Investment Cash Flow Sensitivities Really Reflect Related Investment Decisions
- 5 August 2011
- preprint
- Published by Elsevier BV in SSRN Electronic Journal
Abstract
An important, unresolved issue in finance is whether the sensitivity of capital investment to internally generated cash flows reflects the impact of binding financing constraints on firms’ investment decisions. We contribute new insight to this debate by providing systematic evidence that investment-cash flow sensitivity (ICFS) primarily reflects the fundamental connection between capital investment and working capital investment as interrelated manifestations of firm growth. We decompose the cash flow measure used in the literature, earnings before depreciation (EBD), into cash flow from operations (CFO), and working capital accruals (WCACC) which reflects net investment in working capital items like inventory and accounts receivable. We demonstrate that ICFS is driven by the natural co-movement between fixed investment and the working capital investment aspect of WCACC as complementary factors of production. In contrast, investment-CFO sensitivity is often negative and tends to decrease as financing constraints increase, inconsistent with CFO serving as a source of investment financing for constrained firms. What does this growth interpretation imply about the connection between ICFS and financing constraints? We argue that the nature of ICFS depends directly on the underlying catalyst of firm growth. If investment is driven solely by a reduction in the cost wedge between external and internal financing, ICFS reflects the investment consequences of this reduction in financing constraints. However, if capacity expansion is instead driven by macro shifts in the opportunity cost of firms’ internal funds, shocks in investment opportunities, empire building behavior, or managerial irrationality, ICFS will not reflect financing frictions but rather the natural consequence of capacity expansion on the co-movement of fixed and working capital investment.Keywords
This publication has 14 references indexed in Scilit:
- New Evidence on Measuring Financial Constraints: Moving Beyond the KZ IndexThe Review of Financial Studies, 2010
- The Persistence and Pricing of the Cash Component of EarningsJournal of Accounting Research, 2008
- Accrued Earnings and Growth: Implications for Future Profitability and Market MispricingThe Accounting Review, 2003
- Measurement Error and the Relationship between Investment andqJournal of Political Economy, 2000
- Investment-Cash Flow Sensitivities are Useful: A Comment on Kaplan and ZingalesThe Quarterly Journal of Economics, 2000
- Capital Adjustment Patterns in Manufacturing PlantsReview of Economic Dynamics, 1998
- Evidence on the role of cash flow for investmentJournal of Monetary Economics, 1995
- Working Capital and Fixed Investment: New Evidence on Financing ConstraintsThe RAND Journal of Economics, 1993
- Financing Constraints and Corporate InvestmentBrookings Papers on Economic Activity, 1988
- Tobin's Marginal q and Average q: A Neoclassical InterpretationEconometrica, 1982