Do adjustment costs explain investment-cash flow insensitivity?

✍ Scribed by Sangeeta Pratap

• Publisher: Elsevier Science
• Year: 2003
• Tongue: English
• Weight: 261 KB
• Volume: 27
• Category: Article
• ISSN: 0165-1889
• DOI: 10.1016/s0165-1889(02)00113-6

✦ Synopsis

In this paper, I explain two "puzzles" that have been observed in ÿrm level data. First, ÿrms that display a high sensitivity of investment to cash ow (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. Second, ÿrms that are perceived to be extremely liquidity constrained actually show very little sensitivity of investment to cash ow.

I show how a dynamic model of ÿrm investment with liquidity constraints and non-convex costs of adjustment of capital can explain these facts. These two features together imply that ÿrms need to have a certain threshold level of ÿnancial resources before they can a ord to increase investment. Once they cross this threshold, ÿrms' investment will be positively correlated with their ÿnancial resources until they reach their desired level of capital stock. However, even if investment is sensitive to cash ow, ÿrms may borrow below their credit limit to guard against future bankruptcy or binding liquidity constraints.