How the Availability of Cash Impacts the Likelihood of Investing Wisely
Research by Marianne Bertrand
As a firm's cash flow increases, it is expected that its
investment in potential revenue-generating opportunities will
also increase. However, recent research examining the auctions
of oil and gas leases shows that greater cash flow does not
lead to investment in a greater number of tracts, a larger
amount of acreage, or more productive, revenue-generating
tracts. Instead, greater cash flow leads to paying more for
leases that are not more productive.
A number of investment studies have demonstrated that cash
flow is an effective way to predict investment. There are
three primary interpretations of this relationship. The first
states that a surge in company cash flow is a good indicator
of an increased availability of valuable investment projects.
The second interpretation argues that companies already know
about potential investment opportunities, but are prevented
from investing because of limited access to external sources
of financing. As cash flow improves, companies are able to
partake of attractive opportunities that would be otherwise
The third, known as the "free cash flow theory,"
asserts that managers do not behave in a manner consistent
with profit maximization, as the first two interpretations
suggest. Managers instead use increased cash flow to pursue
objectives that have little to do with increasing profits
and a great deal to do with making the managers' lives better
(such as increasing the size of their company), or easier.
In the study "Cash Flow and Investment Project Outcomes:
Evidence from Bidding on Oil and Gas Leases," University
of Chicago Graduate School of Business professor Marianne
Bertrand and Sendhil Mullainathan of Massachusetts Institute
of Technology gauge the accuracy of these interpretations.
They use data from federal auctions of mineral rights to offshore
tracts to create a more vivid picture of the link between
investment and cash flow.
Their results appear to confirm a version of the "free
cash flow theory" interpretation.
"Some have argued that managers may have a preference
for building empires, and therefore if I give a manager more
cash, he will try to expand the company," says Bertrand.
"Our findings contradict this view. When there is more
cash, managers do end up spending more, but they are not bidding
on more tracts. They are bidding more per tract on tracts
that seem to be of approximately the same value."
Bidding for a Bonanza
For the past 50 years, firms have bid on leases that provide
mineral exploration rights to federal land tracts in Alaska
and off the coasts of the Gulf of Mexico and the Pacific Ocean.
The leases, typically five years in length, are auctioned
by the U.S. Department of the Interior.
A company with a winning bid is permitted to explore a tract,
drill holes, and test for the presence of gas, oil, and other
minerals. If no mineral reserves are found during the lease
period, ownership of the tract reverts to the federal government.
However, if minerals are found, the lease is automatically
renewed for as long as minerals are produced. In essence,
exploration leases provide monopoly rights to extraction.
To study the relationship between cash flow and investment,
Bertrand and Mullainathan focused on leases for tracts in
the Gulf of Mexico. The authors used Minerals Management Service
(MMS) data, which provides bidding information, tract characteristics,
contract characteristics, and whether leases were productive
by the time the exploration period ended. The authors then
merged this information with balance sheet data from COMPUSTAT
for publicly-held companies bidding on tracts. They combined
the two data sources and tracked approximately 120 companies
from 1963 to 1999.
Because they focused on a specific industry and investment
type, Bertrand and Mullainathan first had to answer two fundamental
questions. First, did companies in this industry, like those
elsewhere, display a strong correlation between cash flow
and balance sheet capital expenditures? Second, did overall
capital expenditures by firms correlate with the amounts bid
and expended on oil and gas leases? In each case, they found
the answer was yes.
The authors then investigated the relationship between cash
flow and total lease expenditures within the mineral exploration
field. They found that an increase in cash flow also boosted
the total amount bid and spent on tracts.
Exploring a Quantity Effect
If the "empire building" interpretations were correct,
it would be reasonable to expect that as cash flow increased,
so too would the number of leases or the total number of acres
on which companies would bid. However, Bertrand and Mullainathan
found no relationship between cash flow and either quantitative
"There is no quantity effect," Bertrand says. "Greater
cash flow doesn't necessarily mean companies are investing
in more projects or in more acreage. Companies are just spending
more per project."
The finding that the average price per lease or per acre
increased with cash flow left the authors with two possible
interpretations. One is that firms experiencing increases
in cash flow might be opting to bid on less risky leases that
boasted a higher probability of eventually yielding a profit.
Such leases would thus merit higher bids. The second possible
interpretation is that rich firms may simply be wasting cash
by paying too much for leases of equal quality.
To determine which interpretation was most plausible, Bertrand
and Mullainathan analyzed how various characteristics of tracts
impacted the price of bids. Recognizing that larger tracts
tend to be less productive, they examined lease acreage and
its impact on bid prices. Similarly, they studied the depth
of the tracts, because deeper tracts have historically proven
harder to exploit. The authors also looked at the productivity
of previously auctioned tracts in the same geographic area,
and its effect on the price of bids.
As predicted, larger tracts were found to sell at lower prices,
and lower bids were recorded for deeper tracts.
Bids were higher for tracts in the same geographic areas
as other tracts that were productive. However, controlling
for those characteristics had little impact on the connection
between greater cash flow and higher bid prices.
Another characteristic, "next highest bid," was
even more revealing. The authors tracked winning and second-highest
bids and found that when cash flow increased, companies not
only bid more for leases, they also bid more after Bertrand
and Mullainathan accounted for the next highest bid.
The authors also examined the proximity of tracts to areas
already explored by the firm, which might lower exploration
and extraction costs. Such proximity could lead firms to justify
higher bid prices. But the authors found that increased cash
flows did not result in firms being more likely to bid on
tracts located in areas where they had a greater presence.
Bertrand and Mullainathan conclude that the relationship
between cash flow and bid prices is not affected by tract
characteristics. Instead, the link between greater cash flow
and greater bid price appears robust after accounting for
these observable tract characteristics.
Access to Private Information
Was it possible that firms with higher cash flow were privy
to private data about tract quality, and therefore bid more
based on this information?
To test this alternative explanation, the authors examined
whether the cash flows of firms at the time of auction could
predict the eventual productivity of tracts on which those
firms bid. When cash flow-driven increases in bid price per
acre were compared with tract productivity, no correlation
If any pattern emerged, it was that a small increase in bid
price per acre due to a surge in cash flow was associated
with a tract eventually proving slightly less, not more, productive.
"The beauty of the data is that we could actually observe
individual investment projects," says Bertrand. "Furthermore,
we could observe some measure of return on the projects; basically
whether or not the companies found any oil or gas. Looking
at the outcome of the projects should theoretically give us
a sense of whether private information can explain the positive
relationship between cash flow and bid price. We find that
not the case."
Just as productivity of tracts did not increase with cash
flow-driven increases in bid price, neither did revenues.
"We do not find a connection between revenue and cash
flow," says Bertrand. "When companies have greater
cash flow, they spend more on these investment projects, but
when they have this additional cash flow, it does not lead
to these projects generating more revenue."
A final question was whether cash-rich firms took bigger
risks, bidding on tracts that might be less likely to yield
oil or gas, but would provide greater amounts of oil or gas
when minerals were found. Here again, bid price was not a
predictor of greater output. Higher bids fueled by cash flows
did not result in the acquisition of tracts producing greater
amounts of minerals conditional on being productive. The clear
message: Bidders are not able to accurately predict the amount
of resources in the ground.
Bertrand and Mullainathan suggest that future research might
look at how the separate divisions of companies make their
bidding decisions based on the cash flow available to them.
Researchers may also want to examine other industries for
the same tendencies evident in oil and gas exploration.