Is Investment-Cash Flow Sensitivity Caused by Agency Costs or Asymmetric Information? Evidence from the UK


  • Grzegorz Pawlina recognises support from the European Union's Phare ACE Programme. Luc Renneboog is grateful for financial support by the European Union under the Sixth Framework Programme New Modes of governance (Contract no. CITS-CT-2004-506392); coordinated by the RSCAS of the European University Institute) and by the Netherlands Organisation for Scientific Research. The content of this paper is the sole responsibility of the authors and does not represent the views of the Commission or its services. The authors are grateful to John Doukas, Carles Gispert, Marc Goergen, Klaus Gugler, Harijono Harijono, Abe de Jong, Joe McCahery, Chris Veld, an anonymous referee and participants of the Investment and Corporate Governance Workshop in Cambridge and the European Financial Management Association Annual Meeting in Basle for helpful comments. All remaining errors are ours. Corresponding author: Grzegorz Pawlina.


We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive. Is this sensitivity a result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that investment-cash flow sensitivity results mainly from the agency costs of free cash flow. The magnitude of the relationship depends on insider ownership in a non-monotonic way. Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring. Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets. We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.