Applied Economics, 1998, 30, 95Ð 104

The investment decision: a re-examination

of competing theories using panel data
C H ER I A N S A M U E L
International Finance Corporation, 2121 Pennsylvania Avenue, N.W . W ashington DC
20433, USA

A re-examination of the competing theories of investment using panel data for US

manufacturing ® rms ® nds that the time-series regressions rank the neoclassical model
as the best and the cross-section and ® xed e€ ects regressions give the number 1 spot to
the cash ¯ ow model. If the results from cross-section regressions are viewed as
representing the long-run equilibrium, the single-most important determinant of
capital expenditures appears to be cash ¯ ows. These results are consistent with earlier
® ndings in the literature, support the need for an eclectic approach to the study of
capital expenditure decisions at the ® rm level, and vindicate the choice of the ® rm as
the basic unit of analysis in the study.

I N T R O D U C TI O N 1952; Koyck, 1954); (ii) cash ¯ ow theory;1 (iii) neoclassical

Economists have been concerned with the analysis of the
determinants of investment (capital) expenditures for a long
time. This analysis has been conducted at all levels of
disaggregation, i.e. economy, industry, and the ® rm. This
paper compares the alternative theories of investment using
a panel of US manufacturing ® rms from the Standard and
Poor’s COMPUSTAT database for the 1972Ð 90 period.
The paper is organized into four sections. Section I begins
with a discussion of the alternative models of investment
and then examines the empirical evidence for these models.
Section II reports the results of the time-series regressions.
Section III has results from cross-section regressions. Sec-
tion IV deals with ® xed e€ ects models. The ® nal section
concludes the study.
I . M O D E L S O F I N V E S T M EN T
Broadly speaking, one can distinguish at least ® ve theories
of investment: (i) accelerator theory (Clark, 1917; Chenery,
theory (Jorgensen, 1963, 1966, 1967, 1971); (iv) modi® ed
neoclassical (Bischo€ ) theory (Bischo€ , 1971); and (v) Q
theory (Brainard and Tobin, 1968; Tobin, 1969).2
For analytical purposes, the alternative theories of invest-
ment can be classi® ed in various ways. One division could
be based on the optimal adjustment path for the ® rm’s
capital stock. While the accelerator, neoclassical, modi® ed
neoclassical, and the cash ¯ ow models do not explicitly
consider the optimal adjustment path for the ® rm’s capital
stock when it is away from that level, the Q theory charac-
terizes the complete evolution of the capital stock from the
underlying optimization problem.3 This therefore provides
a rationale for expectational lags and leaves room for lags in
delivery and installation only.
Another way to think about the di€ erent models of in-
vestment is to highlight the factors that underlie the mar-
ginal returns to investment and the marginal cost of ® nance
in the di€ erent models. For instance, a sharp distinction can
be drawn between the managerial and neoclassical theories
of investment (Grabowski and Mueller, 1972). In the neo-
classical theory, internal and external ® nance are perfect

