Firms investment under financing constraints

Transcription

1 MŰHELYNULMÁNYOK DISCUSSION PAPERS MT-DP 26/6 Firms invesmen under financing consrains A euro area invesigaion ROZÁLIA PÁL - ROMAN KOZHAN INSTITUTE OF ECONOMICS, HUNGARIAN ACADEMY OF SCIENCES BUDAPEST, 26

2 Discussion papers MT-DP 26/6 Insiue of Economics, Hungarian Academy of Sciences KTI/IE Discussion Papers are circulaed o promoe discussion and provoke commens. Any references o discussion papers should clearly sae ha he paper is preliminary. Maerials published in his series may subjec o furher publicaion. Firms invesmen under financing consrains A euro area invesigaion (1) Rozália Pál (2), European Universiy Viadrina, pal@euv-frankfur-o.de Roman Kozhan (3), The Universiy of Warwick, Roman.Kozhan@wbs.ac.uk ISBN ISSN X July 26 1) The paper draws from a projec on financial consrains in he euro area, conduced while Rozália Pál was visiing he European Cenral Bank (ECB). We would like o hank he hospialiy and research suppor of he ECB. The provided commens and suggesions of Brînduşa Anghel Annalisa Ferrando, Francesco Drud David Marqués Ibañez, Marin T. Bohl, Pera Köhler-Ulbrich, Peer Drejer and Marco Lo Duca are graefully acknowledged. The opinions expressed herein are hose of he auhors and do no necessarily reflec hose of he ECB. 2) Corresponding auhor. Posgraduae Research Programme "Capial Markes and Finance in he Enlarged Europe", European Universiy Viadrina, Große Scharrnsraße 59, 1523 Frankfur (Oder), Germany, Phone: , Fax: , pal@euv-frankfur-o.de 3) Warwick Finance Research Insiue, Covenry, CV4 7AL, UK, Roman.Kozhan@wbs.ac.uk Publisher: Insiue of Economics, Hungarian Academy of Sciences

3 Firms invesmen under financing consrains A euro area invesigaion Rozália Pál - Roman Kozhan Absrac In his paper we describe a heoreical model of opimal invesmen of various ypes of financially consrained firms. We show ha he resuling relaionship beween inernal funds and invesmen is non-monoonic. In paricular, he magniude of he cash flow sensiiviy of he invesmen is lower for firms wih credi raioning compared o firms ha are able o obain shor-erm exernal financing. The inverse relaionship is driven by he leverage muliplier effec. A posiive cash flow shock increases he shor-erm borrowing capaciy of he firm, which in urn has a posiive effec on invesmen and firm s growh. Moreover, he leverage muliplier effec is he highes for firms relying on shor-erm credis and i is lower for firms ha are able o obain long-erm financing. Analysing a large euro area daa se we find srong empirical suppor for our heoreical predicions. The resuls also help o explain some conradicory findings in he financing consrains lieraure. JEL classificaion: D92, G3, G32 Keywords: Financing consrains, growh, invesmen, cash flow sensiiviy 3

4 Az eurozóna vállalai beruházásai finanszírozási korláok melle Pál Rozália Roman Kozhan Összefoglaló A dolgozaban elérő finanszírozási korláú vállalaok opimális beruházásának elmélei modelljé muajuk be. Megmuajuk, hogy a belső pénzügyi források és beruházás kapcsolaára adódó összefüggés nem monoon. A hiel-korláos vállalaoknál a beruházások kevésbé érzékenyek a pénzforgalomra, min azoknál a cégeknél, amelyek hozzáférnek rövidávú külső finanszírozáshoz. Az inverz összefüggés a őkeáéeli muliplikáor haás haározza meg. Egy poziív pénzforgalmi sokk növeli a cég rövid-ávú hielfelvéeli korlájá, ami poziívan ha a vállala növekedésére. Továbbá a őkeáéeli muliplikáor haás a rövidávú hielekre szoruló cégeknél a legmagasabb, és alacsonyabb azoknál, amelyek képesek hosszú-ávú hielhez juni. Egy az eurozóna vállalaai lefedő nagyméreű adabázis felhasználó empirikus elemzés eredményei nagyon ponosan egybeesnek az elmélei kövekezeésekkel. Ezek az eredmények hozzájárulnak a finanszírozási korláok irodalma ellenmondásos kövekezeéseinek jobb érelmezéséhez. Tárgyszavak: Finanszírozási korláok, növekedés, beruházás, pénzforgalom érzékenység. 4

5 INTRODUCTION Undersanding he firms invesmen decisions under imperfec marke condiions is one of he cenral issues of he financial economics. Sudying firm s invesmen in such environmen can provide insigh ino he dynamics of is growh as a funcion of inernal and exernal financial sources. Fazzari e al. (1988) argue ha in he presence of financing consrains he firms invesmen varies no only wih he availabiliy of he profiable invesmen projecs, bu also wih he inernal funds. Consequenly, he severiy of he financing consrains is proposed o be measured by he magniude of he cash flow sensiiviy of invesmen. However, here is debae on he inerpreaion of he sensiiviy in he ligh of he financing consrains. Differen conclusions are drawn mosly because of he differen ways of a-priori classificaion in financially consrained and unconsrained groups. Fazzari e al. (1988) consider firms a-priori as consrained if hey pay low dividend payou raio, and hey inerpre he esimaed significan cash flow sensiiviy of his group of firms as an evidence of financing consrains. The lower sensiiviy is aken as an evidence of he less severe financing condiions.1 Kaplan and Zingales (1997) define as financially consrained hose firms ha are in violaion of deb convenans, have been cu ou of heir usual source of credi, are negoiaing deb paymens, or declare ha hey are forced o reduce invesmens because of liquidiy problems. Their classificaion is based on he managers repor on operaions, capial resources and liquidiy (qualiaive informaion) and financial saemens and noes (quaniaive informaion). Conrary o previous resuls, hey documen he highes sensiiviy for leas consrained firms. In a recen sudy, Moyen (24) shows, ha boh resuls can be replicaed wih he help of a simulaed sample jus by changing he a- priori classificaion, however no all of hese a-priori classificaions is able o group firms based on heir rue financing condiions. In his paper we propose an alernaive perspecive o invesigae he relaionship beween financing condiions and he sensiiviy measure. Firs, we argue ha in he real world i is hard o idenify a group of firms in he absence of he financing consrains. Jus considering he exernal relaive o he inernal coss of financing, we could hardly find any unconsrained firm (Kaplan and Zingales (1997)). Consequenly, we focus on he severiy of he consrains insead of is absence or presence. We model he firms cash flow sensiiviy of oal invesmen wih respec o he reliance on he exernal financial marke. Furher on, 1 Supporing resuls wih alernaive classificaions are summarised in he lieraure overview presened by Schianarelli (1995) and Hubbard (1998).

