Corporate Investment and Financing Constraints: The Nepalese Evidence1

Kapil Deb Subedi

Tribhuvan University
Saptagandaki Multiple Campus
Bharatpur, Chitwan

Abstract
This study examines the relationship between the corporate investment and liquidity constraints of non-
financial sector of Nepalese enterprises. The study derives a theoretical investment- liquidity constraint model
to test the hypothesis that the investment decisions of more financially constrained firm will be more sensitive to
their internal funds as compared to the less financially constrained firms. The proposed methodology classifies
firm-year observations into different groups according to a beginning of period financial constraint index (Zfc),
with classification model updated every period to reflect the fact that financial constraint changes continuously.
The index is determined using multiple discriminant analysis; similar to Altman's Z factor for predicting
bankruptcy, which considers an entire profile of characteristics, shared by a particular firm and transforms
them into a univariate statistic. And this study estimated the investment liquidity constraint model for different
portfolios of firms using ordinary least square regression estimate. The empirical result indicates that internal
liquidity is the significant determinants of investment for all Nepalese enterprises. Further the study results
strongly support the hypothesis that the investment decisions of more financially constrained firms are more
sensitive to their internal funds as compared to the less financially constrained firms.

1. General background

Investment and capital accumulation have traditionally been accorded a prime place in the
development literature. The evidence from the vast literatures on growth empirics shows investment
in capital goods as one of the most robust determinants of cross-country growth (Levine and Renelt,
1992). Over the last couple of decades, economic liberalization and deregulation policies have been
widely adopted by developing countries that assign a central role to the private sector. The emphasis
on the private sector as the engine of economic growth and development has brought the focus on
study of the behavior of private investment in developing countries. (Gilchrist and Himmelberg,
1995)

In a perfect capital market, the variation of firm investment behavior is fully explained by the market
opportunity and expected profitability of the proposed investment because the firms intend to
maximize their profitability. The firm's financial structure is irrelevant since the market value of the
firm depends only on the expected profit stream from the investment project and not on the financial

1
This paper was presented in Seminar on Emerging Issues and Challenges in Nepalese Finance, organized by
Central Department of Management, Tribhuvan University kathmandu, Nepal, July 12 and 13, 2010. The author
is acknowledged to Professor Dr.Rdhe S. Pradhan, Professor Dr. Manohar Krishna Shrestha, Professor Dr.Rajan
Bahadur Poudel and Professor Dr.K.D. Manandhar for their valuable comments and suggestions. E-mails are
welcomed at kapilsapta@yahoo.com.
structure. Firms are thus indifferent between the internal or external means to finance their
investment. Investment project will be carried out if their expected return exceeds the given cost of
capital, which is thought to be the same for all firms fixed in central capital markets. In this neo-
classical view of financial market, internal and external funds are perfect substitutes and investment
can never be constrained by a lack of internal funds. Consequently, adjusting capital expenditure in
response to changes in expected future profitability represents rational economic behavior at the firm
level that reduces inefficient investment outlays and lead to optimal investment at the aggregate level.

But due to the absence of perfect capital markets in real world, the other factor affecting corporate
investment pattern has been identified as the existence of capital market imperfection that restrict
access to or increases the cost of funds necessary to maintain, desirable investment level. Capital
market imperfections lead to firms into different financing hierarchies facing different financing
constraints (Agung, 2000). When firms face financing constraints, investment spending will vary with
the availability of internal funds, rather than just with the availability of positive Net Present Value
(NPV) projects (Cleary, 2005).

Existence of incomplete asymmetric information between the borrowers and lenders of external funds
leads to problem of adverse selection and moral hazard. For example, Greenwald, Stiglitz and Weiss
(1984), Myers and Majluf (1984) and Myers (1984) provide a foundation for these market
imperfections by appealing to asymmetric information problems in capital markets. In perfect capital
market it is assumed that decision makers in the firm and external suppliers of funds have the same
information about the firm’s choice and use of inputs, investment opportunities, riskiness of projects,
and output or profits. In practice, the firm decision makers have significantly better information than
outside investors about most aspects of investment and production. Information asymmetries can lead
to adverse selection, moral hazard, or both. These problems of asymmetric information lead to a
difference between the cost of internal and external funds. The providers of external finance will
require a (firm specific) premium because they are unable to monitor or screen all the aspects of
investment projects. The size of external finance premium depends on firm characteristics, like firm
size or net worth, which provide an imperfect indication for the lender of the creditworthiness of the
borrowing firms. Due to external finance premium, firms will albeit to a different degree; prefer to
finance their investment by internal funds. The upshot is that internal or external finance are no longer
perfect substitute.
What matters to the present purpose is that these problems of capital market imperfection lead to a
difference between the cost of internal and external funds. As a consequence investment made by
firms facing high information cost is not only determined by expected profitability but also
potentially by the availability of internal funds. Investments by those firms expected to face higher
information cost are thought to be more constrained by the availability of internal finance and vice
versa. In this line of direction, the present study derives a theoretical investment- liquidity constraint
model to test the hypothesis that the investment decisions of more financially constrained firm will be
more sensitive to their internal funds as compared to the less financially constrained firms. The basic
idea to this notion underlies various empirical studies on the severity of liquidity constraints for
investment (e.g. Fazzari et al., 1988; Cleary, 1999 etc.)

