reports the coefficient estimates from the difference-in-difference capital expenditures regressions. The dependent variable is
∆(I/K) i-j which is the difference between the capital expenditures (I/K) change of the treated and control firms. Q i-j: is the difference between the
market-to-book ratio of the treated and control firm in the year prior to the tariff reduction. FC i-j is the difference between the financial constraints
of the treated and control firm in the year prior to the tariff reduction. Financial constraints measures are the Kaplan and Zingales index (KZ),
Working Capital (WK), Cash Flow Shortfalls (CS) and Retention Ratio (RR). Financially constrained (unconstrained) firms are those with Kaplan
and Zingales indexes above (below) the median, working capital ratios below (above) the median, cash flow shortfalls above (below) the median
and earning retention ratios above (below) the median. The *, ** and *** indicate that the coefficients are significant at the 10%, 5% and 1% levels,
respectively. Standard errors of the coefficients are in parentheses.