Investment Behavior

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Investment Behavior, Observable Expectations, and Internal Funds Jason G. Cummins ∗ Assistant Professor New York University 269 Mercer Street New York, NY 10003 Kevin A. Hassett Resident Scholar American Enterprise Institute 1150 17th Street NW Washington, DC 20036 Stephen D. Oliner Asst. Dir. of Research Federal Reserve Board Mail Stop 93 Washington, DC 20551

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. ∗

Presenting/Corresponding author.



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...
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