1
Within the rubric of the cash ¯ ow theory, there are three variants: (a) liquidity model (Dusenberry, 1958; Meyer and Kuh, 1957; Kuh,
1963; Meyer and Glauber, 1964; Meyer and Strong, 1990); (b) managerialmodel (Marris, 1963, 1964; Grabowski and Mueller, 1972); and (c)
information-theoretic model (Myers and Majlu€ , 1984; Greenwald et al., 1984; Stiglitz and Weiss, 1981). This paper does not distinguish
between these three variants.
2
See Appendix I for a description of these models. See Samuel (1996a) for a detailed discussion of the evolution of the di€ erent models of
investment.
3
This feature is also present in the irreversibility models. See Dixit and Pindyck (1994) for a more detailed discussion of irreversibility models.
0003Ð 6846 Ó 1998 Routledge 95
96
substitutes, following ModiglianiÐ Miller (1958) theorems,
and therefore the marginal cost of ® nance equals the share-
holder’s opportunity cost of capital. In the managerial
theory of investment, however, managers prefer to use inter-
nal funds since they are the most accessible part of the
capital market and hence most malleable to managerial
desires for growth. The marginal cost of capital is signi® -
cantly lower for internal ® nance compared to external
® nance, and therefore not equal to the shareholder’s oppor-
tunity cost of capital, but some much lower totally subjec-
tive value set by the managers. In equilibrium, marginal
returns to investment equal the marginal cost of ® nance.
The alternative models of investment can also be classi-
® ed in terms of the relative importance of price variables like
taxes and interest rates, quantity variables like output and
liquidity, and autonomous shocks like `animal spirits’ and
technology shocks as determinants of capital expenditures
(Chirinko, 1993). For the neoclassical model, only price vari-
ables matter; for the accelerator and cash ¯ ow models, only
quantity variables matter. For the Q theory, what is relevant
is autonomous shocks, and for the modi® ed neoclassical
model, what matters is a combination of price and quantity
variables, with the latter being somewhat more important.
These ® ve basic models of investment are useful for a rela-
tive ranking of the various factors (output, cash ¯ ows, cost
of capital, prices, technology shocks etc.) that are important
in shaping investment decisions.4
Empirical evidence
The validity of any model of investment is ultimately judged
by its ability to explain past data as well to make future
predictions. In two separate studies, Jorgensen and Siebert
(1968a, 1968b) carried out detailed empirical testing of com-
peting models Ð accelerator, neoclassical, liquidity, and mar-
ket value5 Ð at the ® rm level and found the neoclassical
model to be the best. The Jorgensen and Siebert sample
consisted of 15 large manufacturing ® rms for the 1949Ð 63
period.6
However, Elliott (1973) re-estimated the models of the
original Jorgensen sample and came to quite di€ erent
C. Samuel
conclusions. Elliott’s sample consisted of 184 ® rms for the
1947Ð 63 period. In cross-section estimates, the cash ¯ ow
model was found to be the best, while in time-series esti-
mates, the accelerator model was better than all others. In
general, Elliott’s results nulli® ed Jorgensen’s results for the
neoclassical model and con® rmed the need to have a more
eclectic framework for understanding investment decisions
by ® rms.
Likewise, studies by Eisner and associates (1963, 1964,
1967, 1968, 1970, 1978) consistently demonstrated the
superiority of the accelerator or accelerator and cash ¯ ow
models compared to the neoclassical model of investment.
Grabowski and Mueller (1972) carried out a testing of the
managerial and stockholder welfare (neoclassical) models of
® rm expenditures using data for 66 ® rms for the 1959Ð 66
period. Their empirical results indicated the managerial
variant of the model to be far superior to the stockholder
welfare maximization version.
From this point onwards, almost all the testing of alterna-
tive models of investment that has been undertaken in the
literature has been con® ned to the level of the aggregate
economy. One addition to the research agenda has been the
estimation of separate models for structures and equipment.
In particular, there has been an emphasis on understanding
the role of tax policy in in¯ uencing overall investment
expenditures as well as its composition between equipment
and structures. 7
Empirical testing of the information-theoretic approach
to investment began with Fazzari and Athey (1987) and
Fazzari et al. (1988). This also marked the revival of panel
data econometrics to the study of investment decisions.8
The information-theoretic approach has really blossomed
since then.9
What is interesting to note from this discussion is that
there has not been any comparison of alternative models of
investment based on ® rm-level data after Elliott’s study in
1973. Even in the studies done at the economy level after
1973, the pure cash ¯ ow model has not been tested. 1 0
On both these counts, this paper di€ ers from the rest of
the literature. The choice of the ® rm as the unit of analysis
is also appropriate, given that investment decisions are