6 we differeniae firms relying mosly on shor-erm credis from hose ha are able o access exernal long-erm sources assuming ha long-erm deb is more preferable for invesmens. Some firms forgo invesmen raher han access capial markes. Consequenly he firm will under-inves relaive o is firs bes level. The reason behind can be diverse, i.e. he firm decides no o ake he credi because of he high cos, managerial agency problem, or no wishing o provide privae informaion on heir projecs o he financing insiuions. Firm s can face he credi raioning resuling from asymmeric informaion, moral hazard, adverse selecion, cosly sae verificaion or low level of angible asses2. Consequenly, we provide a special aenion o such group of firms ha rely exclusively on heir inernal sources, considering hem under he wors financing condiions. Firms wih a financing need (lower cash flow han invesmen value) access exernal financing sources whenever i is possible in order o precede heir invesmen projecs. However he variabiliy in inernal sources, especially a negaive shock, increases no only he likelihood ha a firm will need exernal sources bu is cos as well and a he same ime i also decreases he likelihood o obain i (see Minon and Schrand (1999)). In such case boh borrowing and invesmen became endogenous. An increase in cash flow resuls in a higher borrowing capaciy, which in urn allows for higher invesmen and growh (see also Carpener and Peersen (22) and Almeida and Campello (26)). Consequenly, we expec a higher sensiiviy of levered firms compared o hose relying exclusively on inernal sources. Moreover, we argue ha he leverage muliplier effec associaed wih he endogenous change in exernal credi capaciy following a cash flow shock is he highes for hose consrained firms which need o negoiae each year heir exernal sources. We assume ha firms ha are able o obain longer erm borrowings are he leas consrained or unconsrained firms (despie of some marke imperfecions all of heir posiive ne value projecs can be financed) and a lower cash flow sensiiviy is expeced compared o hose ha are financed by shor-erm borrowings. Their borrowing capaciy is assumed o be deermined by facors less relaed o he curren liquidiy, such as longer-erm credi hisory, sock marke performance, bank-firm relaionship, size, ec. In such case he muliplier effec is reduced or compleely disappears. Sill, he exernal funds could be insufficien for all of heir posiive ne value projecs and each addiional cash flow would have a posiive direc effec on he invesmen and growh. In he opimal case, when inernal and exernal funds are sufficien for all of heir invesmen projecs, invesmen should no vary wih he 2 For heoreical discussion see Sigliz and Weiss (1981), Williamson (1986), Beser (1985), Jaffee and Russell (1976), Sharpe (199). 2

7 inernal funds. Taking ino consideraion boh direc and indirec effecs, he sensiiviy is expeced o be he lowes for his group of firms. We es he predicions of he heoreical model using a euro-area sample. Borrowings from financial insiuions play a special role in he European financial sysem. Firs, conrary o he American sysem, he European financial sysem is more bank han marke oriened3. Privae firms do no have he opion o increase heir capial hrough new issue of shares (around 7% of our sample) and hose lised on he marke rely also on he credis obained from financial insiuions as he priori source4. Second, in line wih he pecking order heory of Myers (1984) and Myers and Majful (1984), only firms, ha are no able o increase heir leverage, issue shares. Our firm classificaion relies on quaniaive informaion aken from balance shees and profis and loss saemens, allowing he reclassificaion of firms financial saus each period. However he final analysis is in a dynamic framework and he firms saus in he whole period is deermined condiional on is yearly changes. We use an error correcion model wih sysem GMM esimaions (Arellano and Bond (1991), Blundell and Bond (1998)). We find srong empirical suppor for our predicions. For firms wih no access o exernal financing sources an addiional euro of inernal finance resuls in less han a euro oal invesmen in fixed and non-cash curren asses. For parially consrained firms, ha have access o exernal financial marke bu wih cerain binding condiions in he sense ha hey are able o obain only shor-erm credi, an addiional euro generaes slighly more han an addiional one euro caused by he leverage muliplier effec. And finally, firms wih available long-erm borrowings face lower invesmen sensiiviy on inernal financing. Considering he classificaions of he previous lieraure, our firs group of firms ha relies exclusively on inernal finance have similar characerisics o hose defined as consrained by he KZ index, Moyen s consrained model and Cleary s index (see Kaplan and Zingales (1997), Moyen (23) and Cleary (1999)). Our resuls are similar o he findings of hese sudies, i.e. firms relying on inernal sources (idenified as consrained) face a lower sensiiviy han hose ha are able o borrow. The lower sensiiviy of long-erm borrowing firms compared o he shor-erm borrowing firms is more in line wih he Fazzari e al. (1988) findings, i.e firms facing higher asymmeric informaion problems and consequenly no able o saisfy he condiions for long-erm borrowing, have higher cash flow sensiiviy. Hence, we presen evidence for he wo conradicory predicions of he lieraure, showing ha hey are more complemenary. 3 In 24, bank loans represened around 9% of he oal deb flows o non-financial corporaions in he euro area. The sock marke capializaion a he end of 23 in Euro Area was 73.4%, which is significanly lower han he US capializaion of 129.6% of GDP (source: World Federaion of Exchanges). 4 For a more deailed descripion of he European financial sysem see Ehrmann e al (21) and Harmann e al. (23). 3

