Do Measures of Financial Constraints Measure Financial Constraints?

55 Pages Posted: 23 Jan 2015

See all articles by Joan Farre-Mensa

Joan Farre-Mensa

University of Illinois at Chicago - Department of Finance

Alexander Ljungqvist

Stockholm School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Research Institute of Industrial Economics (IFN)

Multiple version iconThere are 3 versions of this paper

Date Written: January 2015

Abstract

Financial constraints are fundamental to empirical research in finance and economics. We propose two novel tests to evaluate how well measures of financial constraints actually capture constraints. We find that firms classified as constrained according to five popular measures do not in fact behave as if they were constrained: they have no trouble raising debt when their demand for debt increases exogenously and they use the proceeds of equity issues to increase payouts to shareholders. We propose an alternative proxy for financial constraints, based on Merton's (1974) distance-to-default measure, which successfully identifies firms whose behavior is consistent with being constrained.

Keywords: Financial constraints

JEL Classification: G31, G32, G33

Suggested Citation

Farre-Mensa, Joan and Ljungqvist, Alexander, Do Measures of Financial Constraints Measure Financial Constraints? (January 2015). CEPR Discussion Paper No. DP10326. Available at SSRN: https://ssrn.com/abstract=2554401

Joan Farre-Mensa (Contact Author)

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States

Alexander Ljungqvist

Stockholm School of Economics ( email )

111 60 Stockholm
Sweden

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Research Institute of Industrial Economics (IFN) ( email )

Box 55665
Grevgatan 34, 2nd floor
Stockholm, SE-102 15
Sweden

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