4
In addition to these ® ve models that emphasize the role of a single factor to the exclusion of all others in the determination of investment
expenditures, one can think of at least two other composite models that are combinationsof these basic models that emphasize a number of
factors: (i) accelerator-cash ¯ ow (Eisner, 1978); and (ii) Q-cash ¯ ow (Fazzari et al., 1988; Blanchard et al., 1993; and Rhee and Rhee, 1991).
These composite formulations are essentially a recognition of the complexities involved in the investment process, the attempt being to
capture the multitude of constraints that are operative with regard to capital expenditure decisions. However, the empirical evidence
presented in this paper is limited to the ® ve basic models of investment.
5
The market value model is due to Grunfeld (1960) and proposed the use of the ® rm’s market value as a proxy for expected pro® tability. It
can be viewed as a precursor to the Q model.
6
See Jorgensen (1971) for a survey of other studies of investment up to the 1970s.
7
See Bischo€ (1971), Clark (1979), and Bernanke et al. (1988), for instance.
8
As noted by Hsiao (1986), Kuh (1963) can be regarded as the seminal work in panel data econometrics.
9
See for example the collection of papers in Hubbard (1990). See also Hoshi et al. (1991), Oliner and Rudebusch (1993), and others.
10
While Bischo€ (1971) and Clark (1979) tested the cash ¯ ow-accelerator model, Bernanke et al. (1988) did not include the cash ¯ ow model
in any form at all.
T he investment decision: competing theories
fundamentally made at the ® rm level. More generally, this
approach is also consistent with the view in the literature
that sees the world as a collection of ® rms.1 1
It is also somewhat ironic that even after Kuh (1963)
demonstrated the appropriateness of the ® xed e€ ects ap-
proach to the estimation of investment regressions in panel
data, it was largely ignored. For instance, Jorgensen and
Siebert (1968a, 1968b) largely concentrated on time-series
procedures, believing that the time structure of investment is
the key element. Likewise, Elliott (1973) focused on cross-
section results.1 2
Data and variables
The objective of this paper is to compare the competing
models of investment using panel data. In particular, one
could question the premise of some recent research that
argues that the Q-theoretic approach is the best way to
think about investment decisions.1 3 This study goes back
one step, and re-examines the competing theories of invest-
ment using ® rm-level data.1 4 In that sense, this paper is very
similar in spirit to that of Kuh (1963), Jorgenson and Siebert
(1968a, 1968b), and Elliott (1973), albeit with a bigger
sample and for a later time period. This study is based on
the capital expenditure decisions of a panel of 331 US
manufacturing ® rms, taken from Standard and Poor’s
COMPUSTAT database for the 1972Ð 90 period; the sample
excludes ® rms that were involved in major mergers repres-
enting contribution to sales exceeding 50% of the acquiring
® rm’s net sales for the year in question. As noted before, this
is the ® rst comparison of alternative models of investment
after 1973 using ® rm-level data.
In estimating the neoclassical and Bischo€ models, two
measures of the opportunity cost of capitalÐ used in turn for
computing the user cost of capitalÐ have been used in this
paper. In time-series regressions, the real rate of interestÐ the
nominal rate less in¯ ationÐ is used as the opportunity cost of
capital. In cross-section regressions, the opportunity cost of
capital is proxied by the rate of return on ® rms belonging to
similar risk classes, following the procedure outlined in
Grabowski and Mueller (1972).1 5 In the ® xed e€ ects regres-
97
sions discussed in detail below, the speci® cations use the real
rate of interest. 1 6 The q ratio has been computed following
the procedure in Salinger and Summers (1983).
I I . T I ME - SE R I E S R E G R E S S I O N S
(Tables 1 and 2)
Traditionally, time-series regression estimates have been
viewed as re¯ ecting short-run reactions. For each ® rm,
regressions are run for each model for the 1972Ð 90 period.
The estimation has been done in ® rst di€ erences so as to
correct for serial correlation. All the variables have been
adjusted for in¯ ation. It may be noted that for the cash ¯ ow
and Q models, data are available for 18 years; for the
accelerator, neoclassical, and Bischo€ models, data are
available for 16 years. These di€ erent time periods are due
to the di€ erences in the speci® cations of the models. For the
neoclassical and the Bischo€ models, the opportunity cost
of capital was proxied by the real rate of interest.
Accelerator model
Out of the 331 regressions, there were only 70 (21%) with
signi® cant F-ratios. Within these, the coe cients were sig-
ni® cant (5% level or better) in all 70 cases, and the signs
were correct for 69 ® rms.
Neoclassical model
A total of 129 (31%) out of the 331 regressions had signi® -
cant F-ratios. The coe cients were signi® cant in 102 cases.
The signs were correct in 100 of these regressions.
Bischo¤ model
Out of the 331 regressions, 63 (19%) had signi® cant F-
ratios. The parameters of interest relate to pt ± 1 Y t /ct ± 1 (say
b1) and pt ± 1 Y t ± 1 /ct ± 1 (say b2). Out of the 63 signi® cant
regressions, both b1 and b2 were signi® cant in 31 cases, and
were insigni® cant in 6 cases. In 18 instances, b1 alone was

