The role of working capital as a source and cash flow insensitivity of fixed investment in low cash flow levels

The importance of cash flow in fixed investment of a firm which faces a wedge between the costs of internal and external funds is demonstrated by many studies. However, some studies have provided evidence that the sensitivity of fixed investment to cash flow may not be monotonically increasing with the degree of financing constraints. This paper explains an effect which may cause fixed investment to be less sensitive to cash flow for financially constrained firms with lower cash flow. According to this explanation, financially constrained firms with low cash flow use working capital as a temporary source of funds to undertake new investment opportunities. An increase in cash flow in low cash flow firms means using less working capital while an increase in cash flow in high cash flow firms means a decrease in marginal cost of capital. This explanation predicts that the relationship between investment and cash flow is not monotonic in the traditional investment equation but it is monotonic when the changes in working capital are controlled. In order to test these predictions, regression equations were estimated with panel data fixed effects model and instrumental variable approach using the data of 255 companies traded on Turkish markets in 2005 – 2017 period. The findings support the predictions of the study and the interpretation of these findings is robust against alternative explanations. By showing that the relationship between investment and cash flow may depend on the level of cash flow, this study helps reconciling seemingly contradictory findings about the monotonicity of this relationship.