Empirical studies of firms’ financing, investment, and payout policies typically examine those policies in isolation. For example, dividend policy is typically not considered when examining the determinants of capital expenditures. In this paper, we examine corporate policies simultaneously, subject to the constraint that sources of cash must equal uses of cash. We use this methodology to re-examine the investment/cashflow literature. Unlike single-equation studies that conclude that firms react to cashflow shocks by changing investments, we find that firms react by changing leverage. We conclude that failing to employ a constrained simultaneous-equation framework when examining corporate policies can cause omitted variable bias and result in large estimation errors.
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