Kaplan and Zingales [1997] provide both theoretical arguments and empirical evidence that investment-cash flow sensitivities are not good indicators of financing constraints. Fazzari, Hubbard and Petersen [1999] criticize those findings. In this note, we explain how the Fazzari et al. [1999] criticisms are either very supportive of the claims in Kaplan and Zingales [1997] or incorrect. We conclude with a discussion of unanswered questions.

Luigi Zingales

Steven N. Kaplan

English

Research Papers in Economics

NBER WORKING PAPER SERIES
INVESTMENT-CASH FLOW SENSITIVITIES ARE NOT
VALID MEASURES OF FINANCING CONSTRAINTS
Steven N. Kaplan
Luigi Zingales
Working Paper 7659
http://www.nber.org/papers/w7659
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
April 2000
This research has been supported by the Center For Research in Security Prices and by the Olin Foundation
through grants to the Center for the Study of the Economy and the State.  Heitor Almeida, Andrei Shleifer,
Dick Thaler, and Rob Vishny provided helpful comments. The views expressed herein are  those of the
authors and are not necessarily those of the National Bureau of Economic Research.
© 2000 by Steven N. Kaplan and Luigi Zingales.  All rights reserved.  Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is
given to the source.Investment-Cash Flow Sensitivities are not Valid
Measures of Financing Constraints
Steven N. Kaplan and Luigi Zingales
NBER Working Paper No. 7659
April 2000
ABSTRACT
Kaplan and Zingales [1997] provide both theoretical arguments and empirical evidence that
investment-cash flow sensitivities are not good indicators of financing constraints.   Fazzari,
Hubbard and Petersen [1999] criticize those findings.  In this note, we explain how the Fazzari et
al. [1999] criticisms are either very supportive of the claims in Kaplan and Zingales [1997] or
incorrect.   We conclude with a discussion of unanswered questions.
Steven N. Kaplan Luigi Zingales
Graduate School of Business Graduate School of Business
University of Chicago University of Chicago
1101 East 58th Street 1101 East 58th Street
Chicago, IL  60637 Chicago, IL  60637
and NBER and NBER
steven.kaplan@gsb.uchicago.edu luigi.zingales@gsb.uchicago.edu  1 
  Fazzari, Hubbard, and Petersen [1988] (hereafter, FHP[1988]) introduce a methodology to 
identify the presence of financing constraints based on the differential sensitivity of corporate investment 
to cash flow.  Kaplan and Zingales [1997] (hereafter, KZ) provide both theoretical arguments and 
empirical evidence that this differential sensitivity is not a valid measure of financing constraints.  
Fazzari, Hubbard and Petersen [1999] (hereafter, FHP [1999]) criticize those findings.   In this note, we 
explain that the main arguments in FHP [1999] are, in fact, quite supportive of KZ’s main conclusion, 
while the specific criticisms in FHP [1999] are unjustified.     
 
I.  Points of Agreement 
  FHP [1999] admit that financially distressed firms are likely to have lower investment-cash flow 
sensitivities than less financially constrained firms.  This is exactly the point that the KZ model makes: 
investment-cash flow sensitivities are not necessarily monotonic in the degree of financing constraints.  
The only disagreement FHP [1999] have with KZ is how pervasive the non-monotonicity result is.   But 
this is ultimately an empirical question.  
  FHP [1999] also recognize that the literature on investment-cash flow sensitivities has not been 
based on a solid theoretical foundation.  As KZ point out, the practice of (1) splitting the sample 
according to a measure of financing constraints and then (2) comparing  investment-cash flow 
sensitivities across groups is justified only if investment-cash flow sensitivities increase monotonically in 
the degree of financing constraints.  Neither FHP [1988], nor any other paper of which we are aware, 
spell out the sufficient conditions for monotonicity.    
 
