Financial variables such as cash flow and cash stocks are robust and quantitatively
important explanatory variables for investment at the firm-level. A large body of
recent empirical work attributes these findings to capital market imperfections.
This interpretation is controversial, however, because even in the absence of capital
market imperfections, such financial variables may appear as an explanatory variable
for investment if they contain information about the expected marginal value of capital.
In this paper, we show how structural models of investment with costly external finance
can be used to identify and quantify the fundamental' versus the financial' determinants
of investment. Our empirical results show that investment responds significantly
to both fundamental and financial factors. Point estimates from our structural model
imply that, for the average firm in our sample, financial factors raise the overall
response of investment to an expansionary shock by 25%, relative to a baseline case
where financial frictions are zero. Consistent with theory, small firms and firms
without bond ratings show the strongest response to financial factors, while bond-rated
firms show little if any response once we control for investment fundamentals.