Financial variables such as cash flow and cash stocks are robust and quantitatively important explanatory variables for investment at the firm-level. A large body of recent empirical work attributes these findings to capital market imperfections. This interpretation is controversial, however, because even in the absence of capital market imperfections, such financial variables may appear as an explanatory variable for investment if they contain information about the expected marginal value of capital. In this paper, we show how structural models of investment with costly external finance can be used to identify and quantify the fundamental' versus the financial' determinants of investment. Our empirical results show that investment responds significantly to both fundamental and financial factors. Point estimates from our structural model imply that, for the average firm in our sample, financial factors raise the overall response of investment to an expansionary shock by 25%, relative to a baseline case where financial frictions are zero. Consistent with theory, small firms and firms without bond ratings show the strongest response to financial factors, while bond-rated firms show little if any response once we control for investment fundamentals.
*Published: This paper was subsequently published as Investment: Fundamentals and Finance, Simon Gilchrist, Charles Himmelberg, in NBER book NBER Macroeconomics Annual 1998, volume 13 (1999)
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