Whether financing frictions influence real investment decisions is a central, unsettled issue in modern corporate finance (Stein (2001)). A large number of papers in the theoretical literature explore the interplay between financing frictions and investment to study a large array of issues from optimal organizational design (e.g., Gertner et al. (1994) and Stein (1997)) to optimal hedging and cash policies (Froot et al. (1993) and Almeida et al. (2003)). Yet, identifying financing–investment interactions in the real-world is not an obvious task. In a highly influential paper, Fazzari et al. (1988) propose that when firms face financing constraints their investment spending will vary with the availability of internal funds, rather than only with the availability of profitable investment opportunities. Accordingly, one should be able to gauge the effect of financing frictions on corporate investment by comparing the empirical sensitivity of investment to cash flow across samples of financially constrained and unconstrained firms. Examining these sensitivities have since become the standard in the literature that investigates the impact of capital markets imperfections on investment. In recent years, the use of investment–cash flow sensitivities has become widespread in the empirical corporate finance literature. Investment–cash flow sensitivities is one of the key metrics used for drawing inferences about efficiency in internal capital markets (e.g., Lamont (1997) and Shin and Stulz (1998)), the effect of agency on corporate spending (Blanchard et al. (1994) and Hadlock (1998)), the role of business groups in capital allocation (Hoshi et al. (1991)), and the influence of managerial characteristics on corporate policies (Bertrand and Schoar (2001) and Malmendier and Tate (2003)), among others.

A recent string of papers, nonetheless, have pointed to potential problems in the strategy proposed by Fazzari et al. (1988). Kaplan and Zingales (1997) question the usefulness of investment–cash flow sensitivities as a measure of financial constraints, arguing that the Fazzari et al. hypothesis is not a necessary implication of optimal investment under constrained financing. Alti (2003) demonstrates that variations in the informational content of cash flows regarding investment demand can generate the cross-sectional patterns reported by Fazzari et al. even in the absence of financing frictions (see also Gomes (2001)). Erickson and Whited (2000) further show that differences in investment–cash flow sensitivities across constrained and unconstrained firms can be explained by an empirical model in which investment depends only on investment opportunities, where those opportunities are measured with error (see also Cummins et al. (1999)). These various arguments put into question one’s ability to draw inferences about the relationship between financing frictions and investment by looking at empirical investment–cash flow sensitivities. The current state of the literature is best summarized by Stein (2001, p. 26) in his survey on corporate investment: “While it is becoming very hard to argue with the proposition that financial slack matters for investment, it is much less clear what is the precise mechanism that drives this relationship.”

In this paper we develop and test a theoretical argument that allows us to identify whether financing frictions have a direct effect on firm investment behavior. We build on Fazzari et al. (1988) to show that investment–cash flow sensitivities can be used as a means of identifying the impact of financing frictions on real investment. The main idea behind our tests is to recognize that variables that increase a firm’s ability to contract external finance will have an effect on investment spending when investment demand is constrained by capital market imperfections. One such variable is the tangibility of a firm’s assets. Assets that are more tangible sustain more external financing because tangibility mitigates underlying contractibility problems tangibility increases the value that can be readily recaptured by creditors in default states. Through a simple contracting model, we show that investment–cash flow sensitivities will be increasing in the tangibility of constrained firms’ assets. In contrast, tangibility will have no effect on investment–cash flow sensitivities of unconstrained firms. This theoretical prediction allows us to formulate an empirical test for the link between financial constraints and investment that uses a “differences in differences” approach: we identify the effect of financing frictions on corporate investment by comparing the differential effect of asset tangibility on the sensitivity of investment to cash flow across different regimes of financial constraints.

Why should investment–cash flow sensitivities increase with asset tangibility for some firms but not for others? As we discuss in Section 2, this difference arises from a credit multiplier effect (à la Kiyotaki and Moore (1997)). The intuition is simple. Consider examining the effect of a cash flow shock on investment spending over a cross-section of financially constrained firms that is, firms that are unable to exhaust their profitable investment opportunities due to financing frictions. Since it is optimal for constrained firms to re-invest their internal funds, the direct impact of the income shock on investment is similar for all such firms. However, there is also an indirect effect associated with that shock. This latter effect stems from an endogenous change in borrowing capacity. For a given change in investment, the change in borrowing capacity will be greater for those firms whose assets create the highest collateral values — i.e., firms that invest in more pledgeable (tangible) assets. This indirect amplification effect drives the differences in investment–cash flow sensitivities across financially constrained firms in our model. Because the credit multiplier will be greater when assets have higher tangibility, constrained firms that invest in more tangible assets will be more sensitive to cash flow shocks. On the other hand, however, asset tangibility should have no effect on the investment policy of firms that can exhaust their profitable investments opportunities (unconstrained firms).

The upshot of considering a second dimension in which financing frictions manifest themselves is that we can then sidestep the problems associated with previous literature on financial constraints. Because we focus on the differential effect of asset tangibility upon investment–cash flow sensitivities across constrained and unconstrained firms, it is hard to argue that our results could be generated by a model with no financing frictions where investment opportunities are poorly-measured (Erickson and Whited (2000), Gomes (2001), and Alti (2003)). To wit, while measurement problems might imply a different bias for the levels of the estimated investment–cash flow sensitivities across constrained and unconstrained samples, our empirical test is unaffected by those (level) biases in that we focus on the marginal effect of tangibility on investment sensitivities exploring an independent mechanism (the credit multiplier). In order to explain our findings with a model with frictionless financing, one would have to explain why the residuals from poorly-measured investment opportunity proxies will load onto variations in asset tangibility across the two firm samples precisely along the lines of our predictions. We fail to find such alternative story.

Download
PDF Ebook Financial Constraints, Asset Tangibility, and Corporate Investment