11
See Mueller (1993), for instance.
12
The time-series approach of Bischo€ (1971), Clark (1979), and Bernanke et al. (1988) is perhaps more justi® ed since they use aggregate
rather than disaggregated data.
13
Chirinko (1993) provides a comprehensive survey of the current state of research on investment theory, with particular emphasis on
Q-theoretic models. The Q theory of investment attempts to explain investment on a ® nancial basis in terms of portfolio balance, i.e., based
on the q ratioÐ the ratio of the market value of the capital stock to its replacement cost.
14
In addition, a proper understanding of the determinants of investment is also crucial from the perspective of economic policy. See
Samuel (1996a) for a more detailed discussion.
15
For each ® rm, the market rate of return Ð dividend plus capital gains Ð is computed for each year during the 1972Ð 90 period. Next, ® rms
are ranked based on the variance in these returns and grouped into risk classes consisting of the contiguous 30 ® rms. The average rate of
return of the 30 stocks in each sample ® rm’s risk class is used as the estimate of the ® rm’s opportunity cost of capital. See Grabowski and
Mueller (1972) for more details.
16
Fixed e€ ects regressions were also run with the rate of return as the opportunity cost of capital. These results, while not shown here, were
broadly similar to the results from the speci® cation using the real rate of interest. See Samuel (1996a) for details.
98 C. Samuel
Table 1. Time-series estimates (N = 331), model diagnostics Cash ß ow model

Acceler- Neo- Cash Of the 331 regressions 62 (19%) had signi® cant F-ratios.
ator classical ¯ ow Q The coe cients were signi® cant in all 62 cases. The signs
were correct in 57 cases.
F=0 261 129 269 306
F¹ 0 70 102 62 25
Q model
Signi® cance of
parameters* Only 25 (8%) of the 331 regressions had signi® cant F-ratios.
t¹ 0 70 102 62 25 The coe cients were signi® cant in all 25 cases. The signs
t=0 0 0 0 were correct in only 9 of these cases.
Signs of parameters
Correct signs 69 100 57 9 Based on these results, the ranking of the models is:1 7 (1)
Wrong signs 1 2 5 16 neoclassical model; (2) accelerator model;1 8 (3) Bischo€
model; (4) cash ¯ ow model; and (5) Q model.1 9 Therefore,
* 5% or better. the results based on time-series regressions suggest that, at
the level of the ® rm, the primary determinant of capital
Table 2. Time-series estimates (N = 331), model diagnostics expenditures is the cost of capital, based here on the real
Bischo¤ model interest rate. Thus in the short run, the cost of capital is the
most important determinant of capital expenditures.2 0 It is
pt ± 1 Y t/ct ± 1 also interesting to note that the ® nding with regard to the
pt ± 1 Y t/ pt ± 1 Y t± 1 / and
ct ± ct ± pt ± 1 Y t ± 1 /ct ± superiority of the neoclassical model in time-series regres-
1 1 1
sions is consistent with that of Jorgenson and Siebert
Signi® cance of (1968a, 1968b).
parameters*
t=0 8 18 6
t¹ 0 18 8 31
I I I . C R O S S - S E C T I O N RE G R E S S I O N S
Signs for signi® cant (Tables 3 and 4)
parameters
Correct signs 17 4 29 In the literature, cross-section regressions are viewed as
Wrong signs 1 4 2 more nearly representing adjusted long-run equilibrium.
Cross-section regressions were run for the 1972Ð 90 period.
* 5% or better. Given the way that the models are formulated, only the cash
F-ratio is signi® cant for 63 regressions.
¯ ow and Q models have been estimated for 1972, and all the
® ve models for the years from 1974 to 1990. All the variables
have been de¯ ated by total assets to adjust for heteroscedas-
signi® cant, and in 8 cases, b2 alone was signi® cant. In the 18 ticity.
cases in which b1 alone was signi® cant, it had the correct When the models are judged on the basis of the F-ratio,
signs (positive) in 17 instances. Likewise, in the 8 cases in all the models turn out to be signi® cant, possibly due to the
which b2 alone was signi® cant, the signs were correct in large sample size (N = 331). In the case of the cash ¯ ow and
4 cases and wrong in 4 cases. Out of the 31 cases where both Q models, the coe cients are signi® cant and have the cor-
b1 and b2 were signi® cant, the signs were correct in 29 cases rect signs in all the cases. In the case of the accelerator
and wrong in only two cases. model, the coe cients are signi® cant in 12 out of the 17