8 The paper is organized as follows. The nex secion presens he relaed lieraure of non-monoonic behaviour of invesmen-cash flow sensiiviy. In Secion 3 he heoreical model is presened. Secion 4 describes he daa and sample selecion. In Secion 5 he empirical es of he heoreical model s predicions is described. Main conclusions are summarised in he final secion. 1. Relaed lieraure On he heoreical basis here is no sufficien condiion for monooniciy in he cash flow sensiiviy wih respec o firms financing condiions. A higher sensiiviy of corporae invesmen o cash flow is no sufficien evidence for more severe financing consrains (see Kaplan and Zingales (1997, 2)). Couple of recen papers presen heoreical models supporing he non-monoonous sensiiviy, however here is less clear way abou is paern, especially on he empirical level. Cleary, Povel and Raih (23) presen a non-monoonic relaionship beween invesmen and cash flow. They show ha firms wih negaive cash flow or zero dividends have he lowes sensiiviy and i is he highes for firms wih moderae cash flow or dividend. For he firms wih he highes cash flow or dividend, which hey considered as unconsrained, a lower sensiiviy is esimaed. Boyle and Guhrie (23) presen a dynamic model of invesmen disored by cosly exernal financing. They look a he relaionship of invesmen iming and financing consrains showing ha financing consrains can no only discourage invesmen, bu also accelerae i, resuling in sub-opimal early invesmens. More imporanly, an increase in cash has a smaller posiive effec on he invesmen for consrained firms wih low-cash han i does for consrained firms wih high-cash. Dasgupa and Sengupa (22) invesigae wih he help of a muli-period version of a sandard moral hazard model he case when he firms have he opion o allocae heir liquidiy ineremporally. Their resuls differ from he previous wo sudies. They argue ha he responsiveness of invesmen o changes in liquidiy is he highes for low liquidiy firms, he leas for inermediae liquidiy firms and inermediae for he high liquidiy firms. However, Moyen (23) shows ha he value of cash flow, jus as he dividend payou raio used for a- priori classificaion is no appropriae o disinguish firms facing differen financing condiions. Moyen (23) compares he dynamic model of unconsrained relaive o consrained firm. The caegories of consrained-unconsrained firms are defined based on heir access o exernal financial markes where only unconsrained firms can issue deb. They predic a higher invesmen cash-flow sensiiviy of unconsrained firm. They explain he higher sensiiviy by he effec of deb financing on invesmen ha is no aken ino accoun by he 4

9 regression specificaion. Carpener and Peersen (22) provide also a heoreical model for he leverage muliplier effec. They show ha he leverage effec occurs when firms access o deb depends on he collaeral and each addiional dollar of inernal finance should generae slighly more han one addiional dollar of growh. Similar o his explanaion, Almeida and Campello (26) develop a heory explaining ha sensiiviies will decrease wih financial consrains, so long as firms are no enirely unconsrained. They explain he decreasing sensiiviy by he cash flow borrowing capaciy. They show ha invesmen-cash flow sensiiviies are increasing in he degree of angibiliy of consrained firms asses and for enirely unconsrained firms he invesmen-cash flow sensiiviies drop o zero. This implies ha he relaionship beween capial spending and cash flows is non-monoonic. Our resuls are in line wih he Carpener and Peersen (22) and Almeida and Campello (26) heoreical model predicions. Since Almeida and Campello (26) show ha he muliplier effec is increasing wih projec s angibiliy, we show ha such muliplier effec depends on he ype of borrowing. We conribue o he lieraure of non-monoonic sensiiviy, by differeniaing he shor versus long-erm borrowing firms. The endogenous muliplier effec increases he sensiiviy of shor-erm borrowing firms relaive o hose ha rely exclusively on inernal financial sources. However, for hose firms ha are able o ge long-erm financing, he borrowing capaciy is less dependen on he curren cash flow shocks, bu raher on he long-erm firm characerisics, like credi hisory, size, bank-firm relaionships, ec. In his case he indirec effec of cash flow on invesmens is less significan or even disappears. In addiion, he direc effec of cash flow is expeced o be less significan, since firms are able o make he long-erm invesmen plans relying on long-erm borrowings, weakening he reliance of invesmen and growh on inernal financing. The non-monoonic relaionship of he heoreical lieraure relies parially on he exisence of he oally unconsrained firms. Conrary o simulaed sample, where unconsrained firms by definiion have zero sensiiviy, in real world none of he firms operae in perfec marke condiions. The non-monoonic relaionship derived in his paper is independen of he presence of he oally unconsrained firms. THEORETICAL MODEL In order o discuss he invesmen-cash flow sensiiviy in he ligh of financial consrains le us define several ipes of consrained firms. As i was already menioned before, i is quie difficul o find in he real world a group of oally unconsrained firms. I looks more reliable o deermine he degree of he financing consrains based on he accessibiliy o differen ypes of exernal financial sources. A firm is assumed o be absoluely consrained if i canno 5

