Controlling for investment opportunities, the authors find a strong association between
cash flow and investment, and this effect is greater for financially constrained firms.
Their results refute the q theory investment model, which implies that investment depends
solely on investment opportunities and should be unrelated to cash flow.
The authors show that the cash flow measure in past studies (profit plus depreciation),
reflecting only a weak relationship with investment, does not represent actual cash flow
available for investment. The cash flow measure used by the authors corrects for the effects
of extraordinary items, deferred taxes, unremitted earnings in unconsolidated subsidiaries,
losses from the sale of long-lived assets, and other operating cash flows. The authors also
use broader measures for long-term investment and consider working capital investment and
other uses of cash.
How Is This Research Useful to Practitioners?
According to the authors, one dollar of cash flow from the current year results in a net
working capital investment of $0.11 and a capital expenditure of $0.15, both statistically
significant. The prior year’s cash flow, however, has a greater impact on investment.
One dollar of lagged cash flow is used for total fixed investment ($0.68), working capital
investment ($0.09), dividend payouts ($0.06), and decreases in equity ($0.20). At the same
time, debt in the sample increases by $0.09.
The authors break the sample down into financially constrained and unconstrained firms.
Recognizing that there is measurement bias with market/book value because book value is in
the denominator, they use past returns to estimate q. After correcting for
measurement error and controlling for q, they find that $1.00 of cash flow
in the current and prior years is associated with an additional fixed investment of $0.63
for constrained firms and $0.32 for unconstrained firms. Working capital investment
increases by $0.15 for constrained firms and decreases for unconstrained firms.
Unconstrained firms also use the dollar of cash flow to increase dividends ($0.18), reduce
debt ($0.24), and repurchase shares of stock ($0.29).
After controlling for expected cash flow, the authors find a negative correlation between
investment and market/book value for unconstrained firms, which implies that profitable
growth firms may have free-cash-flow problems. Furthermore, the larger investment related to
cash flow for constrained firms indicates that financial constraints play a role in
How Did the Authors Conduct This Research?
The authors study investment–cash flow sensitivities using data on 1,800 US
nonfinancial firms each year over 1971–2009. They use three different measures for
long-term investment; the most inclusive one captures the increase in all fixed assets,
including acquisitions and patent purchases, no matter how they are financed.
Past studies have defined cash flow as income before extraordinary income plus
depreciation, and results have suggested only a small impact on investment in recent years.
The authors redefine the cash flow measure as one that approximates operating cash flow on
the cash flow statement, excluding changes in working capital because they consider working
capital a type of investment. The correlation between the traditional cash flow variable and
the authors’ cash flow measure diminishes significantly over time, largely because of
an increase in noncash special items beginning in the 1980s. The cash flow measure used in
recent studies explains why a weak investment–cash flow association has been
The authors find that cash flow is strongly linked to both short-term and long-term
investment and that the association is strongest for firms with financial constraints.
The authors recognize and address problems of previous researchers who attempted to link
cash flow to investment. They develop a more relevant cash flow measure that should be
considered by future researchers. Their more inclusive model of how cash flow is
used—for paying dividends, increasing working capital, repurchasing shares, reducing
debt, and investing long term regardless of financing—may be useful for analysts.
The results indicate that financially constrained firms invest more when cash flow
increases, demonstrating that financial constraints affect investment for this subgroup. The
relevance of financial constraints may have implications for economists and policymakers
trying to stimulate the economy.