17
It should be noted that the relative ranking of the models based on the procedure in Elliott (1973), i.e., looking at adjusted R2 , F-ratio,
and the standard error of the regression (without considering the signi® cance of coe cients) is: (1) neoclassical; (2) Bischo€ ; (3) cash ¯ ow;
(4) accelerator; and (5) Q. These results are not shown here. See Samuel (1996a) for more details.
18
It should be noted that even though the change in output is theoretically more appropriate than the level of output for the accelerator
model, the latter fared better in empirical speci® cations, suggesting that businessmen work towards a targeted capitalÐ output ratio. This
result is also consistent with the ® ndings of Clark (1979).
19
Two versions of the Q model were tried: one with capital expenditures (I) as the dependent variable and the other with the ratio of
capital expenditures to the replacement cost of capital (I/K) as the dependent variable. The latter fared better in empirical speci® cations
and only these results are shown here.
20
Regressions were also run with one-period lags and the ranking of models was: (1) neoclassical; (2) accelerator; (3) Bischo€ ; (4) cash ¯ ow;
and (5) Q. With the exception of the neoclassical model, lagged variables improved the ® t of the regression in all cases. These results are not
shown here. See Samuel (1996a) for more details.
T he investment decision: competing theories 99
Table 3. Cross-section estimates (N = 17) model diagnostics the right signs. In the remaining nine cases, only b1 is
signi® cant and the signs are correct in all the nine cases.
Acceler- Neo- Cash Therefore, the ranking of the models is:2 1 (1) cash ¯ ow;
ator classical ¯ ow Q
(2) neoclassical; (3) accelerator; (4) Q; and (5) Bischo€ . It is
N 17 17 19 19 interesting to note that the ® nding with regard to the
F=0 0 0 0 0 superiority of the cash ¯ ow model in cross-section regres-
F¹ 0 17 17 19 19 sions is consistent with that of Elliott (1973).
Signi® cance of
parameters*
t¹ 0
I V . F I X E D E F F EC T S R E G R E S S I O N S
12 16 19 19
t=0 5 1 0 0 (Tables 5, 6, 7, 8 and 9)

Signs of parameters Fixed e€ ects model procedures are designed to take

Correct signs 9 13 19 19 advantage of the panel nature of the data explicitly.
Wrong signs 3 3 0 0 They are useful in eliminating the idiosyncratic di€ erences
across ® rms with regard to investment expenditures, i.e.,
* 5% or better.
di€ erences that cannot be captured adequately by other
independent variables. The primary objective of ® xed e€ ects
estimation is to control for characteristics that are speci® c
Table 4. Cross-section estimates (N = 17), model diagnostics to the ® rm but invariant over time, over and above elements
Bischo¤ model that are captured through other independent variables. In
other words, ® xed e€ ects procedures reduce the omitted
pt ± 1 Y t/ct ± 1
pt ± Y t/ pt ± Y t± / and variable bias.2 2
1 1 1
ct ± 1 ct ± 1 pt ± 1 Y t ± 1 /ct ± 1

Signi® cance of Fixed versus random e¤ ects

parameters* The next issue to consider is ® xed versus random e€ ects.
t=0 0 9 0 One way to think about the di€ erence between these e€ ects
t¹ 0 9 0 8
is to view the former as applying only to the cross-sectional
Signs for signi® cant units (® rms) in the study, and not to additional ones outside
parameters the sample. Random e€ ects, or the error components model,
Correct signs 9 Ð Ð Ð 8 is more appropriate if the sampled cross-sectional units are
Wrong signs 0 Ð Ð Ð 0 drawn from a larger population. In the context of this study,
it would seem therefore that the random e€ ects estimation
Note: F-ratio is signi® cant for 17 regressions. may be more appropriate.2 3
* 5% or better.
Ð Ð Ð = not applicable. Tables 5 to 9 show the results of the estimation of ® xed
e€ ects and random e€ ects models. Model (1) incorporates
both ® rm e€ ects and year e€ ects. Model (2) has only ® rm
cases. Out of these 12 cases, the signs are correct in 9 instan- e€ ects, and no year e€ ects; Model (3) has only year e€ ects,
ces. In the case of the neoclassical model, the coe cients are and no ® rm e€ ects. Therefore, Models (1), (2) and (3) repres-
signi® cant in 16 of the 17 cases. The signs are correct in 13 of ent within-group estimates of the ® xed e€ ects model. Model
these 17 cases. In the case of the Bischo€ model, there are (4) has no ® rm e€ ects and no year e€ ects, and is simply the
only eight instances where the parameters associated with OLS estimate for the pooled regression. Between-group
both pt ± 1 Y t /ct ± 1 (say b1) and pt ± 1 Y t ± 1 /ct ± 1 (say b2) are estimates are shown next. GLS(1) and GLS(2) are random
signi® cant. In all these eight instances, both b1 and b2 have e€ ects estimates; while GLS(1) includes year e€ ects, GLS(2)

