The Interdependent and Intertemporal Nature of Financial Decisions: An Application to Cash Flow Sensitivities

Abstract

We develop a dynamic multi-equation model where firms make financing and investment decisions jointly subject to the constraint that sources must equal uses of cash. We argue that static models of financial decisions produce inconsistent coefficient estimates and that models that do not acknowledge the interdependence among decision variables produce inefficient estimates and provide an incomplete and potentially misleading view of financial behavior. We use our model to examine whether firms are constrained from accessing capital markets. Unlike static single-equation studies which find that firms underinvest when faced with cash flow shortfalls, we conclude that firms maintain investment by borrowing.

Keywords: Casflow sensitivty, investment and financing decisions, capital market access constraints

JEL Classification: G31, G32, G30