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Time to Build Capital: Revisiting Investment-Cashflow Sensitivities

  • John Tsoukalas

Is cash flow important in explaining investment dynamics? A large body of empirical work argues that it is. This finding is further taken as evidence of capital market imperfections. We argue that time-to-build for capital projects creates an investment cash flow sensitivity as found in empirical studies that may not be indicative of capital market frictions. We demonstrate this using a perfect capital markets model with firms that make investment decisions in capital projects indexed by the length of the time-to-build. We show that the typical (empirical) investment regression with q and cash flow is ridden with specification error under time-to-build investment. This error is due to an omitted right hand side state variable (current expenditure on existing capital projects) that fully describes optimal investment along with marginal q and is strongly correlated with cash flow. In addition, time aggregation error can give rise to cash flow effects independently of the time-to-build effect. Importantly, both errors arise independently of potential measurement error in q.

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Paper provided by University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM) in its series Discussion Papers with number 09/05.

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