The major aim of this study is to explain the relationship between corporate investment and liquidity
constraints of non financial sector of enterprises by noting the fundamental issues of Nepalese
financial market. The major issues raised by the study are as follows.

1. Do capital market imperfections have differential effects on the investment behavior of

Nepalese firms?
2. Do the financing constraints matter in the investment decisions of the firms?
3. Whether the size of fixed investment and availability of internal funds correlated to each
other?
4. How sensitive are the firms to their investment opportunities?
5. Whether the firm investment decision is sensitive to their internal liquidity?
6. Does the firm investment-internal cashflow sensitivity differ across the financing
hierarchies of the firms?
7. Whether the fifed investment is financially constrained in case of Nepalese industrial
sector?
8. Whether the empirical relationship between investment and liquidity constraints in
Nepalese industrial sector corresponds with that found in similar studies of developed
economies?

The reminder of this paper is organized as follows. Section 2 describes research methodology
employed in this study. It includes selection of enterprises for the study, nature and sources of data
and model to be estimated. Section 3 provides presentation analysis of the data. Finally the results are
summarized in section 4.
2. Research Methodology
Nature and Sources of Data
This study is based on secondary data only. The necessary data and information have been collected
from various sources covering a period of 15 years, i.e., 1990 to 2004. There were 45 non-financial
sector enterprises listed in NPSE Ltd. by the end of 2004, which is regarded as size of the population
for the study. The study does not cover all the Nepalese enterprises. Financial sector of enterprises are
not taken because of the nature of study. In the absence of valid and reliable data, the study period for
each selected enterprises are not homogeneous in nature. To analyze the relationship among different
variables, study uses pooled cross section data of 26 enterprises as shown in appendix (Table A).

The study is based on 159 observations. The enterprises selected for the study can be considered
representatives of hotels, manufacturing and processing companies and trading companies.

Classification Methodology

The study methodology forms different portfolios of enterprises under different financial status
groups as characterized by assets size, dividend payout, discriminant score etc. and it estimates the
investment liquidity constraint model for different portfolios using ordinary least square regression
estimate. In this part, a focus is given on the relevance of financial market imperfection for
investment in Nepal and an investment function is estimated for Nepalese firms to know whether the
investment of these firms are liquidity constrained or not.

The proposed methodology classifies firm-year observations into different groups according to a
beginning of period financial constraint index (Zfc), with classification model updated every period to
reflect the fact that financial constraint changes continuously. The index is determined using multiple
discriminant analysis; similar to Altman's Z factor for predicting bankruptcy, which considers an
entire profile of characteristics, shared by a particular firm and transforms them into a univariate
statistic. The multiple discriminant analysis requires establishing two or more mutually exclusive
groups according to some explicit group classification. It is difficult to categorize explicitly which
firms are financially constrained without considering to a number of firm characteristics
simultaneously. However, it is possible to establish two mutually exclusive groups by making use of
the past knowledge that firms paid dividend or not. This basis suggests us dividing the sample into
two categories; group 1 firms which increase or do not change dividend per share in period t and are
likely not financially constrained; and group 2 firms which cut dividend or do not pay dividends in
period t and are likely financially constrained.

Discriminant analysis uses a number of variables that are likely to influence characterization of a firm
in one of the two mutually exclusive groups of interest. The present study applies the following
variables that are taken as proxy for firm liquidity, leverage, profitability and growth. The
independent variables chosen for the Discriminant analysis are current ratio, debt ratio, net profit
margin, assets turnover ratio, interest coverage and sales growth as selected by the of study of Sean
Cleary (1999). The hypothesis is that these variables will enable us to predict, if firms will increase or
decrease dividends payments in the subsequent period. Coefficient values are estimated that best
distinguish each independent variable between the two groups according to the following equation.

Zfs = B1 CR + B2 NIM % + B3 SALES GROWTH + B4 DEBTRATIO +B5ASSETS TURN. +B6 INT.COV………………..(1)

Cleary (1999) claims that the Discriminant analysis classifies the firms very reasonably according to
their financial constraints as measured by traditional financial ratio.