II.  Points of Disagreement 
  We disagree with FHP [1999] on three specific points:  (1) their comparative statics analysis;  (2) 
their criticism of the KZ classification scheme; and (3) their criticisms of the KZ empirical results. 
 A.  Comparative  Statics 
  As we see it, there are two ways for a firm to be more constrained than another one.     2 
  First, a firm may have fewer internal funds than another.  This corresponds to the parameter,  W, 
in KZ’s  model.   The appropriate comparative static is then obtained by computing d
2I/dW
2, as we did in 
KZ.  Our result is reproduced as equation (2) in FHP [1999].
1 In this case, the appropriate condition for 
monotonicity is the one we report rather than the one proposed by FHP [1999].  
  Alternatively, one firm may be more constrained than another because the firm’s intrinsic 
characteristics make it more costly to raise a given amount of external funds.  The appropriate 
comparative statics exercise requires the explicit parameterization of intrinsic firm differences.  This is 
precisely what we did in KZ, where we introduced a parameter, k, in the cost function of external finance, 
C(I-W, k).  In the KZ model, k represents the extent to which a firm’s inherent characteristics make it 
more or less constrained.
2  In KZ, we discussed, but did not report, how the investment-cash flow 
sensitivity varied with the extent to which a firm was constrained because of its intrinsic characteristics, 
d
2I/dkdW. The appropriate condition for monotonicity is that:  ∂
2I/ ∂ W∂ k  >  0.  This derivative can be 
written as: 
(1) (-F11C112 - F11C111 (∂ I /∂ k) + F111C11 (∂ I /∂ k)) / (C11 - F11)
2 
FHP claim that C112 > 0 (firms with higher k have a higher slope of the external finance schedule) 
is a sufficient condition for monotonicity, if F11 is homogeneous across firms.  The equation above makes 
it clear that this is only the case if we do not take into account the impact of the firm’s intrinsic 
characteristics (k) on total investment (I).  Notice that -F11C112 > 0 if C112 > 0, but the rest of the numerator 
can be either positive or negative, depending on the signs of ∂ I/∂ k,  F111, and C111.   If these derivatives 
were equal to zero, FHP would be correct, but this is hardly a reasonable case.   In other words, the FHP 
condition C112 > 0 does not guarantee monotonicity.  
Substituting for ∂ I/∂ k in (1), the correct condition for monotonicity is:  
 (2)  d
2I/dkdW  = [ C112 F11
2  - C112C11F11 + C12 C111F11  - C12C11F111 ]/ (C11 - F11)
3  > 0. 
                                                            
1 This formulation is relevant for papers in the literature that split firms on the basis of the availability of internal 
funds, such as FHP[1988], who split on the basis of the amounts of dividends paid. 
2 This formulation is relevant for papers in the literature that split firms by corporate grouping such as Hoshi, 
Kashyap, and Scharfstein [1991].   3 
It is difficult to argue that (2) is always satisfied – as FHP [1999] and the existing literature on financing 
constraints would require.  In fact, it is easy to construct examples in which this derivative is positive and 
in which it is negative.  For example, if the cost function and the production function are quadratic and 
the cost of external finance is of the form C=ke
2, then d
2I/dkdW will be positive.  Alternatively, if the 
production function is of the form, F=I
a where 0<a<1, and the cost of external finance is of the form C= 
ke + e
2, then d
2I/dkdW will be negative. 
  Finally, the FHP [1999] arguments assume that the cost of raising external funds C(.,.) is convex, 
while KZ hypothesize and Stafford [1999] presents evidence that C11 is negative. This further weakens 
the case for monotonicity. 
 
 B.  Classification  Scheme   
  FHP [1999] also question the validity of the KZ classification scheme, which relies, at least in 
part, on a company’s cash balances or unused lines of credit.  FHP claim that large amounts of these 
accounts indicate that a firm is taking the precaution of saving for fear of becoming constrained in the 
future.  Thus, according to FHP [1999], firms with more cash holdings are more financially constrained.  
In fact, our methodology of considering management’s statements of liquidity was designed precisely to 
reduce the ambiguity of “objective” criteria.   Such a detailed analysis can distinguish between 
precautionary savings and pure financial slack.   
  For example, in 1997, Microsoft had net income of $3.5 billion, capital expenditures of $0.5 
billion, no investment in inventories, no dividends, and no debt, yet held almost $9 billion of cash  – or 18 
times capital expenditures.  By the logic of both FHP [1988] (no dividends) and FHP [1999] (high cash 
balances), Microsoft would be classified as financially constrained.  This classification would be lent 
support by Microsoft’s investment-cash flow sensitivity of 0.53 from 1986 to 1997 – higher than the 
sensitivity of the most constrained group in FHP [1988].   In contrast, by our criteria, Microsoft would 
qualify as not financially constrained.  We believe that our classification is the more plausible one.   4 
  At the same time, the endogeneity of a firm’s financial position strengthens the theoretical 
reasons why investment-cash flow sensitivities are not monotonically increasing in the degree of financial 
constraints, as recently shown by Almeida (1999). He analyzes the response of investment to profitability 
shocks when leverage is endogenously determined.  Firms with more liquid assets borrow more and, thus, 
are more sensitive to profitability shocks because of the well-known leverage effect.  Less financially 
constrained firms, then, exhibit higher investment-cash flow sensitivities than similar firms, which have 
less liquid assets, and thus are more financially constrained.  
 
