Extrapolation and Real Investment

54 Pages Posted: 24 Mar 2017 Last revised: 14 Nov 2020

See all articles by Mikael Paaso

Mikael Paaso

Erasmus University Rotterdam (EUR)

Date Written: November 2, 2020


I show that managers of small businesses extrapolate from past growth when making corporate investment decisions, even when past growth is uninformative about future growth. This extrapolation leads to a higher rate of firms shutting down in subsequent years. My identification strategy uses rainfall as an instrumental variable for cash flow shocks to firms that are weather sensitive. I find that companies increase investment 43% relative to mean yearly investment following a onestandard-deviation drop in summer rainfall, even though the drop is transitory. Traditional explanations, such as loosening of credit constraints or agency problems, do not fully explain the result.

Keywords: Real investment, investment-cash flow sensitivity, extrapolation, weather shock

JEL Classification: G31, D22, G02

Suggested Citation

Paaso, Mikael, Extrapolation and Real Investment (November 2, 2020). Available at SSRN: https://ssrn.com/abstract=2939895 or http://dx.doi.org/10.2139/ssrn.2939895

Mikael Paaso (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA

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