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Financial Decisions and Firm Location

By Harvard Law School Program on Corporate Governance

(Editor’s Note: This post comes to us from Andres Almazan of the University of Texas, Adolfo de Motta of McGill University, Sheridan Titman of the University of Texas, and Vahap Uysal of the University of Oklahoma.)

In our paper Financial Structure, Acquisition Opportunities, and Firm Locations, which was recently accepted for publication in the Journal of Finance, we investigate the relation between firms’ locations and their corporate finance decisions. More specifically, we examine whether these choices are related to whether or not the firm is located within an industry cluster, that is, close to many of its industry peers.

We start by developing a simple model that describes the relation between a firm’s location, financial structure and acquisition activities. Our model assumes that firms located in industry clusters have more acquisition opportunities but also face greater competition from other potential acquirers. To take advantage of these opportunities, the firms in clusters maintain more financial slack, because by doing so they can bid more aggressively for acquisitions.

To test this model we examine the extent to which firms located in industry clusters are more acquisitive, the interaction between financial structure, location and acquisition activity, and finally, the extent to which firms in clusters maintain more financial slack. We find that after controlling for industry affiliation, firms located in clusters make more acquisitions, which is consistent with the idea that firms in clusters have more opportunities. In addition, we find that firms with more financial slack tend to make more acquisitions, which is consistent with firms maintaining more slack when opportunities are greater. More importantly, we show that the positive relation between acquisition activity and financial slack is stronger in clusters. If we assume that competition for targets is more intense in clusters then this finding is consistent with our model’s implication that debt plays a more important role when there is competition. Moreover, the fact that this relation is stronger for acquisitions of public targets and within industry targets, which are likely to attract more competition, provides further support for this implication of the model. Our results indicate that firms in clusters have less debt and hold more cash, and these relations continue to hold after controlling for the empirical determinants of capital structure. The relation between financial slack and location is particularly robust and economically significant. After controlling for other determinants of capital structure and cash holdings, firms located in clusters decrease their net market leverage by 19% and increase their cash holdings by 43% with respect to the sample averages.

Since an industry cluster is somewhat of a nebulous concept our empirical tests examine the robustness of our results with respect to a number of cluster definitions. One set of definitions uses the absolute number of firms within an industry in a metropolitan area. A second set defines clusters as the proportion of firms in an industry located in the metropolitan area. Finally, we do an in-depth analysis of the software industry (SIC code 737) since this is an industry with a large number of firms and a very well defined industry cluster in Silicon Valley. We document that firms in high tech cities and growing cities also maintain more financial slack.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 24, 2009 (boomark / email).