Wednesday, Oct 24, 2018     | 2:00pm-3:30pm | Room 335, HSBC Business School Building

Abstract

This paper develops a dynamic tradeoff model with the cross-sectional heterogeneity of production technologies such as the return to scale and the operating cost of assets. As a result, firm characteristics such as Q, cashflow, and leverage ratios are spanned by two dimensions. One is determined by the within-firm variations of productivity and the other is determined by the heterogeneity of production technologies. Understanding the firm heterogeneity can explain why leverage and cashflow are important determinants of investment policy even after controlling for the Q ratio. Leverage and cashflow can predict investments not necessarily because of financial constraints, but because they adjust firm heterogeneity. The model implies that the investment sensitivities to cashflow and leverage can be more significant among less-constrained firms, and also explains the persistent effects of pre-financing market-to-book ratios on subsequent leverage ratios.