10 issue any debs and is inernal sources are no enough o cover he opimal invesmen value (a firm wih higher sources han he opimal invesmen is unconsrained). We consider a firm o be parially consrained if i has no possibiliy o issue long-erm debs bu can rely on he shor-erm credis. And leas consrained firms are hose able o issue debs wih long-erm mauriy. The long-erm borrowings is always preferable relaive o shor-erm borrowings for he financing a long erm projecs. We consider he model wih a firm which is going o finance a long-erm projec (wo periods in his conex). The projec s invesmen sars a ime and a he end he second period he firm collecs he revenues F( I ), where he producion funcion F : R + R + is '' ' wice differeniable sricly concave (i.e. F < ) and increasing ( F > ).There are wo alernaive sources of financing: inernally, using he cash flow (CF) and exernally, borrowing funds (D) from crediors. We also assume ha he firm canno inves ino he projec he whole amoun of he cash flow. For liquidiy reasons i savesα CF, where α < 1, under he form of cash or highly liquid asses. Le us consider now he invesmen policies of he unconsrained and our hree ypes of consrained firms. Unconsrained firms wih sufficien inernal sources: The opimal invesmen can be calculaed as he soluion of he profi maximizaion problem. I F I ) I max, I (1 ) CF. ( α This implies ha he opimal invesmen of he firm is = ( F problem ) * ' 1 (1) F( I * I l = I if * I CF, where 1 α is he firs-bes invesmen he soluion of he unconsrained maximizaion ) I max. In his case we implicily suppose ha he firm can issue debs bu i does no do so because i has enough inernal sources o finance is projec. The cash flow sensiiviy of he invesmen under no financing consrains is: Sens u I u = CF = I. Absoluely consrained firms: Inernal sources are no sufficien, i.e. is cash flow available for invesmen is less han he firs bes invesmen, ( 1 α) CF < I *. This group of firms canno issue any debs. The profi funcion F( I I is increasing on he inerval ) (, I * ) (see Figure 1) and he maximizaion problem of his ype of firm can be wrien as: F( I ) I I (1 α) CF max, 6

11 Is soluion for he amoun of invesmen is: flow sensiiviy is: I a = (1 )CF, and he invesmen-cash α Sens a I = = 1 α < 1 CF a. II. Parially consrained firms: The insufficien inernal sources, * I CF <, can be 1 α compensaed by he issue of shor-erm debs. Firms financed by shor-erm debs need o renegoiae is credi conracs a ime 1 or o find anoher credi in order o pay he financial obligaions. We assume ha he negoiaion coss are fixed and smaller han he saved amoun of cash, α CF, so hese reserves can be used a ime 1 for conrac renegoiaion. We assume ha borrowing capaciy is a funcion of he projec angibiliy (see also Carpener and Peersen (22) and Almeida and Campalo (26)). The projec can be liquidaed a ime 1 and is liquidaion value is equal o qi, wih q < 1. Due o he risk of he projec s defaul he bank is no going o lend more han he liquidaion value of he projec plus he cash savings of he firm. In his case he firm is faced wih a deb consrain of he form: D α CF + qi. We assume ha he maximum oal financing of he shor-erm firm * ( 1 α) CF + Dmax < I and he profi funcion F(I ) I is increasing on he inerval (, I * ). When * I = I, he firm is assumed o have an infiniely elasic borrowing and consequenly ener he caegory of leas consrained firms (III). The maximizaion problem of he parially consrained firms is: F( I I ) I max, (1 α ) CF + D, D αcf + qi We conclude ha he opimal invesmen for he parially consrained firms is and he invesmen-cash flow sensiiviy of his ype of firm equals: Sens I 1 = > 1 1 q p p =. CF I p CF = 1 q III. Leas consrained firms: Firms wih available long-erm debs do no face he problem of renegoiaion risk and do no pay he fixed coss of he credi conrac a ime 1. For his ype of firms he borrowing capaciy is assumed o be less dependen on he projec angibiliy, bu raher on oher characerisics, like size, firms angibiliy, credi hisory, 7

12 quoaion on he sock marke or bank-firm relaionships. Technically, we assume ha: B( CF) = q < q. CF Thus, he leas consrained firm solves he maximizaion problem: F( I I ) I (1 α ) CF + D, D B( CF). max, * The opimal invesmen I l * = if ( 1 α) CF + B( CF) I (he global maximum I * I of he funcion F( I I lies wihin he consrain inerval (,(1 α ) CF + B( CF)) and ) = (1 α) CF + B(CF) I l if ( 1 α) CF + B ( CF) < I flow sensiiviy of he leas consrained firms firm can be described as: *. Hence, he opimal invesmen-cash Sens l l I = CF, (1 α) CF + B( CF) I = 1 α + q, oherwise. *, In summary we can conclude ha Sens absoluely c. < Sens parially c. > Sensleas c., i.e. he parially consrained firms are expeced o have always he highes sensiiviy. Firms relying on he long-erm debs are expeced o have he lowes sensiiviy, however i depends on he percenage of firms ha are able o finance all of heir posiive ne value projecs wih he help of exernal financing. Our model shows a non-monoonic invesmen-cash flow sensiiviy wih respec o financing consrains even in he case when all firms faces some under-financing problem (he direc effec of cash flow on invesmen is always presen for he companies wih underfinanced projecs). DA SAMPLE CONSTRUCTION We use a comprehensive daabase of euro area firms colleced from he AMADEUS daabase of Bureau van Dijk. Amadeus conains financial informaion on abou 2.6 millions privae and publicly owned firms across euro area counries. Daa is creaed by collecing sandardised daa received from vendors of each European counry. In addiion o financial 8

