The financing of uncertain future investments

Abstract

Purpose - This study investigates the effects of two important financing sources, debt and cash, on a firm’s investment decisions and explores the intertemporal impact of this financing on future investment volatility. Design/methodology/approach - We first report our results using ordinary least squares (OLS) estimation and then employ an instrumental variable (IV) strategy which addresses potential endogeneity that arises from future investment volatility on current capital structure and cash levels. Findings - We find i) firms with low levels of debt or high levels of cash experience higher future investment volatility, and ii) the probability of large future investment increases with high cash levels. Our findings are economically important; for example, a one-standard-deviation increase from the mean of debt ratio implies an approximate 7.8% decrease in future investment volatility; and a one-standard-deviation increase from the mean of a firm’s cash level leads to a 47% increase in the probability of a large investment in the next year. Originality/value - The findings of this study help firms understand the impact of their present financing decisions on the plausibility of their future investments. This paper contributes to the literature by making both novel and confirmatory findings. We structure our paper to include confirmatory findings for two reasons. First, we use different methods to construct investment volatility and the related investment spike. Second, and more importantly, the hypotheses are interrelated and communicate how firms plan for and execute against uncertain future investments. Growth options are ephemeral, and the hypotheses structure provides a guideline for how a firm finances future growth options.