do investment-cash flow sensitivities provide useful measures of financing constraints?
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DO INVESTMENT-CASH FLOW SENSITIVITIES PROVIDEUSEFUL MEASURES OF FINANCING CONSTRAINTS
STEVEN N KAPLAN AND LUIGI ZINGALES
No This paper investigates the relationship between nancing constraintsand investment-cash ow sensitivities by analyzing the rms identied by Faz-zari Hubbard and Petersen as having unusually high investment-cash ow sen-sitivities We nd that rms that appear less nancially constrained exhibitsignicantly greater sensitivities than rms that appear more nancially con-strained We nd this pattern for the entire sample period subperiods and indi-vidual years These results (and simple theoretical arguments) suggest thathigher sensitivities cannot be interpreted as evidence that rms are more nan-cially constrained These ndings call into question the interpretation of mostprevious research that uses this methodology
ldquoOur nancial position is sound Most of the companyrsquos funds aregenerated by operations and these funds grew at an average annualrate of 29 [over the past 3 years] Throughout the companyrsquos historythis self-nancing concept has not been a constraint on the com-panyrsquos growth With recent growth restrained by depressed economicconditions the companyrsquos net cash position has grown substantiallyrdquo[Hewlett-Packard 1982 Annual Report]
A large nance and macroeconomics literature studies therelation between corporate investment and cash ow to test forthe presence and importance of nancing constraints Beginningwith ldquoFinancing Constraints and Corporate Investmentrdquo by Faz-zari Hubbard and Petersen [1988] (hereinafter FHP [1988])these studies divide a sample of rms according to an a priorimeasure of nancing constraints and compare the investment-
Previous versions of this paper [Kaplan and Zingales 1995] circulated underthe title ldquoDo Financing Constraints Explain Why Investment Is Correlated withCash Flowrdquo Benjamin Bridgman and Violet Law provided excellent research as-sistance Comments from Charles Calomiris John Cochrane Zsuzsanna FluckRobert Gertner David Gross R Glenn Hubbard Bengt Holmstrom Anil Kas-hyap Owen Lamont Stewart Myers Walter Novaes Bruce Petersen RaghuramRajan Andrei Shleifer Amy Sweeney Sheridan Titman Robert Vishny and espe-cially David Scharfstein and Jeremy Stein (the referees) were very helpful Semi-nar participants at Boston College the CEPR Summer Symposium in FinancialMarkets in Gerzensee the Federal Reserve Board Harvard Business School In-diana University Massachusetts Institute of Technology the NBER Summer In-stitute the University of California at Los Angeles the University of Chicagothe University of Southern California the University of Texas the University ofWashington and the Nobel Symposium on Law and Finance also provided usefulcomments We also thank Bruce Petersen for providing a list of sample companiesThis research has been supported by the Center For Research in Security Pricesand by the Olin Foundation through grants to the Center for the Study of theEconomy and the State Address correspondence to Graduate School of BusinessUniversity of Chicago 1101 East 58th Street Chicago IL 60637
q 1997 by the President and Fellows of Harvard College and the Massachusetts Instituteof TechnologyThe Quarterly Journal of Economics February 1997
cash ow sensitivities of the different subsamples The studiesinterpret a greater investment-cash ow sensitivity for rms con-sidered more likely to face a larger wedge between the internaland the external cost of funds as evidence that the rms are in-deed constrained This methodology has been widely applied toidentify rms that are more affected by nancing constraintsand institutions that are more likely to alleviate those con-straints For example Hoshi Kashyap and Scharfstein [1991]nd that investment by Japanese rms that belong to a keiretsu(corporate group) is less sensitive to cash ow than investment byindependent rms They conclude that a group (and concomitantbank) afliation alleviates underinvestment problems caused bycapital market imperfections
Despite the size and policy-importance of this literature thefundamental assumptions underlying it have remained largelyunexplored While subsequent work has replicated the ndingsof FHP [1988] by using different a priori criteria no paper (ofwhich we are aware) has veried directly whether a higherinvestment-cash ow sensitivity is related to nancing problemsand if it is in what way In particular there is no test of thefundamental assumptionmdashimplicit in all these testsmdashthatinvestment-cash ow sensitivities increase monotonically withthe degree of nancing constraints As we show in Section I thisis particularly surprising because there is no strong theoreticalreason to expect a monotonic relationship
This paper investigates the relation between investment-cash ow sensitivities and nancing constraints by undertakingan in-depth analysis of a sample of rms exhibiting an unusuallyhigh sensitivity of investment to cash ow These rms are the49 low dividend rms that FHP [1988] identify as nancially con-strained according to the investment-cash ow criterion
By using detailed and previously unexplored data sourceswe try to determine the availability of and the demand for fundsfor each of the sample rms We examine each rmrsquos annualreport or 10-K for each sample year and we read managementrsquosdiscussion of liquidity that describes the rmrsquos future needs forfunds and the sources it plans to use to meet those needs Weintegrate this information with quantitative data and with publicnews to derive as complete a picture as possible of the availabilityof internal and external funds for each rm as well as each rmrsquosdemand for funds On this basis we rank the extent to which thesample rms are nancially constrained each year We use the
QUARTERLY JOURNAL OF ECONOMICS170
rm-year classications to group the sample rms over seven- oreight-year subperiods and over the entire sample period Finallywe compare investment-cash ow sensitivities across the differ-ent groups of rms for the entire sample period for subperiodsand for individual years
Surprisingly we nd that in only 15 percent of rm-years isthere some question as to a rmrsquos ability to access internal orexternal funds to increase investment In 85 percent of rm-yearsthe rms could have increased their investmentmdashin many casessubstantiallymdashif they had so chosen In fact almost 40 percent ofthe sample rms including Hewlett-Packard (cited above) couldhave increased their investment in every year of the sample pe-riod Our partially qualitative measures of nancial constraintsare strongly corroborated by quantitive data on debt to total capi-tal interest coverage the presence of restrictions on dividendsand nancial slack (the level of cash and unused line of creditrelative to investment)
More strikingly those rms classied as less nanciallyconstrained exhibit a signicantly greater investment-cash owsensitivity than those rms classied as more nancially con-strained We nd this pattern for the entire sample period forsubperiods and for individual years This pattern is also robustto different criteria to divide constrained and unconstrainedrms For example rms with healthy interest coverage in everysample year or in every subperiod year have investment-cashow sensitivities twice as large as the remaining rms in thesample
As we explain in Section I these results should not be verysurprising There is no strong theoretical reason for investment-cash ow sensitivities to increase monotonically with the degreeof nancing constraints Nevertheless we consider several pos-sible reasons why estimated investment-cash ow sensitivitiescould decrease in the degree of nancing constraints even if thetrue relationship is increasing
First cash ow may act as a proxy for investment opportuni-ties not captured by Tobinrsquos Q and do so differentially acrossrms Our results however are robust to the use of an Eulerequation test [Bond and Meghir 1994] which does not rely onTobinrsquos Q and thus is not affected by its mismeasurement
Second differences in sensitivities might be driven by a fewinuential outliers We nd evidence that the high overall sensi-tivity of our sample (FHPrsquos [1988] low dividend payout rms) rela-
INVESTMENT-CASH FLOW SENSITIVITIES 171
tive to FHPrsquos higher dividend payout rms is explained by a rela-tively few company-years characterized by exceptionally highsales growth We also nd however that these outliers do notexplain our cross-section results that the least constrained rmshave the highest sensitivities
Third our nding of nonmonotonic relationship may be spe-cic to a few distressed rms that are forced to use cash ow torepay their debt and may not apply to more ldquonormalrdquo samplesThe nancial conditions of the constrained rms though are notconsistent with this hypothesis
In sum we provide both theoretical reasons and empiricalevidence that a greater sensitivity of investment to cash ow isnot a reliable measure of the differential cost between internaland external nance In so doing we address (and refute) thecriticisms in Fazzari Hubbard and Petersen [1996] [FHP 1996]
We conclude the paper with a discussion of the generalityof our results We argue that our analysis calls into questionthe interpretation of most previous research that uses thismethodology
The paper proceeds as follows Section I presents the theoreti-cal framework Section II describes the sample Section III ex-plains the criteria used to identify the extent to which rms arenancially constrained Section IV reports the investment-cashow regression results Section V discusses the results and con-siders alternative explanations for them Section VI discusses theimplications and generality of our results for the previous litera-ture Section VII concludes
I THEORETICAL FRAMEWORK
A Denition of Financing Constraints
In order to discuss the relationship between investment-cashow sensitivity and the degree of nancing constraints we mustdene what it means to be nancially constrained The most pre-cise (but also broadest) denition classies rms as nanciallyconstrained if they face a wedge between the internal and exter-nal costs of funds By this denition all rms are likely to be clas-sied as constrained A small transaction cost of raising externalfunds would be sufcient to put a rm into this category Thisdenition however provides a useful framework to differentiaterms according to the extent to which they are nancially con-
QUARTERLY JOURNAL OF ECONOMICS172
strained A rm is considered more nancially constrained as thewedge between its internal and external cost of funds increases
Our classication scheme which we detail below is designedto distinguish the relative differences in the degree to which rmsare nancially constrained In general our unconstrained or lessconstrained rms are those rms with relatively large amountsof liquid assets and net worth
In classifying rms we are agnostic on whether the wedgebetween the cost of internal and external funds is caused by hid-den information problems as in Myers and Majluf [1984] andGreenwald Stiglitz and Weiss [1984] or agency problems as inJensen and Meckling [1976] Grossman and Hart [1982] Jensen[1986] Stulz [1990] and Hart and Moore [1995] In fact unlikeBlanchard Lopez-de-Silanes and Shleifer [1994] the purpose ofour analysis is not to identify the source of the capital marketimperfection but rather to understand the effects capital marketimperfections have on investment We next review what economictheory has to say about the impact of nancing constraints oninvestment
B The Impact of Financing Constraints on Investments
FHP [1988] was the rst of many papers to consider higherinvestment-cash ow sensitivities as evidence of greater nancingconstraints Given the magnitude and the importance of thisliterature it is surprising that little attention has been given tothe theoretical foundation of the investment-cash ow sensitivitycriterion1 While it is easy to show that constrained rms shouldbe sensitive to internal cash ow while unconstrained rmsshould not it is not necessarily true that the magnitude of thesensitivity increases in the degree of nancing constraints Thisis the crucial question given that investment is sensitive to cashow for the vast majority of rms analyzed (It is easy to justifythis sensitivity based on the fact that external funds are morecostly than internal funds for all rms as long as some trans-action costs are involved)
The difculty of interpreting cross-sectional differences ininvestment-cash ow sensitivities can be illustrated with asimple one-period model Consider a rm that chooses the levelof investment to maximize prots The return to an investmentI is given by a production function F(I ) where F 9 and F 0 0
1 We thank Jeremy Stein for encouraging us to develop this point
INVESTMENT-CASH FLOW SENSITIVITIES 173
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
cash ow sensitivities of the different subsamples The studiesinterpret a greater investment-cash ow sensitivity for rms con-sidered more likely to face a larger wedge between the internaland the external cost of funds as evidence that the rms are in-deed constrained This methodology has been widely applied toidentify rms that are more affected by nancing constraintsand institutions that are more likely to alleviate those con-straints For example Hoshi Kashyap and Scharfstein [1991]nd that investment by Japanese rms that belong to a keiretsu(corporate group) is less sensitive to cash ow than investment byindependent rms They conclude that a group (and concomitantbank) afliation alleviates underinvestment problems caused bycapital market imperfections
Despite the size and policy-importance of this literature thefundamental assumptions underlying it have remained largelyunexplored While subsequent work has replicated the ndingsof FHP [1988] by using different a priori criteria no paper (ofwhich we are aware) has veried directly whether a higherinvestment-cash ow sensitivity is related to nancing problemsand if it is in what way In particular there is no test of thefundamental assumptionmdashimplicit in all these testsmdashthatinvestment-cash ow sensitivities increase monotonically withthe degree of nancing constraints As we show in Section I thisis particularly surprising because there is no strong theoreticalreason to expect a monotonic relationship
This paper investigates the relation between investment-cash ow sensitivities and nancing constraints by undertakingan in-depth analysis of a sample of rms exhibiting an unusuallyhigh sensitivity of investment to cash ow These rms are the49 low dividend rms that FHP [1988] identify as nancially con-strained according to the investment-cash ow criterion
By using detailed and previously unexplored data sourceswe try to determine the availability of and the demand for fundsfor each of the sample rms We examine each rmrsquos annualreport or 10-K for each sample year and we read managementrsquosdiscussion of liquidity that describes the rmrsquos future needs forfunds and the sources it plans to use to meet those needs Weintegrate this information with quantitative data and with publicnews to derive as complete a picture as possible of the availabilityof internal and external funds for each rm as well as each rmrsquosdemand for funds On this basis we rank the extent to which thesample rms are nancially constrained each year We use the
QUARTERLY JOURNAL OF ECONOMICS170
rm-year classications to group the sample rms over seven- oreight-year subperiods and over the entire sample period Finallywe compare investment-cash ow sensitivities across the differ-ent groups of rms for the entire sample period for subperiodsand for individual years
Surprisingly we nd that in only 15 percent of rm-years isthere some question as to a rmrsquos ability to access internal orexternal funds to increase investment In 85 percent of rm-yearsthe rms could have increased their investmentmdashin many casessubstantiallymdashif they had so chosen In fact almost 40 percent ofthe sample rms including Hewlett-Packard (cited above) couldhave increased their investment in every year of the sample pe-riod Our partially qualitative measures of nancial constraintsare strongly corroborated by quantitive data on debt to total capi-tal interest coverage the presence of restrictions on dividendsand nancial slack (the level of cash and unused line of creditrelative to investment)
