THE CASH FLOW INVESTMENT RELATIONSHIP - EVIDENCE FROM UNITED-STATES MANUFACTURING FIRMS

This paper explores reasons for the strong relationship between cash flow and capital investment spending. The equilibrium level of Tobin's Q is used to distinguish between liquidity constraints arising from asymmetric information and managerial overinvestment of free cash flow. Results suggest that both the Jensen (1986) free cash flow and the Myers and Majluf (1984) pecking order hypotheses are potential explanations for the investment/cash flow relationship. Free cash flow behavior appears to arise most strongly in large, low-dividend firms when they invest in tangible assets. Pecking order behavior appears to arise in smaller, low-dividend firms and in firms making less tangible investments.