Financial constraints on investments: A three-pillar approach

• Published in: Research in economics Vol. 55; no. 2; pp. 219 - 254
• Main Authors: Bagella, M., Becchetti, L., Caggese, A.
• Format: Journal Article
• Language: English
• Published: Elsevier Ltd 01-06-2001; Elsevier
• Series: Research in Economics
• Subjects: Financing constraints, firm investment; Financing constraints, firm investment
• ISSN: 1090-9443; 1090-9451
• DOI: 10.1006/reec.2000.0249

Recent theoretical analyses demonstrate how informational asymmetries between financiers and investors may generate credit rationing and positive cost differentials between external and internal financing sources. The traditional empirical approach used to test for the presence of financing constraints at firm level is based on two pillars: a priori identification of relatively more financially constrained firms and econometric estimation of an investment demand function. This approach has been seriously questioned due to several methodological problems. This paper intends to amend it by adding a third pillar: the informational content of direct revelation through qualitative data. The paper estimates a reduced form investment equation following the Euler equation approach, and combines a priori information and direct qualitative information to consistently estimate for each firm the probability of being financially constrained. Our main finding is that when financially constrained firms are properly identified, the neoclassical model is rejected only for unconstrained firms. This indirectly rescues the validity of the Euler equation approach. Moreover, financially constrained firms show a positive correlation between investment and lagged cash flow.