How Firms Make Capital Expenditure Decisions: Financial Signals, Internal Cash Flows, Income Taxes and the Tax Reform Act of 1986

Abstract

This paper empirically assesses the determinants of future net capital expenditures for a broad cross-section of COMPUSTAT firms from 1973 to 1989. We explore three general categories of factors expected to affect investment: (1) external equity financing, (2) internally generated accounting information, and (3) tax incentives. We find that external financing and information plays a role in that both positive stock returns and equity issuances indicate future increases in investment. The results suggest that high stock prices not only lower the cost of capital, but also signal good investment opportunities. Accounting information about internal sources and uses of funds are also important in the investment decision. In particular, net income and depreciation are positive indicators of future investment while there is a tradeoff between the payment of dividends and investment. Further, positive changes in available cash liquidity also motivate future investment. While taxes are not important in the investment decision on average, we find that firms with previously higher income taxes invested substantially more in 1985 and 1986. This coincides with the repeal of the investment tax credit and the accelerated depreciation schedules in the Tax Reform Act of 1986. We view this as evidence that federal tax policy in the 1980's induced firms with high income tax obligations to accelerate capital expenditures just before the favorable tax treatment of capital expenditures was eliminated.

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Beatty, R., Riffe, S. & Welch, I. How Firms Make Capital Expenditure Decisions: Financial Signals, Internal Cash Flows, Income Taxes and the Tax Reform Act of 1986. Review of Quantitative Finance and Accounting 9, 227–250 (1997). https://doi.org/10.1023/A:1008211016618

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  • capital expenditures
  • stock returns
  • earnings and income taxes