In order to explain the aggregate behavior of investment and production, it is necessary to understand the factors that affect investment. The pioneering work by Fazzari, Hubbard and Petersen (1988) documents that firms facing tighter financial constraints rely more on internal funds for financing investments. In other words, the level of investment of a more financially constrained firm is more sensitive to the level of internal cash flow than that of a less constrained firm. Hence, a more financially constrained firm will have stronger investment-cash flow sensitivity. Financing imperfections may prevent firms from accessing external finance, rendering firms unable to invest unless internal finance is available.

Kaplan and Zingales (1997) and Cleary (1999) challenge the generality of the conclusion made by Fazzari et al. (1988). They provide contrary evidence, suggesting that firms with easier access to external funds rely more on internal funds for financing investments. Kaplan and Zingales (1997) claim that managers in financially constrained firms may be overly risk-averse in their investment decisions so that the level of investment becomes less sensitive to the availability of internal funds.

Cash holdings can be valuable when other sources of funds, including cash flows, are insufficient to satisfy firms’ demand for capital. That is, firms facing external financing constraints can use available cash holdings to fund the necessary expenditures. Consistent with this view, several studies report that firms with greater difficulties in obtaining external capital accumulate more cash. Similarly, Almeida, Campello, and Weisbach (2004) provide evidence that firms with greater frictions in raising outside financing save a greater portion of their cash flow as cash than do those with fewer frictions. Studies by Faulkender and Wang (2006) and Pinkowitz and Williamson (2006) report evidence consistent with the view that cash holdings are more valuable for constrained firms than for unconstrained firms. Collectively, these studies support the view that higher cash holdings are more valuable for financially constrained firms.

Accordingly, in the present study, we attempt to study the effects of internal and external financial constraints on firms’ investment. Using firms’ cash flow as a proxy for internal funds and firms debt ratio, cash flow to capital stock ratio as the degree of internal constraints while age and size as proxy for external constraints.

1.2 Problem Statement:

At firm level, investment is determined by expected benefits as well as funds, both in term of availability and cost (interest rate). Benefits relate to the effects of investment in terms of increased value added, reduced costs, larger production, higher competitiveness. Hence, profits are expected to be higher, too. Therefore it is important to get rid of all constraints which come in the way of investment. The purpose of the study is to know the extent to which the internal and external financial constraints are affecting the investment decision in Pakistan.

1.3 Research Question:

To what extent the internal and external financial constraints effect the investment by a company?

1. 4 Delimitation:

In this study I will not work on the non-financial institutions because I want to first research about the effects of financial constraint on investment by the financial institutions only.

1.5 Objectives of The Study

The objective of this study are two dimensional: to determine the relation between the financial constraints and investment and also to what extent the financial constraints are effecting the investment of a company.

2. LITERATURE REVIEW

Alessandra Guariglia, (2007) uses a panel of 24,184 UK firms over the period 1993-2003 to study the extent to which the sensitivity of investment to cash flow differs at firms facing different degrees of internal and external financial constraints. It was conducted in School of Economics, University of Nottingham, University Park, and Nottingham NG7 2RD, UK in 2007. The first-difference generalized method of moments (GMM) estimator developed by Arellano and Bond (1991). Findings are that the sensitivities are the highest for those externally financially constrained firms that have a relatively high level of internal funds.

Andrea Caggese (2006), developed a model of an industry with many heterogeneous firms that face both financing constraints and irreversibility constraints. that not only expected productivity but also current and future expected financing constraints affect investment decisions. Despite the firm being risk neutral, future expected financing constraints may reduce current investment in fixed capital. This ‘‘precautionary” reduction in investment may substantially affect aggregate Investment dynamics in a way similar to the effect of convex adjustment costs. More importantly, we have shown that the irreversibility and the financing constraint are complementary.

Andrea Caggese (2006), used a dynamic multifactor model of investment with financing imperfections, adjustment costs and fixed and variable capital to derive a test of financing constraints based on a reduced form variable capital equation. Barcelona, Spain. three main results. First, the effect of the irreversibility constraint on fixed capital investment is reinforced by the financing constraint. Second, the effect of the financing constraint on variable capital investment is reinforced by the irreversibility constraint. Finally, the interaction between the two constraints is key for explaining why input inventories and material deliveries of US manufacturing firms are so volatile and procyclical, and also why they are highly asymmetrical over the business cycle.

Dr Xin Chang et al (2007) examines the separate impact and joint effect of financial constraints and financial market mispricing on the sensitivity of investment to internal cash flow. Unconstrained firms exhibit higher investment-cash flow sensitivity compared to constrained firms, insightful. It seems that financially unconstrained firms are financially more flexible in adjusting their investment policies, compared to constrained firms, when responding to mispricing.

David J. Denis, Valeriy Sibilkov, (2010), We examine why cash holdings are more valuable for financially constrained firms than for unconstrained firms and why some constrained firms appear to hold too little cash. Construct a similar criterion using the S&P Short-term Debt Rating available on Compustat. Results indicate that higher cash holdings are associated with higher levels of investment for constrained firms with high hedging needs and that there is a significantly stronger positive association between investments and value for constrained than for unconstrained firms.

Garrick Blalock et al studied whether capital market imperfections constrain investment during an emerging market financial crisis. It was conducted in Center for International and Development, Economics Research, UC Berkeley. Findings provide evidence that capital market im