INVESTMENT-CASH FLOW SENSITIVITIES ARE USEFUL: A COMMENT ON KAPLAN AND ZINGALES* STEVEN M. FAZZARI R. GLENN HUBBARD BRUCE C. PETERSEN A recent paper in this Journal by Kaplan and Zingales reexamines a subset of firms from work of Fazzari, Hubbard, and Petersen and criticizes the usefulness of investment-cash flow sensitivities for detecting financing constraints. We show that the Kaplan and Zingales theoretical model fails to capture the approach employed in the literature and thus does not provide an effective critique. Moreover, we describe why their empirical classification system is flawed in identifYing both whether firms are constrained and the relative degree of constraints across firm groups. We conclude that their results do not support their conclusions about the usefulness of investment-cash flow sensitivities. In a recent paper in this Journal Kaplan and Zingales [1997, hereinafter KZ] argue that investment-cash flow sensitivities do not provide useful evidence about the presence of financing constraints. Because KZ use a subset of the same firms and the same regressions as Fazzari, Hubbard, and Petersen [1988, hereinafter FHP] and claim [page 176] that FHP "can legitimately be considered the parent of all papers in this literature," it is appropriate that we respond. Based on a simple theoretical model, KZ reach the provocative conclusion [page 211] that "the invest- ment-cash flow sensitivity criterion as a measure of financial constraints is not well-grounded in theory." In Section I we show that the KZ model does not capture the theoretical approach employed in FHP and many subsequent studies. Most of the KZ paper attempts to show that empirical investment-cash flow sensitivities do not increase monotonically with the degree of financing constraints within the 49 low-dividend firms from the FHP sample. In Section II we explain why the KZ classification of the degree of constraints is flawed in identifYing both whether or not firms are constrained (absolute constraints) as well as the relative degree of constraints across firms. As a result, we argue in Section III that there is no expected ex ante pattern for the * We thank Michael Athey, Charles Calomiris, Robert Carpenter, Robert Chirinko, Mark Gertler, Simon Gilchrist, Kevin Hassett, Charles Himmelberg, Anil Kashyap, Ronald King, Wende Reeser, Joachim Winter, and two referees, one ofthe editors (Andrei Shleifer), and participants in seminars at the London School of Economics and the NBER Summer Institute Conference on Corporate Finance for comments and suggestions. © 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, May 2000 695 INVESTMENT-CASH FLOW SENSITIVITIES ARE USEFUL: A COMMENT ON KAPLAN AND ZINGALES* STEVEN M. FAZZARI R. GLENN HUBBARD BRUCE C. PETERSEN A recent paper in this Journal by Kaplan and Zingales reexamines a subset of firms from work of Fazzari, Hubbard, and Petersen and criticizes the usefulness of investment-cash flow sensitivities for detecting financing constraints. We show that the Kaplan and Zingales theoretical model fails to capture the approach employed in the literature and thus does not provide an effective critique. Moreover, we describe why their empirical classification system is flawed in identifYing both whether firms are constrained and the relative degree of constraints across firm groups. We conclude that their results do not support their conclusions about the usefulness of investment-cash flow sensitivities. In a recent paper in this Journal Kaplan and Zingales [1997, hereinafter KZ] argue that investment-cash flow sensitivities do not provide useful evidence about the presence of financing constraints. Because KZ use a subset of the same firms and the same regressions as Fazzari, Hubbard, and Petersen [1988, hereinafter FHP] and claim [page 176] that FHP "can legitimately be considered the parent of all papers in this literature," it is appropriate that we respond. Based on a simple theoretical model, KZ reach the provocative conclusion [page 211] that "the invest- ment-cash flow sensitivity criterion as a measure of financial constraints is not well-grounded in theory." In Section I we show that the KZ model does not capture the theoretical approach employed in FHP and many subsequent studies. Most of the KZ paper attempts to show that empirical investment-cash flow sensitivities do not increase monotonically with the degree of financing constraints within the 49 low-dividend firms from the FHP sample. In Section II we explain why the KZ classification of the degree of constraints is flawed in identifYing both whether or not firms are constrained (absolute constraints) as well as the relative degree of constraints across firms. As a result, we argue in Section III that there is no expected ex ante pattern for the * We thank Michael Athey, Charles Calomiris, Robert Carpenter, Robert Chirinko, Mark Gertler, Simon Gilchrist, Kevin Hassett, Charles Himmelberg, Anil Kashyap, Ronald King, Wende Reeser, Joachim Winter, and two referees, one ofthe editors (Andrei Shleifer), and participants in seminars at the London School of Economics and the NBER Summer Institute Conference on Corporate Finance for comments and suggestions. © 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, May 2000 695 at National Chiao Tung University Library on July 9, 2011 qje.oxfordjournals.org Downloaded from