Finance Constraints or Free Cash Flow? The Impact of Asymmetric Information
Robert E. Carpenter
Department of Economics
Atlanta, GA 30322
January 13, 1994
I thank Steven Fazzari, Bruce Petersen, Gerald Dwyer, Phil Keefer and Mark Vaughan for
comments. I gratefully acknowledge the University Research Committee of Emory University for financial
support and Robert Parks for technical advice and support.
It has long been known that firms prefer internal to external finance for funding their investments.
William Baumol (1965, p.74) clearly articulated what would be called a "financing hierarchy" by later
researchers, stating "[i]t would appear that the bulk of business enterprise should finance its investment
insofar as possible entirely out of retained earnings because that is, characteristically, the cheapest way to
raise additional funds. Only when it becomes impossible to provide enough money from internal sources
should the firm turn to the stock market or to borrowing for resources" (emphasis in original). And
although many researchers agree that the information asymmetries which are that root cause of the
preference for internal finance have an important impact on investment, there is substantially less
agreement about their cause. The question of whether information asymmetries between borrowers and
lenders, lead to firms that face "financing constraints," where profitable investment projects are not
exploited, or whether agency costs lead managers to waste the firms resources by using its "free cash flow"
to pursue unprofitable projects remains largely unanswered.1
By far, the largest portion of the research examining the empirical effects of these asymmetries has
taken their source as given. For example, much of the recent literature in macroeconomics emphasizes the
view that some firms face constraints which limit access to external finance.2 In effect, firms "prefer"
internal finance because external finance is unavailable or prohibitively costly. These finance constraints
limit investment expenditure which may cause or propagate the business cycle. Bernanke (1983) and
Calomiris (1993) suggest that capital market imperfections were contributing factor in the Great
Depression.3 Kashyap, Lamont, and Stein (1993) and Gertler and Gilchrist (1993) suggest that some of
the impact of monetary policy works through a financial propagation mechanism where internal finance
1 Jensen (1987) defines free cash flow as the portion of cash flow that remains after all positive net present value projects are
2 Recent papers include Fazzari, Hubbard and Petersen (1988), Devereux and Schianterelli (1990), Hoshi, Kashyap and Scharfstein
(1991), and Oliner and Rudebusch (1992).
3 Financial elements play an important role in Minsky's (1975) and Greenwald and Stiglitz's (1993) explanation of the business cycle.
plays a central role and Carpenter, Fazzari and Petersen (1993) suggest that finance constraints link the
procyclical movements of inventory investment and cash flow.
An alternative body of research suggests that the separation of ownership from control, in concert
with costly monitoring, leaves managers with the ability to deploy the firm's resources in unprofitable
configurations. The recognition of the divergence of the incentives of managers and the owners of a public
corporation dates back at least to Berle and Means (1932). Gordon Donaldson (1961) suggests that
managers prefer internal funds because "internal financing is the line of least resistance" and "are funds
over which management has complete control." Using internal finance "avoids the glare of
publicity...which accompanies the decisions and actions of management if [investment is] externally
financed" (Donaldson, 1961 p.54). Jensen and Meckling (1976) show that incomplete monitoring provides
managers with incentives to expand the scale of the firm faster than optimal. Jensen (1986) has proposed
that, for some firms, information asymmetries between the managers and the owners of the firm provides
incentives for managers to "over-invest," using free cash flow for unprofitable investment projects that
increase managerial utility. From both the owners' and society's standpoints, it would be desirable for these
firms to disgorge their free cash flow to the owners of the firm.
This paper examines the source of information-driven imperfections in financial markets and their
impact on corporate investment decisions. To date, very little research has attempted to address this issue
and the evidence is mixed. Lang and Litzenberger (1989) attempt to distinguish between under and over-
investment theories by examining the response of stock prices to changes in dividends. They split firms
into two categories, designating firms with Tobin's Q ratios of less than one as over-investors. Their
results show that over-investing firms exhibit positive changes in the price of their equity in response to an
increase in the amount of free cash flow paid to owners in the form of higher dividends, which they
interpret as evidence consistent with the free cash flow hypothesis. Hoshi, Kashyap, and Scharfstein
(1990) argue that if managers waste free cash flow investment should be highly sensitive to changes in
internal finance because internal finance is difficult for outsiders to monitor. They find evidence against
free cash flow theory, noting that firms with low values of Tobin's Q are less sensitive to changes in
internal finance. Vogt (1993) also focuses on this interaction between level of Q and cash flow, reporting
evidence in support of free cash flow theory. Griffin (1988) interprets his finding of a role for cash flow in
the determination of exploration activity in the petroleum industry as providing only limited support for free
cash flow theory. Oliner and Rudebusch (1992) report evidence in favor of a financing hierarchy when
compared to an alternative model motivated by transactions costs.
