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    WCR and Fixed Asset Investment

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    Working Capital and Fixed Investment: New Evidence on Financing Constraints Steven M. Fazzari; Bruce C. Petersen The RAND Journal of Economics, Vol. 24, No. 3 (Autumn, 1993), 328-342. Stable URL htp:/Mlinks jstororg/sicisici=074 1-626 1% 28 199323% 292473 A3% 3C328%3A WCAFIN%3E2,0,CO%3B2-Z, ‘The RAND Journal of Economies is currently published by The RAND Corporation, ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hup:/www,jstororglabout/terms.hml. ISTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www jstor.org/jouals/rand.html. Each copy of any part of @ JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission. STOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact jstor-info@umich edu upslwww jstor.org/ Wed Mar 17 00:06:44 2008 RAND Journal of Esonomics, Vol 24 No.3, Aut 1993 Working capital and fixed investmen new evidence on financing constraints ‘Steven M. Fazzari* and Bruce C. Petersen** This article presents new tests for finance constraints on investment by emphasizing the often- neglected role of working capital as both a use and a source of funds. The coefiicient of endogenous working capital investment is negative in a fixed-investment regression, as ex- pected if working capital competes with fixed investment for a limited pool of finance. This Jinding addresses a criticism of previous research on finance constraints, that cash flow may simply proxy shifis in investment demand. In addition, previous studies may have under- estimated the impact of finance constraints on growth and investment because firms smooth {fixed investment in the short run with working capital 1. Introduc Recent theoretical research explains why access to internal finance may affect firms’ investment and growth, and a number of empirical studies support this proposition. These findings have potentially important implications for industrial organization, public finance, and macroeconomics. Empirical research has proceeded along two lines: reduced-form regressions of investment on cash flow, ' and tests of financial constraints using Euler equation ‘methods. Both approaches have limitations. In the reduced-form approach, a positive cash- flow coefficient may arise because cash flow proxies investment demand rather than providing evidence for finance constraints, even afier including variables such as Tobin's g.? A limi * Washington Universit in St. Louis, and the Jerome Levy Economics Institut. ‘+ Washington University in St. Louis ‘We thank participants in the NBER Summer Insitute, Ben Bernanke, Olver Blanchard, Robert Carpenter, Robert Chirinko, Gary Dymski, Charles Himmelberg, Glenn Hubbard, Anil Kashyap, John Keating, Dorothy Petersen, James Potera, Steven Strongin and an anonymous referee for helpful comments on earlier versions of this article, Initial research for this article was undertaken while Petersen was at the Federal Reserve Bank of Chicago, * Some rocent papers are Fazzai, Hubbard, and Petersen (1988), Gertler and Hubbard (1988), Devereux and Sehianterell (1980), Hoshi, Kashyap, and Scharfstein (1991), and Otiner and Rudebuseh (1992), * Seo Gilchrist (1990), Himmelberg (1990), Hubbard and Kashyap (1992), Whited (1992), and Carpenter (1992) » Poterba (1988) summarizes this pont. “If... measured Q provides an eror-ridden indicator of fms tive prospets, then econometric results may find that current cashflow affects investment only because this variable, just lke measured Q, i correlated withthe "tru’ marginal Q variable that firms consier in making investment ‘decisions (p. 201) 328 FAZZARI AND PETERSEN / 329 tation of the Euler equation approach is that rejections of the perfect-capital-market null hypothesis could occur for reasons other than the existence of finance constraints. Fu thermore, Euler equation hypothesis tests do not measure the quantitative importance of internal finance for investment. This article addresses these problems by emphasizing the often-ignored role of working ital as both an input and a readily reversible store of liquidity. Working capital is current assets (chiefly accounts receivable, inventories, and cash) less current liabilities (primarily accounts payable and short-term debt), and it measures the firm’s net position in liquid asses. Our basic argument proceeds as follows. For a number of reasons, itis costly for firms to change the level of fixed investment, and thus they will seek to maintain a stable fixed-investment path, other things equal. Financial constraints may impede this objective ‘whenever firms cannot costlessly offset cash-flow fluctuations with external funds. Even constrained firms, however, can offset the impact of cash-flow shocks on fixed investment by adjusting working capital, even setting working capital investment at negative levels. ‘These actions release short-run liquidity, allowing firms to smooth fixed investment relative to cash-flow shocks. The marginal opportunity cost of adjusting working capital in this manner, and therefore the extent of investment smoothing, should depend on the firm's initial stock of working capita, a variable related to the strength of its balance sheet.” Developing this role of working capital leads to two empirical predictions. First, as mentioned above, cash-flow effects on