The relationship between firm investment and financial slack

grantor: University of TorontoThis thesis examines the relationship between investment and financial factors, with particular emphasis on the role of 'financing constraints' in determining investment. Fazzari, Hubbard and Petersen (1988) and several subsequent authors provide strong support for the significance of financial factors among firms that have been identified as facing a high level of financial constraints. Their results suggest investment decisions of firms that are more financially constrained are more sensitive to firm liquidity than those of less constrained firms. Debate over the nature of the relationship between investment decisions and financial constraints has been fueled by the recent work of Kaplan and Zingales (1997) who challenge the generality of the conclusions above. They classify firms according to their degree of financial constraint, based on quantitative and qualitative information obtained from company annual reports. Contrary to previous evidence, they find that investment decisions of the least financially constrained firms are the most sensitive to the availability of cash flow. Kaplan and Zingales are criticized for the use of a small, homogeneous sample, as well as for the subjectivity associated with their classification scheme. This thesis examines the generality of the Kaplan and Zingales conclusions using a large, diversified sample and an objective classification scheme of firm financial status. Firms are classified using financial variables that are related to financial constraint. Firm financial status is determined using multiple discriminant analysis, similar to Altman's Z factor for predicting bankruptcy. This multivariate classification scheme effectively captures desired cross-sectional properties of firms. In addition, it allows reclassification of firm financial status every period and group composition is allowed to vary over time to reflect changing levels of financial constraints at the level of the firm. The results demonstrate that firm investment decisions are directly related to financial factors. Investment decisions of firms with high creditworthiness (according to traditional financial ratios) are extremely sensitive to the availability of internal funds while less creditworthy firms are much less sensitive to internal fund availability. This evidence supports the conclusions of Kaplan and Zingales (1997) using an objective classification scheme and a large, diversified sample of 1080 U.S. firms.Ph.D