How Do Firms Allocate Internal Cash Flow? The Effect of Misvaluation and Costly External Financing

Abstract

We examine the effects of costly external financing and firm misvaluation on the allocation of internal cash flow to corporate investment, cash holdings, and financing activities. In the process, we correct methodological and data errors in a recent paper by Gatchev, Pulvino, and Tarhan (Journal of Finance, Vol. 65, pp. 725-763, 2010). We provide the correct estimates for the cash flow sensitivities, and, in addition, provide new evidence on how firm misvaluation affects the allocation of cash flow. We show that if firms are undervalued, they allocate more cash flow to investment and less to replace costly external finance.

Keywords: Cash flow, misvaluation, catering channel, financial constraints, investment, cash holdings, external finance

JEL Classification: G21, G31, G32