Asset Liquidity and the Cost of Capital

Hernán Ortiz-MolinaUniversity of British Columbia

Gordon M. PhillipsUniversity of Maryland & NBER

1

MotivationMotivation• What determines a firm’s cost of capital?

– Corporate finance: affects investment, capital structure, etc.

– Asset pricing: the sources of risk that drive expected returns.

• Our basic insight: The liquidity of the market for a firm’s real assets is an important determinant of its cost of capital.

• Reason: Asset liquidity gives a firm flexibility to react to changing business conditions, especially in bad times:– Allows the firm to redeploy unproductive assets to

alternative uses and to reduce fixed costs.– Allows the firm to raise cash using asset sales.

• Examples: – Constellation Energy needed cash and (after failed merger

with MidAmerican), was recently able to sell half of it nuclear-power business for 4.5 billion (double the price offered by MidAmerican).

– Currently Quest wants to sell its struggling long-distance business, and cash would also help pay down debt, but bids are at a 50% discount. 2

Conceptual FrameworkConceptual Framework• Main idea: Assets are often industry specific (Shleifer & Vishny

(1992)); asset sales in illiquid markets receive a large price discount (Pulvino (1998)). Thus, asset liquidity determines whether a firm can sell assets and which ones it will sell (Schlingeman et al. (2002)).

• Corporate finance: Asset liquidity increases a firm’s operating flexibility, especially in bad times, because it allows the firm to exit unprofitable businesses (cut costs) and to raise cash in an asset sale.– Asset sales are key in firms’ restructurings (Maksimovic & Phillips

(1998)); sellers are often poor performers or have high leverage (Lang et al.(1995)).

– Asset liquidity allows firms to maneuver in distress (Weiss & Wruck (1998)).

• Asset pricing: Costly reversibility of assets increases a firm’s equity risk & cost of capital (Kogan (2004), Zhang (2005), Cooper (2006)).– If reversing real investments is costly, firms will not scale down their

operations in bad times and will have high fixed costs.– A larger covariance of a firm’s performance with the market during

economic downturns leads to higher required returns. 3

Hypothesis & Related LiteratureHypothesis & Related Literature• Main hypothesis: A more liquid market for a firm’s real

assets reduces its cost of capital by increasing its operating flexibility.

• Our study bridges two empirical literatures:• 1. The literature on the importance of asset sales and asset

liquidity discussed before – asset liquidity increases operating flexibility.

• 2. The literature on operating flexibility and equity risk, which faces the difficulty of measuring the costs of unwinding real assets:– Mandelker & Rhee (1984) find a positive relation

between operating leverage and market beta.– Gulen, Xing, and Zhang (2008) find that inflexibility

(proxied by FA/TA, recent disinvestment, financial and operating leverage) increases the return spread between value and growth stocks.

• We use asset liquidity to measure operating flexibility ex-ante and show that asset liquidity significantly reduces the cost of capital.

4

Specific PredictionsSpecific PredictionsPredictions: Time series:• At the aggregate level, there should be an asset-liquidity

discount in the cost of capital that exhibits a counter-cyclical time-series variation.

Cross-sectional:• Firms with a more liquid market for their assets should have a

lower cost of capital.• Inside asset liquidity should decrease a firm’s cost of capital more

than outside asset liquidity.• Asset liquidity should reduce the cost of capital more for firms in

more competitive industries and for smaller firms.• Asset liquidity should reduce the cost of capital more for firms

with less access to capital and for firms that are closer to default and facing negative demand shocks.

5

Data & Measures of Key VariablesData & Measures of Key Variables• Data: 6,858 firms operating in 327 different 3-digit

SIC industries (36,672 firm-year obs.) during the period 1984-2006. Sample excludes financials & utilities, and firms not covered in IBES.

• 3 measures of asset liquidity:• NoPotBuy: Number of potential buyers with

investment grade credit ratings.• MnLev: - Mean leverage net of cash of rival firms.

