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Testing financing constraints on firm investment using variable capital

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  • Caggese, Andrea

Abstract

A recent literature has criticised the sensitivity of a firm's investment to its own cash flow as an adequate measure of financing constraints. In this paper we develop a new method to detect the presence of financing constraints at firm level. We consider a structural dynamic model of investment with financing imperfections and with both fixed and variable capital. We solve the model and simulate an industry with many firms. We show that the irreversibility of fixed capital is the main reason why the sensitivity of fixed investment to cash flow is not a good measure of financing constraints. Using the fact that variable capital is reversible, we develop a new test of financing constraints based on a reduced form variable capital investment equation. Simulation results show that our test correctly identifies financially constrained firms also when the estimation of firms' investment opportunities is very noisy. Moreover our test is valid regardless of the type of adjustment costs of fixed capital. We confirm empirically the validity of this method on a sample of US companies.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 86 (2007)
Issue (Month): 3 (December)
Pages: 683-723

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Handle: RePEc:eee:jfinec:v:86:y:2007:i:3:p:683-723

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Web page: http://www.elsevier.com/locate/inca/505576

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Citations

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Cited by:
  1. Bazdresch, Santiago, 2013. "The role of non-convex costs in firms' investment and financial dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 37(5), pages 929-950.
  2. Agustinus Prasetyantoko, 2006. "Financing Constraint and Firm Investment Following a Financial Crisis in Indonesia," Post-Print halshs-00133964, HAL.
  3. Caggese, Andrea, 2007. "Financing constraints, irreversibility, and investment dynamics," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2102-2130, October.
  4. Christian Bayer, 2004. "Aggregate investment dynamics when firms face fixed investment cost and capital market imperfections," Macroeconomics 0411018, EconWPA.
  5. Andrea Caggese & Vicente Cuñat, 2008. "Financing Constraints and Fixed-term Employment Contracts," Economic Journal, Royal Economic Society, vol. 118(533), pages 2013-2046, November.
  6. Bayer, Christian, 2006. "Investment dynamics with fixed capital adjustment cost and capital market imperfections," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 1909-1947, November.
  7. Andrea Caggese, 2005. "Financing Imperfections and the Investments Decisions of Privately Owned Firms," Working Papers 265, Barcelona Graduate School of Economics.
  8. Santiago Carbó Valverde & Francisco Rodríguez-Fernández & Gregory F. Udell, 2008. "Bank lending, financing constraints and SME investment," Working Paper Series WP-08-04, Federal Reserve Bank of Chicago.
  9. Christian Bayer, 2004. "On the Interaction of Financial Frictions and Fixed Capital Adjustment Costs: Evidence from a Panel of German Firms," Macroeconomics 0410006, EconWPA.
  10. Chris Edson, 2012. "The capital constraining effects of the norwegian wealth tax," Discussion Papers 724, Research Department of Statistics Norway.
  11. Alessandra Guariglia & John Tsoukalas & Serafeim Tsoukas, . "Investment, irreversibility, and financing constraints in transition economies," Discussion Papers 10/03, University of Nottingham, School of Economics.
  12. Bellmann, Lutz & Gerner, Hans-Dieter & Hübler, Olaf, 2013. "Investment under Company-Level Pacts," IZA Discussion Papers 7195, Institute for the Study of Labor (IZA).
  13. Guariglia, Alessandra & Tsoukalas, John & Tsoukas, Serafeim, 2012. "Investment, irreversibility, and financing constraints: Evidence from a panel of transition economies," Economics Letters, Elsevier, vol. 117(3), pages 582-584.

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