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Where Did All the Dollars Go? The Effect of Cash Flows on Capital and Asset Structure

Published online by Cambridge University Press:  29 June 2011

Sudipto Dasgupta
Affiliation:
Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong, dasgupta@ust.hk
Thomas H. Noe
Affiliation:
Said Business School and Balliol College, University of Oxford, Park End St., Oxford OX1 1HP, UK, thomas.noe@sbs.ox.ac.uk
Zhen Wang
Affiliation:
School of Finance, Shanghai University of Finance and Economics, 777 Guoding Rd., Shanghai, China, wang.zhen@mail.shufe.edu.cn

Abstract

This paper documents the short- and long-term balance sheet effect of cash flows. We show that cash savings in the short run and debt reduction in both the short and the long run account for a substantial fraction of cash flow use. Although, in the long run, investment exhibits substantial sensitivity to cash flows, investment does not absorb the entire cash flow shock. In fact, the tighter the financial constraints, the smaller the fraction of cash flow absorbed by investment and the more by leverage reduction. Firms stage their response to increases in cash flow, delaying investment while building up cash stocks and reducing leverage. These results suggest that much of the short-run economic effect of cash flow shocks to the corporate sector may be channeled into the corporate debt market rather than the capital goods market, especially when financing constraints tighten.

Type
Research Articles
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

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