Testing financing constraints on firm investment using variable capital

Abstract

We consider a dynamic multifactor model of investment with financing imperfections, adjustment costs and fixed and variable capital. We use the model to derive a test of financing constraints based on a reduced form variable capital equation. Simulation results show that this test correctly identifies financially constrained firms even when the estimation of firms investment opportunities is very noisy. In addition, the test is well specified in the presence of both concave and convex adjustment costs of fixed capital. We confirm empirically the validity of this test on a sample of small Italian manufacturing companies.