Research Discussion Paper – RDP 9402 The Influence of Financial Factors on Corporate Investment


Recent theoretical developments have shown that cash flows and the structure of a firm's balance sheet may have an important influence on investment. Establishing a link between cash flows, leverage and investment provides insights into the way that monetary policy and cyclical factors more generally influence the corporate sector. If cash flows are an important determinant of investment, then changes in monetary policy (by changing interest rates) will influence investment through a cash flow effect as well as through altering the rate at which the returns to investment are discounted. If this is the case, the higher leverage of the corporate sector implies, other things being equal, that monetary policy may have a larger impact on investment than in the past. Furthermore, it suggests that the effects of monetary policy will be felt unevenly across the corporate sector. The cash flows of highly geared firms will be more sensitive to changes in interest rates than cash flows of firms with minimal leverage.

In this paper we use panel-data analysis to examine the impact of financial factors on investment decisions of firms in the Australian corporate sector. We find strong support for the influence of financial factors on investment decisions. Leverage, internally-generated cash flows, and the stock of cash and liquid financial assets are all important influences on investment behaviour, particularly for smaller firms, highly leveraged firms, and firms with high retention ratios.

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