Investment-Cash Flow Sensitivity and Proxy Quality Thresholds

44 Pages Posted: 13 Mar 2003

See all articles by Toni M. Whited

Toni M. Whited

University of Michigan, Stephen M. Ross School of Business; National Bureau of Economic Research

Timothy Erickson

U.S. Department of Labor - Bureau of Labor Statistics

Date Written: November 25, 2002

Abstract

We revisit the problem of error-laden proxies being used for 'q' in regressions of investment on cash flow and q. We give a menu of different prior information sets that can identify the sign of the coefficient on cash flow or the sign of the difference in cash-flow coefficients between groups of firms. The prior informations sets are arguably weaker than those necessary to identify the precise values of the coefficients. An element of each set is a prior lower bound on a correlation between the proxy and q. Like most researchers, we obtain positive OLS estimates of the coefficient on cash flow. We show, however, that the partial correlation between observed and true q must be believed to very large (from an objective viewpoint, unrealistically large) before one can legitimately infer that there is a positive coefficient on cash flow in the regression of investment on cash flow and true q.

Keywords: external finance constraints, investment, errors-in-variables, coefficient sign, prior information

JEL Classification: G31, E22, C40

Suggested Citation

Whited, Toni M. and Erickson, Timothy, Investment-Cash Flow Sensitivity and Proxy Quality Thresholds (November 25, 2002). Available at SSRN: https://ssrn.com/abstract=354700 or http://dx.doi.org/10.2139/ssrn.354700

Toni M. Whited (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Timothy Erickson

U.S. Department of Labor - Bureau of Labor Statistics ( email )

2 Massachusetts Avenue, NE
Postal Square Building, Room 3105
Washington, DC 20212
United States
202-691-6575 (Phone)
202-691-6583 (Fax)

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