The existing literature has had a debate about the appropriate relationship between investment cash flow sensitivity of a firm and its financial constraints. Fazzari, Hubbard, and Petersen (1988, FHP from this point on) was the first paper to examine this relationship both theoretically and empirically by adding cash flow to the classical investment equation. Investment-cash flow sensitivity is then posited as a positive measure of financial constraints by FHP. They show that financially constrained firms, defined as low-dividend-paying firms, have higher investment-cash flow sensitivities than financially unconstrained firms.
This relationship can be explained by the information asymmetry theory of Myers and Majluf (1984). The wedge between internal and external financing is high for financially constrained firms, because they have very costly external financing due to their higher level of information asymmetry. On the other hand, financially unconstrained firms do not have much incentive to use their internal cash flow as a source of fund, because of their relatively lower level of information asymmetry. Thus the investment-cash flow sensitivity is not high for unconstrained firms.
However, Kaplan and Zingales (1997) demonstrate that the relationship between financial constraints and investment-cash flow sensitivity is not linear. They use different criteria to categorize financially constrained and unconstrained firms than FHP. They sort sample firms into five categories based on the degree of financial constraints defined by qualitative criteria. They show that the most highly unconstrained firms and the most highly constrained firms have a higher investment-cash flow sensitivity than the middle class firms, therefore there exists nonlinearity between financial constraints and investment-cash flow sensitivity. Moreover, they show that unconstrained firms have higher investment-cash flow sensitivity than constrained firms, which is contradictory to the results of FHP.
The empirical result by Kaplan and Zingales (KZ) is supported by several other empirical papers. Kadapakkam, Kumar, and Riddick (1998) report that financially unconstrained firms have higher investment-cash flow sensitivities than constrained firms when financial constraints are measured by firm size. Cleary (1999) finds similar results while using the measure of financial constraints constructed by applying the discriminant score model. By investigating the empirical results of seven different countries, Cleary (2006) also shows the evidence that financially constrained firms have lower investment-cash flow sensitivity than financially unconstrained firms.
Dasgupta et al. (2009) demonstrate that the negative relationship between financial constraints and investment-cash flow sensitivity holds even when a long-time horizon is considered. Cleary, Povel, and Raith (2007) find that there is nonlinear relationship between investment and cash flow. A firm’s investment is a U-shaped function of its internal cash flow. In particular, for sufficiently low levels of internal cash flow, a further decrease leads to an increase in the firm’s investment. Lyandres (2007) and Hovakimian (2009) show the nonlinearity of the relationship between financial constraints and investment-cash flow sensitivity by both theoretical model and empirical evidence.
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The Impact of Cash Holdings on Investment-Cash Flow Sensitivity
