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Firms' Investment under Financial Constraints: A Euro Area Investigation

  • Rozalia Pal
  • Roman Kozhan

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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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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