Endogenous Financial Constraint and Investment‐Cash‐Flow Sensitivity

Published date01 November 2018
Date01 November 2018
DOIhttp://doi.org/10.1111/fire.12165
The Financial Review 53 (2018) 773–792
Endogenous Financial Constraint and
Investment-Cash-Flow Sensitivity
Rui Li
University of Massachusetts Boston
Abstract
This paper studies a dynamic investment model with moral hazard. The moral hazard
problem implies an endogenous financial constraint on investment that makes the firm’s
investment sensitive to cash flows. I show that the production technology and the severity
of the moral hazard problem substantially affect the dependence of the investment-cash-
flow sensitivity on the financial constraint. Specifically, if the production technology exhibits
almost constant returns to scale in capital or the moral hazard problem is relatively severe,
the dependence is negative. Otherwise, the pattern is reversed to some extent. Moreover,
the calibrated benchmark model can quantitatively account for the negative dependence of
investment and Tobin’s Qon size and age observed in the data.
Keywords: dynamic moral hazard, financial constraint, investment-cash-flow sensitivity
JEL Classification:G30
1. Introduction
The literature documents a significant correlation between firms’ investments
and their cash flow after controlling for Tobin’s Q, which contradicts the traditional
Corresponding author: College of Management, University of Massachusetts Boston, 100 Morrissey
Boulevard, Boston, MA 02125; Phone: (617) 287-3182; E-mail: abclirui@gmail.com.
I thank Hengjie Ai, Kyoung Jin Choi, Felix Feng, and Noah Williamsfor their invaluable comments. I also
thank the Editor, Professor Richard Warr, and the anonymous reviewer for their constructive suggestions
on the paper. Any remaining errors are mine.
C2018The Eastern Finance Association 773
774 R. Li/The Financial Review 53 (2018) 773–792
Qtheory in a frictionless economy. People attribute this investment-cash-flow sen-
sitivity to the firm’s financial constraint on investment implied by various frictions.
The subject of research over the past several decades studies the dependency of
investment-cash-flow sensitivity on the tightness of the financial constraint. Under-
standing this dependence enables us to see whether this sensitivity is a quantitative
measure of the financial constraint, which substantially affects firm behavior but is
difficult to observe.However, researchers obtain mixed results about this dependence.
For example, Fazzari, Hubbard and Petersen (1988) and Gilchrist and Himmelberg
(1995) find that more financially constrained firms exhibit greater investment-cash-
flow sensitivities,1whereas Kaplan and Zingales (1997) and Cleary (1999) find the
opposite pattern. Until now, this research question has remained open.2Surprisingly,
no attempt has been made to understand whether a unique correlation exists between
investment-cash-flow sensitivity and the financial constraint in general or to deter-
mine what factors make this correlation positive or negative.Some of these important
factors could potentially vary across industries, countries, or time.
In this paper, I introduce moral hazard into an otherwise standard firminvestment
model where investment is sensitiveto cash flows because of an endogenous financial
constraint on investment. Under this theoretical framework,I quantitatively show that
whether the magnitude of the investment-cash-flow sensitivityincreases or decreases
with the tightness of the financial constraint depends on two important factors: (1)
the returns to scale in capital of the production technology and (2) the severity of
the moral hazard problem. Specifically, if the returns to scale in capital are close to
constant or the moral hazard problem is relatively severe, the sensitivity decreases
with the financial constraint; otherwise, the dependence is reversed to some extent.
In my model, the economy consists of a large number of entrepreneurs, each of
whom is endowed with a technology that allows him to produce consumption goods
from capital over a long time horizon. The cash flows generated by the firms are sub-
ject to random shocks, and the firms incur temporary losses. Since the entrepreneurs
do not have initial wealth, they ask an investor for financing to cover their losses
so that their firms can maintain capital input. Because the cash flow shocks are not
observable to the investors, the entrepreneurs could misreport the temporary losses
and divert cash flows, creating moral hazard. Therefore, to deter hidden diversions,
an entrepreneur’s stake in the firm, the fraction of the firm’s future cash flows that
belongs to him, is sensitive to the reported cash flows. The entrepreneur is protected
by limited liability so that the firm has to be liquidated when this stake reaches zero
after a sequence of negative cash flow shocks. Since liquidation is inefficient, an
agency cost of incentive provisions arises, which implies a financial constraint on
1Based on this result, some researchers use investment-cash-flowsensitivity as an indicator of the financial
constraint (e.g., Hoshi, Kashyap and Scharfstein, 1991; Almeida and Campello, 2007).
2Kadapakkam, Kumar and Riddick (1998) and Vogt (1994) find that large firms that seem to be less
financially constrained exhibit greater investment-cash-flowsensitivity.

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