Credit Constraints and Investment-Cash Flow Sensitivities

Abstract

This paper analyzes the investment behavior of firms under a quantity constraint on the amount of external funds which can be raised at a given cost (credit constraints). In this world, investment-cash flow sensitivities decrease in the degree of credit constraints, until a firm becomes effectively unconstrained. This generates a “U-shaped” curve for the relationship between sensitivities and credit constraints. From an empirical perspective, the good news is that we suggest a theoretically consistent way to identify the impact of financial constraints on investment behavior, at least under the condition that financial constraints affect primarily the quantity of credit available to firms. The bad news is that our prediction is in a sense the opposite as the one explored in previous empirical literature.