13 informaion, he 4-digi NACE code, which is he European sandard of indusry classificaion, is also given. We selec for our sudy only hose firms ha provide he consolidaed balance shees resuling in a sample of abou 26, firms. The consolidaed annual accouns are seleced because hese are considered o be he mos suiable forma for providing informaion abou he financial siuaion of he paren company since he rue financial boundaries of firms are a group level and no a individual plans. I akes in consideraion he financial ineres and he ne asses owned by he paren in subsidiaries ha will conribue o fuure earnings and dividends. Addiionally, he consolidaed accouns make our sudy more comparable across he resuls of he previous lieraure. The ime period covered is , however we exclude he firs four years because of he poor coverage and an addiional year is los by consrucing he variables of ineres as he firs difference of he balance shee iems. We exclude firms operaing in financial services indusries (Nace code 65 and 66) because heir financial raios are no comparable o hose of non-financial companies. In addiion, we drop several counry-specific indusries, like he Agriculure (Nace code 1), Foresry (Nace code 2), Fishing (Nace code 5) and Mining (Nace code 1-14) indusry secors. Finally, we drop he governmen/public secor, Educaion, Healh and social secor, Aciviies of organizaions, privae households and exra-erriorial organizaions, and firms ha canno be classified (NACE codes 75, 8, 85, 91, 92, 95 and 99). The seleced sample consiss of 15,145 firms wih 69,136 observaions. We apply several qualiy checks on he daa. Only hose firms are seleced ha provide informaion on he oal asses and sales. The sample size is furher reduced afer checking he repored balance-shee iems of seleced firms o be posiive and ha he sum of he subcaegories of a balance-shee iem no o differ more han 5% from he repored value of he iem. Finally, we exclude firms ha are inacive. We apply a 1% rimming of he variables of main ineres: logarihm of oal asses, oal asses growh, sales growh, oal invesmen, cash flow o beginning of period oal asses and shor/long erm borrowings o he beginning of year oal asses. We reain only hose firms ha repor daa for, a leas, hree consecuive years. The main sample consiss of 5,131 firms wih 31,499 observaions (for a deailed sample selecion see he appendix). Amadeus is especially useful because of is large coverage of boh public and privae firms (8% of oal sample), however i faces some limiaions. The coverage varies across euro area counries reflecing he peculiariies of European accouning legislaion and is heerogeneiy across counries. For example, Greece firms do no provide consolidaed iems and daa on Irish firms were filered ou by he qualiy conrols due o he low coverage. Ausrian and Luxembourgian firms have a very low coverage. The Neherlands and Finland are over-represened due o sauory reporing requiremens of he consolidaed saemens. 9

14 Counries such as France, Ialy and Spain are well covered by he sample (for a deailed cross-counry coverage of he sample see he appendix). FIRMS CLASSIFICATION While here is a consensus o consider financially consrained firms hose ha face difficulies in obaining exernal finance, here is no clear way how o idenify hese firms a- priori and he poserior sensiiviy measures are influenced by he alernaive a-priori classificaion. Jus as Kaplan and Zingales (1997) argue, he definiion of financial consrains is based on he cos of inernal and exernal financing is he mos precise one bu also he broades as well. Based on his definiion almos all firms can be classified as consrained, jus considering he ransacion coss of exernal finance. However here is a significan difference among firms wih respec o heir accessibiliy o exernal financing, which in urn affecs heir corporae invesmen policy and growh. Our classificaion does no measure he inernal relaive o exernal coss bu i capures cross-secional differences in financing condiions defined as he availabiliy of he exernal financial sources. Since all firms face he imperfec marke condiions on some degree we propose a new classificaion insead of he radiional consrained-unconsrained classificaion. We idenify hree differen ypes of firms: I.) firms relying mosly on inernal financial sources noed as absoluely consrained firms, II.) firms relying on shor-erm exernal sources wih mauriy less han one year, noed as parially consrained, and III.) firms relying on exernal financial sources in form of long-erm borrowings wih mauriy above one year, considered as he leas consrained firms. We classify firm-years in he firs caegory, only when here is a sign of consrains, i.e. despie of he financing needs (higher invesmen value han curren cash flow) firms canno ge exernal sources and hey need o use he cash savings from he previous periods or o liquidae is asses. We assume ha firms wih long-erm projecs would always prefer long-erm insead of shor-erm borrowings because of he addiional renegoiaion coss and renegoiaion risk of he shor-erm financing. Moreover, firms wih higher borrowing coss end o use less exernal finance han firms under favourable condiion. The long-erm borrowing firms obain he credis under beer condiions, jus if we consider he fixed cos of credi renegoiaion. We are no able o deermine, wheher firms wih long-erm borrowings are able o finance all of heir posiive ne value projecs bu we can expec o be closer o he opimal invesmens han firms belonging o he oher wo groups and we can consider hem he leas consrained firms. Table 1 summarizes he crieria used in he classificaion and he cross-groups firm-years disribuion. 1

15 [Inser Table 1 here] Afer having classified each observaion we apply a dynamic view of consrains. For his, we look a he characerisics o be presen for minimum of hree consecuive years and in he mos of he available years of he given company (oal number of years divided by wo plus one). In order o classify a firm as absoluely consrained, minimum of hree consecuive years should use only inernal financial sources despie of he financing need or hey liquidae heir asses. Our sample is an unbalanced sample of firms and since 3 years of consrained years could be followed by 7 years of unconsrained years, for he firm classificaion we give he addiional condiion ha he majoriy of is firm-years should be absoluely consrained. This means ha he number of consrained years should be more han he oal number of available years of he given firm divided by wo (in case of maximum available of 1 years, in a minimum of 6 years he firm should be absoluely consrained). The firm is considered as parially consrained, if minimum of hree consecuive years and in majoriy of is available years was caegorised as parially or absoluely consrained. The leas consrained firms are hose ha are no included in he previous wo caegories and consequenly for such firms he financial consrains do no persis for more han half of he available years and less han 3 consecuive years. The final oucome of he classificaion is presened in Table 2 and he regression analyses are based on his dynamic firm classificaion. [Inser Table 2 here] EMPIRICAL TEST To gain some firs insigh ino he firms characerisics and heir financing condiion, key characerisics of firms of he hree groups are repored in Table 3. Differences in mean values of he variables among he firm-groups are esed based on he saisic. [Inser Table 3 here] The firs variable presened in Table 3 indicaes ha firms ha rely more inensively on exernal financial sources are in general larger. The growh of oal asses (2 nd variable) is significanly higher for he firms wih financial deb. Less risky firms ge beer financing, 11

