Introduction.

Modigliani and Miller (1958) in their paper concluded in perfect markets firms investment decision is not related to its internal cash flows. It has been opposed and assumed that companys investment and value maximization decisions are not related to its financial decisions. But recent studys shows that companys do not operate in perfect markets and hence for them external finance is more expensive than internal finance. FHP and KZ work. An empirical study done by Fazzari, Hubbard and Peterson (FHP) in 1988 had supported cash flow-investment relationship and financing hierarchy. FHP tests whether components of investment differ between firms for which the cost of internal financing and external financing are same and firms for which the cost external financing is more than cost of internal financing. The FHP work can be outlined as, to calculate the change in net worth by using the net cash-flow. FHP in their analysis focus on the Q theory of investment, which suggests that f(X/K) is represented by a firms Tobins Q value. FHP stated that firms with higher retention ratios face higher informational asymmetry problems and hence likely to be liquidity constrained. And it is stated that the investment levels of these firms are much more sensitive to changes in cash flow than that of established and the firms paying high dividends. Other empirical studies also show above relationship. Hayashi and Inoue in 1991, their paper used data of 687 Japanese manufacturing firms for the period 1977- 1986, and Blundell, Bond, Devereux and Schiantarelli 1992 used data for 532 UK manufacturing firms for the period 1971-1986 and both studies find that cash flows had a positive and highly significant effect on Firms investments. This literature based on the assumption that external finance is more costly than internal finance due to asymmetric information and that the premium on external finance is an inversely proportionate to the borrowers net worth. But not all studies support the FHP results. Kaplan and Zingales (KZ, 1997) challenged the conclusions of FHP and related studies. And to prove their point they used qualitative and quantitative information taken from the companys K-10 or annual reports, public news, and managements discussion of liquidity needs to rank the firms by their degree of financial constraint. KZ re-examined the sample of low dividend paying firms used by FHP. The KZ sample consists of the 49 low-dividend paying firms identified by FHP as having extremely

high investmentcash flow sensitivity. On this basis they divided the firms into three categories 1) not financially constraint, 2) Less financially constraint, and 3) financially constraint. They find that the group of financially constrained firms shows the lowest sensitivity of investment to cash flows of the three groups. This result is a contradiction to the FHP result. Based on these findings they claimed that investment cash flow sensitivities is no good measure to identify presence of financing constraints. Criticism of KZ. KZ paper mainly criticised for their small sample size and their classification criteria. FHP in 1996 and Schiantarelli in 1995 argued that the criteria of using managerial statements about liquidity may be problematic and every manger may have different definition for the firm to be financially constrained. FHP noted that the KZ used very few observations for the firms classified as most financially constrained and those observations are actually from the years when firms are actually distressed. They argue that the data sample of KZ study was intentionally excluded financially distressed firms and hence very few observations taken into the consideration in financially constrained category. Hence the sample lacks sufficient heterogeneity to identify differences across their sample. Sean Cleary in his paper in 1999 tried to acknowledge this problem. His study follows the approach of KZ by classifying firms according to financial constraints. He used multiple discriminant analysis to determine firms financial status. As per the changing levels of financial constraints at the level of the firm he reclassified the firms financial status and accordingly changed the group composition as well. Clearly improved on KZs methodology and also used larger and diversified sample of 1317 US firms for the period 1987-1994. His results are also consistent with KZ and shows that firms are sensitive to the firms liquidity and also firms which are more creditworthy shows greater investmentliquidity sensitivity than less credit worthy firms. FHP, KZ and Clearys criteria of dividend pay-out for classification of firms is controversial as KZ pointed out by the example of Microsoft and HP that these companies are low dividend paying firms with high cash balance. This problem is addressed by Aggarwal and Zong (2006) by using fixed charge coverage (FCCOV) ratio which is more appropriate indicator of firms liquidity. And their results are consistent with the results of KZ and Cleary.

KZ also criticised by FHP for their empirical results. KZ results are unclear because they suggest that firms choose to rely primarily on internal cash flow for investments, despite the availability of additional external funds. But more recent studies also support the conclusion of KZ and Cleary findings. Agarwal and Zong in 2006, in there paper used different and better set of variables in the discriminant function to calculate Z scores of the firms and also used data set for longer period of 1988-2000. Their results also shows cash flow- investment relationship gets stronger with decreasing financial constraints. The above analysis shows contradicting views of theoretical and empirical studies. In the study of FHP it is stated that the most financially constrained firms to have the strongest positive cash flow-investment relationship. However the empirical study by KZ has shown opposing views of the impact of financial constrained on the cash flow and investment relationship and it is supported by subsequent literature by Cleary, Aggarwal and Zong and many others.

References. Aggarwal, Raj & Zong, Sijing, (2006). "The cash flow-investment relationship: International evidence of limited access to external finance, "Journal of Multinational Financial Management, vol. 16(1), pages 89-104. Almeida, H. and M. Campello (2001), Financial Constraints and Investment-Cash Flow Sensitivities: New Research Directions, New York University. Blundell, R., S. R. Bond and C. Meghir (1996), Econometric Models of Company Investment, in: Matyas, L. and P. Sevestre, The Econometrics of Panel Data, Volume 33. Bond, S. and J. Van Reenen (1999), Microeconomic Models of Investment and Employment, Forthcoming In: J. J. Heckman and E. E. Leamer, Volume 5, Amsterdam. Chirinko Robert S, Kalckreuth Ulf von, (2002). Further Evidence On The Relationship Between Firm Investment And Financial Status Discussion paper 28/02, Economic Research Centre of the Deutsche Bund. Cleary, Sean, The Relationship between Firm Investment and Financial Status, Journal of Finance, (1999), 673692. Fazzari et al. (1988). Financing constraints and corporate investment, Brooking Papers on Economic Activity. Fazzari et al. (2000). Investment-cash flow sensitivities are useful: A comment on Kaplan and Zingales Quarterly Journal of Economics. Pages 695-705 Hayashi, F., Prescott, E., 2002. The 1990s in Japan: A lost decade. Rev. Econ. Dynam, 206 235. Kaplan and Zingales, (1997). Do investment-cash-flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics. Pages 169-215. Kaplan and Zingales, (2000). Investment-cash flow sensitivities are not valid measures of financing constraints?, Quarterly Journal of Economics Pages 707-712 Schiantarelli, F. (1995), Financial Constraints and Investment: A Critical Review of Methodological Issues and International Evidence, Federal Reserve Bank of Boston.