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Firms' Investment under Financial Constraints: A Euro Area Investigation

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  • Rozalia Pal
  • Roman Kozhan

Abstract

In this article we describe a model of optimal investment of various types of financially constrained firms. We show that the resulting relationship between internal funds and investment is nonmonotonic. In particular, the magnitude of Cash Flow (CF) sensitivity of the investment is lower for the firms with credit rationing compared to the firms that are able to obtain short-term external financing. The inverse relationship is driven by the leverage multiplier effect. A positive CF shock increases the short-term borrowing capacity of the firm, which in turn has a positive effect on investment and the firm's growth. Moreover, the leverage multiplier effect is the highest for firms relying on short-term credits and it is lower for firms that are able to obtain long-term financing. Analysing a large euro area data set we find strong empirical support for our theoretical predictions. The results also help to explain some contrasting findings in the financial constraints literature.

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Bibliographic Info

Paper provided by Warwick Business School, Finance Group in its series Working Papers with number wp08-07.

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Date of creation: 2008
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Handle: RePEc:wbs:wpaper:wp08-07

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  1. Sean Cleary, 1999. "The Relationship between Firm Investment and Financial Status," Journal of Finance, American Finance Association, vol. 54(2), pages 673-692, 04.
  2. Steven N. Kaplan & Luigi Zingales, 2000. "Investment-Cash Flow Sensitivities are not Valid Measures of Financing Constraints," NBER Working Papers 7659, National Bureau of Economic Research, Inc.
  3. Kaplan, Steven N & Zingales, Luigi, 1997. "Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints," The Quarterly Journal of Economics, MIT Press, vol. 112(1), pages 169-215, February.
  4. Aydogan Alti, 2003. "How Sensitive Is Investment to Cash Flow When Financing Is Frictionless?," Journal of Finance, American Finance Association, vol. 58(2), pages 707-722, 04.
  5. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
  6. Michael Faulkender & Mitchell A. Petersen, 2006. "Does the Source of Capital Affect Capital Structure?," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 45-79.
  7. R Blundell & Steven Bond, . "Initial conditions and moment restrictions in dynamic panel data model," Economics Papers W14&104., Economics Group, Nuffield College, University of Oxford.
  8. Myers, Stewart C., 1984. "Capital structure puzzle," Working papers 1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  9. Glenn W. Boyle & Graeme A. Guthrie, 2003. "Investment, Uncertainty, and Liquidity," Journal of Finance, American Finance Association, vol. 58(5), pages 2143-2166, October.
  10. Steven M. Fazzari & R. Glenn Hubbard & BRUCE C. PETERSEN, 1988. "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 141-206.
  11. Neslihan Ozkan, 2002. "Effects of financial constraints on research and development investment: an empirical investigation," Applied Financial Economics, Taylor & Francis Journals, vol. 12(11), pages 827-834.
  12. Yi-Chen Lin, 2007. "The cash flow sensitivity of cash: evidence from Taiwan," Applied Financial Economics, Taylor & Francis Journals, vol. 17(12), pages 1013-1024.
  13. R. Glenn Hubbard, 1998. "Capital-Market Imperfections and Investment," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 193-225, March.
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  15. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  16. Williamson, Stephen D., 1986. "Costly monitoring, financial intermediation, and equilibrium credit rationing," Journal of Monetary Economics, Elsevier, vol. 18(2), pages 159-179, September.
  17. Fuss, Catherine & Vermeulen, Philip, 2004. "Firms' investment decisions in response to demand and price uncertainty," Working Paper Series 0347, European Central Bank.
  18. Myers, Stewart C, 1984. " The Capital Structure Puzzle," Journal of Finance, American Finance Association, vol. 39(3), pages 575-92, July.
  19. Mizen, Paul & Vermeulen, Philip, 2005. "Corporate investment and cash flow sensitivity: what drives the relationship?," Working Paper Series 0485, European Central Bank.
  20. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
  21. Stewart C. Myers, 1984. "Capital Structure Puzzle," NBER Working Papers 1393, National Bureau of Economic Research, Inc.
  22. Timothy Erickson & Toni M. Whited, 2000. "Measurement Error and the Relationship between Investment and q," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 1027-1057, October.
  23. Nathalie Moyen, 2004. "Investment-Cash Flow Sensitivities: Constrained versus Unconstrained Firms," Journal of Finance, American Finance Association, vol. 59(5), pages 2061-2092, October.
  24. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September.
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Cited by:
  1. Saeed Abubakr & Franco Esposito, 2012. "Bank concentration and financial constraints on firm investment in UK," Studies in Economics and Finance, Emerald Group Publishing, vol. 29(1), pages 11-25, March.

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