First Draft: September 8, 1997 Second Draft: July 6, 1998 Third Draft: March 31, 1999
Abstract We use earnings forecasts from securities analysts to construct more accurate measures of the fundamentals that aﬀect the expected returns to investment. We ﬁnd that investment responds signiﬁcantly — in both economic and statistical terms — to our new measures of fundamentals. Our estimates imply that the elasticity of the investmentcapital ratio with respect to a change in fundamentals is generally greater than unity. In addition, we ﬁnd that internal funds are uncorrelated with investment spending, even for selected subsamples of ﬁrms — those paying no dividends and those without bond ratings — that have been found to be “liquidity constrained” in previous studies. Our results cast doubt on the evidence for liquidity constraints from the many studies that have used Tobin’s Q to control for the expected returns to investment. JEL Classiﬁcation: D92, E22. Keywords: Investment; Tobin’s Q; Cash Flow; Liquidity Constraints.
We thank Steve Bond, Ricardo Caballero, Mark Gertler, Simon Gilchrist, John Hand, Glenn Hubbard, Steve Kaplan, Owen Lamont, Plutarchos Sakellaris and seminar participants at Brandeis University, UC Berkeley, the Econometric Society Winter Meetings, the Federal Reserve Board, University College London, the University of Maryland, the NBER Economic Fluctuations and Monetary Economics Program Meetings, Northwestern University, New York University, Tilburg University, and Yale University for helpful comments and suggestions. Cummins gratefully acknowledges ﬁnancial support from the C. V. Starr Center for Applied Economics. The views expressed in this paper are those of the authors, and do not reﬂect those of the Board of Governors of the Federal Reserve System or its staﬀ. The data on earnings expectations are provided by I/B/E/S International Inc. ∗
Until recently, the consensus among researchers was that neoclassical fundamentals fail to explain the observed movements in business investment (see, e.g., Chirinko 1993). For example, in a well-known study, Summers (1981) found that a one percent increase in the shadow value of capital increases investment by a paltry 0.02 percent. Furthermore, models derived from neoclassical fundamentals have fared poorly in horseraces against ad hoc accelerator models of investment (see, e.g., Bernanke, Bohn, and Reiss 1988). This result could reﬂect the consequences of asymmetric information in ﬁnancial markets: Lenders become more favorably inclined to make loans when a ﬁrm’s net worth improves, leading to an expansion of business investment. In an important study, Fazzari et al. (1988) used ﬁrm-level panel data to try to isolate ﬁrms for which investment may be constrained by internal funds. They found that the ﬁrms most likely to face liquidity constraints tend to have the highest sensitivity of investment to cash ﬂow. Subsequent empirical research has generally supported this ﬁnding.1 Although this literature suggests that neoclassical models of investment perform poorly because many companies face ﬁnancial constraints, such a conclusion may be premature. A parallel literature, which attempts to control more fully for measurement error and allows non-convexities in marginal adjustment costs, has shown that neoclassical fundamentals are important determinants of investment. For example, Cummins and Hassett (1992) and Cummins, Hassett, and Hubbard (1994) used ﬁrm-level panel data to construct tax...