Debt, Liquidity Constraints, and Corporate Investment: Evidence from Panel Data

Abstract

This paper presents evidence supporting the theory that problems of asymmetric information in debt markets affect financially unhealthy firms' ability to obtain outside finance and, consequently, their allocation of real investment expenditure over time. I test this hypothesis by estimating the Euler equation of an optimizing model of investment. Including the effect of a debt constraint greatly improves the Euler equation's performance in comparison to the standard specification. When the sample is split on the basis of two measures of financial distress, the standard Euler equation fits well for the a priori unconstrained groups, but is rejected for the others.

Corporate Governance and Investment Decisions

“…Several other studies reach the same conclusion, including Schaller (1993) for Canadian firms as well as Whited (1992), Lamont (1997), and Ascioglu, Hegde, and McDermott (2008) for U.S. firms. Other empirical work, including Aggarwal and Zong (2006) and Islam and Mozumdar (2007), uses international data to examine the investment cash flow relationship.…”

Over-investment of free cash flow

“…In addition to prior empirical work on agency based explanations for the link between firm level investment and internally generated free cash flow, there exists a stream of research dedicated to examining the role of financing constraints (e.g., Fazzari et al (1988), Hoshi, Kashyap, andScharfstein (1991), Fazzari and Petersen (1993), Whited (1992) and Hubbard (1998)). Myers and Majluf (1984) suggest that information asymmetries increase the cost of capital for firms forced to raise external finance, thereby reducing the feasible investment.…”

“…Some early work in this area examined the sensitivity of investment to cash flow for high versus low dividend paying firms (Fazzari et al, 1988), comparing differing organizational structures where the ability to raise external financing was easier/harder (Hoshi, Kashyap and Scharfstein, 1991, with Japanese keiretsu firms) and debt constraints (Whited, 1992). These papers find evidence of greater sensitivity of investment to cash flow for sets of firms which appeared to be financially constrained (e.g., low dividend paying firms, high debt firms and firms with limited access to banks).…”

Cash Holdings, Use of Debt and Dividend Structure of Family Firms

“…Small firms may hold more cash not only because doing so allows them to avoid the higher issuance costs they incur when raising external funds, but also because they are more likely to face borrowing constraints (Whited, 1992;Brown and Petersen, 2011). Kim et al (1998) find that cash holdings are inversely related to debt ratios while Opler et al (1999) argue that firms with greater likelihood of financial distress should hold more cash.…”