21
It should be noted that the relative ranking of the models based on the procedure in Elliott (1973), i.e., looking at adjusted R2 , F-ratio,
and the standard error of the regression (without considering the signi® cance of coe cients) is: (1) cash ¯ ow; (2) Bischo€ ; (3) neoclassical;
(4) accelerator; and (5) Q. These results are not shown here. See Samuel (1996a) for more details.
22
In general, the relationship is speci® ed as Y it = b0 + b itX it + a i + vt + e it where a i is the individual ® rm e€ ect and vt is the year e€ ect.
There are two equivalent approaches to estimate this equation: (i) OLS with ® rm dummies; and (ii) OLS based on deviations from
® rm-speci® c means (for each ® rm, the mean over time is computed and the deviation taken from this mean). These latter (ii) estimates are
also referred to as the `within-group’ estimate in the literature. This paper uses the former (i) approach.
23
A general model would be Y it = a + bXit + u i + e it where a i is ® xed in the ® xed e€ ects estimation and random (a + u i) in the random
e€ ects model. Consequently, the random e€ ects model has to be estimated using generalized least squares (GLS). The Hausman test (1978)
was also used to see if ® xed or random e€ ects is more appropriate for the data. See Greene (1993) for a more detailed discussion.
100
does not have year e€ ects. Model (5) is a regression with only
the ® rm e€ ects on the right-hand side. Model (6) is a regres-
sion with only the year e€ ects on the right-hand side. 2 4
It is interesting to start the discussion of the results with
Models (5) and (6). As noted before, Model (5) is a regression
with only ® rm dummies on the right-hand side and Model
(6) has only year dummies. These models attempt to answer
the following question. If only the identities (names) of the
® rms and time periods (years) were known, how much of the
variation in capital expenditures could be explained? The
C. Samuel
surprising result is that ® rm e€ ects matter a lot, while year
e€ ects alone are not so important. For instance, in the case
of the Q model with ® rm dummies, R2 is 0.49 (Table 9).
Interestingly, this level of explanation (value of R2 ) is not
exceeded by any of the models that do not involve ® rm e€ ects.
Accelerator model (Table 5)
While year e€ ects together with ® rm e€ ects turn out to
be signi® cant, year e€ ects alone are not signi® cant.

Table 5. Accelerator model

D Y Firm e€ ects Year e€ ects R2 SER F

Model (1) 0.055* Yes Yes 0.891 149.43 131.37*

(37.31)
Model (2) 0.055* Yes No 0.890 149.82 137.26*
(38.77)
Model (3) 0.079* No Yes 0.735 226.03 916.32*
(128.15)
Model (4) 0.079* No No 0.734 226.12 1648.29*
(128.29)
Between-group 0.080* Ð Ð Ð Ð Ð Ð 0.826 167.67 1563.61*
(39.54)
GLS (1) 0.065* Ð Ð Ð No 0.338 152.30 3046.54*
(55.20)
GLS (2) 0.065 Ð Ð Ð Yes 0.341 151.97 172.33*
(54.24)
Model (5) Ð Ð Ð Yes No 0.859 166.91 109.96*
Model (6) Ð Ð Ð No Yes 0.004 432.51 1.26

Note: t-statistics are in parentheses; *signi® cant at 1% level; SER = standard error of regression
Ð Ð Ð = not applicable.

Table 6. Neoclassical model

D (ptY t /ct ) Firm e€ ects Year e€ ects R2 SER F

Model (1) 0.063* Yes Yes 0.871 164.34 102.63*

(19.43)
Model (2) 0.063* Yes No 0.868 165.85 105.30*
(19.60)
Model (3) 0.242* No Yes 0.164 405.83 64.56*
(32.81)
Model (4) 0.238* No No 0.159 406.42 1061.90*
(32.59)
Between-group 1.272* Ð Ð Ð Ð Ð Ð 0.779 188.90 1162.20*
(34.09)
GLS (1) 0.073* Ð Ð Ð No 0.069 185.24 418.11*
(20.45)
GLS (2) 0.073* Ð Ð Ð Yes 0.081 184.02 30.25*
(20.32)

