The Implications of Investment–Cash Flow Sensitivities for Franchising Firms: Theory and Evidence From the Restaurant Industry

Expansion through franchising could help restaurant firms solve financial constraints, but it could also make overinvestment easier for misaligned CEOs. Whereas the former topic has been extensively examined, the latter has received scant attention from researchers. The purpose of this study is to investigate whether franchising alleviates financial constraints or leads to overinvestment problems in restaurant firms. For this purpose, we analyzed and compared investment–cash flow sensitivities between constrained and unconstrained; franchising and nonfranchising; constrained, franchising and unconstrained, franchising; and constrained, nonfranchising and unconstrained, nonfranchising restaurant firms. The results show that unlike other industries, unconstrained restaurant firms depend more on cash flows for investment than constrained restaurant firms do. Although investment–cash flow sensitivity in nonfranchising restaurant firms was similar to that of firms in other industries, unconstrained restaurant firms that expand through franchising rely more on cash flows. These findings suggest that restaurant firms’ expansion through franchising is likely to increase overinvestment problems. Franchising could serve as a long-term method of financing for financially constrained firms as well as a short-term financing tool. However, unconstrained, franchising firms should distribute their excess cash flows to shareholders. Theoretical implications are discussed within the realms of the franchising, pecking order, and free cash flow theories