Financial Constraints and the Investment-Cash Flow Correlation

Abstract

A growing body of research has studied the effects of financial constraints on investment. The corporate finance and the investment literature have approached this issue from different angles; they find broadly the same results: financially constrained firms are more sensitive to internal funds in their investment decisions. However, the results hinge crucially on the criteria used to classify firms; furthermore, the relationship between the severity of financial constraints and the investment-cash flow sensitivity need not be monotonic. In this paper, to identify financially constrained firms I suggest a new set of variables, that take into account their opportunity cost of holding cash and how close these firms are to their borrowing limit. I also use some well-established results from the investment literature, such as the role of uncertainty, irreversibility and imperfect competition, to better control for the determinants of investment and thus limit the potential for a spurious relationship with cash flow. For a large sample of mostly unlisted Italian firms that spans twenty years I find that firms that are likely to be constrained have a positive investment-cash flow sensitivity as expected. However, the relationship is not monotonic in the severity of financial constraints: it is high for firms mildly and strongly constrained and low for firms with intermediate levels of financial constraints. I identify a subsample of firms that are able to generate cash flow in order to meet their investment demand and have thus a high investment – cash flow correlation regardless of whether they are financially constrained or not; when I exclude them from the sample the investment – cash flow correlation for the remaining firms is highest for the most strongly constrained firms.