More strikingly those rms classied as less nanciallyconstrained exhibit a signicantly greater investment-cash owsensitivity than those rms classied as more nancially con-strained We nd this pattern for the entire sample period forsubperiods and for individual years This pattern is also robustto different criteria to divide constrained and unconstrainedrms For example rms with healthy interest coverage in everysample year or in every subperiod year have investment-cashow sensitivities twice as large as the remaining rms in thesample
As we explain in Section I these results should not be verysurprising There is no strong theoretical reason for investment-cash ow sensitivities to increase monotonically with the degreeof nancing constraints Nevertheless we consider several pos-sible reasons why estimated investment-cash ow sensitivitiescould decrease in the degree of nancing constraints even if thetrue relationship is increasing
First cash ow may act as a proxy for investment opportuni-ties not captured by Tobinrsquos Q and do so differentially acrossrms Our results however are robust to the use of an Eulerequation test [Bond and Meghir 1994] which does not rely onTobinrsquos Q and thus is not affected by its mismeasurement
Second differences in sensitivities might be driven by a fewinuential outliers We nd evidence that the high overall sensi-tivity of our sample (FHPrsquos [1988] low dividend payout rms) rela-
INVESTMENT-CASH FLOW SENSITIVITIES 171
tive to FHPrsquos higher dividend payout rms is explained by a rela-tively few company-years characterized by exceptionally highsales growth We also nd however that these outliers do notexplain our cross-section results that the least constrained rmshave the highest sensitivities
Third our nding of nonmonotonic relationship may be spe-cic to a few distressed rms that are forced to use cash ow torepay their debt and may not apply to more ldquonormalrdquo samplesThe nancial conditions of the constrained rms though are notconsistent with this hypothesis
In sum we provide both theoretical reasons and empiricalevidence that a greater sensitivity of investment to cash ow isnot a reliable measure of the differential cost between internaland external nance In so doing we address (and refute) thecriticisms in Fazzari Hubbard and Petersen [1996] [FHP 1996]
We conclude the paper with a discussion of the generalityof our results We argue that our analysis calls into questionthe interpretation of most previous research that uses thismethodology
The paper proceeds as follows Section I presents the theoreti-cal framework Section II describes the sample Section III ex-plains the criteria used to identify the extent to which rms arenancially constrained Section IV reports the investment-cashow regression results Section V discusses the results and con-siders alternative explanations for them Section VI discusses theimplications and generality of our results for the previous litera-ture Section VII concludes
I THEORETICAL FRAMEWORK
A Denition of Financing Constraints
In order to discuss the relationship between investment-cashow sensitivity and the degree of nancing constraints we mustdene what it means to be nancially constrained The most pre-cise (but also broadest) denition classies rms as nanciallyconstrained if they face a wedge between the internal and exter-nal costs of funds By this denition all rms are likely to be clas-sied as constrained A small transaction cost of raising externalfunds would be sufcient to put a rm into this category Thisdenition however provides a useful framework to differentiaterms according to the extent to which they are nancially con-
QUARTERLY JOURNAL OF ECONOMICS172
strained A rm is considered more nancially constrained as thewedge between its internal and external cost of funds increases
Our classication scheme which we detail below is designedto distinguish the relative differences in the degree to which rmsare nancially constrained In general our unconstrained or lessconstrained rms are those rms with relatively large amountsof liquid assets and net worth
In classifying rms we are agnostic on whether the wedgebetween the cost of internal and external funds is caused by hid-den information problems as in Myers and Majluf [1984] andGreenwald Stiglitz and Weiss [1984] or agency problems as inJensen and Meckling [1976] Grossman and Hart [1982] Jensen[1986] Stulz [1990] and Hart and Moore [1995] In fact unlikeBlanchard Lopez-de-Silanes and Shleifer [1994] the purpose ofour analysis is not to identify the source of the capital marketimperfection but rather to understand the effects capital marketimperfections have on investment We next review what economictheory has to say about the impact of nancing constraints oninvestment
B The Impact of Financing Constraints on Investments
FHP [1988] was the rst of many papers to consider higherinvestment-cash ow sensitivities as evidence of greater nancingconstraints Given the magnitude and the importance of thisliterature it is surprising that little attention has been given tothe theoretical foundation of the investment-cash ow sensitivitycriterion1 While it is easy to show that constrained rms shouldbe sensitive to internal cash ow while unconstrained rmsshould not it is not necessarily true that the magnitude of thesensitivity increases in the degree of nancing constraints Thisis the crucial question given that investment is sensitive to cashow for the vast majority of rms analyzed (It is easy to justifythis sensitivity based on the fact that external funds are morecostly than internal funds for all rms as long as some trans-action costs are involved)
The difculty of interpreting cross-sectional differences ininvestment-cash ow sensitivities can be illustrated with asimple one-period model Consider a rm that chooses the levelof investment to maximize prots The return to an investmentI is given by a production function F(I ) where F 9 and F 0 0
1 We thank Jeremy Stein for encouraging us to develop this point
INVESTMENT-CASH FLOW SENSITIVITIES 173
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
rm-year classications to group the sample rms over seven- oreight-year subperiods and over the entire sample period Finallywe compare investment-cash ow sensitivities across the differ-ent groups of rms for the entire sample period for subperiodsand for individual years
Surprisingly we nd that in only 15 percent of rm-years isthere some question as to a rmrsquos ability to access internal orexternal funds to increase investment In 85 percent of rm-yearsthe rms could have increased their investmentmdashin many casessubstantiallymdashif they had so chosen In fact almost 40 percent ofthe sample rms including Hewlett-Packard (cited above) couldhave increased their investment in every year of the sample pe-riod Our partially qualitative measures of nancial constraintsare strongly corroborated by quantitive data on debt to total capi-tal interest coverage the presence of restrictions on dividendsand nancial slack (the level of cash and unused line of creditrelative to investment)
More strikingly those rms classied as less nanciallyconstrained exhibit a signicantly greater investment-cash owsensitivity than those rms classied as more nancially con-strained We nd this pattern for the entire sample period forsubperiods and for individual years This pattern is also robustto different criteria to divide constrained and unconstrainedrms For example rms with healthy interest coverage in everysample year or in every subperiod year have investment-cashow sensitivities twice as large as the remaining rms in thesample
As we explain in Section I these results should not be verysurprising There is no strong theoretical reason for investment-cash ow sensitivities to increase monotonically with the degreeof nancing constraints Nevertheless we consider several pos-sible reasons why estimated investment-cash ow sensitivitiescould decrease in the degree of nancing constraints even if thetrue relationship is increasing
First cash ow may act as a proxy for investment opportuni-ties not captured by Tobinrsquos Q and do so differentially acrossrms Our results however are robust to the use of an Eulerequation test [Bond and Meghir 1994] which does not rely onTobinrsquos Q and thus is not affected by its mismeasurement
Second differences in sensitivities might be driven by a fewinuential outliers We nd evidence that the high overall sensi-tivity of our sample (FHPrsquos [1988] low dividend payout rms) rela-
INVESTMENT-CASH FLOW SENSITIVITIES 171
tive to FHPrsquos higher dividend payout rms is explained by a rela-tively few company-years characterized by exceptionally highsales growth We also nd however that these outliers do notexplain our cross-section results that the least constrained rmshave the highest sensitivities
Third our nding of nonmonotonic relationship may be spe-cic to a few distressed rms that are forced to use cash ow torepay their debt and may not apply to more ldquonormalrdquo samplesThe nancial conditions of the constrained rms though are notconsistent with this hypothesis
In sum we provide both theoretical reasons and empiricalevidence that a greater sensitivity of investment to cash ow isnot a reliable measure of the differential cost between internaland external nance In so doing we address (and refute) thecriticisms in Fazzari Hubbard and Petersen [1996] [FHP 1996]
We conclude the paper with a discussion of the generalityof our results We argue that our analysis calls into questionthe interpretation of most previous research that uses thismethodology
The paper proceeds as follows Section I presents the theoreti-cal framework Section II describes the sample Section III ex-plains the criteria used to identify the extent to which rms arenancially constrained Section IV reports the investment-cashow regression results Section V discusses the results and con-siders alternative explanations for them Section VI discusses theimplications and generality of our results for the previous litera-ture Section VII concludes
I THEORETICAL FRAMEWORK
A Denition of Financing Constraints
In order to discuss the relationship between investment-cashow sensitivity and the degree of nancing constraints we mustdene what it means to be nancially constrained The most pre-cise (but also broadest) denition classies rms as nanciallyconstrained if they face a wedge between the internal and exter-nal costs of funds By this denition all rms are likely to be clas-sied as constrained A small transaction cost of raising externalfunds would be sufcient to put a rm into this category Thisdenition however provides a useful framework to differentiaterms according to the extent to which they are nancially con-
QUARTERLY JOURNAL OF ECONOMICS172
strained A rm is considered more nancially constrained as thewedge between its internal and external cost of funds increases
Our classication scheme which we detail below is designedto distinguish the relative differences in the degree to which rmsare nancially constrained In general our unconstrained or lessconstrained rms are those rms with relatively large amountsof liquid assets and net worth
In classifying rms we are agnostic on whether the wedgebetween the cost of internal and external funds is caused by hid-den information problems as in Myers and Majluf [1984] andGreenwald Stiglitz and Weiss [1984] or agency problems as inJensen and Meckling [1976] Grossman and Hart [1982] Jensen[1986] Stulz [1990] and Hart and Moore [1995] In fact unlikeBlanchard Lopez-de-Silanes and Shleifer [1994] the purpose ofour analysis is not to identify the source of the capital marketimperfection but rather to understand the effects capital marketimperfections have on investment We next review what economictheory has to say about the impact of nancing constraints oninvestment
B The Impact of Financing Constraints on Investments
FHP [1988] was the rst of many papers to consider higherinvestment-cash ow sensitivities as evidence of greater nancingconstraints Given the magnitude and the importance of thisliterature it is surprising that little attention has been given tothe theoretical foundation of the investment-cash ow sensitivitycriterion1 While it is easy to show that constrained rms shouldbe sensitive to internal cash ow while unconstrained rmsshould not it is not necessarily true that the magnitude of thesensitivity increases in the degree of nancing constraints Thisis the crucial question given that investment is sensitive to cashow for the vast majority of rms analyzed (It is easy to justifythis sensitivity based on the fact that external funds are morecostly than internal funds for all rms as long as some trans-action costs are involved)
The difculty of interpreting cross-sectional differences ininvestment-cash ow sensitivities can be illustrated with asimple one-period model Consider a rm that chooses the levelof investment to maximize prots The return to an investmentI is given by a production function F(I ) where F 9 and F 0 0
1 We thank Jeremy Stein for encouraging us to develop this point
INVESTMENT-CASH FLOW SENSITIVITIES 173
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
tive to FHPrsquos higher dividend payout rms is explained by a rela-tively few company-years characterized by exceptionally highsales growth We also nd however that these outliers do notexplain our cross-section results that the least constrained rmshave the highest sensitivities
Third our nding of nonmonotonic relationship may be spe-cic to a few distressed rms that are forced to use cash ow torepay their debt and may not apply to more ldquonormalrdquo samplesThe nancial conditions of the constrained rms though are notconsistent with this hypothesis
In sum we provide both theoretical reasons and empiricalevidence that a greater sensitivity of investment to cash ow isnot a reliable measure of the differential cost between internaland external nance In so doing we address (and refute) thecriticisms in Fazzari Hubbard and Petersen [1996] [FHP 1996]
We conclude the paper with a discussion of the generalityof our results We argue that our analysis calls into questionthe interpretation of most previous research that uses thismethodology
The paper proceeds as follows Section I presents the theoreti-cal framework Section II describes the sample Section III ex-plains the criteria used to identify the extent to which rms arenancially constrained Section IV reports the investment-cashow regression results Section V discusses the results and con-siders alternative explanations for them Section VI discusses theimplications and generality of our results for the previous litera-ture Section VII concludes
I THEORETICAL FRAMEWORK
A Denition of Financing Constraints
In order to discuss the relationship between investment-cashow sensitivity and the degree of nancing constraints we mustdene what it means to be nancially constrained The most pre-cise (but also broadest) denition classies rms as nanciallyconstrained if they face a wedge between the internal and exter-nal costs of funds By this denition all rms are likely to be clas-sied as constrained A small transaction cost of raising externalfunds would be sufcient to put a rm into this category Thisdenition however provides a useful framework to differentiaterms according to the extent to which they are nancially con-
QUARTERLY JOURNAL OF ECONOMICS172
strained A rm is considered more nancially constrained as thewedge between its internal and external cost of funds increases
Our classication scheme which we detail below is designedto distinguish the relative differences in the degree to which rmsare nancially constrained In general our unconstrained or lessconstrained rms are those rms with relatively large amountsof liquid assets and net worth
In classifying rms we are agnostic on whether the wedgebetween the cost of internal and external funds is caused by hid-den information problems as in Myers and Majluf [1984] andGreenwald Stiglitz and Weiss [1984] or agency problems as inJensen and Meckling [1976] Grossman and Hart [1982] Jensen[1986] Stulz [1990] and Hart and Moore [1995] In fact unlikeBlanchard Lopez-de-Silanes and Shleifer [1994] the purpose ofour analysis is not to identify the source of the capital marketimperfection but rather to understand the effects capital marketimperfections have on investment We next review what economictheory has to say about the impact of nancing constraints oninvestment
