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The U-Shaped Investment Curve: Theory and Evidence

  • Cleary, Sean
  • Povel, Paul
  • Raith, Michael

We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 42 (2007)
Issue (Month): 01 (March)
Pages: 1-39

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Handle: RePEc:cup:jfinqa:v:42:y:2007:i:01:p:1-39_00
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  17. Sean Cleary, 1999. "The Relationship between Firm Investment and Financial Status," Journal of Finance, American Finance Association, vol. 54(2), pages 673-692, 04.
  18. Heitor Almeida & Murillo Campello & Michael S. Weisbach, 2004. "The Cash Flow Sensitivity of Cash," Journal of Finance, American Finance Association, vol. 59(4), pages 1777-1804, 08.
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