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Debt, Liquidity constraints, and Corporate Investment; Evidence from Panel Data

Toni Whited

Market imperfections exist that make it difficult for small firms in financial distress to raise external financing. These imperfections impose constraints on the firms and force them to alter their investment strategy.

This theoretical paper looks at the market imperfections associated raising new money. Specifically, it looks at firms that are in financial distress and finds that these firms have a difficult time raising new money and hence must pass up positive investment opportunities.

Fazzari and Athey (1987) and Fazzari, Hubbard, And Petersn (1988) show the connection between a firm having difficulty obtaining outside financing and that firm's investment policy. Whited claims that previous work on this was flawed in that it used is impossible to measure the potential investments, they used average and not marginal Q, and that the studies used cash flow which may not be correct. (See Mahar 1998).

Borrowing from the economic literature, specifically on consumption, Whited uses the Euler equation "to isolate the precise role of finance constraints in the investment process. (The author also credits Abel (1980 and Shapiro 1986) for earlier work on this.

Informational asymmetries may increase the cost of borrowing which "may induce finaicail market inefficiencies that spill over to the real side of the economy" by forcing the firm to alter its investments. (Note remember that in a Modigliani and Miller world the LHS of balance sheet does not affect RHS.)

High levels of debt " can raise the cost of availability of borrowing in two important ways."

1. Agency Costs of debt:

• Myers (1977 shows that firms with high debt may pass up positive NPV investments.
• Jensen and Meckling (1976) explain that limited liability may lead shareholders to take on excessively risky projects. (idea of equity as a call option).

1. Information Asymmetry

• Myers and Majluf (1984) and Akerlof (1970) firms may attempt to signal that they are "good firms" by issuing debt.
• It costs money to monitor firms and the closer to default, the more monitoring the debt holders will be required to do.

After stating that "One goal of this paper is to determine whether the empirical failure of the previous work on investment is due to finaicail market imperfections of to other auxiliary assumptions," the author is forced to make many "simplifications" but does come out with a at least somewhat understandable model. (equation 11--it is not reprinted for lack of space and difficulty in replicating).

Some of the model's assumptions are that the firms issue no new equity, owners and managers are risk neutral, and that managers act for shareholders. Note in concluding remarks Whited does urge caution in interpreting the results (although they do fit theory) because of the many assumptions that had to be made.

Data:

325 manufacturing firms from the Compustat combined files from 1972-1986 (Note this data source lists Nasdaq, Amex, and NYSE firms. Further note it is beneficial to have a wide range on the size of firms to capture any constraints that are imposed on smaller firms. I.e. if only small firms were examined, all would have the same constraint that would then not be apparent.)

The author breaks the sample into those firms that have bond ratings and those that do not. Not surprisingly those that do have bonds that are rated are larger. Table 1 provides summary statistics. Possibly the most striking fact showed is that the 119 firms who had bond ratings showed debt growth whereas the 206 firms that did not have bond ratings reduced their debt.

These findings are even more pronounced when firms with low debt to assets ratios and low coverage ratios were investigated.