EVIDENCE ON THE ROLE OF CASH FLOW FOR INVESTMENT

Recent work in macroeconomics argues that imperfections in capital mar kets may lead to business cycle fluctuations by propagating relatively modest shocks. Evidence for such a mechanism (also known as the 'fina ncial accelerator') consists largely of firm-level studies showing tha t cash flow is an important predictor of investment. But this evidence is often viewed with skepticism because cash flow is also a good indi cator of investment opportunities. In this paper, we develop a framewo rk for estimating the extent to which the predictive power of cash how can be attributed to its role as a 'fundamental' versus its role in a lleviating credit frictions. For firms with access to commercial paper and bond markets, we find that the perfect capital markets model of i nvestment can fully account for the role of cash flow. For firms with only limited access to capital markets (as indicated by lack of partic ipation in public debt markets) however, investment appears to be 'exc essively' sensitive to fluctuations in cash flow. These results thus c larify the role of cash flow in investment equations and provide suppo rt for the existence of a financial accelerator.