– Capture the financial liquidity and purchasing power of rival firms a la Shleifer and Vishny (1992(

• TotLiq (total asset liquidity) is that value of M&A involving publicly traded targets in each 3-digit SIC industry, scaled by the value of assets in the industry, and averaged over the past 5 years.– The discounts that sellers must offer to attract buyers are

smaller in industries with a higher volume of transactions (Shleifer & Vishny (1992)).

– Schlingeman et al. (2002) show that this asset liquidity measure explains how firm structure corporate divestitures.

6

Measures of Cost of CapitalMeasures of Cost of Capital

• ICC (the implied cost of capital of Gebhardt et al. (2001)), is the discount rate that makes the present value of expected future cash flow equal to the current stock price. – Address Elton’s critique of using realized returns in

asset pricing tests.– ICC is a good proxy for a stock’s expected return

(Pástor et al. (2008)).– Tests using ICC detect the risk-return tradeoff (Pástor

et al. (2008) and a positive effect of distress risk on expected returns (Chava & Purn. (2008)).

• FFCC: Fama French Expected Cost of Capital– linear projection of returns based on the market, size, and value factors.– Estimate actor loadings, for each stock j in year t (between 1984 and

2006), we estimate the following time-series regression using monthly data from year t-4 to t (we require a minimum of 36 months of data):

– Project forward using long-term risk premiums: 7

jSMBj

HMLjfM

MKTjjfj SMBHMLrrrr )(

SMBHMLrrrFFCC SMBtj

HMLtjfM

MKTtjftj ,,,,

ˆˆ)(ˆ

Asset Liquidity for Selected Asset Liquidity for Selected IndustriesIndustries

A:A: Highest Asset Liquidity Industries Highest Asset Liquidity IndustriesSICSIC

33 Industry DescriptionIndustry DescriptionAvg. 84-Avg. 84-

0606198198

44 19951995200200

66

808808 Home health care servicesHome health care services 9.87%9.87%2.352.35

%%10.6210.62

%%7.987.98

%%

265265 Paperboard containers & boxesPaperboard containers & boxes 8.83%8.83%9.519.51

%%5.675.67

%%2.242.24

%%

737737Computer programming & data Computer programming & data

processingprocessing 8.69%8.69%5.115.11

%%7.837.83

%%6.106.10

%%

483483Radio & television broadcasting Radio & television broadcasting

stationsstations 8.45%8.45%4.514.51

%%6.286.28

%%1.581.58

%%

781781Motion picture production & Motion picture production &

allied servicesallied services 8.44%8.44%9.519.51

%%7.227.22

%%8.798.79

%%

B:B: Lowest Asset Liquidity Industries Lowest Asset Liquidity IndustriesSICSIC33 Industry DescriptionIndustry Description

Avg. 84-Avg. 84-0606 19841984 19951995 20062006

371371Motor vehicles & motor vehicle Motor vehicles & motor vehicle equipmentequipment 0.38%0.38%

0.160.16%%

0.120.12%%

0.260.26%%

375375 Motorcycles, bicycles, & partsMotorcycles, bicycles, & parts 0.38%0.38%0.000.00

%%0.300.30

%%0.840.84

%%

321321 Flat glassFlat glass 0.20%0.20%0.000.00

%%0.000.00

%%0.780.78

%%

533533 Variety storesVariety stores 0.10%0.10%0.120.12

%%0.010.01

%%0.020.02

%%

211211 CigarettesCigarettes 0.09%0.09%0.000.00

%%0.450.45

%%0.010.01

%%

8

Initial EvidenceInitial Evidence• Our main hypothesis has two broad implications that

should hold at the aggregate level (prediction 1): – There should be an asset-liquidity discount in

firms’ cost of capital.– This discount should be counter-cyclical.