Note: t-statistics are in parentheses; * signi® cant at 1% level; SER = standard error of regression.
Neoclassical model uses the real rate of interest as the cost of capital.
Ð Ð Ð = not applicable.
24
Following the standard practice in the literature, F-ratios have been computed to make inferences from the various models presented.
While Model (1) can be viewed as the unrestricted model, Models (2), (3), (4), (5) and (6) are the restricted models. In practice, the
signi® cance of the particular restriction in question is tested for and can be viewed as an alternative approach to gauge the importance of
® rm-speci® c and year-speci® c e€ ects.
T he investment decision: competing theories 101
Table 7. Bischo¤ model

pt ± 1 Y t/ct ± 1 pt ± 1 Y t± 1 /ct ± 1 Firm e€ ects Year e€ ects R2 SER F

Model (1) 0.044* - 0.005** Yes Yes 0.884 155.93 115.35*

(14.74) ( - 1.64)
Model (2) 0.043* - 0.003 Yes No 0.883 156.43 120.00*
(14.61) ( - 1.04)
Model (3) 0.064* - 0.002 No Yes 0.743 225.06 899.81*
(15.04) ( - 0.54)
Model (4) 0.062* - 0.0004 No No 0.742 225.17 8 079.11*
(14.79) ( - 0.08)
Between-group 0.226** - 0.168 Ð Ð Ð Ð Ð Ð 0.839 161.39 857.36*
(2.23) ( - 1.62)
GLS (1) 0.051* 0.0003 Ð Ð Ð No 0.343 159.28 1 470.12*
(17.14) (0.09)
GLS (2) 0.053* - 0.002 Ð Ð Ð Yes 0.346 158.93 166.35*
(17.42) ( - 0.47)

Note: t-statistics are in parentheses; * signi® cant at 1% level; ** signi® cant at 5% level; SER = standard error of regression.
Bischo€ model uses the real rate of interest as the cost of capital.
Ð Ð Ð = not applicable.

Table 8. Cash ß ow model

Cash ¯ ow Firm e€ ects Year e€ ects R2 SER F

Model (1) 0.380* Yes Yes 0.885 151.10 130.69*

(33.86)
Model (2) 0.389* Yes No 0.883 151.87 136.16*
(35.20)
Model (3) 0.708* No Yes 0.845 170.63 1797.64*
(184.42)
Model (4) 0.707* No No 0.844 171.17 33 884.43*
(184.08)
Between-group 0.741* Ð Ð Ð Ð Ð Ð 0.975 63.86 12 718.38*
(112.78)
GLS (1) 0.649* Ð Ð Ð No 0.653 185.24 418.11*
(108.73)
GLS (2) 0.650* Ð Ð Ð Yes 0.655 160.17 629.71*
(108.63)

Note: t-statistics are in parentheses; * signi® cant at 1% level; SER = standard error of regression.
Ð Ð Ð = not applicable.

Comparison of Models (4) and (1) clearly shows that the
improvement is brought about by the addition of ® xed ® rm
and year e€ ects; R2 increases from 0.73 to 0.89. Given that
year e€ ects are not signi® cant, it is no surprise that the
parameter estimates from Model (1) and Model (2) are
similar, as are the estimates from Models (3) and (4), and the
between-group model. The R2 values for the GLS models
are signi® cantly lower than those for other models. In fact,
the results from the Hausman test (based on Models (1) and
GLS(1)) categorically reject the random e€ ects model.
Neoclassical model (Table 6)
The basic result is that year e€ ects and ® rm e€ ects are
important, separately as well as together. Again, the im-
provement in the ® t of the regression is considerably better
with the addition of ® rm e€ ects, compared to year e€ ects.
When the Hausman test is done, the null hypothesis cannot
be rejected, implying that the random e€ ects model is more
appropriate for the neoclassical model.
Bischo¤ model (Table 7)
The results provide good support for the Bischo€ model.
When the Hausman test is done, the null hypothesis cannot
be rejected implying that the random e€ ects model is more
appropriate for the Bischo€ model.
Cash ß ow model (Table 8)
The basic result is that year e€ ects and ® rm e€ ects are
important, separately as well as together. However, year
102 C. Samuel
Table 9. Q model

Q Firm e€ ects Year e€ ects R2 SER F

Model (1) 0.057* Yes Yes 0.517 0.52 18.19*

(11.41)
Model (2) 0.048* Yes No 0.502 0.52 18.17*
(10.14)
Model (3) 0.117* No Yes 0.097 0.69 35.48*
(24.26)
Model (4) 0.109* No No 0.078 0.70 530.17*
(23.03)
Between-group 0.184* Ð Ð Ð Ð Ð Ð 0.198 0.46 82.58*
(9.09)
GLS (1) 0.056* Ð Ð Ð No 0.022 0.53 142.05*
(11.92)
GLS (2) 0.065* Ð Ð Ð Yes 0.047 0.52 17.14*
(13.26)
Model (5) Ð Ð Ð Yes No 0.494 0.53 17.61*
Model (6) Ð Ð Ð No Yes 0.012 0.72 4.34*

Note: t-statistics are in parentheses; * signi® cant at 1% level; SER = standard error of regression.
Ð Ð Ð = not applicable.

