Firm Investment and Financial Frictions

In this paper we investigate the analytical and empirical linkages between firms' capital investment behavior and financial frictions arising from asymmetric information, proxied by firms' liquidity and degree of uncertainty. Measures of intrinsic and extrinsic uncertainty are derived from firms' daily stock returns and S&P 500 index returns along with a CAPM-based risk measure. We employ a panel of U.S. manufacturing firm data obtained from COMPUSTAT over the 1984-2003 period. Financial frictions captured by interactions between firms' cash flow and both intrinsic and CAPM-based measures of uncertainty have a significant negative impact on firms' investment spending, while extrinsic uncertainty has a positive impact.