A:A: Sort firms into quintile portfolios based on Sort firms into quintile portfolios based on TotLiq.TotLiq.Tot:Liq Tot:Liq Quintile:Quintile:

Q1 Q2 Q3 Q4 Q5 Q5 – Q1

p-value

Avg. TotLiq 0.43%

1.68%

2.98% 4.90%

9.35% 8.92%

0.000

EW ICC12.53

%11.25

%10.36

%10.27

%8.46

%

-4.07%

0.000

VW ICC10.82

%9.56

%8.92

% 9.15%6.90

%

-3.92%

0.000

B:B: Regress the asset-liquidity discount (-) on business- Regress the asset-liquidity discount (-) on business-cycle indicators.cycle indicators.

GDP Gr.

Capacity. Util.

Inflation

T-Bill Rate

Default Spr.

Market Ret.

Coef.

0.007 0.004 0.010 0.009 -0.027 0.038

T-stat

(5.45) (5.45) (3.95) (9.81) (4.21) (3.21)

9

Multivariate EvidenceMultivariate Evidence

(1) (2) (3) (4) (5) (6)

TotLiq -0.338 -0.380 -0.120 -0.240 -0.218 -0.109(5.27) (9.54) (2.50) (5.25) (3.01) (2.29)

All ControlsAll Controls Yes Yes Yes Yes Yes YesYear

DummiesYes No Yes Yes No Yes

SIC3 Dummies

No No Yes No No Yes

Aggregation Firm Firm Firm Industry

Industry

Industry

Estimation OLS Between

OLS WLS Between

WLS

Observations 36672 6845 36672 5070 327 5070R2 0.30 0.31 0.52 0.58 0.53 0.84

10

At the firm level and industry level, there should be a At the firm level and industry level, there should be a negative association between negative association between TotLiqTotLiq and and ICCICC (prediction 2).(prediction 2).

ICC/FFCC = ICC/FFCC = αα + + ββTotLiq + TotLiq + γγControls + Controls + εε ; ; cluster cluster std. errors by 3-digit SIC.std. errors by 3-digit SIC.

Controls:Controls: size; leverage; ROE; volatility of ROE; fixed size; leverage; ROE; volatility of ROE; fixed assets/total assets; R&D expenses; age; dividend assets/total assets; R&D expenses; age; dividend payer; sales growth.payer; sales growth.

Inside vs. Outside Asset LiquidityInside vs. Outside Asset Liquidity

(1) (2) (3) (4) (5) (6)

InsLiq -0.590 -0.206 -0.187

(5.74) (2.39) (2.12)

OutLiq -0.241 -0.076 -0.072

(2.16) (1.73) (1.68)

All Controls

Yes Yes Yes Yes Yes Yes

Year Dummies

Yes Yes Yes Yes Yes Yes

SIC3 Dummies

No Yes Yes No Yes Yes

Aggregation

Firm Firm Industry

Firm Firm Industry

Estimation OLS OLS WLS OLS OLS WLS

11

““Inside” asset liquidity should decrease a firm’s cost Inside” asset liquidity should decrease a firm’s cost of capital by more than “outside” asset liquidity of capital by more than “outside” asset liquidity (prediction 3). (prediction 3).

– Inside buyers can better redeploy the asset to a Inside buyers can better redeploy the asset to a productive use and are willing to pay higher prices productive use and are willing to pay higher prices (Shleifer & Vishny (1997). (Shleifer & Vishny (1997).

– Outside buyers are willing to pay lower prices due to Outside buyers are willing to pay lower prices due to less synergies and lack of experience in operating the less synergies and lack of experience in operating the asset.asset.

– Firms forced to sell to industry outsiders obtain lower Firms forced to sell to industry outsiders obtain lower prices than if they were able to sell to insiders (e.g., prices than if they were able to sell to insiders (e.g., Pulvino (1998).Pulvino (1998).

Industry Structure & Industry Industry Structure & Industry PositionPosition

High HHI

Low HHI Leaders Followers

TotLiq -0.033 -0.166 -0.029 -0.136(0.66) (2.13) (1.19) (2.45)

All Controls Yes YesYes YesYes YesYesYear Dummies Yes Yes Yes Yes3-Dig SIC

DummiesYes Yes Yes Yes

Clustering by SIC3

Yes Yes Yes Yes12

Asset liquidity should reduce the cost of capital Asset liquidity should reduce the cost of capital more for firms in more competitive industries more for firms in more competitive industries (prediction 4.a). (prediction 4.a).

