Financial Constraints and Firm Investment

Various studies have found that financial constraints and internal finance play important roles in firm investment decisions. A recent study found that high-credit-worthiness firms were more sensitive to changes in internal cash flow than those of lower-credit-worthiness firms. However, more research is needed to determine whether financial constraints are a causal factor in firm investment decisions. In this article, we examine two alternative hypotheses: the shared sentiment hypothesis and the economic competition hypothesis.

Firm Investment

The shared sentiment hypothesis predicts a positive relationship between public firm misvaluation and private peer investments, while the economic competition hypothesis suggests a negative relationship. We use an exogenous instrument, the price-to-fundamental ratio, to measure misvaluation. The empirical evidence supports the latter hypothesis, and it is robust to alternative growth opportunities. A common explanation for this relationship is that private firms finance their investments with debt to capitalize on misvaluation.

The relationship between financial leverage and firm investment is significant when firm ownership and management are asymmetric. In contrast, the relationship is negative when firms are less liquid and less likely to obtain external financing. Further, a small firm’s sensitivity to debt is a determinant of its ability to get external financing. Despite its importance, however, small firms do not have an advantage over larger ones when it comes to government funding. The lack of adequate legal and financial systems means that smaller firms cannot compensate for their lack of access to external capital.

In contrast, highly credit-worthy firms depend more on internal funds. The Kaplan and Zingales study reveals that the financial constraint of small firms increases the impact of cash flow on their investment than that of larger firms. Thus, these studies suggest that if a firm is underdeveloped, it may not be able to access external funding. In such cases, it would be difficult to attract outside sources of funding. The alternatives are not adequate to fill the void.

External financing is one of the most important factors in firm investment. According to the World Bank, more than 40 percent of firms in developing countries have access to external finance. This type of finance is characterized by several forms, including equity investment, debt, and a large proportion of firms are financed by borrowing through debt. In contrast, less than two percent of firms receive funding from informal sources. The latter is more common in developing countries, while the former has access to little external funding.

The lack of external financing is a major source of a firm’s success. This is because of the insufficient resources to invest. While many government-sponsored programs are designed to support small-scale businesses, it is not likely to help small firms significantly. As a result, they tend to focus on large-scale enterprises. Then, the more funds a firm has to invest, the more it can benefit from it. The more money a firm has, the more likely it is to succeed.