Investment - Cash Flow Sensitivity and Capital Market Imperfections: Theory and Evidence from Indian Panel Data

Debkumar Chakrabarti
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Debkumar Chakrabarti: Department of Economics, Ramakrishna Mission Vidyamandira, Belur Math, Howrah, West Bengal, India

Indian Economic Review, 2006, vol. 41, issue 2, 209-227

Abstract: Theories of capital market imperfections point out the role of financial factors in determining investment behaviour of firms. However, no attempt has been made so far to provide a framework that can directly verify the link between capital market imperfections and firm level investment decisions. This paper tries to fill up the lacuna by incorporating agency cost of external funds in the value-maximizing problem of the firm. Our findings cast serious doubt on the monotonicity of investment - cash flow sensitivity with respect to financial market imperfections - the central assumption underlying most of the empirical work in this particular field. Moreover, results point out that increase in internal cash flow engenders two separate effects - the Internal Fund Effect and the Net Worth Effect both of which have a positive impact on the level of investment. We have also conducted an empirical survey on Indian firms which also highlights the separate existence of the two effects.

Keywords: Cash Flow; Net Worth; Internal Fund; Investment; Panel Data (search for similar items in EconPapers)
JEL-codes: C23 E22 (search for similar items in EconPapers)
Date: 2006
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