Both theories predict that the preference for internal funds will lead to a positive relationship
between investment and internal finance. As a result, it is difficult to develop empirical tests based soley on
the firm's response to changes in cash flow that will fully distinguish between them. Instead, we focus not
only on cash flow, but also on the fundamental difference in the role that debt plays in the corporation's
financing decision in each model. If asymmetric information leads to finance constraints and under-
investment, then debt is a source of external finance used to fund profitable investment projects. If firms
over-invest because of managerial opportunism, debt may be used as a monitoring device to restrict
managers' ability to invest in unprofitable projects.
We construct a sample of manufacturing firms from the COMPUSTAT files over the period 1980-
1990. Following Lang and Litzenberger (1989) we divided the sample into over-investors and under-
investors based on the firm's average Tobin's Q. We use this criterion as a starting point, dividing the
sample more finely, by both Q and the firm's dividend behavior, to more sharply differentiate between over
and under-investing firms. In addition, we construct a sample of firms based on Jensen's (1986) suggestion
that firms can pledge their free cash flow by issuing debt without retention of its proceeds. We examine a
group of firms classified as over-investors on the basis of their average Q ratios that use new issues of
long-term debt to repurchase equity, a restructuring that Jensen (1987) argues maximizes the control effects
of debt. Free cash flow theory suggests that over-investing firms use debt to reduce investment in
unprofitable projects. If the control effect of long-term debt is exceptionally strong, these firms should
reduce their capital expenditures upon this restructuring. Donaldson (1961, p.83) also recognized the
relationship between added debt and increased managerial efficiency noting "[a]dded debt has
the...disadvantage of adding to the rigidity of outflows...Substantial additions to debt invariably mean
increased attention to cash flow forecasting and tighter controls over cash flow."
We find that the financing hierarchy stems from both finance constraints and from the agency
problems associated with the separation of ownership from control. Most of the empirical evidence is
consistent with a financial hierarchy that is based on limited access to external finance. Firms with poor
investment opportunities (as defined by low values of Tobin's Q) or who pay low dividends exhibit
investment that responds positively and strongly to changes in long-term debt; behavior consistant with the
relaxation of a binding constraint. Firms with high values of Tobin's Q, and that also pay high dividends
are least likely to view external finance as a constraint on their behavior. We find that debt has little
explanatory power for these firms.
However, when we examine a small subset of the data that includes firms that restructure by
swapping debt for equity, we find some evidence consistent with asymmetric information theories based on
the agency costs of free cash flow. Even though investment exhibits a strong, positive response to an
increase in long-term debt for these firms, after a debt-for-equity restructuring debt's effect on investment,
as well as that of internal finance variables, falls.
The rest of the paper proceeds as follows: In section 2, we discuss the alternative theories in more
detail, drawing testable hypotheses from the theoretical framework of the models. Section 3 describes the
empirical model of investment, estimated with firm-level data and modified to include measures of internal
and external finance, used to determine the source of the financing hierarchy and highlights the key
empirical predictions from each model. Section 4 describes the construction of the sample and presents
summary statistics. Section 5 contains the results of the estimation for each of the main splits of the
sample and section 6 concludes.
