The Intertemporal and Interdependent Nature of Financial Decisions: An Applicacation to Cash Flow Sensitivities
54 Pages Posted: 18 Feb 2009 Last revised: 25 Feb 2010
Date Written: February 15, 2009
Abstract
Empirical studies of firms' financing, investment, and payout policies routinely examine these policies in isolation. In this paper we develop a dynamic multi-equation model where firms make financing and investment decisions jointly subject to the constraint that sources of cash must equal uses of cash. We argue that static models of financial decisions produce inconsistent coefficient estimates. We also argue that models that do not acknowledge the interdependence among decision variables produce inefficient coefficient estimates and provide an incomplete and potentially misleading view of firms' financial behavior. We use our model to study the relationship between investment and cash flow. Unlike static single-equation studies that conclude that firms react to cash flow shocks by changing investments, we find that regardless of financial health, firms react by changing leverage.
Keywords: Capital market frictions, Financing and investment decisions, Cash flow sensitivities
JEL Classification: G31, G32, G10
Suggested Citation: Suggested Citation
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