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Financial Market Imperfection, Overinvestment, and Speculative Precaution

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The author uses panel data to assess the sensitivity of investment to cash flow in non-financial firms, taking into account the role their financial health plays in investment decisions. Firms are categorized using a method called the Z-score, a contemporaneous indicator of financial stress that is inversely related to firms' probability of financial failure. Based on this method, empirical evidence suggests that firms that have the greatest sensitivity of investment to cash flow display the lowest average Z-score. The author also shows that, in this class of firms, investment seems to be partly driven by excessive conservatism, or precaution.

JEL Code(s): D, D9, D92, E, E2, E22, E4, E44, G, G3, G33