How Do Misvalued Firms Deploy Internal Cash Flow?

Abstract

We examine how firms deploy internal cash flow across primary uses when they are misvalued in capital markets. Our integrated regression framework depicts a complete picture of what firms do with cash flow by jointly estimating the cash flow sensitivities of various uses (i.e., investment, cash holdings, dividends, and external finance reductions). The results show that, given an additional dollar of cash flow, overvalued firms allocate more cash flow to substitute for external financing and less to investment and cash savings. Conversely, undervalued firms shift cash flow away from external finance reductions toward investment and cash savings. When separating external finance into equity and debt, we find that overvalued firms use more cash flow to substitute for equity instead of debt. Collectively, our findings illustrate how firms tune cash flow allocation to absorb the valuation shocks in capital markets and reveal that misvaluation can impact corporate decisions and the real economy through an internal financing channel.

Keywords: Cash flow, misvaluation, market inefficiencies, financial constraints, corporate policies

JEL Classification: G31, G32