Working Paper: NBER ID: w19551
Authors: Joan Farre-Mensa; Alexander Ljungqvist
Abstract: Financial constraints are not directly observable, so empirical research relies on indirect measures. We evaluate how well five popular measures (paying dividends, having a credit rating, and the Kaplan-Zingales, Whited-Wu, and Hadlock-Pierce indices) identify firms that are financially constrained, using three novel tests: an exogenous increase in a firm's demand for credit; exogenous variation in the supply of bank loans; and the tendency for firms to pay out the proceeds of equity issues to their shareholders ("equity recycling"). We find that none of the five measures identifies firms that behave as if they were constrained: public firms classified as constrained have no trouble raising debt when their demand for debt increases, are unaffected by changes in the supply of bank loans, and engage in equity recycling. The point estimates are little different for supposedly constrained and unconstrained firms, even though we find important differences in their characteristics and sources of financing. On the other hand, privately held firms (particularly small ones) and public firms with below investment-grade ratings appear to be financially constrained.
Keywords: Financial Constraints; Corporate Finance; Capital Supply
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 |
|---|---|
| five popular measures of financial constraints (G32) | do not accurately identify firms that are financially constrained (G32) |
| public firms classified as constrained (L39) | able to raise debt without difficulty when their demand for debt increases (F34) |
| public firms classified as constrained (L39) | unaffected by changes in the supply of bank loans (E51) |
| public firms (L32) | engage in equity recycling (G32) |
| public firms (L32) | do not show the same sensitivity to capital supply shocks (D29) |
| junk bond issuers (G33) | behave in a manner consistent with being financially constrained (D10) |
| junk bond issuers (G33) | do not increase their debt levels in response to tax changes (H32) |