 C.  Empirical  Results   
  Finally, FHP [1999] criticize the empirical findings in KZ on two primary dimensions.   
  First, they claim the KZ results are due to the lack of heterogeneity in the sample. While it is 
possible that the KZ sample is homogeneous, Cleary [1999] obtains similar results for a large (over 1300) 
and undeniably heterogeneous sample of firms. 
  Second, they claim the financially constrained firms in KZ are financially distressed and the non-
financially constrained firms are, in fact, financially constrained.  As we stressed earlier, we believe that 
financial distress is a form of being financially constrained so that the distinction FHP [1999] make is not 
relevant to our arguments.  Nevertheless, it is difficult to claim that the firms KZ classify as possibly 
financially (PFC), which exhibit the lowest sensitivity of all, are in fact distressed.  For example, the 
median interest coverage ratio in PFC firm-years is 4.2 – which is roughly the average coverage ratio for 
firms rated BBB (investment grade) by Standard & Poor’s.
3  
 
 III.  Questions for Future Research  
  The empirical analysis in KZ shows that less constrained firms exhibit a higher sensitivity of 
investments to cash flow.   KZ also shows that this is perfectly compatible with value-maximizing 
                                                            
3 FHP[1999] criticize Cleary [1999] on the same grounds.  Yet Cleary [1999] also finds a relatively low sensitivity 
for partially constrained (clearly not distressed) firms.   5 
behavior by firms facing different degrees of financing constraints.   But, in practice, is the non-
monotonicity we observe driven by the value-maximizing behavior assumed in the model?  
  Most of the papers in this literature assume value-maximizing behavior by firms, and then 
attribute all observed deviations to financing constraints.  In fact, it is hard to explain the high investment-
cash flow sensitivities of firms like Hewlett-Packard (see KZ) and Microsoft as the result of financing 
constraints.  It is also difficult to explain them as the result of traditional agency problems, because both 
Hewlett-Packard and Microsoft have high levels of managerial ownership.   
  FHP’s [1999] defense of investment-cash flow sensitivities as measures of financial constraints 
distracts attention from the more important question:  what causes this sensitivity?  We do not pretend to 
have given an answer to this.   We conjecture that the sensitivities are at least partially caused by 
excessive conservatism by managers, which may arise because of the way firms are organized internally 
or because of non-optimizing behavior by managers as suggested by Hines and Thaler [1995].  
 
References 
 
Almeida, Heitor, “Financial Constraints, Asset Liquidity and Investment,” working paper, University of  
  Chicago,  April 1999. 
 
Cleary, Sean, “The Relationship Between Firm Investment and Financial Status,” Journal of Finance,  
  LIV (1999), 673-692. 
 
Fazzari, Steven, R. Glenn Hubbard and Bruce Petersen, “Financing Constraints and Corporate 
Investment,” Brookings Papers on Economic Activity (1988), 141-195. 
 
Fazzari, Steven, R. Glenn Hubbard and Bruce Petersen, “Investment-Cash Flow Sensitivities are Useful:   
  A Comment on Kaplan and Zingales,” Quarterly Journal of Economics, this issue. 
 
Hines, James and Richard Thaler, “The Flypaper Effect,” Journal of Economic Perspectives, Volume 9,  
  No. 4 (1995), 217-226. 
 
Hoshi, Takeo, Anil Kashyap, and David Scharfstein, “Corporate Structure Liquidity and Investment:   
Evidence from Japanese Panel Data,” Quarterly Journal of Economics, CVI (1991), 33-60. 
 
Kaplan, Steven and Luigi Zingales, “Do Financing Constraints Explain Why Investment is Correlated with 
Cash Flow?”  Quarterly Journal of Economics, CXII (1997), 169-215. 
 
Stafford, Erik, “Managing Financial Policy. Evidence from the Financing of Extraordinary Investments,” 
    Working paper, University of Chicago (1999).  

Corporate Structure Liquidity and Investment: Evidence from Japanese Panel Data,”

Do Financing Constraints Explain Why Investment is Correlated with Cash Flow?”

Financial Constraints, Asset Liquidity and Investment,” working paper,

Financing Constraints and Corporate Investment,” Brookings Papers on Economic Activity

Managing Financial Policy. Evidence from the Financing of Extraordinary Investments,” Working paper,

The Flypaper Effect,”

The Relationship Between Firm Investment and Financial Status,”

Investment-Cash Flow Sensitivities are not Valid Measures of Financing Constraints

Investment-Cash Flow Sensitivities are not Valid Measures of Financing Constraints

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