B The Impact of Financing Constraints on Investments
FHP [1988] was the rst of many papers to consider higherinvestment-cash ow sensitivities as evidence of greater nancingconstraints Given the magnitude and the importance of thisliterature it is surprising that little attention has been given tothe theoretical foundation of the investment-cash ow sensitivitycriterion1 While it is easy to show that constrained rms shouldbe sensitive to internal cash ow while unconstrained rmsshould not it is not necessarily true that the magnitude of thesensitivity increases in the degree of nancing constraints Thisis the crucial question given that investment is sensitive to cashow for the vast majority of rms analyzed (It is easy to justifythis sensitivity based on the fact that external funds are morecostly than internal funds for all rms as long as some trans-action costs are involved)
The difculty of interpreting cross-sectional differences ininvestment-cash ow sensitivities can be illustrated with asimple one-period model Consider a rm that chooses the levelof investment to maximize prots The return to an investmentI is given by a production function F(I ) where F 9 and F 0 0
1 We thank Jeremy Stein for encouraging us to develop this point
INVESTMENT-CASH FLOW SENSITIVITIES 173
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
strained A rm is considered more nancially constrained as thewedge between its internal and external cost of funds increases
Our classication scheme which we detail below is designedto distinguish the relative differences in the degree to which rmsare nancially constrained In general our unconstrained or lessconstrained rms are those rms with relatively large amountsof liquid assets and net worth
In classifying rms we are agnostic on whether the wedgebetween the cost of internal and external funds is caused by hid-den information problems as in Myers and Majluf [1984] andGreenwald Stiglitz and Weiss [1984] or agency problems as inJensen and Meckling [1976] Grossman and Hart [1982] Jensen[1986] Stulz [1990] and Hart and Moore [1995] In fact unlikeBlanchard Lopez-de-Silanes and Shleifer [1994] the purpose ofour analysis is not to identify the source of the capital marketimperfection but rather to understand the effects capital marketimperfections have on investment We next review what economictheory has to say about the impact of nancing constraints oninvestment
B The Impact of Financing Constraints on Investments
FHP [1988] was the rst of many papers to consider higherinvestment-cash ow sensitivities as evidence of greater nancingconstraints Given the magnitude and the importance of thisliterature it is surprising that little attention has been given tothe theoretical foundation of the investment-cash ow sensitivitycriterion1 While it is easy to show that constrained rms shouldbe sensitive to internal cash ow while unconstrained rmsshould not it is not necessarily true that the magnitude of thesensitivity increases in the degree of nancing constraints Thisis the crucial question given that investment is sensitive to cashow for the vast majority of rms analyzed (It is easy to justifythis sensitivity based on the fact that external funds are morecostly than internal funds for all rms as long as some trans-action costs are involved)
The difculty of interpreting cross-sectional differences ininvestment-cash ow sensitivities can be illustrated with asimple one-period model Consider a rm that chooses the levelof investment to maximize prots The return to an investmentI is given by a production function F(I ) where F 9 and F 0 0
1 We thank Jeremy Stein for encouraging us to develop this point
INVESTMENT-CASH FLOW SENSITIVITIES 173
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
Investment can be nanced either with internal funds (W) or withexternal funds (E) The opportunity cost of internal funds equalsthe cost of capital R which for simplicity we set equal to 1 Be-cause of information agency or risk aversion problems we as-sume that the use of external funds generates a deadweight costwhichmdashin a competitive capital marketmdashis borne by the issuingrm We represent (in reduced form) this additional cost of exter-nal funds with the function C(Ek) where E is the amount of ex-ternal funds raised and k is a measure of a rmrsquos wedge betweenthe internal and the external costs of funds It is natural to as-sume that the total cost of raising external funds increases inthe amount of funds raised and in the extent of the agency orinformation problems (represented by k) All the a priori mea-sures of nancing constraints used in the literature can bethought of as different proxies for k (which is unobservable) or ofW (the availability of internal funds)
Each rm then chooses I to maximize
(1) max ( ) ( ) F I C E k I I W E such that + - - =
To guarantee that the above program is well behaved we alsoassume that C() is convex in E2
The rst-order condition of problem (1) then is given by
(2) F I C I W k1 11( ) ( ) + = -
where C1(0) represents the partial derivative of C with respect toits rst argument and F1() the rst derivative of F with respectto I The effects of the availability of internal nance on invest-ments can be easily obtained by implicit differentiation of (2)
(3)dI
dWC
C F
11
11
=- 11
which is clearly positive (to the extent that C is convex) In otherwords in an imperfect capital market world investments aresensitive to internal funds while in a perfect capital marketworld they are not (because C() 5 0 and thus C11 5 0)
Similarly it is possible to derive the sensitivity of investmentto the wedge between the cost of internal and external nancingBy implicit differentiation of (2) we obtain
2 This is a reasonable but not obvious assumption For example Calomirisand Himmelberg [1995] document that the average transaction cost of issuingsecurities decreases in the amount raised which suggests that C() may be con-cave While these transaction costs may be only a small component of the overallcost C() we note that this basic assumption might not be warranted
QUARTERLY JOURNAL OF ECONOMICS174
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
(4)dIdk
CC F
12
11
=-
- 11
which is negative if the marginal cost of raising external nanceis increasing in k (ie C12 0)
Most papers in this literature however do not test either ofthese two propositions On the one hand the estimatedinvestment-cash ow sensitivity is generally positive and signi-cant for all rms suggesting that all rms are constrained insome sense and so making the test of the rst implication redun-dant Second most of the proxies for W or k used in the literatureare only able to identify constrained rms not constrained rm-years This makes it impossible to disentangle the effect of -nancing constraints from a rm-specic effect on the level of in-vestment
For these reasons previous papers focus on cross-sectionaldifferences in the investment-cash-ow sensitivity across groupsof rms likely to have a different wedge between internal andexternal funds But this corresponds to looking at differences indIdW as a function of W or k Such an exercise is meaningfulonly if the investment-cash ow sensitivity is monotonically de-creasing with respect to W (or increasing with respect to k) inother words only if d2IdW2 is negative (or d2IdWdk is positive)From equation (3) we obtain
(5)d IdW
F C C FC F
2
2111 11
2112
113
111
11
=--( )
If both C11() and F11() are different from zero we can rewrite equa-tion (5) as
(6) d IdW
FF
CC
F CC F
2
2111
112
111
112
112
112
113
11
= -aelig
egraveccedil
ouml
oslashdivide -( )
Given that the second term is always positive it follows that d2IdW2 is negative if and only if [F111F11
2 2 C111C112] is negative
This condition implies a certain relationship between the curva-ture of the production function and the curvature of the cost func-tion at the optimal level of investment It is easy to see how sucha condition can be violated For example if the cost function isquadratic d2IdW 2 will be positive if the third derivative of theproduction function is positive (as is the case with a simple pro-duction function like I r where 0 r 1) In such a case theinvestment-cash ow sensitivity increases with a rmrsquos internal
INVESTMENT-CASH FLOW SENSITIVITIES 175
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
liquidity Of course many simple production functions have posi-tive third derivatives Although we will not produce them herethe conditions necessary to ensure that d2IdWdk be positive areat least as demanding
In sum even in a one-period model investment-cash owsensitivities do not necessarily increase with the degree of nan-cing constraints In a multiperiod model precautionary savingsmotives make it even more difcult to assess the theoretical rela-tionship between investment-cash ow sensitivities and the de-gree of nancing constraints For example Gross [1995] buildsand simulates an intertemporal investment model and nds anonmonotonic relationship between investment-cash ow sensi-tivities and the extent of nancing constraints
Finally the relationship between investment-cash ow sen-sitivities and degree of nancing constraints can be further com-plicated by the presence of irrational or overly risk-averse man-agers who choose to rely primarily on internal cash ow to investdespite the availability of low cost funds
II SAMPLE
In this paper we analyze the sample of 49 low-dividend pay-ing rms in FHP [1988] FHP divide all manufacturing rms inthe Value Line database with uninterrupted data from 1970 to1984 into three classes based on dividend payout policy Their 49Class 1 rms (which we analyze) have a dividend payout ratio ofless than 10 percent in at least ten of the fteen years FHP clas-sify 39 rms that have a dividend payout ratio between 10 per-cent and 20 percent as Class 2 rms and all 334 other rms intheir sample as Class 3 rms FHP argue that the Class 1 rmsare more likely a priori to have been nancially constrained Intheir analysis they nd that the Class 1 rms have aninvestment-cash ow sensitivity that is signicantly greater thanthat for rms that pay higher dividends
We choose this sample for three reasons First these rmsexhibit a strong relation between investment and cash ow Sec-ond FHP argue strongly that these rms are nancially con-strained most likely because of information problems BecauseFHP [1988] can legitimately be considered the parent of all pa-pers in this literature there can be no disagreement that we haveadversely selected our sample Finally given the high cost of ourresearch design the number of rms is manageable
We follow this sample for the same fteen years 1970 to
QUARTERLY JOURNAL OF ECONOMICS176
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
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uss
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the
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est
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tile
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ears
(les
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erty
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ant
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pmen
t)
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the
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edit
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egre
ssio
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der
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xed
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cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
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aln
anci
alIn
tera
ctan
nua
lIn
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ctan
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low
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kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
1984 studied by FHP [1988] For each rm we collected datafrom several sources First we collected letters to shareholdersmanagement discussions of operations and liquidity (when avail-able) nancial statements and the notes to those statementsfrom the annual report or 10-K for each rm-year We obtainedWall Street Journal Index entries over the fteen-year sample pe-riod3 We obtained standard accounting variables from COMPU-STAT except those for Coleco which we obtained from Colecorsquosannual reports Because FHP obtained their data from ValueLine not COMPUSTAT our data are not precisely the same astheirs
We measure investment or capital expenditures usingCOMPUSTAT item 128 We measure cash ow as the sum ofearnings before extraordinary items (item 18) and depreciation(item 14) We deate investment and cash ow by capital whichwe measure as net property plant and equipment (item 8) at thebeginning of the scal year This measure of capital differsslightly from the replacement cost measure employed by FHP
We measure average Tobinrsquos Q as the market value of assetsdivided by the book value of assets (item 6) where the marketvalue of assets equals the book value of assets plus the marketvalue of common equity less the sum of the book value of commonequity (item 60) and balance sheet deferred taxes (item 74) Asdo most papers in this literature we calculate Q at the beginningof a rmrsquos scal year4 (Our results are similar when we use end-of-period Q)
In Table I we compare the basic regression results for oursample with those reported in Table 4 of FHP [1988] These re-gressions regress investment on cash ow and Q and control forxed rm and year effects Our results are qualitatively similarto those reported by FHP although they differ slightly in somedetails5 For each of the three time periods our coefcients oncash ow are lower than those reported by FHP Those differ-
3 Fiscal years ending before June 15 are assigned to the previous calendaryear scal years ending after June 15 are assigned to the current calendar year
4 Our measure differs from FHPrsquos in two ways First FHP compute Q basedon replacement costs while we simply use a market-to-book ratio The results inPerfect and Wiles [1994] indicate that the improvements obtained from the moreinvolved computation of Q are fairly limited particularly when regressions areestimated with rm xed effects Second FHP use the average market value ofequity in the fourth quarter while we use the actual market value of equity atscal year end
5 We use 719 observations not 735 because rms switched scal years(three rm-years) rms did not le nancial statements with the SEC (six rm-years) and rms did not have an available stock price (seven rm-years) FHP[1988] do not report how many observations they include
INVESTMENT-CASH FLOW SENSITIVITIES 177
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
TAB
LE
IC
OM
PA
RIS
ON
OF
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
WIT
HFA
ZZ
AR
IH
UB
BA
RD
AN
DP
ET
ER
SE
NR
ES
UL
TS
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
Faz
zari
H
ubba
rd
and
Pet
erse
n[1
988]
(h
erei
naft
erF
HP
[198
8])
from
1970
to19
84co
mpa
red
wit
hes
tim
ates
inF
HP
KZ
refe
rsto
our
esti
mat
esI
nves
tmen
tis
capi
tale
xpen
ditu
res
(CO
M-
PU
STA
Tit
em12
8)C
ash
ow
equ
als
the
sum
ofea
rnin
gsbe
fore
extr
aord
inar
yit
ems
(CO
MP
US
TA
Tit
em18
)and
depr
ecia
tion
(CO
MP
US
-TA
Tit
em14
)In
vest
men
tan
dca
sh
owar
ede
ate
dby
begi
nnin
gof
year
capi
tal
(Kt2
1)
wh
ich
we
de
neas
net
prop
erty
pl
ant
and
equi
pmen
t(C
OM
PU
STA
Tit
em8)
Qeq
ual
sth
em
arke
tva
lue
ofas
sets
divi
ded
byth
ebo
okva
lue
ofas
sets
(CO
MP
US
TAT
item
6)M
arke
tva
lue
ofas
sets
equa
lsth
ebo
okva
lue
ofas
sets
plu
sth
em
arke
tva
lue
ofco
mm
onst
ock
less
the
sum
ofth
ebo
okva
lue
ofco
mm
onst
ock
(CO
MP
US
TA
Tit
em6)
and
bala
nce
shee
tde
ferr
edta
xes
(CO
MP
US
TAT
item
74)
All
regr
essi
ons
incl
ude
rm
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
KZ
KZ
FH
PK
ZK
ZF
HP
KZ
KZ
FH
P19
70ndash8
419
70ndash8
419
70ndash8
419
70ndash7
919
70ndash7
919
70ndash7
919
70ndash7
519
70ndash7
519
70ndash7
5
CF
tK
t21
039
50
500
046
10
477
057
80
540
055
80
634
067
0[0
026
][0
023
][0
027
][0
035
][0
030
][0
036
][0
040
][0
034
][0
044
]Q
t21
003
90
0008
003
00
0002
002
12
000
10[0
005
][0
000
4][0
006
][0
000
4][0
006
][0
000
4]A
djR
20
584
054
80
460
649
062
70
470
764
075
30
55N
obs
719
719
NA
47
647
6N
A
280
280
NA
QUARTERLY JOURNAL OF ECONOMICS178
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
