Investment Financing of Organizational Capital

• Author: Daniel X. Jiang,Miao Luo,Jun Cai
• Date: 01 June 2016
• DOI: http://doi.org/10.1111/ajfs.12132
• Published date: 01 June 2016

Investment Financing of Organizational

Capital*

Daniel X. Jiang

Smeal College of Business, The Pennsylvania State University

Miao Luo**

Sun Yat-Sen Business School, Sun Yat-Sen University

Jun Cai

College of Business, City University of Hong Kong

Received 11 January 2016; Accepted 12 February 2016

Abstract

We identify that the cost of external capital and the frontier technology (FT) shock level are

two important factors affecting external capital supply. We explore how they interact to affect

the investment financing of organizational capital (OC). We show that the FT shock level has

experienced a dramatic change from being counter-cyclical before 1991 to pro-cyclical after

1991. This structural break alters the OC investment sensitivities during the two sub-periods.

We find that the OC investment-cash flow sensitivity is low and the OC investment-qsensi-

tivity is high only when the cost of external capital is low and the FT shock level is simulta-

neously high. These patterns are mainly driven by financially constrained firms. In addition,

our empirical findings suggest that OC investments made during recessions when the FT

shock level is also low generate higher productivity than in other conditions.

Keywords Organizational capital; Investment-cash flow sensitivity; Investment-qsensitivity;

Financial constraints; Frontier technology; Business cycle

JEL Classification: E32, G31, G32

*The authors would like to thank the editor (Professor Hee-Joon Ahn), the associate editor,

two anonymous referees, seminar participants at Shanghai Jiaotong University and the Chi-

nese Academy of Sciences for their helpful suggestions and comments. City University of

Hong Kong Strategic Grant (SRG 7008142) is also gratefully acknowledged. All errors remain

our own responsibilities.

**

Corresponding author: Miao Luo, Department of Finance and Investment, Sun Yat-Sen

Business School, Sun Yat-Sen University, 135 West Xingang Road, Guangzhou 510275,

China. Tel: +86-20-8411-1450, Fax: +86-20-8403-6924, email: luomiao.work@gmail.com.

Asia-Pacific Journal of Financial Studies (2016) 45, 343–379 doi:10.1111/ajfs.12132

©2016 Korean Securities Association 343

1. Introduction

Organizational capital (OC) refers to the stock of knowledge or “know-how” firms

accumulate over time (Atkeson and Kehoe, 2005). It measures the knowledge used

to combine human skills and physical capital into a system for producing and deliv-

ering products (Evenson and Westphal, 1995). Compared with physical or human

capital, OC is a unique factor which is capable of yielding abnormal or above cost

of capital returns, thereby generating enterprise growth (Lev and Radhakrishnan,

2005). This distinguishing feature reveals the importance of having a good under-

standing of this intangible capital.

Recent works on this issue have concentrated on the measurement of OC and

its effect on the firm production process (Prescott and Visscher, 1980; Ichniowski

et al., 1997; Hall, 2000; Atkeson and Kehoe, 2005; Lev and Radhakrishnan, 2005;

Lustig et al., 2011; Carlin et al., 2012; Eisfeldt and Papanikolaou, 2012).

1

However,

the literature is silent on financing for OC investment. In this article, we aim to

examine two issues. First, we wish to understand the funding for OC investment

at the firm level. Following the accounting literature (Lev and Radhakrishnan,

2005), we recursively construct the stock of OC by accumulating the value of sell-

ing, general, and administrative expenditures (XSGA), and use XSGA scaled by

OC stock as a measure of OC investment. We will examine the relation between

OC investment and internal and external funding sources by estimating a panel

regression model in which we control for the investment opportunity measured

by Tobin’s Q. OC investment should be positively correlated with both internal

and external funding sources and investment opportunities. Second, we will exam-

ine whether the funding of OC investment varies with business cycles and the

frontier technology (FT) shock initially phrased in Atkeson and Kehoe (2005).