Table 10. Ranking of investment models

Accelerator Neoclassical Bischo€ Cash ¯ ow Q

Time-series 4 1 2 3 5
Cross-section 4 3 2 1 5
Fixed e€ ects (with ® rm and year e€ ects) 4 3 2 1 5
Between-group 4 3 2 1 5
Pooled regressions 4 3 2 1 5
GLS (with year e€ ects) 5 3 2 1 4

e€ ects are only weakly important, since the improvement in V. C O N C L U S I O N S

the ® t of the regression is signi® cantly better with the addi-
tion of ® rm e€ ects, compared to year e€ ects. When the
Hausman test is done, the null hypothesis is rejected and
therefore the ® xed e€ ects model can be accepted as being
more appropriate for the cash ¯ ow model.
Q model (Table 9)
Again, year e€ ects and ® rm e€ ects are important, separately
as well as together. The ® t of the regression improves
signi® cantly with the addition of ® rm e€ ects, compared
to year e€ ects. When the Hausman test is done, the
null hypothesis is rejected and therefore the ® xed e€ ects
model can be accepted as being more appropriate for the Q
model.
The ranking of the models based on these regressions is:
(1) cash ¯ ow; (2) Bischo€ ; (3) neoclassical; (4) accelerator;
and (5) Q.
The results of the study clearly support an eclectic approach
to the study of capital expenditure decisions at the ® rm
level.2 5 While the time-series analysis ranks the neoclassical
model as the best, the cross-section regressions gives the
number 1 spot to the cash ¯ ow model (Table 10). Likewise,
the ® xed e€ ects regressions support the cash ¯ ow model and
emphasize the prevalence of ® rm-speci® c, idiosyncratic dif-
ferences regarding capital expenditure decisions. This result
can also be viewed as vindicating the choice of the ® rm as
the basic unit of analysis in the study. As noted earlier, these
® ndings of the study are consistent with earlier evidence in
the literature. If the results from cross-section regressions
can be viewed as representing the long-run equilibrium, the
single most important determinant of capital expenditures
appears to be cash ¯ ows.
These results, based on the comparison of alter-
native models of investment, are indicative of the relative

25
This is similar to the result of the pioneering study by Meyer and Kuh (1957) who found that the investment decision is subject to
a multiplicity of in¯ uences and evidences di€ erent behaviour under di€ erent circumstances and time periods.
T he investment decision: competing theories
importance of the determinants of capital expenditures at
the ® rm level. The results suggest that managers care more
about cash ¯ ows and cost of capital than the level of output
and stock market signals (q-ratio). In other words, manage-
rial perceptions of fundamentals facing the ® rm are more
important than market perceptions with regard to capital
expenditure decisions at the ® rm level.2 6
These results also suggest that, contrary to the presump-
tion in the literature, the Q model of investment performs
the worst among competing models of investment in empiri-
cal speci® cations, even though it is superior to other models
in terms of theoretical elegance. This ® nding regarding the
poor empirical performance of the Q model is consistent
with the results of Bischo€ (1971), Clark (1979), and
Bernanke et al. (1988) based on aggregate data.
Given this overall lacklustre performance of the Q model,
it would seem that managers are not primarily guided by
the stock market with regard to investment decisions. In
other words, the stock market may be a sideshow as far as
capital expenditures at the ® rm level are concerned. There-
fore, these models are consistent with the ® ndings of Morck
et al. (1990) regarding the limited implications of stock
market activity for the resource allocation process in the
economy. This conclusion then raises two related issues: (i) if
the stock market is really a sideshow, market volatility may
not really be an issue from the point of view of resource
allocation in the economy; and (ii) if the stock market is not
important for the ® rm with regard to the investment deci-
sion, what are the other implications of stock market activ-
ity for the ® rm. 2 7
A C K N O WL ED G EM E N T S
I would like to thank Drew Lyon, Plutarchos Sakellaris and
Dennis Mueller for their comments on an earlier version of
this paper. The International Finance Corporation (IFC),
a member of the World Bank Group, bears no responsibility
for the views expressed herein. The views are those of the
author and should not be attributed to the IFC or to its
a liated organizations.
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