Regression Analysis:
Firms can finance their investment by external funds by equity or debt. Alternatively the firm can also
use internal funds to finance its investment projects. In the case of perfect capital markets, the firm’s
financial structure is irrelevant since the market value of the firm depends on the expected profit
stream from the investment project and not on the financial structure. But in incomplete capital
market, asymmetric information leads to problems of adverse selection and moral hazard resulting the
role of internal funds in shaping the corporate investment behavior of firms. What matters to present
purpose is that these problems of asymmetric information lead to a difference between the cost of
internal and external funds. As a consequence, investments by firms facing high information costs are
not only determined by expected profits but also potentially by the availability of internal funds.
Investments by those firms expected to face higher (lower) information costs are thought to be more
(less) constrained by the availability of internal finance. This basic idea underlies various empirical
studies on the severity of liquidity constraints for investment (e.g.; Fazzari et al., 1988; Kaplan &
Zingales, 1997). The reduced form investment equation in this type of study has the following general
form (Hubbard, 1998: 202):
(I/k)it = Co + C1f (X/Kit) + C2f (L/K)it + µit
Where I is the net investment in fixed assets and the dependent variable in the regression, it is
obtained as the first difference of tangible fixed assets plus depreciation in our present study.
Investment opportunity (X) in equation (1) is an important explanatory variable. Theoretically
marginal Q could be used for the approximation of present and expected future investment
opportunities. Since marginal Q is unobservable, many investment/liquidity studies for industrialized
countries use average Q as a proxy. However in order to be able to calculate average Q, the country
concerned should have a well developed stock market. In Nepal this is still not the case, and only a
limited number of companies are listed and do not have their market trading regularly. In this study,
therefore Return on Assets (ROA) is used as a proxy for the investment opportunities of the firm. For
the accelerator model, the proxy used for market opportunity is the difference in sales scaled by net
fixed assets. This proxy is also used in other studies on transition economies (see e.g.; Lensink and
Sterken, 1998). Cash flow is used as a proxy for the liquidity variable in above equation. So in this
empirical study, above equation becomes:
(I/K)it = Co + C1 (∆SAL/K)it + C2 (CF/K)i + µit ... for accelerator model……………………..(2)
OR
(I/K)it = Co + C1 (ROA)it + C2 (CF/K)i + µit ... for liquidity constraint model………………(3)

Where I/Kt denotes the ith firm-year observation in period t, I is net investment in fixed assets, ∆SAL
denotes the change in sales and proxies for investment opportunities, ROA denotes the Return On
Assets and proxies for profitability and CF represents the cash flow variable; µ is the error term and
the scalar, K is the net fixed assets at the beginning of each year.

3. Data Analysis and Empirical Results

Classification results and firm characteristics

Table 1 reports summary statistics of mean and standard deviations of various financial variables for
the sample period which confirm that firms likely to reducing dividend payout or no dividends
(Predicted group 2 or financially constrained group) exhibit lower current ratios, lower assets
turnover ratio, higher debt ratios, lower net profit margin and lower sales growth, than the firms that
are likely to increase or no change in dividend payout in period t (Predicted group 1 or not financially
constrained group).
 Table 1 -Sample Summary Statistics:
The followings are the reports of financial variable means for the sample of firms-year observations of
Nepalese non-financial sectors of enterprises. All financial variables are for the beginning of period of the
fiscal year except for cash flow, investment and ROA, which represents firm cash flow, investment in fixed
assets and return on assets during period t. k is the firm's beginning of period net fixed assets value. The
discriminant score (zfs) is calculated using discriminant analysis according to equation 1. A full-description of
the variables is included in the Appendix.

Panel A: Classification of firm-years observation by Fisher's linear discriminant functions

a. Summary statistics of financial constraints variables

Predicted Group Current Assets Debt Net Profit Interest Sales
Ratio Turnover Ratio Margin coverage Growth
PG 1 Mean 2.00 1.95 .152 -.041 12.19 .144
N=105 Std. Dev. 1.29 2.09 .252 .296 18.66 .416
PG 2 Mean .785 .703 .425 -.064 9.31 .126
N=55 Std. Dev. .394 .332 .342 .301 17.95 .314
Total Mean 1.58 1.52 .246 -.049 11.20 .138
N=160 Std. Dev. 1.21 1.81 .314 .297 18.41 .383

b. Summary statistics for Investment, Cash flow and Growth

Predicted Investment in Investment in Investment Cash ROA

Group fixed assets t/Kt-1 Current Assets t in Total flowt/Kt-1
/Kt-1 Assets t /Kt-1
PG1 Mean .203 .149 .146 1.007 .076
N=105 Std. Dev .426 .431 .392 1.924 .207
PG 2 Mean .118 .124 .105 -.035 .050
N=55 Std. Dev .392 .370 .231 .596 .237
Total Mean .174 .140 .132 .644 .067
N=160 Std. Dev .416 .410 .344 1.666 .217

Panel B: Classification of firm-years observation by Dividend Payout Ratio

Summary statistics of financial constraints variables
Current Assets Debt Ratio Net Profit Interest Sales
Group Ratio Turnover Margin coverage Growth
Dividend group 1 Mean 2.112 1.159 .181 .123 17.77 .146
(Increased DPS) Std. Dev 1.211
N=26 .756 .221 .188 21.23 .279
Dividend group 2 Mean 1.292 .784 .366 -.012 14.24 .146
(Decreased DPS) Std. Dev 1.086 .449 .268 .167 21.71 .287
N=31
Total Mean 1.666 .955 .282 .049 15.85 .146
N=57 Std. Dev 1.207 .631 .263 .188 21.37 .281
 b. Summary statistics for Investment, Cash flow and Growth

Investment in Investment in Investment in Cash ROA

fixed assets Current Assets Total Assets t flowt/Kt-1
Group t/Kt-1 t /Kt-1 /Kt-1
Dividend group 1 Mean .057 .107 .113 .616 .122
(Increased DPS) Std. Dev
N=26 .126 .152 .115 .550 .065
Dividend group 2 Mean .126 .244 .132 .280 .078
(Decreased DPS Std. Dev
N=31 .368 .396 .172 .646 .064
Total Mean .095 .183 .123 .439 .099
N=57 Std. Dev .284 .317 .148 .621 .068

Univariate significance level indicates that the net profit margin and debt ratio are significant at 1
percent level of significance where as current ratio; sales growth and interest coverage ratio are
significant at five, seventeen, and thirty three percent levels of significance respectively. In part B of
panel A, the investment, growth and cashflow variables are presented across the categories. The
reported result discloses that the average investment in fixed assets, current assets, and total assets are
higher for predicted group 1 (not financially constrained) firms than for the predicted group 2
(financially constrained) firms.

