Investment Cash Flow Sensitivity: The Role of Cash Flow Volatility

Abstract

Low cash flow volatility firms receive stronger signals about future cash flow from a given cash flow shock, yielding a larger drop in demand for external finance and their cost of external finance, implying higher investment-cash flow sensitivities (ICFS). Empirical analysis in 6 European countries confirms this. Considering firms with the same cash flow volatility, ICFS are more pronounced for financially constrained firms (cf. Fazzari et al. (1988)). Considering firms with the same level of financial constraints, ICFS are more pronounced for firms with low cash flow volatility (cf. Kaplan and Zingales (1997)). The contradictory findings in the literature may be explained by cash flow volatility.