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Authors:

• Sudipto DASGUPTA
  Hong Kong University of Science and Technology

• Thomas H. NOE
  University of Oxford

• Zhen WANG
  Hong Kong University of Science and Technology

There is surprisingly little documented evidence regarding how firms respond to a dollar of cash flow shock. There are at least three questions that need to be addressed in this context: (1) How do firms allocate an additional dollar of cash in the short run (2) How do they allocate a dollar of cash intertemporally, and (3) Is there any difference between the so-called "financially constrained" and "unconstrained" firms? We find that reduction of external financing and savings constitute the most significant uses of a dollar of cash inflow in the same period – a result that is consistent with the noted lack of responsiveness of capital expenditure (Capex) to cash flow in existing literature. However, we also find that current cash flow has significant lagged effects on future Capex and investment (a broader category than Capex), so that over three periods, the "cash flow sensitivity of Capex", and especially that of investment, is substantial. Over three periods, unconstrained (or "less-constrained") firms spend 81 cents on investment in response to an additional dollar of cash flow compared to 62 cents for constrained (or "more-constrained") firms. The difference is mainly accounted for by the fact that (a) constrained firms replace more external financing immediately than unconstrained ones, and (b) while unconstrained firms raise additional external financing over the next two years in response to the cash inflow, constrained firms do so to a much lesser extent. Our results suggest that additional cash flow today allows both types of firms to "ease" constraints through saving and reduction of external financing. Investment responds subsequently; however, this effect is more significant for the less-constrained firms.