The Impact of Cash Holdings and External Financing on Investment-Cash Flow Sensitivity

Abstract

In this paper, we propose several factors which can explain the negative relationship between financial constraints and investment-cash flow sensitivity. First, we find that substitutability between reserved cash holdings and internal free cash flow can partially explain why financially constrained firms do not depend on cash flow as heavily as we expect. Second, we confirm that the level of net external financing can also partially explain the investment-cash flow puzzle. Lastly, by examining the relationship between bank dependency and investment-cash flow sensitivity for recession and non-recession periods, we show that investment-cash flow sensitivity can be used as a proxy for a relative measure of financial constraints.

Keywords: investment-cash flow sensitivity, corporate cash holdings, financial constraints

JEL Classification: G30, G32