ences however appear to be only marginally signicant if at allAt the same time our coefcients for Q are signicantly greaterthan those reported by FHP
We attribute the differences between our results and FHPrsquosto the different denitions of Q When we exclude Q from ourregressions we obtain coefcients on cash ow that exceed thosein FHP except for the 1970ndash1975 period where our coefcient isinsignicantly smaller Because the FHP measure is constructedwith an average stock price in the previous year rather than the(more appropriate) stock price at the beginning of the year wesuspect that our measure of Q provides better information aboutinvestment opportunities The FHP measure will not distinguishbetween a rm whose stock price declines from 20 to 10 and arm whose stock price increases from 10 to 20 at the end of theprevious year6
III CLASSIFICATION SCHEME
A Description
The SEC requires companies listed on a stock exchange thathave more than 500 shareholders and $5 million in assets to lean annual report or 10-K that contains the basic nancial state-ments and their notes as well as all material information regard-ing a companyrsquos business and nancial condition The annualreports are generally introduced by a letter to shareholders fromthe chief executive ofcer (CEO) This letter usually describes themajor events of the previous scal year and the major projectsplanned for the future
In 1977 the SEC strengthened these reporting requirementsby adopting Regulation S-K which requires rms to discuss ex-plicitly their liquidity capital resources and results of opera-tions This section is usually titled managementrsquos discussion ofoperations Item 303 of Regulation S-K states
(1) Liquidity Identify any known trends or any known demandscommitments events or uncertainties that will result in theregistrantrsquos liquidity increasing or decreasing in any material way
6 FHP [1996] question our measure of Q as a possible source of error becausewe use book value rather than replacement value of assets This concern is un-founded for two reasons First our measure of Q explains more variation in in-vestment than the measure used by FHP suggesting that their measure is noisierthan ours Second as we show below we obtain similar results using an Eulerequation approach that does not rely on Q
INVESTMENT-CASH FLOW SENSITIVITIES 179
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
If a material deciency is identied indicate the course of actionthat the registrant has taken or proposes to take to remedy thedeciency Also identify and separately describe internal and exter-nal sources of liquidity and briey discuss any material unusedsources of liquid assets
(2) Capital Resources (i) Describe the registrantrsquos material commit-ments for capital expenditures as of the end of the latest scal pe-riod and indicate the general purpose of such commitments and theanticipated source of funds needed to fulll such commitments (ii) Describe any known material trends favorable or unfavorablein the registrantrsquos capital resources Indicate any expected materialchanges in the mix and the relative cost of such resources
Instructions 5 The term ldquoliquidityrdquo refers to the ability of anenterprise to generate adequate amounts of cash to meet the enter-prisersquos needs for cash Liquidity shall generally be discussed onboth a long-term and short-term basis7
In short Regulation S-K explicitly requires rms to disclosewhether or not they are having difculty in nancing their in-vestments Consistent with the timing of the new SEC regula-tions post-1977 annual report information for our sample rmstends to be more detailed than the information for earlier yearsTo the extent that our classication scheme has errors theyshould be smaller for years after 1977
We use the qualitative information in the annual reports to-gether with quantitative information in the companiesrsquo nancialstatements and notes to classify each rm-year into one of vegroups
The rst group contains rms that we deem denitely notnancially constrained in that year We refer to these rm-yearsas not nancially constrained (NFC) We place a rm-year in theNFC group if the rm initiated or increased cash dividends re-purchased stock or explicitly indicated in its annual report thatthe rm had more liquidity than it would need for investment inthe foreseeable future8 We also were more likely to label a rm-year NFC if the rm had a large cash position (relative to invest-ment) or if the rmrsquos lenders did not restrict the rm from making
7 See SEC 63031 in Murray Decker and Dittmar [1993]8 For example Plantronicsrsquo 1971 annual report states ldquoWe ended the year
in an exceptionally strong nancial condition for a company of our size Duringthe year we paid off all long-term debt and our cash and cash-equivalent assetshave throughout the year exceeded all current liabilitiesrdquo
QUARTERLY JOURNAL OF ECONOMICS180
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
large dividend payments (relative to investment) NFC rm-years therefore tend to include nancially healthy companieswith low debt and high cash In NFC rm-years therefore wend no evidence that the rms could not have invested appreciablymore if their managers had so chosen In NFC rm-years rmsalso have large amounts of internal funds and collateralizable re-sources relative to the amount of funds required
The second group includes rm-years that we label likely notto be nancially constrained (LNFC) In LNFC rm-years therms are healthy nancially and do not give any indication ofbeing liquidity constrained These rms also tend to have sizablecash reserves unused lines of credit and healthy interest cover-age We distinguish LNFC rm-years from NFC rm-years by themagnitude of the liquidity measures and by the absence of anexplicit statement of excess liquidity Again in LNFC rm-yearswe nd no evidence that these rms could not have invested moreif their managers had so chosen For example despite the quotein our introduction we classify Hewlett-Packard as LNFC in verm-years in the 1970s
The third group includes rm-years we found difcult to clas-sify either as nancially constrained or as unconstrained We callthese rm-years possibly nancially constrained (PFC) In PFCrm-years rms do not report any clear signs of nancing con-straints but they do not look particularly liquid either Fre-quently these rms face an adverse product market environmentbut are not explicitly strapped for cash This category also in-cludes rm-years that provide contradictory indications of theirnancial situation For example this might include a companythat increases its dividend but laments its lack of nancial re-sources in the letter to shareholders
The fourth group contains all rm-years in which rms arelikely to be nancially constrained (LFC) This group includesrms that mention having difculties in obtaining nancing Forexample we include rm-years in which rms postpone an equityor convertible debt offering due to adverse market conditions orclaim they need equity capital but are waiting for improved mar-ket conditions Generally these rms are prevented from payingdividends and have little cash available Firms that cut dividendsalso are more likely to fall in this category unless other adversefactors assign them to the fth group
The last group includes all rm-years in which rms are un-doubtedly nancially constrained (FC) In these rm-years these
INVESTMENT-CASH FLOW SENSITIVITIES 181
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
companies are in violation of debt covenants have been cut outof their usual source of credit are renegotiating debt paymentsor declare that they are forced to reduce investments because ofliquidity problems
Our classication scheme is subject to the criticism thatmanagers do not always report truthfully and therefore somerm-years will be misclassied We do not view management mis-reporting as a serious problem for several reasons First manag-ers are held liable not only for disclosing false information butalso for not disclosing material information This is particularlytrue after 1977 when Regulation S-K is in effect9 Second we readannual reports over a fteen-year period While a rm may beable to misreport in any given rm-year it seems unlikely that arm can misreport every year Third we do not rely exclusivelyon the management discussions but also read the nancial state-ments carefully Finally any management reluctance to reportnegative information should bias our results against nding -nancially constrained companies and differences across groupsTo the extent that we nd some companies to be nancially con-strained we can be certain that they are indeed constrained
Overall our classication scheme captures relative differ-ences in sample rmsrsquo availability of internal and external fundsin a given year The nancial statements and management dis-cussions strongly indicate that NFC (and LNFC) rms could haveinvested more (often substantially more) in that year had they sochosen In the language of our model these are rms for whomW is very high even after they invest Therefore these rmsshould face a C(Ek) that is close to 0 if not equal to 0 This isunlikely to be true for the PFC rms and denitely not true forthe LFC and FC rms Our classication scheme therefore cap-tures relative differences in sample rmsrsquo wedge between exter-nal and internal nance
B Classication Results
Table II summarizes our classication of rm-years We clas-sify 545 percent of rm-years as not (NFC) and 309 percent ofrm-years as likely not nancially constrained (LNFC) for a totalof 853 percent of rm-years in which we nd no evidence of nan-cing constraints that restrict investment We classify 73 percent
9 For example the SEC took action against Caterpillar Inc for not re-porting that a large increase in Caterpillarrsquos 1989 net income was caused by ahyperination in Brazil
QUARTERLY JOURNAL OF ECONOMICS182
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
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ally
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llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
INVESTMENT-CASH FLOW SENSITIVITIES 183
TA
BL
EII
SU
MM
AR
YO
FA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
S
Dis
trib
utio
nof
nan
cin
gco
nstr
aint
sby
year
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]
from
1970
to19
84
Fir
mn
anci
ngco
nstr
ain
tst
atu
sfo
rea
chye
arar
eno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyno
t
nanc
ially
cons
trai
ned
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)
NF
C1
LN
FC
PF
C1
LF
C1
FC
NF
CL
NF
CP
FC
LF
CF
CN
otor
Pos
sibl
ylik
ely
orN
otL
ikel
yno
tP
ossi
bly
Lik
ely
De
nite
lyli
kely
not
den
itel
y
nan
cial
ly
nan
cial
lyn
anci
ally
nan
cial
lyn
anci
ally
na
ncia
llyn
anci
ally
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
cons
trai
ned
con
stra
ined
1970
340
44
7
149
2
14
378
7
213
19
7138
334
017
010
70
072
327
719
7243
835
412
58
30
079
220
819
7339
645
86
34
24
285
414
619
7436
728
612
216
36
165
334
719
7530
642
914
38
24
173
526
519
7651
038
82
04
14
189
810
219
7759
228
64
10
08
287
812
219
7867
326
52
02
02
093
86
219
7961
226
510
22
00
087
812
219
8073
520
44
12
00
093
96
119
8171
420
46
10
02
091
88
219
8269
424
52
02
02
093
96
119
8369
424
52
04
10
093
96
119
8469
422
40
06
12
091
88
2
Tota
l54
530
97
34
82
685
314
7
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
of rm-years as possibly constrained 48 percent as likely con-strained and 26 percent as denitely constrained for a total ofonly 147 percent rm-years in which there is some possibility ofnancing constraints The fraction of rms that are at least pos-sibly constrained varies over time with more rms being poten-tially constrained in the early part of the sample (when theserms were smaller) and particularly around the 1974ndash1975 re-cession This time pattern is consistent with the results in FHP[1988] and in Table I that investment-cash ow sensitivities de-cline over the sample period (In the Appendix we report the year-by-year classications for all 49 rms)
We consider the accuracy of our classication scheme by re-porting quantitative measures of operational and nancial healthacross our ve classications in Table III In panel A mediancash ow net cash ow (cash ow less investment) and TobinrsquosQ decline monotonically across the ve categories For examplethe median level of net cash ow for NFC rms is 11 percent ofcapital (net property plant and equipment) while the medianlevel of net cash ow for FC rms is almost 2 20 percent Thissuggests that NFC rms could have increased their investmentwithout tapping external sources of capital
Panel A also suggests that our classication scheme is suc-cessful in capturing the degree of nancing constraints Equation(3) predicts that investment will decline as nancing constraintsincrease Consistent with this the median level of investment issignicantly lower for LFC and FC rm-years than for the otherthree groups (We test this more formally in subsection IVCwhere we control for investment opportunities) Furthermore themean level of investment in acquisitions (as a fraction of capital)is substantially higher for rms in the rst two groups (NFC andLNFC) than for rms in the other three groups10 Acquisitions arecompletely absent in FC rm-years
Panel B reports summary statistics on rm nancial statusInterest coveragemdashearnings before interest taxes depreciationand amortization or EBITDA (COMPUSTAT item 13) to interestexpense (item 15)mdashdeclines monotonically across our classica-tions11 Debt to total capital also decreases monotonically debt is
10 We calculate acquisitions as the value of businesses or companies ac-quired in a given rm-year as a fraction of beginning-of-year capital We valuepurchase acquisitions using information in the statement of changes We valuepooling acquisitions using the notes to nancial statements
11 We set interest coverage to 100 if coverage exceeds 100 or interest ex-pense is negative We set interest coverage to 0 if EBITDA is negative
QUARTERLY JOURNAL OF ECONOMICS184
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
TABLE IIISUMMARY STATISTICS FOR FIRM CHARACTERISTICS BY YEARLY FINANCING
CONSTRAINT STATUS
Distribution of nancial variables by annual nancing constraint status for49 low-dividend rms from FHP [1988] from 1970 to 1984 Firm nancing con-straint status for each year is not nancially constrained (NFC) likely not nan-cially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) Each entry re-ports the median mean tenth percentile ninetieth percentile and number ofobservations Investment (It) cash ow Q and capital (Kt 2 1) are dened in TableI Acquisitions (Acqs) equals the value of purchase and pooling acquisitions In-terest coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value short-term andlong-term debt Total capital is the sum of debt the book value of preferred stockand the book value of common equity Free divs is the amount of retained earn-ings that are not restricted from being paid out as dividends Cash is cash andmarketable securities Unused linet is the amount of unused line of credit at theend of year t Slack is the sum of cash and unused line Change in debt is thechange in sum of the book value of short-term and long-term debt Equity issueis the sum of the equity issued to the public and to acquisition targets
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
A Investment cash ow growth
It Kt 2 1 0368 0324 0359 0273 0243 03480461 0413 0450 0350 0313 04360159 0159 0122 0073 0068 01270831 0831 0824 0909 0544 0810
393 221 52 34 19 719
Cash FlowtKt 2 1 0506 0350 0313 0243 0020 04210614 0435 0366 0191 2 0047 05050209 0104 2 0125 2 0126 2 0436 01221075 0871 1084 0528 0366 1007
393 221 52 34 19 719
(Cash Flowt 2 It )Kt 2 1 0110 0026 2 0026 2 0071 2 0198 00510155 0022 2 0085 2 0159 2 0360 0069
2 0180 2 0316 2 0474 2 0642 2 0785 2 02850503 0323 0420 0141 2 0076 0442
393 221 52 34 19 719
Qt 1313 1171 1159 1096 1082 12311647 1542 1312 1527 1402 15800809 0755 0793 0734 0795 07852781 2799 1934 2659 1789 2749
393 221 52 34 19 719
Fraction rms with 0244 0244 0154 0176 0000 0228acquisitions in 393 221 52 34 19 719yeart
INVESTMENT-CASH FLOW SENSITIVITIES 185
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
AcqstKt 2 1 0000 0000 0000 0000 0000 00000122 0159 0063 0023 0000 01210000 0000 0000 0000 0000 00000287 0300 0044 0029 0000 0252
388 217 52 34 19 710
Sales growtht 0211 0150 0123 0136 0008 01800226 0165 0097 0113 0049 01880021 2 0071 2 0136 2 0145 2 0275 2 00510484 0385 0319 0338 0305 0452
393 221 52 34 19 719
