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Inventory Accumulation, Cash Flow, and Corporate Investment

Research output: Chapter in Book/Report/Conference proceedingConference contribution

Original languageEnglish
Title of host publicationMidwest Finance Association 2013 Annual Meeting Paper
Publisher or commissioning bodySocial Science Research Network (SSRN) working paper
Pages1-58
VolumeNovember 2012
DOIs
DatePublished - 2013

Abstract

I show that firms' ability to adjust variable capital in response to productivity shocks has important implications for the interpretation of the widely documented investment-cash flow sensitivities. The variable capital adjustment is sufficient for firms to capture small variations in profitability, but when the revision in profitability is relatively large, limited substitutability between the factors of production may call for fixed capital investment. Hence, firms with lower substitutability are more likely to invest in both factors together and have larger sensitivities of fixed capital investment to cash flow. By building a frictionless capital markets model that allows firms to optimize over fixed capital and inventories as substitutable factors, I establish the significance of the substitutability channel in explaining cross-sectional differences in cash flow sensitivities. Moreover, incorporating variable capital into firms' investment decisions helps explain the sharp decrease in cash flow sensitivities over the past decades. Empirical evidence confirms the model's predictions.

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