Similarly, the average cash flow ratio and ROA is smaller for financially constrained groups
(Predicted group 2) in comparison of ‘Not financially constrained group’. However the standard ratio
performs higher variability in all cases for ‘Not financially constrained group’.

For classification purpose, 159 firms-year observations were taken into account for the discriminant
analysis using the independent variables as mentioned in equation 1. Standardized Canonical
Discriminant Function Coefficients for the study observations showed the following results for group
classification.
Zfs = .880 CR + -.583 NIM % + .016 SALGRT + -.801 DEBTRATIO +0. 610 ATR………………(2)

The discriminant function classified the 105 observations as predicted group one (likely to increase or
no change in dividend) and 55 firms-year observations were classified as predicted group two (likely
to decrease or no dividends) firms. While in the original grouped cases, the 26 firm- years
observations were classified into first group (increase or no change in dividend payout) and 31 firm-
years observations were classified into second group (decrease or no dividend payout) of firms.
The table 2 presents the classification result. Overall, the independent variables do a good job of
successfully predicting the firms in group one if they will increase or do not change in dividend
payout in period t and predicting the firms in group two which cut or do not pay their dividends in
period t. In aggregate, the firms are being properly classified at 71.9 percent of the time. The
discriminant function result suggests that firms are classified very reasonably according to their
financial constraints as measured by traditional financial ratios for the purpose of this study

In addition to the predicted group classification, firms are also classified into three separate groups
according to their discriminant score (Zfs) value. The firms with discriminant scores in the top third
over the entire period are categorized as not financially constrained (NFC), the next third as partially
financially constrained (PFC), and the bottom third as financially constrained (FC).

Table -2
Classification Results
The following are classification result of the sample of firms-year observations of Nepalese non-financial
sectors of enterprises. Firms are classified into groups according to a beginning of period financial constraints
index (Zfs), The index is determined using multiple discriminant analysis considering an entire profile of
characteristics shared by a particular firm and transforming them into a univariate statistic.

Group Predicted Group Membership Total

1.00 2.00

Original Count 1.00 20 6 26

2.00 10 21 31
Ungrouped cases 75 28 103
% 1.00 76.9 23.1 100.0
2.00 32.3 67.7 100.0
Ungrouped cases 72.8 27.2 100.0
a . 71.9% of original grouped cases correctly classified.

Summary statistics for these groups presented in table 3 indicate the classification strategy has
successfully captured the desired cross-sectional properties. The financial ratios are superior for the
NFC groups, inferior for the FC groups and for the PFC groups lying somewhere between these two
groups of firms. For illustration, it is note worthy to state here that the current ratio, assets turnover
ratio, net profit margin, and sales growth all increased monotonically across the FC, PFC, and NFC
groups respectively as seen in table 3 but the debt ratio has been decreased proportionately to the FC,
PFC, and NFC groups.
Summary statistics for Investment, Cash flow and Growth of FC, PFC, and NFC groups are reported
in part b of table 3. These results also conform that the measures of cash flow, growth and investment
variables increases monotonically corresponding to the FC, PFC, and NFC groups.

Table -3
Firm's financial constraints group-wise sample summary statistics

The followings are the reports of financial variable statistics (mean and standard deviation) for the sample of
firms-year observations of Nepalese non-financial sectors of enterprises. Sorting all firms according to their
discriminant scores forms the FC, PFC and NFC groups. Every year, the firms with the lowest discriminant
scores (the bottom one-third) are categorized as financially constrained (FC); the next one third are
categorized as partially financially constrained (PFC); and the top one-third are categorized as not financially
constrained (NFC).

a. Summary statistics of financial constraints variables

Discriminant Current Assets Debt Ratio Net Profit Interest Sales
Scores Ratio Turnover Margin coverage Growth
FC Group .7708 .6991 .4382 -.0688 8.7076 .1245
(<= .02129) (.3904) (.3304) (.3424) (.3064) (17.35) (.3195)
n=53
PFC Group 1.9448 .9222 .2142 -.0377 16.19 .0695
(.02130 - 1.2593) (1.2914) (.5094) (.2664) (.3131) (22.30) (.3243)
n=54
NFC Group 2.0403 2.9716 .0872 -.0413 8.6200 .2214
(1.2594+) (1.2899) (2.5388) (.2180) (.2771) (13.78) (.4771)
n=53
Total 1.5875 1.5271 .2464 -.0492 11.2068 .1381
n=160 (1.2181) (1.810) (.3140) (.2978) (18.41) (.3832)

b. Summary statistics for Investment, Cash flow and Growth

Investment Investment in Investment in Cash ROA
Discriminant Scores in F.A. t/Kt-1 C. A. t /Kt-1 T. A. t /Kt- flow/Kt-
FC Group .1184 .1134 .0950 -.0433 .0507
(<= .0213) (.4001) (.3663) (.2253) (.6062) (.2416)
n=53
PFC Group .1100 .0786 .0813 .2368 .0331
(.0213 - 1.259) (.2830) (.2279) (.1936) (.9003) (.2294)
n=54
NFC Group .2967 .2293 .2245 1.732 .1175
(1.259+) (.5147) (.5577) (.5178) (2.317) (.1706)
n=53
Total .1746 .1407 .1321 .6445 .0673
n=160 (.4161) (.4102) (.3449) (1.666) (.2177)
Correlation among the study variables

