Why has the investment-cash flow sensitivity declined so sharply? Rising R&D and equity market developments

The study of the investment-cash flow (ICF) sensitivity constitutes one of the largest literatures in corporate finance, yet little is known about changes in the ICF relationship over time, and the literature has largely ignored how rising R&D investment and developments in equity markets have impacted ICF sensitivity estimates. We show that for the time period 1970-2006, the ICF sensitivity: (i) largely disappears for physical investment, (ii) remains comparatively strong for R&D, and (iii) declines, but does not disappear, for total investment. We argue that these findings can largely be explained by the changing composition of investment and the rising importance of public equity as a source of funds, particularly for firms with persistent negative cash flows.