Inventory growtht 0199 0117 0144 0063 2 0064 01540215 0160 0135 0049 2 0013 0179
2 0073 2 0175 2 0056 2 0499 2 0487 2 01350545 0475 0376 0562 0543 0512
393 221 52 34 19 719
B Financial policy
Interest coveraget 7971 5886 4203 2836 1093 640618026 11777 4745 3455 1650 140232746 1608 0000 0666 0000 1707
46722 23605 9598 6960 3827 33325393 221 52 34 19 719
Debtt to total capitalt 0296 0351 0431 0541 0565 03490293 0352 0454 0573 0621 03440051 0117 0258 0316 0361 00750526 0585 0689 0791 0912 0585
393 221 52 34 19 719
DividendstKt 0000 0000 0000 0000 0000 00000015 0006 0006 0002 0001 00110000 0000 0000 0000 0000 00000046 0023 0028 0028 0007 0037
393 221 52 34 19 719
Fraction of years 0061 0276 0462 0686 0789 0206dividends restricted 393 221 52 34 19 719
Free divst Kt 2 1 0208 0013 0000 0000 0000 01010334 0139 0043 0019 0000 02290004 0000 0000 0000 0000 00000740 0430 0078 0089 0000 0634
247 129 34 29 15 454
QUARTERLY JOURNAL OF ECONOMICS186
TABLE III(CONTINUED)
NFC LNFC PFC LFCNot Likely Possibly Likely FC Alln not n n n Fin rm-
constr constr constr constr constr years
CashtKt 2 1 0331 0150 0150 0077 0085 01680726 0253 0263 0156 0139 03640050 0034 0041 0029 0016 00331276 0596 0721 0389 0292 0784
393 221 52 34 19 719
Unused linet 0 0723 0652 0654 0529 0579 0683393 221 52 34 19 719
Unused linet Kt 2 1 0270 0178 0136 0043 0072 02030523 0313 0291 0151 0159 04150000 0000 0000 0000 0000 00001097 0733 0900 0449 0900 0979
393 221 52 34 19 719
Slackt Kt 2 1 0725 0420 0344 0211 0229 05571249 0566 0449 0374 0320 09190217 0118 0059 0044 0001 01262039 1129 0923 0721 1065 1679
393 221 52 34 19 719
Ch debtt Kt 2 1 0048 0048 0153 0272 0017 00620168 0157 0405 0473 0012 0191
2 0304 2 0354 2 0470 2 0414 2 0546 2 03540718 0760 0983 1581 0974 0797
393 221 52 34 19 719
Equity issuet Kt 2 1 0000 0000 0000 0000 0000 00000224 0149 0042 0020 0046 01770000 000 000 0000 0000 00000634 0419 0044 0000 0256 0455
373 193 38 31 16 651
the sum of the book value of short-term and long-term debt (items9 and 34) while total capital is the sum of debt the book value ofpreferred stock and the book value of common equity It is worthpointing out that NFC rm-years have a large median interestcoverage of almost eight times while the LNFC rm-years havea median coverage of almost six In contrast the median coveragein LFC rm-years is less than three times and in FC rm-yearsbarely exceeds one
INVESTMENT-CASH FLOW SENSITIVITIES 187
The notes to the nancial statements typically state whethera rmrsquos debt covenants if any restrict a rm from paying divi-dends We interpret a rm as being more nancially constrainedthe greater the restrictions placed on dividend payments by cove-nants Table III reports that the fraction of rm-years in whichdebt covenants forbid the payment of dividends increases mono-tonically across our classications NFC rm-years are restricted61 percent of the time while LFC and FC rms are restrictedmore than 68 percent of the time
In the majority of rm-years the notes to nancial state-ments also report exactly how much of retained earnings are freefor dividend payments under the strictest debt covenants12 PanelB of Table III indicates that this amount falls monotonicallyacross our ve groups In NFC rm-years the median amount ofearnings free for dividends equals 208 percent of beginning-of-year capital and almost 58 percent of the yearrsquos investment Inother words the median NFC rm could have paid out a dividendequal to 58 percent of its capital expenditures without the permis-sion of existing lenders
Finally cash (COMPUSTAT item 1) unused line of creditand slack (the sum of cash and unused line of credit) all declinemonotonically across our classications Slack provides a mea-sure of the amount of funds or liquidity immediately availableto a rm at year-end Slack may overstate true liquidity slightlybecause some rms were required to maintain compensating bal-ances That qualication notwithstanding the median slack inNFC rm-years is 725 percent of beginning-of-year capital and191 percent of the yearrsquos investment In LNFC rm-years theanalogous amounts are 42 percent and 119 percent
As an additional check we estimate ordered logit models ofthe probability that a rm falls in one of the ve categories withNFC being the lowest state and FC the highest The results arepresented in Table IV The likelihood of being classied as nan-cially constrained is signicantly greater in rms with higherdebt to total capital higher Q and for whom dividend paymentsare forbidden The likelihood is signicantly lower in rms withhigh cash ow high cash high dividends paid high retainedearnings free for dividends and with any unused line of credit at
12 This information is not reported in years that a rm has no debt as wellas some of the earlier rm-years
QUARTERLY JOURNAL OF ECONOMICS188
TABLE IVORDERED LOGITS FOR PREDICTABILITY OF FINANCING CONSTRAINT STATUS
Ordered logits for the determination of annual nancing constraint status for49 low-dividend rms are from FHP [1988] from 1970 to 1984 Financing con-straint for each year is ordered from not nancially constrained (NFC) likely notnancially constrained (LNFC) possibly nancially constrained (PFC) likely -nancially constrained (LFC) to nancially constrained (FC) Variable denitionsare in Tables I and III Standard errors are in brackets
Dependent variable is nancing constraint status
Cash owt Kt 2 1 2 0886 2 1164 2 0688 2 0839[0230] [0256] [0222] [0235]
Qt 0276 0370[0080] [0087]
Debttotal capitalt 2071 2251 1825 1938[0470] [0480] [0464] [0471]
DividendstKt 2 1 2 23039 2 21787 2 22551 2 20409[5949] [6134] [5905] [6043]
Dividends restricted (Y 5 1 N 5 0) 1496 1365 1472 1294[0213] [0224] [0213] [0222]
Unrestricted ret earningsKt 2 1 2 1897 2 1936 2 1896 2 1956[0497] [0513] [0499] [0513]
CashtKt 2 1 2 1704 2 1590 2 1675 2 1567[0311] [0323] [0311] [0320]
Unused line of credit 0 2 0711 2 0547 2 0758 2 0511[0176] [0207] [0175] [0206]
_cut1 2 0252 0608 2 0693 0119[0312] [0480] [0285] [0462]
_cut2 1973 2928 1510 2413[0328] [0499] [0298] [0478]
_cut3 2987 3988 2501 3433[0353] [0518] [0320] [0494]
_cut4 4307 5353 3790 4736[0413] [0562] [0378] [0532]
Year dummies No Yes No YesLog likelihood 2 6450 2 6270 2 6506 2 6357Pseudo-R2 0201 0223 0194 0213
all All the coefcients are statistically signicant at the 1 percentlevel and all the coefcients except perhaps the one on Q havethe expected sign Q has a positive impact on the probability ofbeing nancially constrained This is true despite the univariateresult in Table III that Q decreases with rm nancial healthThe likely explanation for this result is Qrsquos partial correlationwith cash ow In the absence of cash ow the coefcient onQ becomes negative One way to interpret this result is that con-
INVESTMENT-CASH FLOW SENSITIVITIES 189
ditional on having a low cash ow we classify a rm as morelikely to be constrained if it has more investment opportunities(high Q)
Overall we feel that the monotonic patterns of most of theoperating and nancial variables in Table III and the results inTable IV provide a strong quantitative validation of our classi-cation scheme
C Overall Financial Status
In order to analyze investment-cash ow sensitivities overfteen years we aggregate each rmrsquos annual nancial statusinto an overall measure of nancial status We refer to this assample nancial status (rather than rm-year nancial status)We distinguish rms that were never nancially constrainedfrom those that were We do this to account for the likelihood thatrms which become constrained will behave as if they areconstrained
Our classication provides a great deal of variation Nine-teen rms are never constrained they are classied as NFC orLNFC in all fteen sample years These rms never showed anysign of being nancially constrained over the entire period Eightrms are possibly constrained These rms were possibly con-strained in at least one year and not constrained (NFC andLNFC) in all the rest Finally 22 rms are likely constrainedThese rms were classied as LFC or FC in at least one sampleyear
We also aggregate annual nancial status into overall statusover two subperiods 1970 to 1977 and 1978 to 1984 We classifyrms according to whether they were likely constrained possiblyconstrained or not constrained within each subperiod We do thisfor four reasons First the classication over the entire sampleperiod will classify a rm as nancially constrained even if thatrm was constrained in only one of fteen years By measuringnancial status over subperiods we increase the precision of ourclassications Second the research design in FHP biases thesample toward companies that were small in 1970 but were es-tablished enough by 1984 to be included in the Value Line dataset Therefore a rm in the earlier part of the sample is conceiv-ably different from the same rm later on Third as noted earlierthe information contained in the management discussions andfootnotes of annual reports improves after 1977 Therefore webelieve that the precision of our classications increases in the
QUARTERLY JOURNAL OF ECONOMICS190
second subperiod Finally as noted earlier FHP [1988] reportthat the sensitivity of investment to cash ow is particularlystrong in the rst half of the sample when these rms weresmaller and more likely to have been nancially constrained
IV REGRESSION RESULTS
Armed with a direct measure of a rmrsquos nancially con-strained status we can now test whether the worsening of nan-cing constraints is associated with a monotonic increase ininvestment-cash ow sensitivity (as would occur if d 2IdW2 werenegative)
A Financing Constraints and Investment-Cash FlowSensitivities
We rst examine the relationship between nancing con-straints and investment-cash ow sensitivities by following theFHP methodology and estimating separate regressions by rmsample nancial status We use the regression specications pre-sented in Table I over the entire sample period Table V presentsour basic results Firms classied as never constrained (NFC orLNFC in every sample year) exhibit the highest investment-cashow sensitivity (0702) exceeding that for the entire sample(0395) for rms that were likely constrained (0340) and forrms that were possibly constrained (0180) The coefcient forthe never constrained rms is economically and statisticallygreater than the coefcients for the other rms
As we noted earlier we are not entirely comfortable with theclassication of possibly constrained rms If managers tend tounderreport negative information about their rmrsquos nancial con-dition then it would be appropriate to group the eight possiblyconstrained rms with the likely constrained rms Not surpris-ingly this grouping lowers the coefcient on constrained rms to0250 and widens the gap between constrained rms and uncon-strained rms It is worth pointing out that the 0250 sensitivityis insignicantly different from that of the high-dividend FHPClass 3 rms and actually smaller than that of the FHP Class2 rms
Alternatively it is possible that we have been excessivelyconservative and have classied rms as possibly constrainedwhen they were in fact unconstrained Accordingly we also esti-mate a regression in which we group the possibly constrained
INVESTMENT-CASH FLOW SENSITIVITIES 191
QUARTERLY JOURNAL OF ECONOMICS192
TA
BL
EV
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
RE
NT
IRE
SA
MP
LE
PE
RIO
D
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nst
rain
edst
atus
wh
ere
19
rms
are
neve
rn
anci
ally
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyn
ot
nan
cial
lyco
nstr
ain
ed(L
NF
C)
poss
ibly
na
nci
ally
cons
trai
ned
(PF
C)
like
ly
nanc
ially
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lylik
ely
neve
rpo
ssib
lypo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nst
rain
edco
nstr
ain
edco
nstr
aine
dco
nst
rain
edN
549
N5
19N
58
N5
22N
527
N5
30
CF
tKt2
10
395
070
20
180
034
00
439
025
0[0
026
][0
041
][0
060
][0
042
][0
035
][0
032
]Q
t21
003
90
009
001
60
070
003
30
059
[00
05]
[00
06]
[00
49]
[00
18]
[00
06]
[00
17]
Adj
R2
058
40
793
024
00
410
065
50
358
Nob
s71
927
911
332
739
244
0
rms with the never constrained rms While this lowers theinvestment-cash ow sensitivity substantially (to 0439) it doesnot alter the basic result that unconstrained rms exhibit agreater investment-cash ow sensitivity
In Tables VI and VII we repeat our basic analysis but breakthe sample into two subperiods 1970 to 1977 and 1978 to 1984Table VI treats a rm in the 1970ndash1977 subperiod as differentfrom the same rm in the 1978ndash1984 subperiod The regressionspresented in Table VI therefore include 98 rm-subperiods (withrm-subperiod xed effects) Again the coefcients sharply rejectthe hypothesis that nancially constrained rms have greaterinvestment-cash ow sensitivities In Table VI rms that are notconstrained in a subperiod have an investment-cash ow sensi-tivity of 0680 This is signicantly greater than the sensitivity of0436 for all rm subperiods and greater than the sensitivity ofrms that are possibly constrained (at 0259) or likely con-strained (at 0274)
Table VI also presents regression results for the fteen rm-subperiods for which we classify the rm as NFC in every year inthe subperiod13 Ten of the fteen subperiods fall in the 1978ndash1984 period during which even FHP argue the sample rms wereless likely to be constrained Strikingly the investment-cash owsensitivity for these fteen subperiods of 0779 exceeds any of thecoefcients for any group of rms we present in Tables VI and VII
Based on our classication scheme and the quantitative sup-port for that scheme in Tables III and IV we nd it impossible toargue that these rms were unable to invest more during any ofthese fteen subperiods We also nd it difcult to argue thatthese rms faced a particularly high cost of external nanceHewlett-Packard for example is included among these fteensubperiods in 1978ndash1984 (although not in 1970ndash1977) AndHewlett-Packard has an investment-cash ow sensitivity of 097over the 1978ndash1984 subperiod 091 over the 1970ndash1977 subpe-riod and 115 over the entire sample period It is worth stressingthat the fteen rms that are NFC in every subperiod year havenancial characteristics that are similar to those of FHPrsquos Class3 rms that pay high dividends and have a low investment-cashow sensitivity (023) For example the NFC rms and FHPrsquosClass 3 rms have interest coverage ratios that are economically
13 We do not create this classication over the entire sample period becausewe classify only two rms as NFC in all fteen years
INVESTMENT-CASH FLOW SENSITIVITIES 193
QUARTERLY JOURNAL OF ECONOMICS194
TA
BL
EV
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
IN
TW
OS
UB
PE
RIO
DS
TR
EA
TIN
GF
IRM
-SU
BP
ER
IOD
SA
SD
IFF
ER
EN
TF
IRM
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
mn
anci
alco
nstr
ain
tst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
enr
m-s
ubpe
riod
sar
ene
ver
nan
cial
lyco
nstr
ain
ed(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
aine
d(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
lyn
anci
ally
con
stra
ined
(LF
Cor
FC
inso
me
year
)an
d15
rm
-su
bper
iods
are
NF
Cev
ery
year
O
vera
llsu
bper
iod
stat
usis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
lyn
anci
ally
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ion
sin
clud
er
mx
edef
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
dx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyli
kely
NF
CA
llr
ms
con
stra
ined
con
stra
ined
con
stra
ined
cons
trai
ned
con
stra
ined
ever
yye
arN
598
N5
57N
514
N5
27N
571
N5
41N
515
CF
tKt2
10
436
068
00
259
027
40
523
026
20
779
[00
28]
[00
41]
[00
67]
[00
50]
[00
34]
[00
37]
[00
84]
Qt2
10
033
001
00
081
004
80
025
005
40
002
[00
05]
[00
06]
[00
59]
[00
23]
[00
06]
[00
21]
[00
09]
Adj
R2
060
40
721
040
20
391
066
10
402
083
7N
obs
719
416
9820
551
430
311
0
INVESTMENT-CASH FLOW SENSITIVITIES 195T
AB
LE
VII
RE
GR
ES
SIO
NO
FIN
VE
ST
ME
NT
ON
CA
SH
FL
OW
AN
DQ
BY
FIN
AN
CIA
LL
YC
ON
ST
RA
INE
DS
TA
TU
SO
VE
R19
70ndash1
977
AN
D19
78ndash1
984
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Sam
ple
isdi
vide
din
totw
osu
bper
iods
197
0ndash19
77an
d19
78ndash1
984
Fir
m
nan
cing
cons
trai
ntst
atus
isde
term
ined
wit
hin
each
subp
erio
dF
ifty
-sev
en
rm-s
ubp
erio
dsar
ene
ver
nan
cial
lyco
nstr
aine
d(N
FC
orL
NF
Cev
ery
year
)14
rm
-su
bper
iods
are
poss
ibly
nan
cial
lyco
nstr
ain
ed(P
FC
inso
me
year
)27
rm
-sub
peri
ods
are
like
ly
nan
cial
lyco
nst
rain
ed(L
FC
orF
Cin
som
eye
ar)
and
15r
m-
subp
erio
dsar
eN
FC
ever
yye
ar
Ove
rall
subp
erio
dst
atu