Table 4 presents the correlations among the financial variables, as well as those used in the
subsequent regression analysis. The largest positive correlation between discriminant score (Zfs) and
the independent variable is 0.568 with assets turnover ratio, second large correlation coefficient is
with net cash flow ratio and third one is with current ratio. These all coefficients are significant at one
percent level of significance. These observations suggest that firms tend to increase the dividend
payout ratio during periods of increasing turnover (sales) and liquidity. At the same time, the largest
negative correlation between discriminant scores (Zfs) and debt ratio is 0.36 and the coefficient is
significant at one percent level of significance. This result suggests that the firms tend to decrease or
pay no dividends at the period when they have higher debt ratio. The correlation coefficient between
fixed assets purchase and discriminant score (Zfs) is 0.164 and it is significant at 5 percent level. This
observation suggests that the firms are likely to be related with dividend payout and fixed assets
purchase decision.

Table 4
Correlation among the financial variables

Current Assets Debt NP Int.cov Sales Inv. in CF/K ROA Disc.

Variables
Ratio turn. ratio Ratio Grwth F.A. score
Current Ratio 1
Assets turn. .339** 1
Debt ratio -.185* -.323** 1
N P ratio .341** .155 -.463** 1
Int.Cov. .167* -.160* -.430** .471** 1
Sales Growth -.040 .206** -.059 .045 -.033 1
Inv. in F.A .091 .180* -.061 -.006 -.034 .118 1
Cashflow/K .406** .583** -.413** .371** .104 .297** .150 1
ROA .218** .273** -.476** .609** .271** .015 .025 .524** 1
Disc. score .353** .568** -.360** .000 -.088 .052 .164* .403** .111 1
** Correlation is significant at the 0.01 level (2-tailed).
* Correlation is significant at the 0.05 level (2-tailed).

Regression Results for full sample

The regression equation is estimated in splitted sample and the results are presented in Table – 5. The
prior hypothesis in liquidity constraint model is that a positive and significant coefficient of the
liquidity variable C2 is thought to indicate that liquidity constraints matter to the extent that
investment is sensitive to fluctuation in internal finance. The first column in Table – 5 represents the
full sample estimation results, where cash flow coefficient is positive and significant. The regression
results for investment-opportunity sensitivity of Nepalese enterprises indicate that the coefficient is
positive as per prior expectation but it is very small and not significant. This result suggests that the
liquidity constraints are relevant for the Nepalese enterprises whereas, the investment sensitivity to
market opportunity is not so significant for investment decision in Nepalese enterprise in our sample.
In order to identify the regression coefficient of constrained and unconstrained firms, the equation
mentioned above is estimated for sub samples where the sub- sampling is based on above mentioned
discriminant analysis. The predicted group one (firms likely to increase dividends or no change in
dividends) firms’ regression estimation (as shown in Table – 5 column two) shows the positive cash
flow coefficients for all investment model (see model 1,2, and 3) and the coefficient is significant for
model 2. But at the same estimation, these firms showed a negative co-efficient for profitability as
proxied by ROA and the coefficient is nil for market opportunity as proxied by first difference of
sales to fixed assets. It also estimated the regression equation for predicted group two; the regression
results for these firms show the larger cash flow co-efficient (Table – 5 Column - III). However the
coefficients are insignificant for model 1 and 2, the co-efficient value is positive and significant for
model 3.
Table -5 Regression Estimates Including of ROA or ∆ SALES/K
Values reported are OLS regression estimates over the whole sample period. See Table 1 for details on the
construction of the data set and the variables. Capital expenditure (normalized by net fixed assets) is the
dependent variable. The independent variables are the Cash flow (CF/K) in Model 1, Cash flow (CF/K) and
Return On Assets (ROA) in Model 2 and Cash flow (CF/K) and Difference in Sales normalized by beginning of
period fixed assets (∆ SALE/K) in model 3 respectively for full sample, predicted group 1 and group 2 firms.
Full sample Predicted Group 1 Predicted Group 2

Model 1 2 3 1 2 3 1 2 3
CF/K .038 0.047 .032 .030 .045 .033 .096 .128 .117
(1.895)* (2.025)** (1.531) (1.35) (1.66)* (1.42) (1.07) (1.071) (1.72)*

ROA -.141 -.241 -.124

(-.787) (-.954) (-.411)
∆ SAL/K .085 .000 .128
(.937) (-.462) (6.40)**
Constant .153 0.156 .144 0.178 .189 .175 0.122 .129 .063
(4.314)* (4.37)*** (3.94)** (3.73)** (3.79)*** (3.61)** (2.303)** (2.30)* (1.52)

F-stat. 3.59 2.102 2.23 1.822 1.36 1.01 1.14 .648 21.51
N 157 157 157 102 102 102 54 54 54
t-statistics in the brackets.***,** and *:significance levels at the 1, 5, and 10 percent levels respectively

The main conclusion to arise from Table – 5 is that liquidity constraints are relevant for the Nepalese
enterprises whereas the firms that are financially unhealthy are relatively more sensitive to the
availability of internal funds, while the opposite result holds for firms with reasonably good financial
positions. This result supports the main findings of FHP (1988) and contradicts the results of KZ
(1997) regarding the impact of financial health. This result suggests that the investment decisions of
firms with stronger financial positions are less sensitive to the availability of internal funds.