16 hus have less impedimen in heir growh. This relaionship is imporan wih respec o one of he main criics addressed o he sensiiviy measure. Previous sudies emphasize ha he magniude of he sensiiviies, which should measure he presence of financing consrained is acually reflecing fuure invesmen opporuniies and i is higher for growing firms (see Ericson and Whied (2), Ali (23), Bond e al. (24)). Thus he cash flow sensiiviy could reflec he fuure invesmen opporuniy, no efficienly capured by oher proxies like Tobins Q or sales growh. If he hidden invesmen opporuniies would rule he invesmencash flow sensiiviy of our sample, we should esimae a monoonic increase in sensiiviy from absoluely o leas consrained firms. If here is any disorion caused by fuure invesmen opporuniy, his would resul in a higher increase of sensiiviy of leas consrained firms. A higher growh of less consrained firms is documened also by Cleary (1999) and Whied and Wu (24). They classify firms based on he dividend cus and an index measuring he shadow cos associaed wih raising new equiy (he cos of exernal finance relaive o inernal finance), respecively. The significanly higher sales growh (3 r variable) of less consrained firms could be specific for he euro area firms. The euro area of he given period is characerised by a progress owards inegraion of financial sysem, no only in he area of money markes bu also in bond markes, equiy markes and banking. Relaed policy iniiaives provide he opporuniy for boh new- and well-esablished firms o new direcions of developmen. 5 This means ha possible invesmen projecs are above he inernal financial sources and any addiional exernal financing is able o increase heir produciviy and sales. Mizen and Vermeulen (25) sugges using sales growh as a-priori classificaion crieria for some European firms, since he high sales growh could be an indicaor of financial healh and fuure profiabiliy ha opens up access o exernal finance. The lower cash flows (4 h variable) of absoluely consrained firms confirm our assumpion ha he negaive or zero borrowings are caused by he difficulies in obaining exernal sources and no he excess cash flow. The yearly changes in he amoun of shorand long-erm credis (5 h and 6 h variables) are he proxies of he new exernal sources used as a classificaion crieria and he mean values reflec he oucome of he firms classificaion. More imporanly, he leverage (7 h variable) is higher for less consrained firms, indicaing ha firms do no rely on exernal financial sources in general, and no only in he analysed sample period. The lower leverage of he more consrained firms is in line wih he findings of Faulkender and Peersen (23). They argue ha he availabiliy of incremenal capial depends on he risk of he firm s cash flows and characerisics of he firm. Consequenly, 5 For a more deailed descripion of he euro area financial srucure inegraion see Harmann, Maddaloni and Manganelli (23). 12

17 firms wih barriers o some exernal sources are under-levered. The unconsrained firms simulaed by Moyen (24) ake on also more deb han consrained firms since hey can respond o income shocks by varying heir deb level. Based on he leverage (7 h variable) and he proxy for he cos of credis (8 h variable) we find ha less consrained firms despie of he higher leverage face lower financing coss. The bankrupcy cos of leverage suggess a posiive relaionship, in he sense ha higher leverage increases he bankrupcy risk and he higher risk should be compensaed by higher ineres. However, reliable, less risky firms should be able o increase heir leverage wih lower coss. Our daa sugges ha on he one hand, firms wih long-erm borrowing are less risky firms and consequenly hey are able o increase heir leverage wih lower cos. On he oher hand, firms wih shor-erm borrowings and relying mosly on heir inernal sources (absoluely consrained) are under-levered. Absoluely consrained firms pay he highes cos for he credi obained prior he period under consideraion and his could likely be he reason why hey do no ake any furher credi obligaions. The principal specificaion ha we use o es he predicion of he invesmen-cash flow sensiiviy of he seleced hree ypes of firms is an error correcion model and i is as follows: Inv 1 δ D j Inv = δ + δ 1 year + δ D k 1 i 2 indusry + δ + 2 CF 1 δ D l + δ log S 3 counry + ε i + δ 4 [(log Asses.8 log Sales ] (1), where he dependen variable is he oal invesmen of he firm i a ime, measured as he change in fixed and non-cash curren asses plus depreciaion divided by he beginning of period oal asses. Toal invesmen includes besides he fixed invesmens he invesmen in curren asses. Hence, he sensiiviy is no affeced by he emporary flucuaions of he invesmens hrough he draw down of working capial (see Carpener and Peersen (22)). CF denoes he curren cash flow calculaed as he profi for he period (profi afer ax plus exraordinary profi) plus depreciaion and log Sales i, is he firs difference of he logarihm of sales, he proxy for firms invesmen opporuniies. The regression is conrolled for ime-, indusry- and counry- effecs by inclusion of he corresponding dummy variables, D, D, and D respecively and year indusry counry ε is a random disurbance. Since we focus on boh public and privae firms (for which he marke value is no available), he expeced profiabiliy is conrolled, insead of he Tobin s Q, by curren sales growh, specific o he error correcion models used by previous lieraure (see for insance Bond e al. (24), Fuss and Vermuelen (24)). The sales growh, jus as he cash 13

18 flow - relaive o he Tobin s Q - can capure relaively more new informaion obained wihin he year abou he running projecs of he firm based on which he manager decides abou he new invesmen and revise he arge capial sock accordingly (for heoreical model see Ali (23)). Esimaing he dynamic srucure of he growh, he lag value of he dependen variable is also used as an explanaory variable. In addiion, he model includes he error correcion erm, based on he esimaed long-erm relaionship among sales and non-cash oal asses. Table 4 presens he mean, median, sandard deviaion, minimum and maximum values of he variables used for he regression. The median firm has a yearly invesmen represening 1% of he beginning of year oal asses, which drops o 5% for absoluely consrained firms. The median firm has a cash flow of 9% of he beginning of period oal asses and a sales growh of 6%. The annual growh of ne working capial couns on average 1.2% of he oal asses. Mean and median values do no differ significanly and he minimum and maximum values sugges ha none of he coefficien esimaes of he regressions can be influenced by he presence of ouliers. [Inser Table 4 here] Based on he heoreical model, he quaniaive predicions of he cash flow sensiiviy of absoluely consrained firms is less han one. The only source of financing is represened by cash flow; however a par of i is reoriened o precauionary cash savings or credi repaymens. For parially consrained firms he sensiiviy is expeced o be slighly higher han one resuling from he leverage muliplier effec. And finally, for he leas consrained firms a lower cash flow coefficien is expeced, caused by he favourable financing conrac less dependen on curren cash flow shocks (indirec effec) and by he possibiliy ha all long-erm invesmen projecs of he firm are covered by he available financial sources (direc effec). In Table 5 he regression resuls of he wo-sep sysem GMM esimaes are presened. The -saisics are repored in parenhesis. Firm-specific effecs are firs removed by calculaing he firs differences specific o he GMM esimaion. The hird lagged values of endogenous variables are valid insrumens since here is no serial correlaion in he imevarying componen of he error erms of he equaion. This condiion is me, since he es for serial correlaion in he firs difference residuals is rejeced based on he es for secondorder auocorrelaion (he firs-order auocorrelaion is expeced due o model specificaion). 14

