Ebook Testing Financing Constraints on Firm Investment using Variable Capital
In order to explain the aggregate behavior of investment and production, it is necessary to understand the factors that affect investment at the firm level. Financing imperfections may prevent firms from accessing external finance, rendering firms unable to invest unless internal finance is available. It is therefore important to study the extent to which financing constraints matter for firms’ investment decisions. This line of inquiry is also relevant for other areas of research, such as the literature on the role of internal capital markets and banks, as well as the macro literature on the financial accelerator.
Starting with Fazzari, Hubbard, and Petersen (1988), several studies investigate the presence of financing constraints by estimating the Q model of investment with cash flow included as an explanatory variable. They argue informally that under certain conditions, and in the absence of financing frictions, Tobin’s average Q is equal to marginal q, and is a sufficient statistic for firm investment (Hayashi, 1982). It follows that conditional on Q, cash flow should affect only the investment of financially constrained firms.
The motivation for this paper is that recent studies, starting with Kaplan and Zingales (1997, 2000), have shown that the correlation between fixed investment and cash flow is not a good indicator of the intensity of firm financing constraints. In particular, Erickson and Whited (2000) and Bond, Klemm, Newton-Smith, Syed, and Gertjan (2004) show that errors in measuring the expected profitability of firms explain most of the observed positive correlation between fixed investment and cash flow. Moreover, Gomes (2001), Pratap (2003), and Moyen (2004) simulate industries with heterogeneous firms that may face financing frictions.
They show that the correlation between fixed investment and cash flow may be positive for financially unconstrained firms, and even larger than that of financially constrained firms. Finally, Caballero and Leahy (1996) show that the failure of the investment-cash flow correlation as a measure of financing constraints may be caused not only by the measurement error in Q, but also by misspecification and omitted variable problems.
The objective of this paper is to develop a new financing constraints test that is robust to these problems and has the following properties: it is able to detect both the presence and the intensity of financing constraints on firm investment; it is efficient even in the presence of large errors in the measurement of the productivity shock; it is well specified under a wide range of assumptions concerning the adjustment costs of fixed capital.
The test is derived from a structural model of a risk-neutral firm that generates output using two complementary factors of production, namely, fixed and variable capital. Fixed capital is irreversible, while variable capital can be adjusted without frictions. Because of an enforceability problem, the firm can obtain external financing only if it secures the funds with collateral. The assets of the firm can only be partially collateralizable and some down payment is needed to finance investment.
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