The existing literature suggests that the most important factor in determining the

level of various investments such as fixed asset investment or research and devel-

opment (R&D) investment is the cost of external capital. During economic expan-

sion, the cost of external capital is low; therefore, the investment-cash flow

sensitivity will be lower and the investment-qsensitivity will be higher. Specific to

OC, a positive FT is affiliated with the departure or loss of firm-specific talent

that adversely affects the performance of firm profitability and stock price. There-

fore, the FT shock level is likely to be another important factor influencing OC

investment behavior (Eisfeldt and Papanikolaou, 2012). External shareholders are

more willing to invest in OC when the FT shock level is high. To proxy for the

FT shock level, we construct a hedge portfolio return sorted on the ratio of OC

stock to book assets, or the intensity of OC. A high value of FT indicates more

skilled people leaving their jobs on a market-wide basis as new FT emerges and

1

A number of papers examine the quality of firms’ organizational structure and management

practices using survey data (Caroli and Van Reenen, 2001; Bresnahan et al., 2002; Bloom and

Van Reenen, 2007).

D. X. Jiang et al.

344 ©2016 Korean Securities Association

skilled people exercise their outside option. We will explore how the effects of the

cost of external capital and the FT shock level interact with each other to affect

the investment financing of OC.

We begin our analysis by first examining the cyclical behavior of FT shock and

find that it changes dramatically during our sample period (1971 to 2011). The cor-

relation between the cyclical component of the log of real GDP and our proxy for

FT shock is 0.70 during the 1971–1990 period and 0.62 during the 1991–2011

period. In the first half of our sample period prior to 1991, the FT shock level is

counter-cyclical. More skilled people leave jobs in recessions to find better opportu-

nities. This is consistent with the observation that recessions cause a sharp move

toward reorganization. Workers reorganize or find better job matches when the rel-

ative reward to work declines temporarily during recessions (Hall, 2000). This is

also consistent with the fact that the job-finding rate is about the same whether

unemployment is high or low (Blanchard and Diamond, 1990; Hall, 1991). Unem-

ployment that occurs in recessions is concentrated among a small number of firms

making large cutbacks. For the majority of the firms, employment growth occurs at

normal rates (Davis and Haltiwanger, 1990). However, in the second period after

1991, the FT shock level is pro-cyclical. More skilled people leave jobs during times

of expansion. This key talent actively seeks outside options as firms spend more on

information technology when the economy is expanding (Haacker and Morsink,

2001).

2

The structural change is most likely due to the skill-biased technology

change that shifts labor demand toward more highly skilled workers relative to less

skilled workers. The size, breadth, and timing of the recent labor demand shift is

related to the largest and most widespread technology change of the current era,

information technology (Bresnahan et al., 2002). In addition, Bloom et al. (2012)

find that the U.S.A. has experienced a sustained increase in productivity growth

since the mid-1990s, particularly in sectors that intensively use information technol-

ogy. One explanation for this is that U.S. firms are organized in a way that allows

them to use new technologies more efficiently. The break point of 1991 coincides

with the year of productivity paradox in the literature of information technology

spending and financial performance.

3,4

2

Technology shocks and their impact on investment and aggregate spending have become a

main driving force of business cycles (Haacker and Morsink, 2001).

3

The productivity paradox refers to empirical evidence in the 1980s and early 1990s reporting

that there was no statistical association between information technology spending and finan-

cial performance. However, by the mid-1990s, a positive relation had been established (Bryn-

jolfsson and Hitt, 1996; Bharadwaj et al., 1999).

4

Brynjolfsson (1993) proposes that during the pre-1991 period, information technology might

have increased organizational slack, rather than firm productivity and improved financial per-

formance. Two examples of organizational slack are overlay of technology and mismanage-

ment of information technology. Dehning et al. (2004) test the Brynjolfsson (1993)

proposition using selling, general, and administrative expenses.

Investment Financing of Organizational Capital

©2016 Korean Securities Association 345