Corporate Governance and the Sensitivity of Investments to Cash Flows

We find very strong and consistent evidence that investments in Strong†Governance firms (managers not entrenched) are strongly sensitive to availability of internal cash flows while such sensitivity is not different from zero for Weak†Governance firms (entrenched management). We interpret this as evidence in support of Kaplan and Zingales' (1997) contention that sensitivity of investments to cash flows is not an adequate measure of financing constraints. More importantly, our findings are consistent with Kaplan and Zingales’ conjecture that the observed sensitivity of investments to cash flows in firms that do not face financing constraints may be driven by excessive risk aversion of managers.