Investment decisions and the role of debt, liquid assets and cash flow: evidence from Italian panel data

In this paper we study the consequences of imperfect substitutability between internal and external sources of finance for firmś real decisions. The relationship between financial variables and investment when capital markets are imperfect is analysed at both the theoretical and empirical level, using two panels of individual Italian firms. Under the hypothesis that the firm incurs costs of agency and financial distress, we derive both a Q and a Euler equation model for investment, which are then estimated together with a more loosely specified investment equation. The empirical results provide support for a significant departure from the hypothesis of perfect substitutability between internal and external sources of finance.