Abstract
This paper explores reasons for the excess sensitivity of (under- or over-) investment to free cash flow. Using accounting information from Chinese listed firms, we find robust support for the fact that higher sensitivities of abnormal investment to free cash flow can be caused by financial constraints or agency costs. The evidence suggests that firms with free cash flow below their optimal levels tend to under-invest due to financial constraints. Moreover, firms whose free cash flow exceeds the optimal level are more likely to over-invest due to agency costs. Evidence from the exogenous split share structure reform via a DID approach confirms that both financial constraints and agency costs led firms’ investments to become inefficient. We also find that there exists some heterogeneity in the degree of financial constraints and agency problems faced by firms according to ownership structures, location and whether they engage in exporting or cross-listing.
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