Regression Result for Sample Split Based on Discriminant Score

The present study also estimated the regression equation of different financial status group; (for
example FC, PFC and NFC groups) as mentioned above according to their discriminant score and
presented the result in Table – 6. They indicate that internal cash flow is the significant determinants
of investment for FC and PFC groups of firms. But the cashflow coefficient is very small and
negative (see model 1 and 3) for NFC groups of firms. For PFC group, all the co-efficients are
positive, and they are significant at 1 percent level of significance. The result also indicates that the
market opportunity as proxied by first difference of sales to fixed assets is insensitive to investment
decisions of PFC and NFC groups of firms. The co-efficient, as opposite to prior expectation, are
negative and also insignificant to FC and NFC groups. As regard to the FC group, the market
opportunity co-efficient is positive as per prior expectation and it is significant also.

Table 6
Regression Estimates for FC, PFC, and NFC group Including ROA or ∆ SALES/K
Values reported are OLS regression estimates over the whole sample period (1990-2004). See Table 1 for
details on the construction of the data set and the variables. Capital expenditure (normalized by net fixed
assets) is the dependent variable. The independent variables are the Cash flow (CF/K) in Model 1, Cash flow
(CF/K) and Return On Assets (ROA) in Model 2 and Cash flow (CF/K) and Difference in Sales normalized by
beginning of period fixed assets (∆ SALE/K) in model 3 respectively for FC, PFC and NFC groups of firms.

FC Group PFC Group NFC Group

Model 1 2 3 1 2 3 1 2 3
CF/K 0.096 0.129 .118 .141 .219 .164 -.006 .033 -.007
(1.054) (1.058) (1.70)* (3.49)*** (4.05)*** (3.75)*** (-.187) (.807) (-.196)

ROA -.126 -.443 -.804

(-.411) (-2.08)* (-1.46)
∆ SAL/K .129 -.010 .0.005
(6.28)*** (-1.32) (.067)
Constant 0.123 0.130 .064 .081 .077 .086 .307 .335 .308
(2.26)** (2.222)** (1.51) (2.17)** (2.13)** (2.30)** (3.43)*** (3.70)*** (3.32)**

Adj.R2 0.002 .000 .432 .180 .231 .192 .000 .004 .000
F-stat. 1.11 .631 20.75 12.17 8.68 7.055 .035 1.092 .019

N 52 52 52 51 51 51 52 52 52
Note: t-statistics in the brackets. ***, ** and * significance levels at the 1, 5, and 10 percent levels respectively
The positive and significant co-efficient for liquidity variable suggests that firm’s investment
decisions are sensitive to the availability of internal funds. More notably, the investment outlays of
the PFC firms are significant and more sensitive to liquidity than that of NFC and FC firms. The
estimated cashflow co-efficients for the NFC, FC, and PFC groups are -.006, 0.096 and 0.141
respectively in model 1. They are 0.033, 0.129 and 0.219 for model 2 and -.003, 0.118 and 0.164
respectively in model 3 for NFC, FC, and PFC groups of firms. The adjusted R² value ranges from 0
percent to 43.2 percent, which is higher than the previous studies. In some models, the adjusted R²
were noticed to be negative also. To these models the R² values were taken as zero strictly following
the approach as suggested by Gujarati (2003).

This result contradicts the main findings of Kaplan and Zingales (1997) and Cleary (1999) regarding
the impact of financial health on investment decisions of firms with stronger financial positions are
much more sensitive to the availability of internal funds. But at the same time, it supported the main
findings of Fazzari et. al. (1988) regarding the impact of financial health on investment decisions of
firms with least financially constrained firms are much less sensitive to the availability of internal
funds

Liquidity Constraints and the Relevance of Firm's Size:

In this section; the present study used firm characteristics i.e firm size to classify firms that a priori
can be considered to differ in their access to external funds or, in other words, in their liquidity
constraints. There are various measures to determine firm size. This study presented estimations
based upon the total assets of each firm for each period. Table –7 reports result for the groups formed
according to firm size. This result suggests that intermediate firms are more liquidity sensitive than
smallest and largest firms. The cashflow co-efficients for all three groups of firm are positive. The TA
Group two has highest cashflow co-efficient than other two groups. The cashflow co-efficients for
largest group are positive as per prior expectation but they are not significant in any models. The
adjusted R2 value for some models are noticed negative and it ranges to highest (5.7 percent) for
model 1 in total assets size group 2. Our objective is not to obtain a high (adjusted R2) per se but
rather to obtain dependable estimate of the true population regression coefficients and draw statistical
inferences about them. In classical linear regression models, smaller R2 is also acceptable (Gujarati,
2003)
 Table- 7
Regression Estimates for assets size group Including ROA or ∆ SALES/K
Values reported are OLS regression estimates over the whole sample period (1990-2004). See Table 1 for
details on the construction of the data set and the variables. Capital expenditure (normalized by net fixed
assets) is the dependent variable. The independent variables are the Cash flow (CF/K) in Model 1, Cash flow
(CF/K) and Return On Assets (ROA) in Model 2 and Cash flow (CF/K) and Difference in Sales normalized by
beginning of period fixed assets (∆ SALE/K) in model 3 respectively for TA Group 1, TA Group 2 and TA Group
3 of firms.

