Do finance constraints affect inventory investment decisions of firms?

Abstract

In recent years there has been an increasing debate on the determinants of a firm’s investment decisions. In fact, according to the investment models that assume perfect capital markets (e.g. Q-Tobin model), the availability of internal funds does not affect investment decisions. Investment outlays in each period are determined in perfectly functioning capital markets. Financial factors are only considered in the cost of capital, which, in turn, is independent of the way in which a firm finances itself (Bond and Meghir, 1994). On the other hand, the finance constraints model rejects the independence between investment and finance decisions of a firm due to problems of asymmetric information in financial markets. In fact, this model assumes that the participants in financial markets do not share the same information. For example, managers of a particular firm have better information on its future perspectives than potential lenders. As consequence, there is no perfect substitution between a firm’s internal and external funds, and this leads to a hierarchy of finance (Myers, 1984), where the cost of internal funds becomes cheaper than the cost of external funds. Therefore, the finance constraints model concludes that the financial status of a firm is a determinant of its investment decisions. The aim of this paper is to analyse the existence of finance constraints on inventory investment decisions of Portuguese manufacturing firms. To test this impact, a modified version of Lovell’s model (1961) was used. The model was extended to include financial variables that are a proxy to the financial position of a firm. The data used related to the period between 1990 and 2000, and was split into subsamples based on size, age, and interest coverage ratio to reflect expected differences in the degrees of asymmetric information problems. Furthermore, an econometric inventory investment equation was estimated for each group of firms. The results of this study showed that, as the finance constraints hypothesis indicates, financial variables have a greater impact on inventory investment decisions of firms that are more subject to information problems in financial markets (e.g., small and young).