2. Asymmetric Information and Investment
The central proposition of models linking information asymmetries to investment decisions is that
the exchange of information is costly. In the most extreme case, Stiglitz and Weiss (1980) suggest that
equilibria in the credit markets can exist concurrently with an excess demand for loans. If lenders engage
in rationing credit some firms' investment may be constrained by their internal finance. In less extreme
cases lenders may charge a price based on the average quality of the borrowers. In this case, borrowers
who are successfully able to conceal high default-risks from lenders will be subsidized by low default-risk
borrowers. Therefore, borrowers with profitable investments will pay a premium that in part reflects the
lender's uncertainty about the prospect of repayment
Empirical evidence linking internal finance to investment dates back to at least to Meyer and Kuh
(1957). More recently, Fazzari, Hubbard, and Petersen (FHP, 1988) show that firms with low dividend-
income ratios exhibit a strong linkage between internal financial flows and investment. Hoshi, Kashyap,
and Scharfstein (1991) find that the integration between Japanese firms and banks reduces the extent to
which internal finance affects investment decisions by reducing the costs of exchanging information
between borrowers and lenders4
The implication of this research is that the linkage between cash flow and investment results from
credit market imperfections that increase the cost of external finance relative to internal finance and leads to
"under-investment," i.e., profitable investment projects are not undertaken because of a shortage of low-
cost internal funds. Firms prefer internal finance because it is relatively less costly than external funds.
Once internal finance is exhausted, firms that suffer from financing constraints may be unable to invest in
their remaining positive NPV investment projects. The existence of a finance constraint leads to a close
relationship between internal finance and investment fluctuations where positive shocks to internal finance
4 See Gertler (1988) for an extensive survey of this literature and footnote 2 for the citations of several more recent studies.
will lead to an increase investment. Unless their prospective investments are of sufficiently high quality to
compensate lenders for uncertainty surrounding the project's prospective payoffs, a constrained firms'
investment expenditures will be limited by their internal finance. As a result, firms that issue debt have
investment projects with expected returns that are sufficient to cover the premium charged for asymmetric
information. If these firms issue debt, they do it to purchase positive NPV investment projects; their
investment expenditures should increase.
Free Cash Flow Theory
Free cash flow theory centers on the agency costs resulting from the separation of ownership and
control and the incentives that managers have to pursue activities that are not in the principals' interest,
reducing the profitability of the firm. For example, managers may be biased toward an above-optimal level
of growth for the firm if their compensation is related to the size or the growth of the firm. Managers may
also prefer growth if the non-pecuniary benefits they can consume grows with the size of the firm.5 The
pursuit of goals that are not in the shareholders interest leads firms to a preference for internal funds to
avoid the "direct disciplining influences of the securities market," and "restrictions on the company's
freedom of action which result from any restrictive provisions involved in the issue [of securities]"
(Baumol, 1965 pp. 70-75).
Jensen (1986) suggests that managers can limit the agency problems of free cash flow by issuing
debt and paying the proceeds to stockholders. Leverage restricts the use of internal finance generated by
the firm by forcing managers to use cash flow to meet their contractually specified interest obligations.
The reduction of managers' incentive to invest in negative net present value (NPV) projects may be
attributed to creditors legal rights to reorganize or even liquidate the firm in the event of default.
5. Murphy (1985) shows that managerial compensation and the growth in the firms sales are positively related. Joskow, Rose, and
Shepard (1993) show that the elasiticty of CEO compensation with respect to the size of the firm is over twice as large as the elasticity of compensation
with respect to the firms stock market return. Also, see the discussion in Jensen and Meckling (1976) that relates managerial consumption of non
pecuniary benefits to the optimal scale of the firm.
Free cash flow theory has important implications for the effect of leverage on a firm's investment-
financing decisions. The free cash flow model implies that for an over-investor an increase in leverage
should lead to a reduction in unprofitable investment spending. Additional leverage leaves less free cash
flow at the discretion of the managers at the same time that it increases the level of intensity at which the
firm's activities are monitored. Overall investment will become more efficient as the firm substitutes
contractually obligated debt service for negative net present value investments. Empirically, the reduction
in unprofitable investment spending should lead to an increase in the price of the firm's equity that reflects
increased efficiency of managerial investment decisions, and indeed, most empirical studies cited in support
of the free cash flow hypothesis rely heavily on evidence that shows an increase in the price of the firms
equity after a leverage increasing transaction.