TA Group 1 (Smallest) TA Group 2 (Intermediate) TA Group 3 (Largest)

Model 1 2 3 1 2 3 1 2 3
CF/K .044 .021 .152 .187 .137 .031 .041 .045
0.096 (1.47) (.719) (2.03)** (1.75)* (1.84)* [1.13) (1.25) (1.26)
(.682)
ROA -.638 -.167 -.118
(-1.85]* (-.467) (-.57)
∆ SALE/K 000 .033 -.002
(-.247) [1.50) (-.612)
Constant .207 .255 .203 .237 .238 .222 .054 .056 .051
(2.69)*** (3.21)** (2.55)** (3.29)** (3.28)** (3.09)** (3.15]*** [3.04)** (2.98)**
F-statistics .465 1.96 .259 4.14 2.15 3.25 1.28 .798 .823
N 53 53 53 52 52 52 50 50 50
t-statistics in the brackets.***,** and *:significance levels at the 1, 5, and 10 percent levels respectively

This observation confirms the result of Gilchrist and Himmelberg (1995) but contradicts with recent
international evidence provided by Kadapakkam et al. (1988), and Cleary (2005) who find that
smaller firms are less sensitive to cashflow than the larger ones. This result supports with prior results
presented in this study and suggested the notion that the smaller firms will be more financially
constrained because they face higher informational asymmetry problems and agency cost so they are
more sensitive to internal funds than the larger firms. This findings is incompliance with the
conclusion of FHP (1988)

The Impact of Leverage on Firm Investment:

A number of prior studies (for example La Porta et al, 1998) find that future growth and investment are
negatively related to leverage; particularly for firms with low Tobin’s q value and high debt ratio. It is
very important to control the firm leverage effect on investment liquidity constraint model. Therefore,
an additional test is performed to examine the robustness of results to the influence of firm leverage.

This implies the significance of examining whether the pattern of investment-liquidity sensitivities
detected in the present study could be attributed to a systematic tendency of the classification scheme
to assign firms to a group whose investment decisions are more sensitive to firm leverage than those
of other groups. This hypothesis is tested by running regression that include debt to total assets as an
independent variable in the regression specification, in addition to ∆SAL/K or ROA and CF/K. The
results are reported in Table – 8. The co-efficient for debt to total assets is found to be negative and
insignificant for PFC groups, hence the cashflow co-efficient virtually remain identical for this group.
For FC group the debt assets coefficient are very small in all model however they are positive, hence
the cashflow co-efficient remain identical for alternative specifications to this group also.

Table 8
Regression Estimates for FC, PFC, and NFC group (Robustness test for impact of Leverage)
Values reported are OLS regression estimates over the whole sample period (1990-2004). See Table 1 for
details on the construction of the data set and the variables. Capital expenditure (normalized by net fixed
assets) is the dependent variable. The independent variables are the Cash flow (CF/K) and Leverage (LTD/TA)
in Model 1, Cash flow (CF/K), Leverage (LTD/TA) and Return On Assets (ROA) in Model 2 and Cash flow
(CF/K), Leverage (LTD/TA) and Difference in Sales normalized by beginning of period fixed assets (∆ SALE/K)
in model 3 respectively for FC, PFC and NFC groups of firms.

FC Group PFC Group NFC Group

Model
1 2 3 1 2 3 1 2 3
CF/K .110 .131 .165 .140 .221 .168 .008 .040 .010
(1.09) [1.05) (2.195)** (3.28)** (4.07)*** (3.55)*** (.233) (.953) (.253)
ROA -.099 -.518 -.728
(-.288) (-2.27)** (-1.30)
∆ SAL/K .134 -.011 .0.005
(6.53)*** (-1.32) (-.016)
Leverage .061 .036 .202 -.015 -.136 .037 .364 .289 .371
(.343) [.180) (1.51) -.107 (-.923) (.249) (1.010) (.773) (1.00)
.096 .113 -.024 .085 .110 .077 .251 .289 .248
Intercept (1.019) [1.010] (-.339) (1.65)* (2.17)** (1.51) (2.39)** (2.67)** (2.25)**

F-stat. .604 .432 14.95 5.97 6.052 4.63 .527 .921 .019
N 52 52 52 51 51 51 52 52 52
t-statistics in the brackets.***,** and *:significance levels at the 1, 5, and 10 percent levels respectively

About the NFC groups, the Debt/Assets co-efficients are positive and larger in comparison of other
two groups and due to their impact, the cashflow co-efficients considerably increased from the range
of -.007 to 0.010. This evidence suggests that the observed pattern of investment-liquidity sensitivity
is attributable to a leverage effect for NFC groups of firms.