– Bankruptcy risk is higher in more competitive Bankruptcy risk is higher in more competitive industries due to lower barriers to entry (Hou & industries due to lower barriers to entry (Hou & Robinson (2006)). Robinson (2006)).

Asset liquidity should reduce the cost of capital Asset liquidity should reduce the cost of capital more for the smallest firms in the industry due to more for the smallest firms in the industry due to their higher default risk (prediction 4.b).their higher default risk (prediction 4.b).

– weaker industry positions (e.g., less customer loyalty).weaker industry positions (e.g., less customer loyalty).– they account for majority of exits in industry they account for majority of exits in industry

restructurings.restructurings.– small stocks have higher distress risk (Chan & Chen small stocks have higher distress risk (Chan & Chen

(1991)).(1991)).

Financial Situation & Business Financial Situation & Business EnvironmentEnvironment

• Asset sales allow the firm to raise cash to fund existing or new operations, and to maneuver in financial distress. Thus, asset liquidity is also valuable because it increases a firm’s financial flexibility.

• Asset liquidity should reduce the cost of capital more for firms with less access to capital (prediction 5.a).

• Asset liquidity should reduce the cost of capital more for firms that are closer to default (prediction 5.b).

• Asset liquidity should reduce the cost of capital more for firms with lower valuations (prediction 5.c).

• Asset liquidity should reduce the cost of capital more for firms facing negative demand shocks (prediction 5.d).

13

Financial Situation & Business Financial Situation & Business EnvironmentEnvironment

A:A: Access to debt financing and default risk. Access to debt financing and default risk.Unrated

DebtRated

DebtHigh Def.

Prob.Low Def.

Prob.

TotLiq -0.103 -0.062 -0.178 -0.049(2.12) (1.59) (3.12) (1.20)

All controls Yes Yes Yes YesYear Dummies Yes Yes Yes YesSIC3

DummiesYes Yes Yes Yes

B:B: Market valuations and demand shocks. Market valuations and demand shocks.Low

V/AHigh

V/ALow Sal.

Gr.High Sal.

Gr.Downtu

rnNorm

al

TotLiq -0.159 -0.102 -0.147 -0.100 -0.615 -0.320

(2.68) (2.09) (2.66) (1.87) (5.03) (5.37)

All Controls

Yes Yes Yes Yes Yes Yes

Year Dum.

Yes Yes Yes Yes Yes Yes

SIC3 Dum.

Yes Yes Yes Yes No No

14

Further InvestigationFurther Investigation• Issue 1: Are our results driven by the variation in industry

valuations? – We run pure cross-sectional regressions using the time-

series averages of the variables. We get similar results.– We control for the industry’s valuation and the industry’s

valuation relative to historical values. We get similar results.

• Issue 2: Role of cash holdings– Are our results driven by the omission of cash holdings?– Do cash reserves diminish the importance of real asset

liquidity?– The effect of TotLiq on ICC holds if we control for

cash/assets, and is similar for firms with low and high cash holdings.

• Issue 3: Are we picking up a financial leverage effect?– We control for financial leverage throughout.– We run tests using unlevered cost of capital, but results are

similar.15

Summary & ConclusionsSummary & Conclusions• We argue that asset liquidity increases a firm’s operating

flexibility and thus it reduces the risk of its equity and its cost of capital.

• We find that asset liquidity significantly reduces firms’ cost of capital, and that this effect varies across firms and over time in ways that are consistent with the operating flexibility channel.

• Asset liquidity has value! It allows firms to unwind investment decisions and raise capital to adapt to new environments. – In the cross section this benefits small firms, firms with a

high probability of default, firms without access to debt markets, and firms with many potential buyers.

– In the time series the largest benefit for firms is in recessions.

• More generally, the results suggests that operating inflexibility is an economically important source of risk.

16