Friday, May 4, 2012

Cash flow is king

And uneasy lies the head that wears the crown who fears his investment in intangibles (such as corporate research and development or human capital) may not pay off soon enough, according to a new paper by Colorado economists Sanjai Bhagat and Iulian Obreja;
yt = F(kTt , kIt , θt, ξ1t ) = θ1−t α(kTt ) + (1 − α)(kIt ξ1t )
Okay, okay (but trust us there's plenty more math where that came from), they also speak English;
Unlike most empirical tests on the relationship between corporate investment and uncertainty, we expand the scope of the notion of corporate investment and include investment in both tangible and intangible assets. In addition, we provide separate investment measures for investment in intangible assets that are explicitly capitalized or expensed but not related to human capital and investment in human capital itself.
Ah, that's more like it.  Though they fail to explain why cash flow is so important to businesses.  It differs from profits mainly due to timing.  When the cash comes into a business (and has to go out) can determine if the business survives, to a much more important degree than if the business produces accounting profits.

The two economists notice that both tangible and intangible investment follow similar patterns, having dropped dramatically around the last three recessions in 1990, 2001, and 2008, and then gradually increasing during the recoveries.

They find a 'quite surprising', 'strong negative relationship between employment change and our measures of cash flow uncertainty.'
....Overall, our findings seem to suggest that firms react swiftly in response to positive innovations in cash flow uncertainty. Firms reduce tangibles investment, intangibles investment, and employ less labor in order to counteract an increase in cash flow uncertainty.
But, something changed with the latest recession, and puzzles many economists and policy makers (imagine that); corporate investment grew very slowly and didn't rebound to pre-recession levels.  Firms often preferred to hoard their cash on their balance sheets.  They certainly didn't jump at the chance to expand their hiring.

Bhagat and Obreja think corporations have assigned, 'larger conditional variances to future cash flows and perceive the net present values of their investment opportunities as being negative.'

And are quite confident their math supports that conclusion.  So, what to do, what to do;
If firms perceive future cash flows as risky they will postpone investment and post-recession corporate investment will take longer to rebound. flow uncertainty during the post-recession period 2008-2009 has declined very slowly, and consequently corporate investment including corporate employment increases very modestly.
These findings have significant policy implications. To wit, if policy makers would like corporations to increase their investment activity, they should focus on policies that decrease corporate cash flow uncertainty. Specifically, to the extent corporations are uncertain about the implementation and the implementation-timeline of the health reform act, and the impact of this act on their costs of hiring and retaining employees - a clarification of the implementation and the implementation-timeline of the health reform act would encourage corporations to invest more and hire more employees. Similarly, to the extent corporations are uncertain about the implementation and the implementation-timeline of the environmental cap-and-trade reform and corporate tax reforms - a clarification of the implementation and the implementation-timeline of these environmental and tax reforms would encourage corporations to invest more and hire more employees.

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