sis
base
don
rm
na
nci
ngco
nst
rain
tst
atu
sfo
rea
chye
arof
not
na
nci
ally
cons
trai
ned
(NF
C)
like
lyno
tn
anci
ally
con
stra
ined
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
lyn
anci
ally
cons
trai
ned
(LF
C)
and
nan
cial
lyco
nstr
aine
d(F
C)
Reg
ress
ions
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
Sta
ndar
der
rors
are
inbr
acke
ts
1970
ndash197
7
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
523
N5
7N
519
N5
80N
519
N5
5
CF
tKt2
10
505
074
60
247
036
40
553
030
60
783
[00
37]
[00
51]
[00
86]
[00
69]
[00
45]
[00
49]
[01
42]
Qt2
10
035
000
60
027
002
50
023
002
90
002
[00
17]
[00
07]
[00
82]
[00
23]
[00
07]
[00
22]
[00
15]
Adj
R2
069
60
827
038
10
454
075
50
446
083
2N
obs
378
179
5014
922
919
940
1978
ndash198
4
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
nev
erpo
ssib
lyli
kely
neve
rpo
ssib
lypo
ssib
lyl
ikel
yN
FC
rm
sco
nst
rain
edco
nst
rain
edco
nst
rain
edco
nstr
ain
edco
nstr
ain
edev
ery
year
N5
49N
534
N5
7N
58
N5
41N
515
N5
10
CF
tKt2
10
326
057
10
272
014
10
470
016
00
800
[00
44]
[00
69]
[01
52]
[00
61]
[00
58]
[00
53]
[01
26]
Qt
005
42
001
90
154
041
30
007
027
22
005
4[0
026
][0
028
][0
088
][0
084
][0
027
][0
073
][0
047
]R
20
392
046
70
422
045
90
439
040
20
703
Nob
s34
123
748
5628
510
470
and statistically indistinguishable It seems difcult to under-stand how one set of rms can be constrained while the otheris not
Table VII presents results for each of the two subperiods sepa-rately Again we nd no evidence that nancing constraints ex-plain the sensitivity of investment to cash ow In both subperi-ods the rms that we classify as NFC every year and as neverconstrained have a signicantly higher investment-cash ow sen-sitivity than the other groups of rms Furthermore in the 1978ndash1984 period where we are more certain of our classications thesensitivity declines monotonically with the extent to which weclassify rms as constrained
B Quantitative Denitions of Financially Constrained Status
Given the results in the previous section some readers maybe concerned that we have misclassied rms by using qualita-tive data (For example see FHP [1996]) To address this concernwe report the results of grouping rms based on quantitativeob-jective data
In regressions (1)ndash(3) of Table VIII we present estimates ofthe investment-cash ow sensitivities for (i) the 25 percent ofsample rms whose interest coverage never drops below 25 and(ii) rms whose dividends are never restricted over the entiresample period Given the two severe recessions over the sampleperiod these criteria should identify rms that were relativelynancially healthy The investment-cash ow sensitivity for thethirteen rms whose coverage never drops below 25 is signi-cantly greater at 0673 than the sensitivity of 0395 for the entiresample The investment-cash ow sensitivity for the seventeenrms whose dividends are never restricted at 0435 also exceedsthe sensitivity for the entire sample although not signicantly
In regressions (4)ndash(6) we split the sample into subperiods aswe did in Table VI We present estimates of the investment-cashow sensitivities for (i) the 25 percent of rm-subperiods whoseinterest coverage never drops below 45 in the subperiod and (ii)rms whose dividends are never restricted over the subperiodThe patterns are qualitatively similar and quantitativelystronger than those for the entire sample period The investment-cash ow sensitivity for the 21 rms whose coverage never dropsbelow 45 in a subperiod is a remarkably high 0801 We shouldpoint out that the median interest coverage for rms rated BBBby Standard amp Poorrsquos in 1979ndash1981 was 382 the median for
QUARTERLY JOURNAL OF ECONOMICS196
INVESTMENT-CASH FLOW SENSITIVITIES 197
TAB
LE
VII
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YO
TH
ER
ME
AS
UR
ES
OF
FIN
AN
CIA
LLY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
ES
AM
PL
EP
ER
IOD
AN
DE
NT
IRE
SU
BP
ER
IOD
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
esI
and
III
Reg
ress
ions
(1)ndash
(3)
are
esti
mat
edfo
rto
tal
sam
ple
and
by(i
)w
het
her
rm
sev
erha
din
tere
stco
vera
gebe
low
25
and
(ii)
rm
sar
eno
tex
plic
itly
rest
rict
edfr
ompa
ying
divi
den
dsov
erth
een
tire
sam
ple
peri
odI
nter
est
cove
rage
isth
era
tio
ofE
BIT
DA
toin
tere
stex
pen
seR
egre
ssio
ns
(4)ndash
(6)a
rees
tim
ated
usin
gr
mn
anci
alst
atu
sov
ersa
mpl
esu
bper
iods
1970
ndash197
7an
d19
78ndash1
984
Reg
res-
sion
s(1
)ndash(3
)in
clud
er
mx
edef
fect
san
dye
aref
fect
sR
egre
ssio
ns
(4)ndash
(6)
incl
ude
rm
xe
def
fect
sfo
rea
chsu
bper
iod
resu
ltin
gin
upto
98r
m-p
erio
d
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(4)
Fir
ms
that
(3)
All
rm
s(5
)(6
)ne
ver
have
Fir
ms
that
subp
erio
dsF
irm
sth
atF
irm
sth
atn
ever
(1)
cove
rage
neve
rha
ve19
70ndash1
984
neve
rh
ave
hav
ere
stri
cted
All
belo
w2
5fr
omre
stri
cted
and
cove
rage
belo
wdi
vide
nds
inr
ms
1970
ndash198
4di
vide
nds
1978
ndash198
44
5in
subp
erio
dsu
bper
iod
N5
49N
513
N5
17N
598
N5
25N
556
CF
tKt2
10
395
067
30
435
043
60
801
049
9[0
026
][0
056
][0
042
][0
028
][0
062
][0
038
]Q
t21
003
90
011
003
50
033
20
003
002
7[0
005
][0
008
][0
007
][0
005
][0
008
][0
006
]A
djR
20
584
075
60
674
060
40
772
071
5N
obs
719
191
247
719
189
402
rms rated A was 656 In other words these rms are not likelyto have faced particularly high costs of external nance in abso-lute terms in the subperiods More importantly in relative termsit is virtually certain that they faced lower costs of external -nance than the other rms in our sample and yet show a higherinvestment-cash ow sensitivity
C Predetermined Classication of Financially ConstrainedStatus
One important potential criticism of our results is that ouruse of nancial status over the entire period (or subperiod) mayldquohardwirerdquo our results Firms that only increase investmentwhen they have the cash ow to do so will exhibit a highinvestment-cash ow sensitivity and will be less likely to becomeconstrained subsequently In contrast rms that increase invest-ment when they do not have cash ow will exhibit a low sensitiv-ity and will be more likely to become constrained later (if theynance some of the investment with debt) It is possible there-fore that the investment-cash ow sensitivities we have esti-mated reect the way investment was nanced and that thisdrives our overall measure of nancial status rather than viceversa
Although it is fairly standard in this literature to sort rmsaccording to within-sample characteristics (for example FHP[1988] Hoshi Kashyap and Scharfstein [1991] and Lamont[1996]) this approach has received an increasing number of criti-cisms (see Schiantarelli [1995]) To address this concern we usea denition of nancial status that reects only past (not future)information Specically we measure rm nancial status basedon the previous yearrsquos nancial status This should isolate theeffect of nancial status rather than possibly reecting the wayin which investment was nanced In other words we believethat this specication is the most appropriate one to use to testfor the effect of nancing constraints on investment-cash owsensitivities
In regression (1) of Table IX we present differential estimatesof the investment-cash ow sensitivities by interacting cash owwith predetermined annual measures of nancing-constraint sta-tus14 We use four nancing constraint dummies LNFC equals
14 Our results are qualitatively identical when we also include dummy vari-ables for the intercept term
QUARTERLY JOURNAL OF ECONOMICS198
INVESTMENT-CASH FLOW SENSITIVITIES 199T
AB
LE
IXR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YA
NN
UA
LF
INA
NC
ING
CO
NS
TR
AIN
TS
TA
TU
SR
ES
TR
ICT
ED
DIV
IDE
ND
ST
AT
US
AN
DL
OW
SL
AC
KS
TA
TU
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
Q
an
dca
sh
owin
tera
cted
wit
hn
anci
ally
cons
trai
ned
stat
us
rest
rict
eddi
vide
ndst
atus
an
dlo
wca
shan
du
nuse
dli
neof
cred
itst
atus
for
49lo
w-d
ivid
end
rm
sar
efr
omF
HP
[198
8]fr
om19
70to
1984
Var
iabl
esar
ede
ne
din
Tabl
esI
and
III
Fir
mn
anci
ngco
nstr
aint
for
each
year
isno
tn
anci
ally
cons
trai
ned
(NF
C)
like
lyn
otn
anci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nanc
ially
cons
trai
ned
(PF
C)
like
ly
nan
cial
lyco
nstr
ain
ed(L
FC
)or
nan
cial
lyco
nstr
aine
d(F
C)
The
noni
nter
acte
dca
sh
owva
riab
lere
pres
ents
year
sin
wh
ich
rm
sar
eN
FC
R
egre
ssio
ns
(1)
and
(2)
use
na
ncia
lco
nstr
aint
stat
usat
the
begi
nni
ng
ofth
es
cal
year
(bas
edon
stat
usat
the
end
ofth
epr
evio
uss
caly
ear)
Reg
ress
ion
(3)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquosco
vena
nts
rest
rict
itfr
ompa
ying
divi
dend
sin
the
prev
iou
ss
cal
year
Reg
ress
ion
(4)
inte
ract
sca
sho
ww
ith
adu
mm
yva
riab
leth
ateq
uals
one
ifa
rm
rsquossl
ack
inth
epr
evio
uss
cal
year
isin
the
low
est
quar
tile
ofr
m-y
ears
(les
sth
an0
28of
net
prop
erty
pl
ant
and
equi
pmen
t)
Slac
kis
the
sum
ofca
shan
dun
used
line
ofcr
edit
R
egre
ssio
nsin
clu
der
m
xed
effe
cts
and
year
effe
cts
Sta
ndar
der
rors
are
inbr
acke
ts
(2)
(1)
Inve
stm
ent
by(3
)(4
)In
tera
ctan
nual
annu
aln
anci
alIn
tera
ctan
nua
lIn
tera
ctan
nual
low
slac
kn
anci
alco
nstr
aint
stat
usco
nst
rain
tst
atus
rest
rict
eddi
vide
ndst
atus
stat
us
CF
tKt2
10
407
Con
stan
t0
202
CF
tKt2
10
358
CF
tKt2
10
359
[00
43]
[00
27]
[00
29]
[00
27]
CF
tKt2
10
013
LN
FC
20
060
CF
tKt2
12
010
6C
FtK
t21
20
061
3L
NF
C[0
035
][0
026
]3
rest
rict
ed[0
052
]3
low
slac
k[0
040
]di
vide
nds
CF
tKt2
12
023
5P
FC
20
112
3P
FC
[00
55]
[00
45]
CF
tKt2
12
038
2L
FC
20
167
3L
FC
[00
86]
[00
54]
CF
tKt2
12
039
4F
C2
025
13
FC
[01
62]
[00
69]
Qt2
10
041
Qt2
10
101
Qt2
10
048
Qt2
10
051
[00
11]
[00
11]
[00
11]
[00
11]
Adj
R2
050
40
342
047
60
475
Nob
s67
467
467
467
4
one if the rm is likely not nancially constrained in the previousscal year PFC if the rm is possibly nancially constrainedthat year LFC if the rm is likely nancially constrained thatyear and FC if the rm is denitely nancially constrained thatyear The base or constant term measures investment in NFCrm-years We stress that this classication scheme uses only in-formation available at the beginning of the scal year The re-sults are qualitatively identical to those in the previous sectionsThe investment-cash ow sensitivities are signicantly lower forFC LFC and PFC rm-years than for LNFC and NFC rm-years The results are qualitatively identical if FC and LFC rm-years and LNFC and NFC rm-years are classied together
Although we prefer the above method because it fully usesthe annual information on each rmrsquos nancial status we alsotried an alternative approach that is somewhat more consistentwith the previous literature (These results are not reported in atable) For each year from 1970 to 1977 we divided the sampleinto two groups depending on whether the rm was classied asunconstrained (NFC and LFNC) or constrained (LFC and FC) inthat year We then used the following seven years to estimateseparate sensitivity coefcients for the two groups In all eightpaired regressions the estimated investment-cash ow sensitiv-ity of the unconstrained rms is higher than that of the con-strained rms In ve of the eight regressions this difference isstatistically signicant
These ndings conrm our previous empirical results andsupport our theoretical claim that investment-cash ow sensitiv-ity is not necessarily increasing in the degree of nancing con-straints The one remaining question perhaps is our measure ofnancing constraints Fortunately the simple model we presentedin Section I provides a way to test the reliability of our indicatorsEquation (3) makes the unequivocal theoretical prediction thatceteris paribus investment should decrease in the degree of -nancing constraints By looking at the relation of our annual -nancing constraint measures to investment we can assess thevalidity of those measures We do this by introducing our annualnancing constraint indicators in a standard Q model of invest-ment (and controlling for xed rm and year effects) This test isnot possible in the earlier regressions because overall nancingconstraint status is collinear with rm xed effects
The results are reported in regression (2) of Table IX Con-trolling for Q investment levels decline monotonically in the de-
QUARTERLY JOURNAL OF ECONOMICS200
gree of nancing constraints For example investment after LFCrm-years is 2 017 lower than after NFC rm-years The resultsare strongly consistent with the predictions derived in equation(3) They also suggest that our lagged measure of nancing con-straints successfully captures the degree of nancing constraint15
In regressions (3) and (4) we repeat the analysis in regression(1) but instead use quantitative measures of nancial statusagain based on the previous yearrsquos results In regression (3) weinteract cash ow with a dummy variable that equals one whendebt covenants restrict the rm from paying dividends Again wend that the investment-cash ow sensitivity is signicantlylower not higher for rms restricted from paying dividends Inregression (4) we interact cash ow with a dummy variable thatequals one if in the previous rm-year our slack variablemdashthesum of cash and unused lines of credit as a fraction of capitalmdashis in the lowest quartile of rm-years The low slack cutoff is 28percent of beginning-of-year capital (net property plant andequipment) Our results are not sensitive to this cutoff It seemsreasonable to assume that rms with less slack are more nan-cially constrained than rms with more slack Again we nd thatthe investment-cash ow sensitivity is lower not higher for rmswith low slack
Overall then we obtain qualitatively identical results usingboth qualitative and quantitative measures of nancing con-straints that are predetermined
D Sensitivity to Cash Stock
Although most of the literature focuses on the sensitivity ofinvestment to cash ow some authors (eg Kashyap Lamontand Stein [1994]) focus on the sensitivity of investment to thecash stock (cash and marketable securities) that a rm has avail-able at the beginning of the year For completeness in Table Xwe reestimate the annual nancing constraint regressions inTable IX using this alternative measure of liquidity (The resultswe report are qualitatively identical when we instrument cashholdings with its lagged value)
In the regression in column (1) we measure liquidity as cash
15 These results are also interesting for the debate on the relationship be-tween investment and Q in nancially constrained rms Chirinko [1995] arguesthat the effects of nancing constraints will be fully reected in a rmrsquos marketvalue and thus on its Q To the contrary our results suggest that Q is not suf-cient to explain the investment of nancially constrained rms
INVESTMENT-CASH FLOW SENSITIVITIES 201
TABLE XREGRESSION OF INVESTMENT ON CASH FLOW CASH STOCK AND Q BY ANNUAL
FINANCING CONSTRAINT STATUS
Regression of investment on cash ow cash stock Q and cash ow and cashstock interacted with nancially constrained status for 49 low-dividend rms fromFHP [1988] from 1970 to 1984 Variables are dened in Tables I and III Firmnancing constraint status for each year is not nancially constrained (NFC)likely not nancially constrained (LNFC) possibly nancially constrained (PFC)likely nancially constrained (LFC) or nancially constrained (FC) The nonin-teracted cash ow variable represents years in which rms are NFC Regressionsinclude rm xed effects and year effects Standard errors are in brackets
(2) (3)(1) Cash stock Sum of cash stock
Cash stock only and cash ow and cash ow
Casht 2 1 Kt 2 1 0164 Casht 2 1 Kt 2 1 0101 [Casht 2 1 1 CFt]Kt 2 1 0163[0015] [0015] [0011]
Casht 2 1 Kt 2 1 0056 Casht 2 1 Kt 2 1 0014 [Casht 2 1 1 CFt]Kt 2 00793 LNFC [0057] 3 LNFC [0060] 3 LNFC [0024]
Casht 2 1 Kt 2 1 2 0154 Casht 2 1 Kt 2 1 0269 [Casht 2 1 1 CFt]Kt 2 2 00373 PFC [0125] 3 PFC [0129] 3 PFC [0041]
Casht 2 1 Kt 2 1 2 0463 Casht 2 1 Kt 2 1 0249 [Casht 2 1 1 CFt]Kt 2 2 01743 LFC [0219] 3 LFC [0257] 3 LFC [0064]
Casht 2 1 Kt 2 1 2 0523 Casht 2 1 Kt 2 1 0321 [Casht 2 1 1 CFt]Kt 2 2 01963 FC [0340] 3 FC [0355] 3 FC [0121]
CFtKt 2 1 0342[0033]
CFtKt 2 1 00763 LNFC [0041]
CFtKt 2 1 2 02223 PFC [0062]
CFtKt 2 1 2 03843 LFC [0108]
CFtKt 2 1 2 04053 FC [0179]
Qt 2 1 0085 Qt 2 1 0040 Qt 2 1 0040[0011] [0010] [0010]
Adj R2 0306 0441 0393N obs 674 674 674
stock deated by net property plant and equipment both at thebeginning of the year The regression estimates the sensitivity ofinvestment to cash stock as a function of a rmrsquos nancial statusOur ndings are qualitatively identical to those in Table IX theleast constrained rms show the highest sensitivity
