The suitability of a new model must be determined before carrying out any tests owing to the complex nature of the measurements involved. The correlations will need to be carried out between loss dummy and dividend payouts as well as between loss dummy and firm size and positive relationships will need to be determined (see Appendix 4 for reference). This means that large firms are more likely to be without loss while also managing to pay dividends, an observation consistent with the results obtained by most researchers and providing evidence that the loss dummy variable can function as a proxy for financial restraints.
In line with the other various researchers, we found out that firms which incur a loss, most of the times hold more cash than financially stable firms. Further examination into the correlation between loss dummy, the investment opportunity and cash flow volatility, we were able to found out that a negative correlation exists between loss dummy and the investment opportunity as well as a negative correlation between loss dummy and cash flow volatility. From this examination we can assume that financial constraints (loss dummy=0) have a positive relationship with cash flow volatility investment opportunity set (see Appendix 5). Financial constrained firms should hold some cash so that they are able to invest in investment projects which are profitable.
The estimate models show us that cash flow volatility does in fact affect a firm’s cash holdings. Cash volatility differs from industry to industry and in order to depict this, we add a dummy variable, industry, into our model so as to determine the differences in cash holdings in each industry. The variable for industry, I, shall be used in out sample meaning that for the 32 industries listed in the London Stock Exchange, we would need to create 21(k-1) dummy variables.
According to the results of the test, we can see that not all dummy variables are of significance.