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Investment Cash Flow Sensitivities Really Reflect Related Investment Decisions


Robert M. Bushman


University of North Carolina Kenan-Flagler Business School

Abbie J. Smith


University of Chicago - Booth School of Business

Frank Zhang


Yale School of Management

August 5, 2011


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.

Number of Pages in PDF File: 52

Keywords: Accruals, Cash flows, growth, investment-cash flow sensitivity

JEL Classification: D21, E22, G31, M4

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Date posted: November 11, 2005 ; Last revised: September 2, 2012

Suggested Citation

Bushman, Robert M. and Smith, Abbie J. and Zhang, Frank, Investment Cash Flow Sensitivities Really Reflect Related Investment Decisions (August 5, 2011). Available at SSRN: http://ssrn.com/abstract=842085 or http://dx.doi.org/10.2139/ssrn.842085

Contact Information

Robert M. Bushman
University of North Carolina Kenan-Flagler Business School ( email )
McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-9809 (Phone)
HOME PAGE: http://public.kenan-flagler.unc.edu/faculty/bushmanr/

Abbie J. Smith
University of Chicago - Booth School of Business ( email )
1101 East 58th Street
Graduate School of Business
Chicago, IL 60637-1561
United States
773-702-7295 (Phone)
773-702-0458 (Fax)
Frank Zhang (Contact Author)
Yale School of Management ( email )
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

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