In column (2) we include both measures of liquidity cash
QUARTERLY JOURNAL OF ECONOMICS202
ow and cash stock The sensitivity of investment to cash owdecreases with the degree of nancing constraintsmdashthe samepattern encountered throughout the paper In contrast the sensi-tivity of investment to cash stock now increases with the degreeof nancing constraints These latter results however are notstatistically signicant none of the coefcients are statisticallydifferent from each other
These results may raise the question of which sensitivity isthe relevant one The theory however does not distinguish be-tween cash ow and cash stock the effect of an extra dollar offunds should be the same independent of whether it enters therm this period (as cash ow) or whether it was present in therm at the beginning of the period (as cash stock) For this rea-son we estimate a regression in column (3) of Table X that mea-sures liquidity as the sum of cash ow and cash stock Our mainnding is conrmed the least constrained rms show a signi-cantly higher sensitivity of investment to internal funds
We also estimated (but do not report in a table) the regres-sions in Tables V and VII with cash stock and cash ow In allregressions our basic nding holds investment-cash ow sensi-tivities decrease signicantly with the degree of nancing con-straints The results for investment-cash stock sensitivities aremixed Over the entire sample period investment-cash stock sen-sitivities increase signicantly with the degree of nancing con-straints However this pattern does not hold for either the1970ndash1977 or the 1978ndash1984 subperiod
E Alternative Specications
We considered but do not report a number of alternativespecications of our basic regressions (1) We removed Q as anindependent variable leaving cash ow as the only independentvariable (2) We added the ratio of sales to capital as an indepen-dent variable with Q and cash ow to capital (3) We included twolags of cash ow and Q as independent variables (4) To reducethe inuence of outliers we (i) winsorized investment cash owand Q (ii) deated investment and cash ow by total assetsrather than by capital (iii) eliminated observations with negativecash ow and (iv) measured cash ow using EBITDA (5) We ranregressions for each rm individually (6) We checked whetherthe results hold if we exclude any particular rm from the sam-ple Our results are qualitatively and statistically identical under
INVESTMENT-CASH FLOW SENSITIVITIES 203
all of these alternatives These specications and results there-fore address the concerns raised by FHP [1996] that our empiri-cal results could be the artifact of a censored regression16
We also tested the robustness of our results with respectto different denitions of investment Besides the standarddenition (COMPUSTAT item 128) we used the following (1)COMPUSTAT item 30 which includes increases in propertyplant and equipment from acquisitions that use purchase ac-counting (2) change in net property plant and equipment (3)change in net property plant and equipment adding back depre-ciation and (4) the sum of capital expenditures and research anddevelopment All four adjustments yield results that are qualita-tively and statistically identical to our basic results Finally weestimated inventory regressions similar to those estimated byCarpenter Fazzari and Petersen [1995] Again we nd no evi-dence that the sensitivity of inventory investment to cash owincreases with nancing constraints
V DISCUSSION OF THE RESULTS
The results indicate that a high sensitivity of investment tocash ow is not associated with nancially constrained rms inour sample This contrasts with the results in FHP [1988] andmany subsequent papers This section argues in greater detailthat our ndings are not specic to our sample but insteadlikely capture general features of the relationship between corpo-rate investment and cash ow Section VI discusses the implica-tions of these ndings for the previous literature
A Cash Flow as a Proxy for Investment Opportunities
One possible criticism is that our sorting criteria are corre-lated with the mismeasurement of Q and that this effect over-comes the effect of nancing constraints (which go in the oppositedirection) This criticism was rst made in Poterbarsquos [1988] dis-cussion of FHP [1988] Poterba points out that if cash ow pro-vides more information about future investment opportunities forcertain groups of rms (like nondividend paying rms) suchrms on average would have a greater investment-cash ow sen-
16 In fact we believe it is telling that FHP [1996] criticize our results hypo-thetically rather than by showing that the criticisms hold in the data
QUARTERLY JOURNAL OF ECONOMICS204
sitivity independent of their nancial status FHP [1996] presenta similar criticism of our results
In the literature following FHP [1988] this measurementproblem has been addressed by using the so-called Euler equa-tion approach (see Whited [1992] Bond and Meghir [1994] andHubbard Kashyap and Whited [1995]) This approach directlytests the rst-order conditions of an intertemporal maximizationproblem that does not require a measurement of Q and thereforeis (supposedly) unaffected by Qrsquos mismeasurement
To test the robustness of our ndings we followed the Eulerequation approach developed in Bond and Meghir [1994] who ex-plicitly model the wedge between internal and external nanceTheir empirical implementation involves regressing investmenton lagged investment and its square sales cash ow and debtsquared and testing whether the coefcient on cash ow is differ-ent across rms with different dividend policies When we imple-ment this approach we obtain results qualitatively identical tothose from our basic specication Our least constrained rms ex-hibit the highest coefcients
In sum the Euler equation approach provides no evidencethat our ndings are driven by mismeasurement of Q (The alter-native interpretationmdashthat the Euler equation approach fails tocontrol for differences in investment opportunitiesmdashwould callinto question all the results in the literature derived using thatmethodology)
B The Impact of Outliers
The papers in this literature typically deate all the vari-ables by the value of capital (net property plant and equipment)at the beginning of the scal year This method provides consis-tent estimates if all variables are recorded at short intervals or ifthere is no growth In practice however neither of the two as-sumptions is satised Variables are recorded at annual inter-vals and companies grow substantially over the sample perioda median of 18 percent per year for our sample If both invest-ment and cash ow grow at a rate similar to the growth rate ofsales then part of the comovement of investment and cash owmay be due to a scale factor This effect would bias the estimatesof the investment-cash ow sensitivity toward one particularlyin rms with higher annual growth rates
To account for this possibility we estimate regressions that
INVESTMENT-CASH FLOW SENSITIVITIES 205
eliminate or downweight observations with high growth ratesThe rst four columns of Table XI report the results of regres-sions that exclude rm-years with more than 30 percent salesgrowth (the upper quartile) When we eliminate these observa-tions the median rate of sales growth for the constrained pos-sibly constrained and not constrained rms is essentially equal(between 11 percent and 12 percent) The investment-cash owsensitivities decline substantially Nevertheless the patternacross the three groups of rms remains qualitatively the sameand the difference in sensitivities is still statistically signicantThe second four columns of Table XI report qualitatively similarresults when we eliminate rm-years in which net propertyplant and equipment more than doubled17 Finally we obtainqualitatively and statistically similar results (in unreported re-gressions) when we apply a robust estimation technique thatdownweights outliers18
In sum our cross-sectional results are not driven by outliersThe same cannot be said for the overall results in FHP [1988]Eliminating or downweighting high growth rm-years reducesthe estimated investment-cash ow sensitivity of the entire lowdividend payout sample to between 020 and 025 This is effec-tively identical to the estimate of 023 obtained by FHP for theirunconstrained high payout rms Given that these rms are lesslikely to experience such extreme growth rates these results in-dicate that FHPrsquos overall ndings (across payout classes) are atleast partially driven by extreme observations
Unfortunately this problem is not likely to be restricted toFHP [1988] Any splitting criterion that sorts rms into subsam-ples with differential outliers in growth ratesmdashfor examplesplits on size and dividend payout ratiosmdashmay be biased towardnding a difference in coefcients on cash ow This bias maypartially account for the large body of evidence nding a higherinvestment-cash ow sensitivity in fast growing companies thattend to be classied as nancially constrained
17 Following a suggestion of David Scharfstein we investigated all the ob-servations where property plant and equipment more than doubled in a singleyear In most of these cases the increase in investment appears to have beendriven by a sudden surge in both the demand for the rmrsquos product and rmprots
18 This method implemented by STATA performs an initial screening toeliminate gross outliers prior to calculating starting values and then performs assuggested by Li [1985] Huber iterations followed by biweight iterations The re-sults are available upon request
QUARTERLY JOURNAL OF ECONOMICS206
INVESTMENT-CASH FLOW SENSITIVITIES 207
TA
BL
EX
IR
EG
RE
SS
ION
OF
INV
ES
TM
EN
TO
NC
AS
HF
LO
WA
ND
QB
YF
INA
NC
IAL
LY
CO
NS
TR
AIN
ED
ST
AT
US
OV
ER
EN
TIR
EP
ER
IOD
WIT
HO
UT
HIG
HS
AL
ES
GR
OW
TH
OR
HIG
HIN
VE
ST
ME
NT
GR
OW
TH
OB
SE
RV
AT
ION
S
Reg
ress
ion
ofin
vest
men
ton
cash
ow
and
Qfo
r49
low
-div
iden
dr
ms
from
FH
P[1
988]
from
1970
to19
84V
aria
bles
are
den
edin
Tabl
eI
Reg
ress
ions
are
esti
mat
edfo
rto
tals
ampl
ean
dby
nan
cial
lyco
nstr
aine
dst
atus
wh
ere
19r
ms
are
nev
er
nanc
ially
cons
trai
ned
over
the
enti
repe
riod
(NF
Cor
LN
FC
inev
ery
year
)8
rm
sar
epo
ssib
lyn
anci
ally
cons
trai
ned
atso
me
tim
e(P
FC
inso
me
year
)an
d22
rm
sar
eli
kely
nan
cial
lyco
nstr
ain
edat
som
eti
me
inth
epe
riod
(LF
Cor
FC
)O
vera
llst
atus
isba
sed
onr
mn
anci
ng
cons
trai
ntst
atu
sfo
rea
chye
arof
not
nan
cial
lyco
nstr
aine
d(N
FC
)li
kely
not
na
nci
ally
cons
trai
ned
(LN
FC
)po
ssib
ly
nan
cial
lyco
nstr
aine
d(P
FC
)li
kely
na
nci
ally
cons
trai
ned
(LF
C)
and
na
nci
ally
cons
trai
ned
(FC
)A
llre
gres
sion
sin
clud
e
rmx
edef
fect
san
dye
aref
fect
sS
tand
ard
erro
rsar
ein
brac
kets
No
rm
-yea
rsw
ith
inve
stm
ent
exce
edin
gN
or
m-y
ears
wit
hm
ore
than
30
sale
sgr
owth
init
ial
capi
tal(
Kt2
1)
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
Fir
ms
All
neve
rpo
ssib
lyli
kely
All
neve
rpo
ssib
lyli
kely
rm
sco
nstr
ain
edco
nstr
ain
edco
nstr
aine
d
rms
cons
trai
ned
cons
trai
ned
cons
trai
ned
N5
49N
519
N5
8N
522
N5
49N
519
N5
8N
522
CF
tKt2
10
246
053
10
104
023
30
203
036
60
149
021
1[0
050
][0
124
][0
045
][0
058
][0
031
][0
042
][0
046
][0
032
]Q
t21
005
10
033
004
80
049
004
60
023
20
001
006
7[0
012
][0
014
][0
053
][0
024
][0
009
][0
010
][0
027
][0
013
]A
djR
20
328
050
20
155
027
00
449
059
70
252
042
7N
obs
535
201
7925
567
926
310
930
7
C Financially Constrained Equals Financially Distressed
It is plausible that nancially distressed rms will exhibitlow investment-cash ow sensitivities For example an insolventrm might be forced by its creditors to use additional cash owto repay debt rather than for capital expenditures This necessar-ily will reduce the sensitivity of investment to cash ow If therms we classify as constrained and possibly constrained are infact nancially distressed this would reduce the generality andimpact of our results
Tables III and XII however refute this argument Table IIIpresents rm characteristics by rm-year nancial status TableXII presents rm characteristics by overall sample nancial sta-tus First the bottom of Table III indicates that rms increasetheir debt rather than repay it in the years we classify them aspossibly likely or denitely constrained Second although onemight argue that the denitely constrained rm-years are dis-tressed (median interest coverage of 109) Table III shows thatthis is not likely to be the case for the likely constrained rm-years (median interest coverage of 284) and denitely not thecase for the possibly constrained rm-years (median interest cov-erage of 420) Third Table XII shows that over the entire sampleperiod rms we classify as possibly constrained are approxi-mately as healthy as rms we classify as never constrained Fi-nally it is unreasonable to describe the likely constrained rmsas distressed over the entire sample period (median interest cov-erage of 484) despite the fact that they are less healthy overallthan the other two groups In fact FHP [1988] intended to elimi-nate distressed rms because they explicitly excluded rms withoverall negative real sales growth from their sample
VI IMPLICATIONS FOR PREVIOUS WORK
The discussion above suggests that our ndings are notcaused by econometric problems or an inappropriate classica-tion scheme In our sample there is a negative rather than posi-tive correlation between investment-cash ow sensitivities andthe degree of nancing constraints This shows that a nonmono-tonic relationship (or even an inverse relationship) is not onlytheoretically possible but is also empirically relevant Only fu-ture work will be able to ascertain how pervasive this nonmono-tonicity is However our paper shows that monotonicity cannotbe taken for granted
QUARTERLY JOURNAL OF ECONOMICS208
TABLE XIIMEDIAN FIRM CHARACTERISTICS BY FINANCIALLY CONSTRAINED STATUS
IN ENTIRE SAMPLE PERIOD
Median rm characteristics by overall nancial status for 49 low-dividendrms from FHP [1988] from 1970 to 1984 Overall status is based on rm nanc-ing constraint status for each year of not nancially constrained (NFC) likelynot nancially constrained (LNFC) possibly nancially constrained (PFC) likelynancially constrained (LFC) and nancially constrained (FC) For the entireperiod 19 rms are never nancially constrained over the entire period (NFC orLNFC in every year) 8 rms are possibly nancially constrained at some time(PFC in some year) and 22 rms are likely nancially constrained at some timein the period (LFC or FC) Each entry reports the median and number of observa-tions Investment (It) cash ow Q and capital (Kt 2 1) are dened in Table I Inter-est coverage is the ratio of earnings before interest taxes and depreciation(EBITDA) to interest expense Debt is the sum of the book value of short-termand long-term debt Total capital is the sum of debt the book value of preferredstock and the book value of common equity Free divs is the amount of retainedearnings that are not restricted from being paid out as dividends Cash is cashand marketable securities Unused linet is the amount of unused line of credit atthe end of year t Slack is the sum of cash and unused line
Never Possibly Likely Allconstrained constrained constrained rm-years
N 5 279 N 5 113 N 5 327 N 5 719
A Investment cash ow growth
It Kt 2 1 0348 0403 0337 0348Cash FlowtKt 2 1 0451 0517 0364 0421(Cash Flowt 2 It)Kt 2 1 0081 0142 0001 0051Qt 1262 1438 1200 1231Sales growtht 0194 0176 0172 0180
B Financial policy
Interest coveraget 8070 9928 4842 6406Debtt to total capitalt 0289 0249 0415 0349Fraction of yearsdividends restricted 0115 0070 0327 0206Free divstKt 2 1 0186 0315 0023 0101CashtKt 2 1 0215 0239 0109 0168Unused linet 0 0631 0649 0730 0683Unused linet Kt 2 1 0153 0208 0256 0203Slackt Kt 2 1 0626 0630 0481 0557Ch debtt Kt 2 1 0048 0000 0094 0062Years with equity issue 0234 0167 0189 0203
One might argue that we have only raised a possibility andthat our ndings do not generalize beyond the specic FHP[1988] sample In fact FHP [1996]mdashciting the large body of evi-dence which nds that an increased sensitivity is associated witha priori measures of nancing constraintsmdashdismiss our resultsas little more than an empirical counterexample
INVESTMENT-CASH FLOW SENSITIVITIES 209
The existing literature however cannot be brought in as evi-dence against our results for two reasons First it is likely that apublication selection bias exists in this literature Because thenull hypothesis before FHP [1988] was that nancing constraintsdid not matter only papers showing otherwise were likely to bewritten and published (See De Long and Lang [1992])
