Working Paper: CEPR ID: DP10326
Authors: Joan Farre-Mensa; Alexander P. Ljungqvist
Abstract: Financial constraints are fundamental to empirical research in finance and economics. We propose two novel tests to evaluate how well measures of financial constraints actually capture constraints. We find that firms classified as constrained according to five popular measures do not in fact behave as if they were constrained: they have no trouble raising debt when their demand for debt increases exogenously and they use the proceeds of equity issues to increase payouts to shareholders. We propose an alternative proxy for financial constraints, based on Merton?s (1974) distance-to-default measure, which successfully identifies firms whose behavior is consistent with being constrained.
Keywords: financial constraints
JEL Codes: G31; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial constraints (curvature definition) (D10) | inability to raise additional capital (G32) |
| financial constraints (wedge definition) (G59) | firm is constrained (D22) |
| traditional measures of financial constraints (G32) | inaccurate identification of constrained firms (L10) |
| distance to default (Y20) | better identification of constrained firms (G32) |
| corporate income tax increases (K34) | firms' leverage response (G32) |
| constrained firms (D22) | ability to increase leverage in response to tax increases (H32) |