The impact of cash holdings and external financing on investment-cash flow sensitivity

Abstract

Purpose

This paper aims to propose several factors which can explain the negative relationship between financial constraints and investment-cash flow sensitivity.

Design/methodology/approach

The author uses traditional fixed effects model and minimum distance panel estimation by Erickson and Whited (2000) to estimate investment-cash flow sensitivity in the cash flow-augmented investment equation. In addition, principal component analysis is used to construct a financial constraints measure.

Findings

First, it was found that substitutability between cash holdings and free cash flow can partially explain why financially constrained firms do not depend on cash flow as heavily as we expect. Second, it was confirmed that the level of net external financing can also partially explain the investment-cash flow sensitivity puzzle. Furthermore, it was argued that the influence of cash holdings and external financing on investment-cash flow sensitivity is caused by the low level of internal cash flow for financially constrained firms. This argument is supported by our findings from an examination of investment-cash flow sensitivity for bank-dependent firms during the recession periods.

Originality/value

This paper contributes to the literature by suggesting possible partial explanations for the contradictory relationship between investment-cash flow sensitivity and financial constraints.

Citation

Kim, T.-N. (2014), "The impact of cash holdings and external financing on investment-cash flow sensitivity", Review of Accounting and Finance, Vol. 13 No. 3, pp. 251-273. https://doi.org/10.1108/RAF-09-2012-0080