Is Financial Flexibility a Priced Factor in the Stock Market?

Published date01 May 2019
Date01 May 2019
The Financial Review 54 (2019) 345–375
Is Financial Flexibility a Priced Factor
in the Stock Market?
Suresh Kumar Oad Rajput
Sukkur IBA University
Udomsak Wongchoti
Massey University
Jianguo Chen
Massey University
Robert Faff
The University of Queensland
This paper develops a factor analysis–based measure for shifts in corporate financial
flexibility (FFLEX) that can be observed from public accounting information. Companies
that experience positive shifts in FFLEX are associated with higher future investment growth
opportunities. We showthat FFLEX is a robust determinant of future stock returns. Firms that
Corresponding author: School of Economics & Finance, Room 2.06, Business Studies West
(BSW), Massey University, Palmerston North, New Zealand; Phone: +64 (06) 356 9099; E-mail:
We thank the editor of The Financial Review, Richard S. Warr, and the anonymous referee for valuable
suggestions. Our thanks also extend to Leigh Roberts, Hai Lin, Ben Marshall, David Tripe, TerryWalter,
Kevin Davis, Petko Kalev, Vitali Alexeev, Paul Docherty, Chris Malone, Michael Naylor, and Song
Shi for their beneficial discussions and other participants at the 2014 SEF Research Symposium at
Victoria University, Wellington, 2014 School of Economics and Finance Seminar at Massey University,
Fourth SIRCA Young Research Workshop at SIRCA in Sydney, and Fourth Auckland Finance Meeting
at Auckland University of Technology, Auckland, for useful comments. Finally, we thank Professor Lu
Zhang for the data on q-factor model factors (ROE and I/A).
C2019 The Eastern Finance Association 345
346 S. K. Oad Rajput et al./The Financial Review 54 (2019) 345–375
have increased their financial flexibility are associated with lower stock returns in the subse-
quent period. A zero-cost return portfolio produces a significant positive monthly premium
of 0.69%, which is driven by covariance (risk). Risk inherent in the flexibility factor is not
explained away by either prominent pricing characteristics or factors.
Keywords: financial flexibility, asset pricing, risk factors
JEL Classifications: G11, G12, G31, G32
1. Introduction
Financial flexibility can be viewed as a firm’scapacity to respond in a timely and
value-maximizing way to unexpected shocks to the firm’s cash flows or investment
opportunity set (Denis, 2011). Such flexibility is considered by U.S. CFOs as the
most important determinant of capital structure (Graham and Harvey, 2001).1While
established as a critical aspect of corporate policy, the asset pricing role of financial
flexibility is largely unresolved, especially regarding its measurement due to the
unobserved nature of management responses to unexpected shocks to the cash flows
and growth options.2Given this background, we have three aims in this paper.
First, we operationalize an alternative measure of financial flexibility (FFLEX)from
publicly available accounting information that can be observed by investors.Second,
we explore the association between this new measure of financial flexibility and
stock returns. Third, we explore the sources of the stock return predictability, with
particular emphasis on whether and to what extent any such predictability is driven
by risk.
To achieve these goals, we employ the correlational structure of accounting
growth information content to create an alternative proxy for financial flexibilitythat
is relevant to the stock market.3This approach is largely motivated by studies that
stress the importance of sophisticated and comprehensive uses of accounting informa-
tion (a primary source of information) by investors. Ou and Penman (1989) combine
a large set of financial statement items into one summary measure that integrally
predicts one-year-ahead earnings of a company. They then showthat this measure, in
turn, predicts future stock returns (through the fundamental relation between stock
returns and companies’ earnings; see, e.g., Ball and Brown, 1968; Ohlson, 1995)
1Financial flexibility considerations also havea significant impact on several aspects of corporate financial
policies including cash management, capital structure, payout policies, and risk management (DeAngelo
and DeAngelo, 2007; Gamba and Triantis, 2008; Marchica and Mura, 2010; Denis, 2011; Denis and
McKeon, 2012; Bonaim´
e, Hankins and Harford, 2013; Agha and Faff, 2014).
2For example, Marchica and Mura (2010) consider financial flexibility as an unobserved measure.
3The study uses growth rates rather than levels of variables—proxies that conserveflexibility—to under-
stand the implications of effective use and accumulation of the financial flexibility.

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