investment have been interpreted as proxies for factors that shift investment demand rather than as evidence of financial constraints. If this inter- pretation is correct, changes in working capital, which are also positively correlated with sales and profits, should have a positive coefficient in a fixed-investment regression. But if firms face financing constraints, working-capital investment competes with fixed investment for the available pool of finance. In this case, working-capital investment should have a negative cocfcient when included as an endogenous variable inafixed-investment regression. ‘Our second empirical prediction is that recent reduced-form studies may underestimate the full impact of financing constraints on investment. The cash-flow coeflicient inthe fixed- investment regressions presented in many recent studies measures only the average “short- run” impact of cash flow shocks, after the frm engages in optimal investment smoothing To estimate the long-run effect, we specify a new investment equation that analyzes the impact of cashflow after controlling for endogenous investment smoothing with working capital. This approach allows us to assess the economic importance of financial constraints fora broader class ofisues than was possible with previous studies (e. the finance effets, fon the growth of the firm). ‘We estimate working-capital and fixed-investment regressions with firm panel data. ur findings support our main predictions. The results appear robust to a variety of other possible interpretations as well as alternative specifications. The concluding section discusses implications ofthe results for industrial organization and macroeconomics, including claims that the recent downturn in the U.S. economy may have been a “balance sheet” recession. 2. Investment in fixed and working capital with finance constraints ‘Recent capital-market research shows that real investment may depend on financial factors. External finance, if available at all, may be more costly than internal finance because of transactions costs, agency problems, or asymmetric information (see the survey by Gertler “ Rejections could result fom misspeciied production technology, mispecified adjustment costs, or because fem make expectation eros that are corelated with the instruments. See Gilchrist (1990) and Carpenter 1992). $"plinder (1988) emphasizes the importance of liquidity forthe investment of inancaly eonseained firms Also seth “internal net worth” arguments of Gerler and Hubbard (1988), Bernanke and Gerler (1989), Calomiris And Hubbard (1990), and Hubbard and Kashyap (1992), 330 / THE RAND JOURNAL OF ECONOMICS (1988). Many of the arguments rest on the distinction between “insiders,” who have full mn about a particular firm’s investment prospects, and “outsiders,” who may cor- rectly perceive the prospects for a population of firms but cannot distinguish the quality of dual firms. In debt markets, Stiglitz and Weiss (1981) argue that asymmetric infor- mation may cause lenders to ration credit. This outcome can arise if higher interest rates either cause relatively good firms to leave the applicant pool (adverse selection or induce firms to undertake riskier projects (moral hazard). In external equity markets, new investors ‘may be less informed than firm managers about the true value of firms’ existing assets and. new investment opportunities. In this environment, Myers and Majluf (1984) explain why firms may be forced to sell new shares at a discount, if they can sell shares at all. When external funds are rationed, or are available only at a premium, variations in internal finance should affect investment. Numerous empirical studies have found evidence of such effects (see footnotes 1 and 2). These studies, however, have ignored the possibility that financially constrained firms will choose to smooth fixed investment relative to cash-flow shocks. D_ Investment smoothing. Eisner and Strotz (1963) and Lucas (1967) motivate investment smoothing because marginal adjustment costs of acquiring and installing capital rise as the rate of investment increases. Estimates of marginal adjustment costs from Tobin's g in- vvestment equations are often very large and increase rapidly as investment rises (see Summers (1981), for example). Smaller but still economically important estimates have been obtained. from multiequation structural models of firm behavior (see Bernstein and Nadiri (1989) and Chirinko and Fazzari (1992), for example). With rising marginal adjustment costs, firms will reduce long-run costs by maintaining stable investment over time, for any given long-run path of capital accumulation, Another motivation for investment smoothing arises because firms cannot costlessly store or delay investment projects. For firms in fast-growing industries, own-firm innovation and innovation spillovers generate new investment opportunities continuously. If these ‘opportunities are not undertaken as they arise, their value to the firm rapidly decays because ‘of short product life cycles, appropriability problems, and the first-mover advantage from commercializing new technologies.