A recent literature has criticised the sensitivity of a firm's investment to its own cash flow as an adequate measure of financing constraints. In this paper we develop a new method to detect the presence of financing constraints at firm level. We consider a structural dynamic model of investment with financing imperfections and with both fixed and variable capital. We solve the model and simulate an industry with many firms. We show that the irreversibility of fixed capital is the main reason why the sensitivity of fixed investment to cash flow is not a good measure of financing constraints. Using the fact that variable capital is reversible, we develop a new test of financing constraints based on a reduced form variable capital investment equation. Simulation results show that our test correctly identifies financially constrained firms also when the estimation of firms' investment opportunities is very noisy. Moreover our test is valid regardless of the type of adjustment costs of fixed capital. We confirm empirically the validity of this method on a sample of US companies.
Published as: Testing Financing Constraints on Firm Investment Using Variable Capital in Journal of Financial Economics , Vol. 86, No. 3, 683--723, January, 2007