More importantly (and ignoring the possible publicationbias) the existing evidence can be used to support the monoton-icity assumption only if the theoretical priors used in those stud-ies unequivocally identify those rms as more likely to beconstrained If this were the case then the fact that most studiesnd a higher sensitivity for rms more likely to be constrainedmay be interpreted in favor of a monotonic relation between sen-sitivities and nancing constraints However if the priors are am-biguous (and monotonicity cannot be taken for granted) then theargument is invalid and the interpretation of many of the resultsin this literature becomes questionable high sensitivities per secannot be taken as evidence of nancing constraints
In our view most of the sorting criteria used in this literatureare indeed theoretically ambiguous Consider for example oneof the better known papers in this literature Hoshi Kashyapand Scharfstein [1991] which divides Japanese rms on the basisof whether they belong to a keiretsu and therefore to a largeextent of whether they have a main-bank relationship Althoughit is easy to argue that such a relationship will have an effect ona rmrsquos nancing and investment policy it is much less clear ona priori grounds what the sign of this effect should be Some the-ories (eg Myers and Majluf [1984]) imply a positive role for amain-bank relationship in reducing informational asymmetriesand thus in alleviating nancing constraints Hoshi Kashyapand Scharfstein nd that Japanese rms with an exclusive bankrelationship have a lower investment-cash ow sensitivity Bystressing these theories Hoshi Kashyap and Scharfstein inter-pret their ndings as evidence that a main-bank relationshipmakes rms less constrained
In contrast other theories (eg Sharpe [1990] and Rajan[1991]) imply that banks can exploit an exclusive main-bank rela-tionship and charge client rms a higher cost of capital (ie makethem more nancially constrained) The nding in HoshiKashyap and Scharfstein [1993] that the healthiest Japaneserms (from their original sample) subsequently broke their exclu-sive bank relationships is consistent with this interpretation
QUARTERLY JOURNAL OF ECONOMICS210
Houston and James [1995] nd that U S rms with an exclusivebank relationship have a higher investment-cash ow sensitivityBy stressing these other theories Houston and James interpretthis as evidence that a main-bank relationship makes these rmsmore not less constrained
The theoretical ambiguity is not unique to Hoshi Kashyapand Scharfstein [1991] and Houston and James [1995] but isshared by most of the splitting criteria used in this literatureFirms with a lower-than-average leverage are sometimes inter-preted a priori as relatively unconstrained rms (eg Whited[1992]) because they retain a large debt capacity and can obtainexternal funds very easily In other papers rms with lower-than-average leverage are considered to be relatively constrained(eg Calomiris and Himmelberg [1995]) because they are as-sumed to maintain low leverage because the costs of being nan-cially constrained or distressed would be extremely high
Similarly rms with unusually high cash holdings are some-times classied a priori as relatively unconstrained [KashyapLamont and Stein 1994] because they can invest that cash Andsometimes rms with unusually high cash holdings are classiedas relatively constrained [Calomiris Himmelberg and Wachtel1995] because they are assumed to need to accumulate that cashas precautionary savings to avoid the high costs of being nan-cially constrained or distressed in the future
In sum the theoretical priors are ambiguous As a result ourndings are not a minor counterexample in a large literature thatnds otherwise Rather this is the rst paper to test the very as-sumption upon which the literature is based19
VII CONCLUSION
Our analysis indicates that the investment-cash ow sensi-tivity criterion as a measure of nancing constraints is not well-grounded in theory and is not supported by empirical evidence inthe case we investigate While we believe that the nonmonoton-icity problem we have documented is pervasive and affects manyof the results in this literature future research will be needed toconrm this hypothesis
19 Our methodology is not subject to the same criticisms for two reasonsFirst we classify rm nancing constraint status using direct observation ratherthan theoretical priors Second we conrm the quality of our nancing constraintindicators using a test for which the theory is unequivocal
INVESTMENT-CASH FLOW SENSITIVITIES 211
QUARTERLY JOURNAL OF ECONOMICS212
If the nonmonotonicity result is general then it will be im-portant to understand its source One explanation (implicitly as-sumed in our theoretical model) involves understanding theshape of the cost function of raising external nance where exter-nal nance is costly because of information or agency problemsAlternatively it is possible that the nonmonotonic behavior of theinvestment-cash ow sensitivity is driven by a mischaracteriza-tion of the reasons why rms are reluctant to raise external -nance The most nancially successful and least constrainedrms in our sample appear to rely primarily on internal cash owto invest despite the availability of additional low cost funds andtherefore exhibit a high investment-cash ow sensitivity Thekey questionmdashthat we do not answermdashis why we observe thisbehavior It seems important that future work attempt to distin-guish among these explanations because of their disparate policyimplications for institutional and incentive design
The nal implication of our paper is a methodological oneOur research design and results point out what we think is aweakness in existing research as well as an opportunity for fu-ture research A great deal can be learned through more directobservation Appendix follows references
GRADUATE SCHOOL OF BUSINESS UNIVERSITY OF CHICAGO AND NATIONAL BUREAU
OF ECONOMIC RESEARCH
REFERENCES
Blanchard Olivier Florencio Lopez-de-Silanes and Andrei Shleifer ldquoWhat DoFirms Do with Cash Windfallsrdquo Journal of Financial Economics XXXVI(1994) 337ndash60
Bond Stephen and Costas Meghir ldquoDynamic Investment Models and the FirmrsquosFinancial Policyrdquo Review of Economic Studies LXI (1994) 197ndash222
Calomiris Charles and Charles Himmelberg ldquoInvestment Banking Costs as aMeasure of Access to External Financerdquo manuscript University of Illinois1995
Calomiris Charles Charles Himmelberg and Paul Wachtel ldquoCommercial PaperCorporate Finance and the Business Cyclerdquo Carnegie Rochester Series onPublic Policy (1996) forthcoming
Carpenter Robert Steven Fazzari and Bruce Petersen ldquoThree Financing Con-straint Hypotheses and Inventory Investment New Tests with Time and Sec-toral Heterogeneityrdquo manuscript Washington University 1995
Chirinko Robert ldquoFinance Constraints Liquidity and Investment SpendingCross-Country Evidencerdquo manuscript Emory University 1995
De Long Bradford and Kevin Lang ldquoAre All Economic Hypotheses Falserdquo Jour-nal of Political Economy C (1992) 1257ndash72
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investmentrdquo Brookings Papers on Economic Activity (1988)141ndash95
Fazzari Steven R Glenn Hubbard and Bruce Petersen ldquoFinancing Constraintsand Corporate Investment Response to Kaplan and Zingalesrdquo NBER Work-ing Paper No 5462 1996
INVESTMENT-CASH FLOW SENSITIVITIES 213
Greenwald Bruce Joseph Stiglitz and Andrew Weiss ldquoInformation Imperfec-tions and Macroeconomic Fluctuationsrdquo American Economic Review LXXIV(1984) 194ndash99
Gross David ldquoThe Investment and Financing Decisions of Liquidity-ConstrainedFirmsrdquo manuscript University of Chicago 1995
Grossman Sanford and Oliver Hart ldquoCorporate Financial Structure and Mana-gerial Incentivesrdquo in J J McCall ed The Economics of Information and Un-certainty (Chicago IL University of Chicago Press 1982)
Hart Oliver ldquoTheories of Optimal Capital Structure A Managerial DiscretionPerspectiverdquo in M Blair Ed The Deal Decade (Washington DC The Brook-ings Institution 1993)
Hart Oliver and John Moore ldquoDebt and Seniority An Analysis of the Role ofHard Claims in Constraining Managementrdquo American Economic ReviewLXXXV (1995) 567ndash85
Hayashi Fumio ldquoTobinrsquos Marginal q and Average q A Neoclassical Interpreta-tionrdquo Econometrica L (1982) 213ndash24
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoCorporate Structure Liquid-ity and Investment Evidence from Japanese Panel Datardquo Quarterly Journalof Economics CVI (1991) 33ndash60
Hoshi Takeo Anil Kashyap and David Scharfstein ldquoThe Choice between Publicand Private Debt An Analysis of Post-Deregulation Corporate Financing inJapanrdquo NBER Working Paper No 4421 1993
Houston Joel and Christopher James ldquoBanking Relationships Financial Con-straints and Investments Are Bank Dependent Borrowers More FinanciallyConstrainedrdquo Working Paper University of Florida 1995
Hubbard R Glenn Anil Kashyap and Toni Whited ldquoInternal Finance and FirmInvestmentrdquo Journal of Money Credit and Banking XXVII (1995) 683ndash701
Jensen Michael ldquoAgency Costs of Free Cash Flow Corporate Finance and Take-oversrdquo American Economic Review LXXVI (1986) 323ndash29
Jensen Michael and William Meckling ldquoThe Theory of the Firm ManagerialBehavior Agency Costs and Ownership Structurerdquo Journal of Financial Eco-nomics III (1976) 305ndash60
Kaplan Steven and Luigi Zingales ldquoDo Financing Constraints Explain Why In-vestment Is Correlated with Cash Flowrdquo NBER Working Paper No 52671995
Kashyap Anil Owen Lamont and Jeremy Stein ldquoCredit Conditions and theCyclical Behavior of Inventoriesrdquo Quarterly Journal of Economics CIX(1994) 565ndash93
Lamont Owen ldquoCash Flow and Investment Evidence from Internal Capital Mar-ketsrdquo manuscript University of Chicago 1996
Li G ldquoRobust Regressionrdquo in Exploring Data Tables Trends and Shapes D CHoaglin F Mosteller and J W Takey eds (New York John Wiley amp Sons1985) pp 281ndash340
Murray Ronald William Decker and Nelson Dittmar The Coopers amp LybrandSEC Manual (New Jersey Prentice Hall 1993)
Myers Stewart and Nicholas Majluf ldquoCorporate Financing and Investment Deci-sions When Firms Have Information That Investors Do Not Haverdquo Journalof Financial Economics XIII (1984) 187ndash221
Perfect Steven and Kenneth Wiles ldquoAlternative Constructions of Tobinrsquos q AnEmpirical Comparisonrdquo Journal of Empirical Finance I (1994) 313ndash41
Poterba James ldquoComments on Fazzari Hubbard and Petersenrdquo Brookings Pa-pers on Economic Activity (1988) 200ndash04
Rajan Raghu ldquoInsiders and Outsiders The Choice between Informed and ArmrsquosLength Debtrdquo Journal of Finance XLVII (1992) 1367ndash1400
Schiantarelli Fabio ldquoFinancing Constraints and Investments A Critical ReviewrdquoWorking Paper Boston College May 1995
Sharpe Steven ldquoAsymmetric Information Bank Lending and Implicit ContractsA Stylized Model of Customer Relationshipsrdquo Journal of Finance XLV(1990) 1069ndash87
Stulz Rene ldquoManagerial Discretion and Capital Structurerdquo Journal of FinancialEconomics XXVI (1990) 3ndash28
Whited Toni ldquoDebt Liquidity Constraints and Corporate Investment Evidencefrom Panel Datardquo Journal of Finance XLVII (1992) 1425ndash60
APPENDIX FINANCIAL STATUS BY FIRM-YEAR BY SUBPERIOD AND BY ENTIRE PERIOD
Distribution of nancing constraints by year for 49 low-dividend rms from Fazzari Hubbardand Petersen [1988] from 1970 to 1984 Firm nancing constraint status for each year is not nan-cially constrained (NFC) likely not nancially constrained (LNFC) possibly nancially constrained(PFC) likely nancially constrained (LFC) or nancially constrained (FC) For subperiods and entireperiod rms are NFC if rms are not nancially constrained (NFC) every year rms are NC if rmsare not or likely not nancially constrained (NFC or LNFC) every year PFC if rms are possiblynancially constrained (PFC) in some year and FC if rms are likely or denitely nancially con-strained (LFC or FC) in some year
Company 1970 1971 1972 1973 1974 1975 1976 1977
Barry NFC NFC NFC NFC NFC NFC NFC NFCDWG LNFC LNFC LNFC LNFC LNFC LNFC LNFC LNFCDigital
Equipment LNFC LNFC LNFC LNFC NFC NFC NFC NFCFluke LNFC NFC LNFC LNFC LNFC LNFC LNFC LNFCForest Labs NFC NFC LNFC NFC NFC NFC NFC NFCGCA NFC NFC NFC NFC NFC LNFC NFC NFCHelene Curtis LNFC NFC NFC NFC LNFC NFC NFC NFCHewlett Packard LNFC LNFC LNFC LNFC LNFC NFC NFC NFCIroquois Brands LNFC NFC NFC NFC NFC LNFC NFC NFCJames River NFC NFC NFC LNFC NFC NFCNational Semi NFC NFC NFC NFC NFC NFC NFC NFCScientic Atlanta LNFC LNFC LNFC LNFC LNFC NFC LNFC NFCSouthdown NFC NFC NFC NFC NFC LNFC LNFC LNFCThermo Electron NFC NFC NFC LNFC LNFC LNFC NFC NFCTrico LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCWang Labs NFC NFC LNFC NFC NFC LNFC NFC NFCWinnebago LNFC NFC NFC LNFC NFC LNFC LNFC NFCCameron Iron
Works NFC NFC NFC NFC NFC NFC NFC NFCData General NFC NFC NFC NFC NFC NFC NFC NFC
Coachmen LNFC LNFC LNFC LNFC LNFC NFC NFC NFCCoherent LNFC LNFC LNFC LNFC LNFC PFC LNFC PFCCommodore Intl PFC PFC LNFC LNFCNucor PFC PFC NFC NFC NFC NFC NFC LNFCPlantronics NFC NFC NFC NFC NFC NFC NFC NFCTeradyne NFC NFC NFC NFC PFC NFC LNFC LNFCVernitron PFC PFC NFC NFC NFC LNFC NFC NFCWhitehall NFC NFC NFC NFC NFC LNFC LNFC LNFC
Adams Russell LNFC LNFC PFC LNFC LNFC LNFC LNFC NFCAnalog Devices PFC PFC PFC LNFC LFC PFC LNFC NFCApplied
Magnetics LNFC LNFC LNFC NFC LFC PFC PFC FCAydin FC LFC LFC PFC LNFC NFC NFC LNFCChampion Home NFC LNFC NFC PFC FC PFC FC FCColeco LNFC LNFC NFC PFC PFC PFC LNFC FCCompugraphic LNFC LNFC LNFC LNFC LNFC LNFC NFC NFCControl Data LNFC LFC LNFC LNFC LFC LNFC LNFC NFCCordis LNFC PFC LNFC LNFC LFC FC FC LNFCGalveston
Houston LNFC PFC LFC LNFC LNFC LNFC NFC NFCGerber Scientic PFC NFC LNFC LNFC FC LFC LNFC NFCHesston NFC NFC NFC NFC NFC NFC LFC FCIntl Rectier LNFC PFC PFC LNFC NFC LNFC NFC NFCKaty Inds PFC LNFC NFC NFC PFC FC LFC PFCMohawk Data
Sciences NFC LNFC PFC FC FC LFC LNFC LNFCRaychem PFC LNFC LNFC LNFC LFC LFC LNFC LNFCRecognition
Equipment LNFC LNFC NFC FC LFC LNFC LNFC LNFCRockcor NFC LFC LFC LNFC LNFC LNFC LNFC NFCRogers PFC PFC PFC LNFC PFC LFC NFC LNFCSCI Systems LFC LFC PFC LFC LFC LNFC LNFC LNFCTyson Foods LNFC PFC LNFC LNFC LFC LNFC NFC NFCUS Surgical FC LFC LFC LFC PFC PFC NFC NFC
APPENDIX CONTINUED
Overall Overall Overall1970ndash 1978ndash 1970ndash
1978 1979 1980 1981 1982 1983 1984 1977 1984 1984
NFC NFC NFC LNFC LNFC LNFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NC
NFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC NFC NFC NFC NC NC NCLNFC LNFC NFC NFC LNFC NFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC NFC NC NC NCNFC NFC NFC NFC LNFC LNFC LNFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC LNFC LNFC LNFC NFC LNFC NFC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC LNFC LNFC NFC NFC NC NC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC NFC NFC NFC NFC NFC NFC NC NFC NCNFC LNFC NFC NFC NFC NFC NFC NC NC NC
NFC NFC NFC NFC NFC NFC NFC NFC NFC NFCNFC NFC NFC NFC NFC NFC NFC NFC NFC NFC
NFC PFC LNFC LNFC NFC NFC NFC NC PFC PFCLNFC LNFC PFC LNFC LNFC NFC NFC PFC PFC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC NFC NFC PFC NC PFCLNFC LNFC NFC NFC NFC PFC LNFC NFC PFC PFCLNFC NFC NFC NFC NFC NFC NFC PFC NC PFCNFC NFC NFC NFC NFC NFC NFC PFC NFC PFCNFC PFC LNFC NFC NFC NFC NFC NC PFC PFC
NFC NFC NFC NFC NFC LNFC LFC PFC FC FCNFC NFC LNFC NFC NFC NFC NFC FC NC FC
LNFC LNFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLFC LFC LFC NFC NFC NFC NFC FC FC FCFC PFC NFC NFC NFC LFC LFC FC FC FCNFC NFC PFC FC NFC NFC NFC NC FC FCNFC NFC NFC NFC NFC NFC LNFC FC NC FCLNFC NFC LNFC LNFC LNFC LNFC LNFC FC NC FC
NFC PFC LNFC NFC LNFC LNFC LFC FC FC FCNFC PFC NFC LNFC NFC NFC NFC FC PFC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FCNFC NFC NFC LNFC LFC LNFC NFC PFC FC FCPFC LNFC NFC NFC NFC NFC LNFC FC PFC FC
NFC NFC NFC PFC PFC LFC FC FC FC FCNFC NFC NFC NFC LNFC LNFC LNFC FC NC FC
LNFC LNFC NFC PFC FC LNFC LNFC FC FC FCNFC NFC NFC NFC NFC LNFC NFC FC NC FCNFC LNFC LNFC PFC LNFC LNFC NFC FC PFC FCLNFC NFC NFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FCLNFC LNFC LNFC NFC NFC NFC NFC FC NC FC
INVESTMENT-CASH FLOW SENSITIVITIES 215
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