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Do adjustment costs explain investment-cash flow insensitivity?

  • Pratap, Sangeeta

In this paper, I explain two "puzzles" which have been observed in firm level data. (1) Firms which display a high sensitivity of investment to cash flow (commonly believed to be an indicator of liquidity constraints) usually have large unutilized lines of credit which, presumably, could be used to overcome the shortage of funds. (2) Firms which are perceived to be extremely liquidity constrained actually show very little sensitivity of investment to cash flow. I use a dynamic model of firm investment with liquidity constraints and non convex costs of adjustment of capital which can explain these facts. The fixed cost of adjustment in the presence of liquidity constraints implies that firms need to have a certain threshold level of financial resources before they can afford to invest and incur these costs. Below this level, investment will not be sensitive to increases in cash flow. Once they cross this threshold, firms' investment will be positively correlated with their financial resources until they reach their desired level of capital stock. However, even if investment is sensitive to cash flow, firms always borrow below their credit limit to guard against future bankruptcy or binding liquidity constraints. I show therefore, that a firm which displays investment cash-flow sensitivity is certainly liquidity constrained. However, the reverse is not necessarily true.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 27 (2003)
Issue (Month): 11-12 (September)
Pages: 1993-2006

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Handle: RePEc:eee:dyncon:v:27:y:2003:i:11-12:p:1993-2006
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