® Suppose that projects are perishable and that th ‘marginal value declines as more of them are undertaken. Then, a firm that allows cash-flow fluctuations to dictate its investment spending would sacrifice projects with high marginal value in periods of below-average cash flow only to undertake projects with comparatively low marginal value in periods of high cash flow. Such investment behavior is clearly sut ‘optimal if there is some mechanism to smooth investment relative to cash-flow variations. Finally, while measured investment spending may take place continuously, investment projects are often discrete and take time to complete. It may be costly for a firm to contract or eliminate spending on a project in progress due to temporary shortfalls in cash flow. The role of working capital. Since Adam Smith, economists have recognized that working capital is an important part ofthe firm’s stock of capital. The explicit accounting distinction between fixed and working capital goes back at least four centuries.” In modern firms, ‘working capital is of the same order of magnitude as fixed capital. In manufacturing, for example, the Statistics of Income show that working capital is more than half as lange as the fixed capital stock. Working capital measures the net position of firms’ liquid assets, “Myers and Mail (1984) emphasize the dificully of storing” investment projects. The personal computer industry provides a good example of an industy with shor product life eyees. Levin etal. (1987) discuss the failure ofthe patent system to del adequately with approprability problems and the need for a firm tobe the fst investor to commercialize new innovation. “in The Wealth of Nations (176), Smith distinguished between ctculating and fixed capital. His notion of cirulating capital i close to the concept of working capital. Dewing (1941) points out thatthe balance sheet, prepared by the Society of Mines Royal in 1871 clearly divided capital into "cutent” and fixed components FAZZARIAND PETERSEN / 331 both real and financial, and it is commonly used by accountants to measure a firm's liquidity. Ttis defined as current assets less current liabilities. The three major components of current assets are accounts receivable, inventories, and cash and equivalents, Inventories are often divided further into materials, work-in-process, and finished goods. The former two categories are more volatile than finished-goods inventories (see Ramey (1989) and Blinder and Macc (1991). Current liabilities consist primarily of accounts payable and debt due in less than one year ‘Dewing (1941), a leading writer in finance during the first part of the twentieth century, explains why working capital, along with fxed capita, is one of the key elements of the firm. A modern literature explores the value of working capital to the firm. Inventory components of working capital enter directly into the production function. For example, firms stockpile materials to reduce the probability of stockouts that could slow production. They also use work-in-process inventories to achieve economies of scale by running large batch sizes. Other components of working capital such as trade credit and finished-goods inventories facilitate sales. Accounts receivable, in particular, can affect sales to customers ‘who are themselves liquidity constrained, Finally, cash and equivalents and current liabilities affect costs through the liquidity of the firm. For example, compensating cash balances can reduce financing costs, and adequate cash stocks allow firms to take advantage of discounts for prompt payment (which often translate into very high rates of return). ‘Dewing ( 1941) also emphasizes that a key difference between fixed and working capital is the liquidity of the latter. While a recent literature has emerged based on the irreversibility oixed capital (see the survey by Pindyck (1991)), we emphasize the reversibility of working capital For example, working-capital investment may be temporarily negative if firms con- sume raw-materals inventories faster than they re replaced. Firms can also liquidate working capital by intensifying efforts to collect accounts receivable (see Meltzer (1960)) or by tightening credit policies on new sales, resulting in lower-than-normal accounts receivable per dollar of sales, Evidence reported by Melizr (1960) implies that firms with weak liquidity Positions doin fact cut accounts receivable when confronted by tight money, while firms with strong liquidity do not, Firms also use liquid assets as collateral for short-term borrowing, which reduces working capital through an increase in current lablities, Fixed investment smoothing with working capital It is well known that a firm facing a binding finance constraint may not be able to equate the discounted marginal rates of return fon assets across time—this is the essence of Euler equation tests for capital market imper- fections, Furthermore, a constrained firm cannot equate marginal returns on investment to the market cost of capital. But finance constraints pose no barrier to equating the marginal returns across different assets, net of adjustment costs, at each point in time. That is, the firm will equate marginal returns on all assets to a shadow value of finance, Now consider what happens when there is a shock to cash flow, other things held constant. Ifthe shock is negative, the shadow value of finance will rise for financially con- strained firms, and they will respond by reducing their rate of asset accumulation. But to equate returns across assets, firms should not cut investment proportionately in both fixed ‘and working capital, because working capital is relatively liquid. That is, the firm reduces adjustment costs and losses due to perishability of projects by choosing working-capital investment to absorb a larger share of temporary cash-flow fluctuations than fixed investment. Because working capital is reversible, it can even become a source of funds, with firms choosing a negative level of working-capital investment. The existence of working capital, then, can be thought of as relaxing firms’ short-run financing constraints, A symmetric argument applies to positive cash-flow shocks. * See Kim and Srinivasan (1988). Ramey (1989, 1991) motivates the role of working capital inthe production function, panicularly inventories and transaction services. 