Question

Finance theory suggests that firms take projects with positive NPVs regardless of the amount of cash the firm has available. However, empirical evidence suggests that the amount that firms invest is heavily dependent on their available cash flows. Why might this be?

Answer 1

Cash flows represent the actual cash inflow and outflow rather thna accounting incomes and expenses. For the purpose of investment, firms require actual cash rather than accounting incomes. They need to purchase plant and machinery and incur other costs for which actual cash is required. Hence it is necessary for them to consider their cash flows for the purpose of making these investments.

A project may have a very high NPV but if the initial outlay is too high, the firm will not be able to invest in the same.