Abstract
We use an alternative model of capital investment to test for the effects of financing constraints and agency costs of free cash flows. This model, derivable from q theory and based on an established body of prior research, specifies capital investment growth as a function of stock returns. Using stock returns removes the measurement problem inherent in Tobin’s q and allows us to directly test the role of markets in investment frictions. We find evidence supporting the existence of financing constraints in that the capital investment growth of the highest financially constrained firms has nearly double the sensitivity to stock returns compared to the least constrained firms. We fail to find evidence supporting the existence of agency costs of free cash flows, even after taking corporate governance into account.
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