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

Abstract

This paper documents the short and long term balance sheet effect of cash flow shocks. 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 positive cash flow shocks, delaying investment while building up cash flow 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 corporate debt market rather than capital goods market especially when financing constraints tighten.