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Endogenous Financial Constraint and Investment‐Cash‐Flow Sensitivity

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  • Rui Li

Abstract

This paper studies a dynamic investment model with moral hazard. The moral hazard problem implies an endogenous financial constraint on investment that makes the firm's investment sensitive to cash flows. I show that the production technology and the severity of the moral hazard problem substantially affect the dependence of the investment‐cash‐flow sensitivity on the financial constraint. Specifically, if the production technology exhibits almost constant returns to scale in capital or the moral hazard problem is relatively severe, the dependence is negative. Otherwise, the pattern is reversed to some extent. Moreover, the calibrated benchmark model can quantitatively account for the negative dependence of investment and Tobin's Q on size and age observed in the data.

Suggested Citation

  • Rui Li, 2018. "Endogenous Financial Constraint and Investment‐Cash‐Flow Sensitivity," The Financial Review, Eastern Finance Association, vol. 53(4), pages 773-792, November.
    • Handle: RePEc:bla:finrev:v:53:y:2018:i:4:p:773-792
    DOI: 10.1111/fire.12165
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