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Evidence on the determinants of investment-cash flow sensitivity

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Abstract

Investment-cash flow sensitivity (ICFS) is commonly used to investigate finance constraints in firms. However, there are several criticisms of ICFS that need to be confronted. First, higher ICFS may signal preference for internal funds, even when external funds are available on competitive terms. Second, ICFS may not increase monotonically with the finance constraints. Finally, cash flows, apart from capturing information on internal liquidity, also capture information on growth opportunities of firms. Evaluating the ICFS at firm level, the results suggest that ICFS is largely non-monotonic and it cannot be unambiguously associated with finance constraints based on firm characteristics.

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Notes

  1. For a comprehensive literature survey on financer constraints see Hubbard (1998), Lensink et al. (2001) and Calcagnini and Saltari (2010).

  2. The use of ICFS to identify financially constrained firms was first suggested by Fazzari et al. (1988).

  3. This is standard in the literature. For a comprehensive note on the construction of replacement value of capital stock see Fazzari et al. (1988) and Gomes (2001).

  4. We allow up to a tenfold jump if the manufactured sales is up to Indian Rupees (INR) 10 million; fivefold if the manufactured sales is between INR 10 million to INR 50 million; fourfold if the manufactured sales is between INR 50 million to INR 100 million; threefold if the manufactured sales is between INR 100 million to INR 250 million; and twofold if the manufactured sales is above INR 250 million. We tried various other cutoffs but these cutoffs are chosen to include the maximum possible number of observations in the sample and yet putting a restriction on the restructuring of firms.

  5. For a comprehensive discussion on this see Lee (2002).

  6. Although the − 0.0262 and 0.0397 cutoff levels are ad hoc, further results are not significantly sensitive to reasonable alternative choices of cut-off levels.

  7. We also estimated Eq. (6) for short term debt, long term debt and interest coverage. We found the explanation in the text valid. Our explanation for negative ICFS firms is consistent with the Cleary et al. (2007) but it differs from Hovakimian (2009). She invokes corporate life cycle hypothesis to explain the evolution of investments and cash flows for the negative ICFS group. She argues that such firms have low cash flows and abundant investment opportunities at start up. With age, they generate greater cash flows, but their investment opportunities decline leading to a fall in investments. We do not find life cycle considerations to be relevant in the Indian context.

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Authors and Affiliations

  1. Indira Gandhi Institute of Development Research, Mumbai, 400065, India

    Vikash Gautam & Rajendra R. Vaidya

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  1. Vikash Gautam
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  2. Rajendra R. Vaidya
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Correspondence to Vikash Gautam.

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Gautam, V., Vaidya, R.R. Evidence on the determinants of investment-cash flow sensitivity. Ind. Econ. Rev. 53, 229–244 (2018). https://doi.org/10.1007/s41775-018-0021-3

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