Corporate Investment and Financing Constraints: Connections with Cash management

When firms find that external finance is costly or rationed, they face financing constraints in their investment decisions. The financing constraints paradigm applies this idea empirically and supports the joint hypothesis that constrained firms can be identified and should display a stronger sensitivity of investment to cash flow. The first part of this paper shows that this paradigm is increasingly criticised, because some proxy variables used to identify constrained firms deliver contradictory results regarding this sensitivity. In addition, some of the firms that display a strong sensitivity have internal funds seemingly in abundance. While this weakens, it does not render useless the financing constraints paradigm. In the second part of this paper, I propose a more comprehensive look at financing constraints in two stages. First, theoretical and applied research into corporate cash holdings suggest that firms react to informational problems in capital markets by specifying cash targets partially for the purpose of circumventing the brunt of future financing constraints. I argue that knowledge of such targets allows us to measure the amount of 'free cash' that firms have at their disposal, which is a clearer measure of the constrainedness of a firm than observed cash levels. Second, the simultaneous modelling of investment and cash management provides for a clearer assessment of the interplay between cash accumulation and investment.