332 / THE RAND JOURNAL OF ECONOMICS ‘The extent of this fixed-investment “smoothing” should depend on its initial stock of ‘working capital, For example, the higher the stock of working capital, the lower its marginal valuation to the firm and the more willing it is to offset negative shocks to cash flow by forgoing working-capital investment. But if the stock of working capital is abnormally low relative to fixed capital, we expect that there will be less fixed-investment smoothing, and cash-flow shocks will have a larger quantitative impact on fixed investment.® Again, a sym- ‘metric argument applies for positive cash-flow shocks. In this sense, the strength ofa firm's balance sheet (measured by its working-capital position) can affect the link between fixed investment and cash flow. Consider how specific internal finance shocks have effects that differ across constrained and unconstrained firms. Ifa cash-flow shock is a pure change in fixed cost, the investment of unconstrained firms is unaffected, while constrained firms will adjust their investment in both fixed and working capital along the lines described above. The case of a demand shock is more complicated. A negative demand shock reduces the marginal revenue product (the derived factor demand curves) for both fixed and working capital, reducing investment in both assets for constrained and unconstrained firms alike."® But for financially constrained firms, the demand shock has an additional impact on the balance sheet. The decline in ‘working-capital investment should be even larger if firms choose to smooth fixed investment, ‘This “excess sensitivity” of working capital to cash-flow shocks leads to new tests for finance constraints, which we describe in the next subsection. ‘Atthe aggregate level, movements in working capital and its components are consistent with this description of firm behavior. We examined all manufacturing corporations listed by Compustat, which account for nearly all of U.S. manufacturing GNP. For 1973 to 1987, ‘working-capital investment was three times as variable as fixed-capital investment. The two ‘most volatile components of working capital were accounts receivable and raw-materials inventories. The pattern of working-capital investment during the 1975 and 1982 recession years was particularly interesting. Working-capital investment, in aggregate, was negative in these years. The largest percentage declines of the working-capital components occurred. for accounts receivable and raw-materials inventories. These declines exceeded the fall in sales. The ratio of accounts receivable to sales fell by 9% in 1975 and 11% in 1982. The raw-materials-to-sales ratio fell by 9% in 1975 and by 12% in 1982. Even finished-goods inventories fell relative to sales in these recessions (by 5% and 9%, respectively). Finally, following the logic of Fazzari, Hubbard, and Petersen ( 1988), who argue that zero-dividend, firms are the most likely to face financial constraints, we split the Compustat data into zero- dividend and positive-dividend groups. Working-capital investment and its components declined much more sharply in recession years for the zero-dividend firms. Empirical predictions. Two main testable predictions emerge from considering invest- ‘ment in fixed and working capital when firms face finance constraints: (1) Working-capital investment, when included as an endogenous variable in a fixed-investment regression, will have a negative coefficient. (2) The standard “within-firm” estimator will understate the full effect of internal finance on fixed investment and overstate the effect of cash flow on ‘working-capital investment, " Working capital may also act as a stock of precautionary liquidity, providing insurance against future shortfalls in cash. From this perspective the expected marginal value of working capital also rises as the sock eclnes, "in general, this point applies to each of the components of working capital. Lower production reduces ested worksin-process and materials inventories. Lower sies will reduce desired accounts receivable and cash stocks. When demand fall, inished-goods inventories may rise temporarily. Over a somewhat longer horizon, however, inventory decisions are endogenous (nishedoods inventory socks are typically equal 1 only a few ays of production). In practice, lower sales seem to result in lower fnished- goods inventories, airing that arises {irom mos tests of production-smeothing models. Se Blinder and Maceni (1991) for further discussion, FAZZARI AND PETERSEN / 333 ‘The explanation for the negative coeficient on working capital is that working capital ‘competes with fixed investment for the limited