However, free cash flow theory also predicts a change in the firms investment financing decisions
that will be reflected in the relationship between debt finance and investment expenditures. If firms use
additional leverage to restrict the manager's ability to pursue wasteful investment projects that are not in the
interests of the shareholders, then debt acts as a monitoring device, rather than as a source of funds for
investment. When a firm that was previously over-investing in unprofitable investment projects uses debt
to pledge the free cash flow from its operations to shareholders investment expenditures should decline
when long-term debt is issued, especially when the managers of the firm pay the proceeds of the issue to the
The response of firms' investment to changes in long-term debt forms the core of the empirical tests
in this paper. Models based on the agency costs of free cash flow suggest that firms that over-invest by
undertaking unprofitable investment projects may use debt to restrict the behavior of managers.
Alternatively, where the primary consequence of capital market imperfections is the existence of finance
constraints, debt is a marginal source of funds used when low-cost internal finance is insufficient or
6 Blair and Litan (1990) use a similar argument to suggest that their finding of a negative relationship between the change in the
capital stock and the level of debt finding at the industry level, is consistent with the predictions of free cash flow theory.
unavailable, and the returns from the investment project are sufficiently large to pay any premium charged
for the lender's lack of knowledge about the projects payoff.
3. Empirical Specification
This section describes the fixed investment regressions that examine the link between internal
sources of finance and long-term debt on investment expenditure. For our primary specification, we modify
a widely used fixed investment equation. For firm i at time t let:
(I / K )
= α + α + β Q
+ β2 + (CF / K) + β ( W / K)
+ β ( LTD / K)
The α are firm-specific intercepts, while the α allow for year effects. The variable u
it is a
random disturbance. Capital expenditures are represented by I. Beginning of period Tobin's Q controls for
changes in investment opportunities. Sources of internal finance are represented by cash flow, CF. Cash
flow is internal funds that are generated from the operation of the business enterprise and are essentially
income before extraordinary items and discontinued operations with non-cash charges against income
added back in.7 The change in working capital, current assets minus current liabilities, is denoted
∆W. Recent research by Fazzari and Petersen (1993) and Carpenter, Fazzari, and Petersen (1993) argues
that firms may respond to shocks to internal finance by reducing the rate at which they accumulate assets.
They argue that if cash flow falls, assets with relatively low adjustment costs (here working capital) will
fall most, freeing up liquidity that may be used to maintain investment in assets with higher adjustment
costs, like fixed investment. If firms use working capital as a source of funds to smooth fixed investment,
working capital investment will enter the regression with a negative coefficient.
The firm's sources of external debt finance are represented by ∆ LTD. We defined ∆ LTD as new
issues of long-term debt less retirements of long-term debt plus the change in current debt. This definition
7 A more precise definition of cash flow may be found in the data appendix.
captures any change in leverage when convertible bonds are redeemed for equity. In addition, since the new
long-term debt variable measures funds actually raised by the issuance of new long-term debt, it accounts
for any discount or premium upon issuance of the debt. Lastly, the change in current debt controls for
reclassification of long-term debt to current debt in the last year before it becomes due.8 Investment, cash
flow, ∆W and ∆ LTD are scaled by the firm's beginning-of-period capital stock to control for
heteroscedasticity and to reflect the theoretical relationship between investment, capital, and Q.9
Both the change in working capital and the net issue of long-term debt are endogenous variables.
We estimated equation (1) with instrumental variables. The instruments include: beginning of period Q,
cash flow, the beginning of period stock of working capital, the beginning of period level of long-term debt,
all predetermined variables and the time dummies. The stock of long-term debt is an especially appropriate
instrument for the change in long-term debt. With higher levels of long-term debt, the probability of default
rises. Therefore, the marginal cost of debt should rise as its stock rises. The stock of outstanding debt
should also be related to the intensity of monitoring so that with a larger stock of debt the ability of
managers to waste cash flow falls. Both stories justify the use of the stock (LTD/K)it as an instrument.
The justification for the use of the beginning of period stock of working capital is similar, and is discussed
in Fazzari and Petersen (1993).
8 Because current debt is also a current liability of the firm, we adjusted our definition of working capital to exclude current debt.
9 The estimated replacement value of the firm's capital stock was calculated with an adaptation of the method used in Salinger and
Summers (1983). See the data appendix of this paper for details on its construction.