I POLICY **RESEARCH WORKING PAPER** 1663

# **Summary findings**

One of the best documented empirical facts in economic research has been the positive relationship between internal finance and cash flows - the sum of retained - earnings and depreciation and capital expenditures and investment. But disputes about the analytical basis for the cash flow theory have been largely unresolved.

There are two distinct approaches to the cash flow theory of investment: the managerial and informationtheoretic approaches. The premise of the managerial approach is that managers are primarily interested in maximizing the growth rate of the firm. The premise of the information-theoretic approach is that managers try to maximize shareholder value.

Using a panel of U.S. manufacturing firms (1972-90), Samuel tries to distinguish between these two approaches on the basis of observed firm characteristics. The results suggest that firms rely on internal finance for capital expenditures because of managerial considerations rather than information-theoretic considerations.

The principal shortcoming of the informationtheoretic approach is its reliance on dividend practices as the decisive criterion for studying firm heterogeneity. But dividend practices are incapable of distinguishing between managerial and information-theoretic approaches since both approaches predict a negative relationship between dividend payout ratios and capital expenditures.

But one can distinguish between managerial and information-theoretic approaches using such variables as size, exchange listings, and the ratio of R&D to sales and make contrasting predictions about the firm's reliance on internal finance for capital expenditures.

The evidence shows that the firm's observed reliance of capital expenditures on internal finance is driven by managerial rather than information-theoretic considerations.

While no current research directly distinguishes between managerial and information-theoretic approaches, preliminary evidence seems to favor the managerial approach. And even though the stock market may play a limited role as a source of finance, policy initiatives to reform the financial sector and develop capital markets are likely to enhance the overall efficiency of the resource allocation process in the economy.

This paper - a product of the Operations Policy Group, Operations Policy Department - is part of a larger effort in the department to. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Cherian Samuel, room MC10-362, telephone 202-473-0802, fax 202-522-3253, Internet address csamuel@worldbank.org. October 1996. (34 pages) _The Policy Research Working Paper Series disseminates the findings of work_ **_in_** _progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings_ **_out_** _quickly, even if the presentations are_ **_less_** _than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors'_ **_oun_** _and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries._ Produced by the Policy Research Dissemination Center