19 The validiy of he used insrumens is also acceped based on he Hansen es of overidenifying resricions. [Inser Table 5 here] In each of he hree samples he cash flow coefficien is saisically significan and i srongly suppors he quaniaive predicions of he model. The poin esimae for cash flow in he case of absoluely consrained firms is.96. For he parially consrained firms he cash flow coefficiens of 1.15 is consisen wih he presence of he leverage muliplier effec. And for he leas consrained firms he cash flow coefficien is again lower, wih he poin esimaes of This lower coefficien is consisen wih he models predicion ha he beer credi conracs should reduce he invesmen dependence on inernal finance. The coefficien of he sales growh is highly significan for leas consrained firms and significan under 5% confidence level for he parially and absoluely consrained firms. The negaive coefficien of he lagged dependen variable, however no saisically significan, suggess a mean-reversion of he invesmen rae. The error correcion erms are negaive as expeced, however no saisically significan. As a robusness es we use an alernaive specificaion for he error correcion erm and re-esimae he equaion 1. The error correcion erm ( Er. Correcion esimaed residuals of he equaion: log α + β log Sales + γ i + ε _ erm ) is he firs lagged = (2), where log and refer o he logarihm of oal asses and sales. i, log Sales i, γ and i represen he firm fixed effecs and a random disurbance, respecively. Resuls are presened in Table 6. The cash flow sensiiviy of invesmen has he same paern as in he case of previous esimaion, wih higher coefficien for parially consrained firms of The coefficien of absoluely and leas consrained firms is abou.95. The coefficiens of he error correcion erms is higher, given ha he value of he esimaed residual is lower han he asses-sales difference, however saisically sill no significan. We can conclude ha using alernaive error correcion specificaion our main resuls of he cash flow sensiiviy is no affeced. ε 6 The magniude of he sensiiviy is higher han hose presened in mos of he financing consrains lieraure. This is simply caused by he fac ha our dependen variable is he invesmen in oal asses insead of he invesmen in fixed asses. The magniude of he coefficien is more comparable wih he resuls presened by Carpener and Peersen (22), using he firm s growh as a dependen variable. 15

20 [Inser Table 6 here] CONCLUSIONS In his paper we develop a heoreical model ha makes quaniaive predicions abou he magniude of he cash flow-invesmen sensiiviy in he ligh of financing consrains. Relying on a sample of more han 5, euro area firms we documen a non-monoonic invesmen-cash flow sensiiviy, which srongly suppors he model s predicions. The explanaion for he higher sensiiviy of parially consrained firms relaive o he absoluely consrained is wofold. Firs, only a par of inernal sources is invesed, since here is a need of precauionary cash savings for liquidiy reasons. Second, invesmens increase he borrowing capaciy of he firm, so he amoun of credis depends also on cash flow shocks. Through his indirec leverage effec, an addiional dollar of inernal finance will generae slighly more han an addiional dollar of oal invesmen. These findings are in line wih he amplificaion effec of Almeida and Campello (26) and he leverage effec presened by Carpener and Peersen (22) and Moyen (24). Moreover, we idenify a group of leas consrained firms among he firms relying on exernal financial marke, for which he sensiiviy is lower han hose wih less favourable credi conracs (only shor-erm borrowings are available). Firms are defined as leas consrained if hey are able o borrow long-erm wihou requiring he perfec marke condiions. We find evidence ha he favourable financing conracs are less dependen on curren cash flow shocks (indirec effec) and/or some of hese firms are able o finance all of heir posiive ne value projecs wih he help of exernal financing (direc effec). The non-monoonic relaionship of he heoreical lieraure relies parially on he exisence of he oally unconsrained firms. Conrary o he simulaed sample, where unconsrained firms by definiion have zero sensiiviy, in real world none of he firms operaes in perfec marke condiions. The non-monoonic relaionship derived in his paper is independen of he presence of he oally unconsrained firms. We provide boh heoreical and empirical evidence for he non-monoonic invesmen-cash flow sensiiviy from a new perspecive. The esimaed cash flow sensiiviy of invesmen led us o conclude ha financing condiions may deermine invesmen and growh of he European firms. 16

