Real effects of separating investment and operating cash flows

This paper investigates the rationale for the measurement of a firm's periodic performance through the accounting classification of its cash outflows into operating cash flow and investment. We show that when the accounting system does not attempt to measure periodic performance and reports only aggregate cash flow, equilibrium capital market prices are such that there is a perverse informational cost to investment over and above the real cost of investment. This induces distortions in the firms' equilibrium investment. We show that other sources of information, consisting of forecasts of future returns to investment play a vital counterbalancing role when the accounting system is inadequate in this way. An accounting signal that provides noisy information on periodic performance decreases the informational cost to investment and moves the economy closer to first best.