Cash Flow Volatility, Financial Slack and Investment Decisions

摘要

We examine firm investment decisions when faced with market imperfections that drive a wedge between the cost of internal and external financing. We consider the role played by both cash flow volatility and financial slack, and how they interact in the presence of financial constraints to affect investment-cash flow sensitivities. We demonstrate that the investment outlays of firms with high cash flow volatility will be less sensitive to a given period’s internal cash flow. The reason for this is simply that such firms will build up financial slack in the full knowledge that such cash flow volatility would otherwise reduce investment due to the wedge between internal and external capital costs. That is, firms facing financial constraints will anticipate their effect by building up more financial slack and having stronger balance sheets. Consequently, firms facing financial constraints will strengthen their balance sheets and exhibit less correlation between future cash flows and investments than will firms facing lower constraints. Our empirical evidence provides strong support for these theoretical predictions. In particular, our results confirm that firms with high cash flow volatility maintain the highest levels of financial slack and that their investment outlays are the least sensitive to the firm’s internally generated cash flows. The model and empirical results in this paper go a long way to reconciling the existing empirical literature where there is significant disagreement on the proxies used to demonstrate whether a firm operates under “financial constraints.”