How Sensitive is Investment to Cash Flow when Financing is Frictionless?

Abstract

This paper analyzes the sensitivity of a firm's investment to its own cash flow in the benchmark case where financing is frictionless. It has been proposed in earlier research that this sensitivity results from financing constraints. This paper shows that the observed investment-cash flow sensitivities obtain in the benchmark case without financing frictions. Cash flow contains information about profitability that is not reflected in Tobin's q, which is a commonly used measure of investment opportunities. As a result, investment is sensitive to cash flow even after conditioning on Tobin's q. Tobin's q is shown to be a worse measure for firms with significant growth opportunities than for mature firms. Consequently, the investment-cash flow sensitivity is higher for firms with growth opportunities, as it is in the data. Given these results, the paper argues that the empirical findings on the investment-cash flow sensitivity cannot be interpreted as evidence for the existence of financing constraints.