Shocks to Cash Flow Are Absorbed By External Financing

The April 2010 issue of the Journal of Finance carries an article providing a statistical analysis of how firms respond to cash flow shocks. The authors are Vladimir Gatchev, Todd Pulvino and Vefa Tarhan. It stands in a long line of empirical research attempting to nail down an answer to that question. The line is long because firms have broad array of ways to respond, and because these responses can involve complicated dynamic strategies through time. Therefore, getting the statistical analysis right so that one can make a reliable inference is a very difficult task. One of the main points of this article is that most of the previous literature oversimplified the representation of a firm’s available responses and consequently obtained an exaggeratedly large estimate of how capital investment responds to cash flow shocks.

These authors find that capital investment is largely insensitive to cash flow shocks. Instead, the shocks are largely absorbed by changes in debt and other external financing. Given the complexity of the issue, this study is unlikely to be the last word on the matter.

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