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Do Measures of Financial Constraints Measure Financial Constraints?

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  • Farre-Mensa, Joan
  • Ljungqvist, Alexander P.

Abstract

Financial constraints are fundamental to empirical research in finance and economics. We propose two novel tests to evaluate how well measures of financial constraints actually capture constraints. We find that firms classified as constrained according to five popular measures do not in fact behave as if they were constrained: they have no trouble raising debt when their demand for debt increases exogenously and they use the proceeds of equity issues to increase payouts to shareholders. We propose an alternative proxy for financial constraints, based on Merton’s (1974) distance-to-default measure, which successfully identifies firms whose behavior is consistent with being constrained.

Suggested Citation

  • Farre-Mensa, Joan & Ljungqvist, Alexander P., 2015. "Do Measures of Financial Constraints Measure Financial Constraints?," CEPR Discussion Papers 10326, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10326
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    More about this item

    Keywords

    Financial constraints;

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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