FRICTIONS AND THE CONTRIBUTION OF INVENTORY TO SHAREHOLDER WEALTH

• Author: Charles F. Beauchamp,Matthew D. Hill,Chris M. Lawrey,William G. Hardin
• Published date: 01 September 2014
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/jfir.12041

FRICTIONS AND THE CONTRIBUTION OF INVENTORY TO

SHAREHOLDER WEALTH

Charles F. Beauchamp

Middle Tennessee State University

William G. Hardin III

Florida International University

Matthew D. Hill

University of Southern Mississippi

Chris M. Lawrey

University of Mississippi

Abstract

Shareholder wealth effects associated with inventory are examined. Initial results

indicate a positive and significant relation between shareholder wealth and inventory.

Additional findings suggest that operating conditions, financial constraints, and working

capital behavior influence the value of inventory. These findings are consistent with

tactical and strategic decisions influencing managers to hold inventory. Overall, the

results suggest that shareholders price the strategic advantages accompanying inventory.

JEL Classification: G31, G32

I. Introduction

This study investigates the shareholder wealth effects associated with inventory after

conditioning on operating frictions, access to financing, and working capital behavior.

These research questions are of interest as effective and efficient inventory management is

a key component of both working capital and liquidity management. Illustrating the

economic importance of inventory policy, during fiscal year 2012 public firms held over

$375 billion worth of inventory, which comprised 6% of total assets. Concurrently,

inventory investment is equal to about 33% of total equity for the typical firm. Hence, the

costs associated with holding inventory are a critical concern for managers.

1

Despite the

We are grateful to Drew Winters (editor) and Mark Griffiths (associate editor) for valuable suggestions that

greatly improved the paper. We also thank seminar participants at the University of Memphis and University of

Mississippi. All remaining errors are the responsibility of the authors.

1

Marginal costs of inventory include storage expenses, shipping fees, and financing costs. Also, the supply

chain management/logistics literatures note the shrinkage and obsolescence risks associated with carrying

inventory.

The Journal of Financial Research Vol. XXXVII, No. 3 Pages 385–403 Fall 2014

385

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

costs associated with holding inventory, a direct link exists between firm value and

inventory management since the proper integration of inventory and trade credit policies

can generate incremental revenues, profits, and cash flows (Kieschnick, LaPlante, and

Moussawi 2013).

Baseline regressions using a sample of publicly traded firms from 1981 to 2010

provide robust evidence of a positive and significant relation between shareholder

wealth and inventory. Consistent with theory and practice, the value that shareholders

place on inventory is lower than for cash and trade receivables. Inferences from the

baseline model are insensitive to alternative model specification and numerous robustness

checks.

The shareholder wealth effects associated with inventory exhibit significant

cross‐sectional variation with respect to firm characteristics. Operating conditions affect

the excess returns to inventory relation through suppliers’variability in revenues and

market share. Further results indicate a significantly stronger relation between shareholder

wealth and inventory for financially constrained firms. This finding suggests that

shareholders support the accumulation of inventory by managers of constrained firms, as

reported by Caglayan, Maioli, and Mateut (2012). The last set of results suggests that the

relation between shareholder wealth and inventory is significantly influenced by various

aspects of working capital policy.

This study provides novel contributions to the working capital literature. An

extensive body of research examines the determinants of inventory investment, leaving

the relation between shareholder wealth and inventory relatively unexamined. An

exception to this is research by Chen, Frank, and Wu (2005), where the authors find

reduced returns for firms with abnormally high inventories. Their evidence supports the

view that excess investment in inventory reduces shareholder wealth. In contrast, the

current study focuses on the relation between shareholder wealth and inventory for

the typical firm. The studies also differ with respect to econometric method; a multivariate

approach comprises the present valuation framework, allowing for stronger statistical

inferences on the relation between shareholder wealth and inventory, relative to the

portfolio sort approach used by Chen, Frank, and Wu.

This article also contributes to the literature by examining the conditional nature

of the relation between shareholder wealth and inventory. The observed variation in this

relation with respect to operating conditions, financing frictions, and working capital

behavior is consistent with the strategic dimensions that motivate managers to hold

inventory. Hence, the study links managerial motives for carrying inventory to

shareholder assessment of these motives.

II. Empirical Model

The valuation framework from Kieschnick, LaPlante, and Moussawi (2013) is used to

estimate the market value of inventory. The model accounts for firm‐specific risk by

specifying excess returns as the dependent variable, while the independent variables

control for unexpected changes in financial characteristics. The baseline specification

follows:

386 The Journal of Financial Research