UC Berkeley

This paper provides evidence consistent with the idea that the implications of investment on future profitability differ for financially constrained and financially flexible firms. In particular, this study finds that the investment of financially constrained firms is associated with higher persistence in profitability than the investment of flexible firms. This paper also finds that this result is related to differences in future write-downs and goodwill impairments, suggesting that the difference in persistence in profitability between both groups of firms is associated with differences in investment quality. Finally, it shows that investors do not fully understand the role of financial constraints on the relation between investment and future profitability, since the investment of financially constrained firms is associated with higher one-year ahead abnormal returns than the investment of flexible firms. Moreover, for financially constrained firms, large levels of investment are not associated with negative abnormal returns, suggesting that the negative relation between corporate investment and future abnormal stock returns documented in previous research is not general to the entire cross-section of firms.