Empirica 22: 185-209, 1995.

185
(~) 1995 Kluwer Academic Publishers. Printed in the Netherlands.

Finance Constraints or Free Cash Flow?

A N e w L o o k at the Life Cycle M o d e l o f the Firm

ROBERT E. CARPENTER*
Department of Economics, Emory University,Atlanta, USA

Abstract. It has long been argued that firms prefer internal to external finance for funding investment.
Modern literatures in industrial organization, macroeconomics, and finance argue this preference is
caused by information asymmetries. There are, however, important disagreements about the effect of
the asymmetries. Asymmetries may lead to binding financing constraints, or they may allow managers
to use free cash flow for unprofitable projects. Each model predicts a different relationship between
investment and changes in debt finance and this paper estimates this relationship using firm-level
data. The principal findings are that both financing constraints and the agency costs of free cash flow
affect investment in a manner consistent with a life cycle model of the firm.
Key words: Investment, cash flow, life-cycle
JEL codes: E2, G3, L2

I. Introduction

It has long been argued that firms prefer internal to external finance for funding
investment. An unsettled issue is, why? The m o d e m literatures in finance, indus-
trial organization, and macroeconomics emphasize that firms prefer internal funds
because o f the existence o f information asymmetries. There are, however, important
disagreements about where the information asymmetries occur and their resulting
effects on investment. In particular, asymmetries m a y occur either between the
firm and potential suppliers of new external finance, causing firms to face binding
financing constraints, or they may exist between the firm and its existing owners,
allowing managers to pursue unprofitable projects.
There are a large number of papers that report evidence that firms under-invest
because of financing constraints. For example, Fazzari, Hubbard, and Petersen
(1988) show that firms paying low dividends, an indicator of binding financing con-
straints, exhibit investment that is more sensitive to cash flow than high-dividend
paying firms. Subsequent studies have argued that financing constraints are respon-
sible for the positive relationship between internal finance and other firm activities,
such as research and development (R&D) and inventory investment. 1
An alternative literature argues that agency problems between managers and
owners allow the former to engage in excessive levels of investment. The recog-
186 ROBERT E. CARPENTER

nition of the divergence of the incentives of managers and the owners of a public
corporation dates back at least to Berle and Means (1932). Later, Marris (1964)
provided evidence supporting a theory of managerial capitalism, a precursor to
more formal agency models. 2 Jensen (1986) has recently revived elements of
the managerial capitalism literature, proposing that, for some finns, information
asymmetries between the managers and the owners of the firm provide incentives
for managers to over-invest by using 'free cash flow' for unprofitable investment
projects. 3
Both the financing constraint and the free cash flow literature predict a positive
relationship between internal finance and investment spending. But each theory
applies to much different types of firms. A 'life cycle' model of the firm proposed
by Mueller (1969, 1972) and Grabowski and Mueller (1972), explicitly develops
the link between internal finance and investment into a unified framework where
young, fast growing firms use internal finance to mitigate the transaction costs of
external finance, and mature finns use internal finance to maximize firm growth at
the expense of shareholder wealth. The life cycle model contains elements of both
the financing constraint and free cash flow models. It suggests that internal finance
can have explanatory power for different types of firms and that both theories could
come into play for the same firm (in different time periods).
This paper sheds some light on the extent to which financing constraints and free
cash flow theories affect firm behavior. To date, only a few studies have attempted
to distinguish between the competing views of asymmetric information and firm
investment behavior. Lang and Litzenberger (1989) attempt to distinguish between
under and over-investment theories by examining the response of stock prices
to changes in dividends. They split firms into two categories, designating firms
with Tobin's Q ratios of less than one as over-investors. Their results show that
over-investing firms exhibit positive changes in equity prices after an increase in
free cash flow paid to owners as higher dividends. They interpret this as evidence
consistent with the free cash flow hypothesis. Hoshi, Kashyap, and Scharfstein
(1991) argue that if managers waste free cash flow, investment should be highly
sensitive to changes in internal finance because its use is difficult for outsiders to
monitor. They report evidence against free cash flow theory, noting that investment
of firms with low values of Tobin's Q is less sensitive to changes in internal finance.
Hubbard, Kashyap, and Whited (1993) find that they cannot reject the fixed capital
investment Euler equation, derived under the assumption of no capital market
frictions, for mature firms. They argue that free cash flow theory 'does not appear
to be important for business fixed investment'. Griffin (1988) interprets his finding
of a role for cash flow in the determination of petroleum exploration activity as
limited support for free cash flow theory. Oliner and Rudebusch (1992) report
evidence in favor of financing constraints when compared to an alternative models
motivated by transactions or agency costs. Vogt (1994) finds evidence supporting
free cash flow theory in fixed investment regressions, but evidence in favor of
finance constraints for the same firms' R&D expenditures. Kathuria and Mueller