21 REFERENCES Almeida, Heior and Murillo Campello, 26, Financial consrains, asse angibiliy, and corporae invesmen, NBER Working Paper No Al Aydogan, 23, How sensiive is invesmen o cash flow when financing is fricionless? Journal of Finance 58, Arrelano, Manuel and Sephen Bond, 1991, Some ess of specificaion for panel daa: Mone Carlo evidence and an applicaion o employmen equaions, Review of Economic Sudies 58, Beser, Helmu, 1985, Screening versus Raioning in Credi Markes wih Imperfec Informaion, American Economic Review 75, Blundell, Richard and Sephen R. Bond, 1998, Iniial condiions and momen resricions in dynamic panel daa models, Journal of Economerics, 87, Bond, Seve, Alexander Klemm, Rain Newon-Smih, Muraza Syed and Gerjan Vlieghe, 24, The roles of expeced profiabiliy, Tobin s Q and cash flow in economeric models of company invesmen, The Insiue for fiscal sudies, working paper No. 4/12. Boyle, Glenn W. and Graeme A. Guhrie, 23, Invesmen, uncerainy, and liquidiy, Journal of Finance 58, Carpener, Rober, and Bruce C. Peersen, 22, Is he growh of small firms consrained by inernal finance?, The Review of Economics and Saisics,84, Cleary, Sean, 1999, The relaionship beween firm invesmen and financial saus, The Journal of Finance 54, Cleary, Sean, Paul E. M. Povel and Michael Raih, 24, The U-shaped invesmen curve: heory and evidence, Working Paper, CEPR. Dasgupa, Sudipo and Kunal Sengupa, 22, Financial consrains, invesmen and capial srucure: Implicaions from a muli-period model, Working Paper, Hong Kong Universiy of Sience and Technology. Ehrmann, Michael, Leonardo Gambacora, Jorge Marinéz Pagés, Parick Sevesre and Andreas Worms, 21, Financial sysems and he role of banks in moneary policy ransmission in he euro area, ECB working paper No. 15. Ericson, Timohy and Toni Whied, 2, Measuremen error and he relaionship beween invesmen and Q, Journal of Poliical Economy 18, Faulkender, Michael and Michell A. Peersen, 23, Does he source of capial affec capial srucure?, NBER working paper No Fazzar Seven M., R. Glenn Hubbard, and Bruce C. Peersen, 1988, Financing consrains and corporae invesmen, Brookings Paper on Economic Aciviy 1, Fuss, Caherine and Philip Vemeulen, 24, Firms invesmen decisions in response o demand and price uncerainy, ECB working paper No Harmann, Phillip; Angela Maddaloni and Simone Manganell 23, The Euro Area financial sysem: Srucure, inegraion and policy iniiaives, ECB working paper No. 23. Hubbard R. Glenn, 1998, Capial marke imperfecions and invesmen, NBER working paper No Jafee M. Dwingh and T. Russell, 1976, Imperfec Informaion, Uncerainy and Credi Raioning, Quarerly Journal of Economics XC,

22 Kaplan, Seven N., and Luigi Zingales, 1997, Do invesmen-cash flow sensiiviies provide useful measures of financing consrains?, Quarerly Journal of Economics 112, Kaplan, Seven N., and Luigi Zingales, 2, Invesmen-cash flow sensiiviies are no valid measures of financing consrains, Quarerly Journal of Economics 115, Minon, Bernadee and Chaerine Schrand, 1999, Does Cash Flow Volailiy Affec Firm Value: Is Impac on Discreionary Invesmen and he Coss of Deb and Equiy Financing, Journal of Financial Economics 54, Mizen, Paul and Philip Vermeulen, 25, Corporae invesmen and cash flow sensiiviy. Wha drives he relaionship? ECB Working paper No Moyen, Nahalie, 24, Invesmen-cash flow sensiiviy: consrained versus unconsrained firms, Journal of Finance 59, Myers, Sewar C., 1984, The capial srucure puzzle, Journal of Finance 39, Myers, Sewar C. and Nicholas S. Majful, 1984, Corporae financing decisions when firm have invesmen informaion ha invesors do no have, Journal of Financial Economics 13, Schianarell Fabio, 1995, Financial consrains and invesmen: a criical review of mehodological issues and inernaional evidence, Boson College working paper. Sharpe, S., 199, Asymmeric Informaion, bank lending and implici conracs: A Sylised model of cusomers relaionships, Journal of Finance 45, Sigliz, J. and A.Weiss, 1981, Credi raioning in markes wih imperfec informaion, American Economic Review 71, Whied, M. Toni and Guojun Wu, 24, Financial consrains risk, Review of Financial Sudies 14, Williamson, S., 1986, Cosly monioring, financial inermediaion, and equilibrium credi raioning. Journal of Moneary Economics 18,

23 Table 1. Financing condiion (% from oal) Firm-years classificaion Toal invesmen Financing gap Changes in Longerm deb Changes in Shorerm deb Firm-years financed by inernal capial (I.) 1. (1%) 2. (19%) < - Firm-years financed by shor-erm exernal capial (II.) 1. (8%) < < - 2. (24%) > 3. (3%) < - > - Firm-years financed by long-erm exernal capial (III.) 1. (2%) < - 2. (16%) > - Table 2. Firms classificaion Final oucome Absoluely consrained firms (I.) Parially consrained firms (II.) Leas consrained firms (III.) No. of observaion ( firm-years) No. of firms % of firms 6,79 1,112 21% 17,266 2,767 54% 7,524 1,252 25% 19

24 Table 3. Summary saisics Variables Mean Median Sd. Dev. P-value P-value ( I. = II.) ( II. = III.) 1. Firms size (logarihm of oal asses).. I II III Firms oal invesmen o beginning of year oal asses.. I II III Sales growh.. I II III Cash flow o he beginning of year oal asses.. I II III Obained long-erm credi o he beginning of period oal asses.. I II III Obained shor-erm credi o he beginning of period oal asses..23 I II III Leverage (oal deb o oal asses).. I II III Cos of credi (ineres paymens o oal deb).. I II III Noe: Firms oal invesmen is calculaed as invesmen in fixed and curren asses plus depreciaion. Cash flow is defined as profi for he period plus depreciaion. Sales growh is calculaed as he firs difference of he logarihm of annual sales. The obained credis are calculaed as he yearly change of he financial deb. Ineres paymens include all ineres paid and similar charges in he given year. We assign he leer I. for absoluely consrained firms, II. for parially consrained firms and III. for he leas consrained firms. We es he hypohesis ha he mean value of variables of one group is no significanly differen across firm groups using a -es. P values of -es are presened in he las wo columns. 2