“Can capital adjustment costs explain the decline in investment-cash flow sensitivity”
by Shushu Liao
Lancaster University Management School
It is well documented that since at least 1960s investment-cash flow (I-CF) sensitivity had been decreasing over time to disappear almost completely by late 2000s. We demonstrate that this pattern is consistent with the observed evolution of the capital adjustment costs in a neoclassical investment model with costly external financing. In particular, we estimate the magnitude of the capital adjustment cost parameter across different periods and show that the decreasing pattern of the I-CF sensitivity can be explained by the gradually increasing costs of capital adjustment. Consistent with the prior literature, we find no evidence of financial frictions being able to significantly contribute to the observed time-series pattern. The main results are further corroborated in a robustness analysis, which exploits the cross-industry and cross-country variation of capital adjustment costs. More generally, our results demonstrate that I-CF sensitivity should only be interpreted as a joint measure of real and financial frictions.