“Internal Cash Flows, Firm Valuation, and the Simultaneity of Corporate Policies ” by George Wong
Hong Kong Polytechnic University
Hong Kong University of Science and Technology
Nanyang Technological University
We outline a simple model in which optimizing firms choose corporate investment, external financing, and cash holding decisions simultaneously. The model generates predictions for the responsiveness of the above three corporate financial decisions to cash flow shocks and firm misvaluation, as well as new predictions for the cross-effects of misvaluation on the cash flow sensitivities of these corporate policy variables. We test all these predictions based on a large sample of public firms in the U.S. and find consistent evidence. Overall, by confirming the model's predictions for the signs of cash flow sensitivities, misvaluation sensitivities and cross-sensitivities for a number of different misvaluation measures, our model provides strong support for the notion that the wedge between the cost of external and internal finance affects corporate policies. Our estimation method follows Gatchev, Pulvino, and Tarhan (2010) in that we employ a dynamic simultaneous-equation model which is subject to the constraint that sources must equal uses of cash. However, contrary to Gatchev, Pulvino, and Tarhan's (2010) claims, we empirically show that this approach does not outperform the unconstrained static single-equation model as long as all corporate policy variables are defined consistently using the flow-of-fund data and all explanatory variables are either exogenous or predetermined.