Thursday, February 5, 2009

Firms' Drastic Actions Dim Long-Term Economic Prospects

Corporations are taking drastic actions, including cancelling investments, scaling back projects, drawing on lines of credit and selling assets, in response to financial constraints resulting from the current credit crisis. This is according to new research from Duke University’s Fuqua School of Business and the University of Illinois at Urbana-Champaign that makes direct comparisons between companies’ operating plans and self reports regarding their current financial health.

In December 2008, Professors John Graham and Campbell Harvey of Duke, and Professor Murillo Campello of the University of Illinois at Urbana-Champaign, surveyed the chief financial officers of 1,275 firms in the U.S., Europe and Asia regarding their outlooks for their companies and the economy in general. The study was part of a larger survey conducted jointly with CFO magazine.

In order to objectively assess firms’ financial constraints, the team asked CFOs to report whether their businesses had been directly affected by the cost or availability of external financing. Of 569 U.S. firms surveyed, 59 percent (or 325 of the respondents) said that they were directly affected by credit constraints.

“We normally assess whether or not firms’ access to capital is constrained via a retrospective review of financial statements,” said Graham, the D. Richard Mead Professor of Finance at Fuqua and Co-Director of the Duke Center for Finance. “To our knowledge, this is the first research to directly assess limitations on firms’ access to funds. Having this information helps us learn more about how companies make investment and financing decisions, and in this case, revealed some startling details about the way corporations are responding to the crisis.”

“Companies are in survival mode,” said Campbell Harvey, the J. Paul Sticht Professor of International Business at Fuqua. “Slashing profitable projects to conserve cash feeds into additional unemployment. More importantly, the credit constraints rob the economy of future growth opportunities. That is, if these projects were completed in years to come, they would generate profits and additional employment opportunities. But, sadly, this is a future these projects will never see. This is a less well-known consequence of the credit crisis.”

The team found that firms that are not experiencing financial constraints have been able to maintain a steady level of cash reserves, while constrained firms have burned through an average of 20 percent of their cash holdings. A comparison of firms’ use of lines of credit during the crisis revealed that constrained firms have drawn on their lines of credit in a precautionary fashion more often than other companies. Moreover, a surprising 17 percent of constrained firms have drawn on their lines of credit out of fear that their banks will limit access to credit in the future.

“This is a frightening trend,” said Harvey. “Yes, credit is limited, but firms that hoard funds right now, instead of using them for investments and operations, are directly contributing to the downward spiral of the economy.”

The researchers also found that nearly all (86 percent) of financially constrained firms report that they are unable to pursue value-enhancing projects because their access to funds from the capital markets is limited.

“Because a financial crisis drains credit from the financial markets, we get the unfortunate result that financial markets matter most for corporate investment precisely when they fail,” the authors write.

“This is shocking” said Campello, the I.B.E. Professor of Finance at the University of Illinois. “In the classroom, we often teach that companies can borrow or lend freely to pursue all positive net present value projects. In stark contrast, we find that in reality, the financial crisis is causing firms to drift far from value-maximizing choices.”

Indeed, Campello, Graham, and Harvey found that 56 percent of constrained companies reported that they would cancel investments when external funding is limited, compared with 30 percent of unconstrained firms. Among constrained firms that cannot use internal cash reserves to fund investments, 71 percent reported that they would cancel investments. CFOs of constrained firms report that they will significantly reduce spending on R&D, marketing, capital expenditures, employment and dividends.

The researchers also found an increase in corporate sales of assets in order to raise cash, with 70 percent of constrained firms, and 37 percent of unconstrained firms, selling more assets than before the credit crisis.

“It may be that some companies are finally cleaning house and shedding unproductive assets because of the downturn,” said Graham. “However, an increase of this magnitude, combined with reduced access to credit, implies that firms are also selling productive assets as an alternative to other sources of capital."

Although many of the figures cited in this release reflect the effects of the credit crisis on U.S. firms, the team found that financially constrained firms in Europe and Asia are taking many of the same actions as their counterparts in the U.S.

Campello, Graham, and Harvey’s full paper “The Real Effects of Financial Constraints: Evidence from a Financial Crisis,” is available via SSRN at:

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