5. Summary and Conclusion

This study classified firms into different groups using the assets size criterion, dividend payout
criterion and on the measure of Discriminant score. The portfolios of firm were compared in terms of
their financial constraints using the statistics like mean, median, and standard deviation. The
regression equation was estimated to test the hypothesis that the financial constraints have significant
impact on the investment decisions of the firms. The regression equations were estimated for different
financial constraint group of firms (for example FC, PFC and NFC groups) as mentioned above
according to their discriminant score. The result indicated that internal cashflow is the significant
determinants of investment for all three groups. The overall results of the study can be summarized as
follows:

-The result indicated that the market opportunity as proxied by first difference of sales to fixed assets
are insensitive to investment decisions of PFC, and NFC groups of firms in almost all models. As
regards to the FC group, the market opportunity co-efficient was positive as per prior expectation in
model 3 and it was significant also.

-ROA as a proxy of profitability is insensitive to investment decisions of FC, PFC, and NFC groups
of firms in almost all models. The ROA co-efficient, as opposite to prior expectation, were negative
and also insignificant to FC, PFC and NFC groups.

-The positive and significant co-efficients for liquidity variable suggested that firm’s investment
decisions are sensitive to the availability of internal funds. More importantly, the investment outlays
of the FC and PFC firms were significantly more sensitive to liquidity than that of NFC firms.

-The result of leverage impact on cashflow coefficient is mixed. For the PFC and FC group of
enterprises. The leverage impact on liquidity coefficient is negligible and insignificant but for PFC
groups. It seems, the leverage has positive impact on investment liquidity model.

-The firm size effect on investment liquidity model indicates that smaller firms will be more
financially constrained because they face higher informational asymmetry problems and agency cost
so they are more sensitive to internal funds than the larger firms. This findings is incompliance with
the conclusion of FHP (1988)

This result supported the main findings of Fazzari et. al. (1988) regarding the impact of financial
health on investment decisions of firms with stronger financial positions are much less sensitive to the
availability of internal funds and contradicted the findings of Kaplan and Zingales (1997) and Cleary
(1999).

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Appendix
Table-A-List of selected companies, period of study and number of observations

S.N. Name of the Enterprises Years Sector

1. Salt Trading Corporation 1999 - 2004 6 Trading
2. Bishal Bazar Company Ltd. 1998 - 2004 7 "
3 Nprograssive Trading Ltd. 1993-1998 6 "

4 Soaltee Hotel Ltd. 1997 - 2001 5 Hotel

5 Bottlers Nepal Ltd. 1998-2004 7 Manuf. & Processing

6 Unilever Nepal Ltd. 1995-2004 10 "

7 Botlers Nepal (Terai) Ltd. 1997-2004 8 "
8 Shree Bhrikuti Pulp and Paper Ltd. 1999-2003 5 "
9 Shree Ram Sugar Mills Ltd. 1998 -2004 6 "
10 Butwal Power Company Ltd. 2000 -2004 5 "
11 Jyoti Spinning Mills Ltd. 1997-2004 8 "
12 Nepal Lube Oil Ltd. 1997-2004 8 "
13 Nepal battery company 1994- 1998 5 "
14 Arun Vanaspati Udhyog Limited 2000-2004 5 "
15 Juddha Match Factory (Biratnagar) Ltd. 1998-2001 3 "
16 Raghupati Jute Mills Limited 2000-2004 5 "
17 Fleur Himalayan Ltd. 2000-2004 5 "
18 Nepal Bitumen and Barrel Udhyog Ltd. 1999-2004 6 "
19 Nepal Banaspati Ghee Udhyog Ltd. 1998-2004 7 "
20 Gorakhkali Rubber Udhyog Limited 1999-2004 6 "
21 Khadhya Udhyog Limited 2001-2004 4 "
22 Birat Shoe Company Ltd. 1998-2004 7 "
23 Agro Co Ltd. 1994-1998 5 "
24 Nepal United Company Limited 1991-1999 9 "
25 Nepal Jugal Wool Publc Limited 1990-1994 5 "
26 Nepal Trade and Temple Public limited 1990-1994 5 "
Total 160
Source: The web page www.nepse.com, http://www.bm.com. and various publications of Nepse. Ltd

Table B Description of variables

Abbreviation Variables Description
CF/K Cash flow by net fixed assets Cashflow is determined by adding depreciation
and other amortization expenses to net profit after
tax
ROA Return On Assets Net profit after tax divided by total tangible assets

∆ SAL/K Sales growth by net fixed assets Difference in the sales amount of end of year
minus beginning of year divided by beginning of
period net fixed assets
Leverage Debt assets ratio Long term debt divided by total assets
NP Ratio/margin Net profit margin Net profit after tax divided by sales
Current Ratio Current ratio Current assets divided by current liabilities
Assets turn. Assets turnover ratio Sales divided by total assets
Debt ratio Debt ratio Long term debt divided by total asstes
Int.Cov. Interest coverage ratio Earning before interest and tax divided by interset
Inv. in F.A(I/K) Capital expenditure in fixed assets Increase in fixed assets during the year normalized
by beginning of period net fixed assets