Misvaluation and Corporate Uses of Cash Flow

Abstract

We model how firms allocate internal cash flow across primary uses when they are misvalued in capital markets. All cash flow uses are jointly determined and interrelated by the identity that sources of funds equal uses of funds. Our model predicts that with an additional dollar of cash flow, more overvalued firms allocate more to substitute for costly external financing and less towards investment and cash savings. These predictions are confirmed empirically using an integrated regression framework that tracks all cash flow uses. Overall, our results imply that misvaluation impacts 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