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The authors study the relationships between firms' internally generated cash flows and their investment, financing, and distribution decisions. Unlike previous studies that examine the cash flow sensitivity of investments in isolation, the authors consider a model where firms make their investment and financing decisions jointly, subject to the constraint that sources and uses of funds are equal. The authors find that the cashflow sensitivity of investment is small compared to the cashflow sensitivity of financing. Whereas a one dollar increase in cashflow causes a $0.03 increase in net investments ($0.07 increase in capital expenditures), it causes a $0.86 reduction in net debt and a $0.11 increase in shareholder distributions.
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