An Application of Causal Forest in Corporate Finance: How Does Financing Affect Investment?

97 Pages Posted: 20 May 2020

See all articles by Huseyin Gulen

Huseyin Gulen

Purdue University - Krannert School of Management

Candace Jens

Tulane University - A.B. Freeman School of Business

T. Beau Page

affiliation not provided to SSRN

Date Written: April 23, 2020

Abstract

Answering a causal question with results extendable outside of a narrow sample is challenging. Regression discontinuity design (RDD) provides causal results with strong internal, but weak external, validity. We introduce a novel machine learning technique, causal forest, into the corporate finance literature because it has several benefits over RDD, including greater precision and extendibility of results. We revisit a well-known RDD setting in corporate finance, debt covenant violations. We show that this RDD framework recovers an overly-large treatment effect of default on investment because firms can manipulate the accounting ratios lenders use to define default thresholds. In contrast to previous literature that shows an economically significant decline in investment following a technical default, we find, on average, no change in investment. Intuitively, this result makes sense because firms that can manipulate their default status will only choose to default if there are no consequences to default. For these firms, which comprise the majority of our sample, the treatment effect of default on investment will be zero. We show that causal forest's ability to recover heterogeneous treatment effects is key to reconciling disparate findings in the debt covenant literature. Causal forest can be a broadly useful empirical technique for answering causal questions.

Keywords: Causal Forest, Investment, Financing, RDD, Machine Learning

JEL Classification: G32, G31, C50

Suggested Citation

Gulen, Huseyin and Jens, Candace and Page, Beau, An Application of Causal Forest in Corporate Finance: How Does Financing Affect Investment? (April 23, 2020). Available at SSRN: https://ssrn.com/abstract=3583685 or http://dx.doi.org/10.2139/ssrn.3583685

Huseyin Gulen

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Candace Jens (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

Beau Page

affiliation not provided to SSRN

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