pool of finance. Thus, other things equal, ‘when firms choose to decrease (increase) working-capital investment, fixed investment should rise (fall). This prediction addresses an important criticism of previous reduced-form tests for financial constraints on fixed investment. Critics point out that the positive coefficient ‘on cash flow—the focus of previous studies—could arise because cash flow might proxy for omitted investment demand factors rather than provide evidence for finance constraints. But as discussed previously, movements in working capital are also positively correlated ‘with movements in demand and cash flow, implying that working-capital investment should have a positive coefficient in a fixed-investment regression, in the absence of finance con- straints. However, in the presence of financing constraints, we predict a negative coeficient ‘on working-capital investment. ‘The explanation ofthe second prediction is similar to Griliches and Hausman’s (1986) argument for why within-irm estimates of labor-demand functions yield unexpectedly small ‘output elasticities. They argue that because of adjustment costs, labor input does not change ‘much in response to transitory movements in output. The parallel point here is that firms have incentives to maintain stable fixed-investment levels in response to temporary flu tuations in cash flow. Thus, even if the firm were completely constrained to finance its growth with internal funds, the estimated cash-flow coefficient in the standard within-firm investment regression could be small. Indeed, if’ such a firm were able to maintain constant fixed investment by adjusting working-capital investment to absorb fluctuations in cash flow, the cash-flow coefficient in the fixed-investment regression could be zero. For this, reason, the estimates of internal finance effects presented in the existing literature may be best interpreted as the average “short-run” effect, tha is, the impact of cashflow fluctuations after firms engage in optimal smoothing.” One way to estimate the “long-run” effect of cash flow on fixed investment, the extent to which firms rely on internal funds for their ‘growth, is to control for smoothing by including (endogenous) changes in working capital in the regression. If our smoothing argument is correct, the estimated cash-low coefficient from this regression should exceed previous estimates in the literature 3. Data sample and summary statistics = We utilize the panel database described in Fazzari, Hubbard, and Petersen (1988) and constructed from Value Line for U.S, manufacturing firms, Because we are interested pri- marily in firms that are most likely to face binding financial constraints, we focus on firms that pay essentially no dividends. Following the approach in Fazzari, Hubbard, and Petersen, we also present evidence for firms that pay out a substantial fraction of their earnings." ‘The logic of this classification criterion is that when the marginal cost of external finance exceeds the opportunity cost of internal funds, firms that exhaust all internal finance are more likely to face a binding finance constraint. Gilchrist (1990) rejects the Euler equation that would hold in perfect capital markets for a sample of low-dividend firms, but not for high-dividend firms, providing additional support for this selection criterion. ‘Our panel covers the period 1970-1979, We chose this time period to take advantage of Value Line’s data-collection procedure. When firms are added to Value Line, historic ° Himmelberg and Petersen (1992) make similar arguments for R&D expenditures. "To maintain comparability to calier esearch, the sample and dividend sclection criteria we used are the same as in Fazza, Hubbard, and Petersen (1988). Firms ae chosen forthe lowdividend sample if they have dlividend-o-income ratios below 10% for atlas ten ofthe fifteen yeas between 1970 and 1986, One firm was ‘excluded fom the sample because of unrealistic Tobin's Q values early i the simple, leaving 48 firms inthe lo iviend group. The high-dvidend sample includes the 334 firms inthe Fazzari, Hubbard, and Petersen class 3 sr0up. Se the source aril for futher details 334 / THE RAND JOURNAL OF ECONOMICS. TABLE 1 Sample Summary Staisties: 1970-1979 (Low-dividend firms) Mean Median [Estimated replacement valve of fixed capital (milions of 1982 dollars) 1970 884 wa 1979 15933 464 Working-apital stock (milions of 1982 dollars) 1970 ans Ma i979 933 310 Fined investment to capital ratio 247 176 Cash flow to capital ratio 290 229 ‘Working-capital investment to capital ratio 220 us, Cashflow to net sources rat 718 628 CChange in debt net sources ratio 169 259 Valle of new share issues to nt sources ratio ° Dividend to capt ° Note: Net sources are defined asthe sum ofcash ow, the change in deb, and the valu of new equity: Mean observations forthe net source ratios ae based on sample aggregates data are also added, going back as far as possible. Therefore, the database contains information on firms before they were of sufficient size and interest to be included in the Value Line sample, a time when information problems are likely to be the most severe. Most of the low-dividend firms had not been added to the database before 1980 (see Fazzari, Hubbard, and Petersen (1988) for further details). Summary statistics for our low- For the low-

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