Investment Financing. An Empirical Study of Indian Manufacturing Sector

Doctoral Thesis / Dissertation, 2018

121 Pages




1.1. An Introduction
1.2. Internal Funds and Investment 2
1.3. Perfect and Imperfect Capital Markets
1.4. Financing Constraints and Investment
1.5. Studies on Indian Firms Financing

2.1. Theories of Fixed Investment Behaviour 18
2.2. Empirical Investment Models

3.1. Industrial Data Compilation
3.2. Historical Analysis
3.3. Major Economic Reforms
3.4. Performance of Manufacturing Sector
3.5. Contribution of Manufacturing Sector
3.6. Manufacturing Sector : Sources of Finance
3.7. Corporate Sector Growth since Economic Reforms

4.1. Research Methodology
4.2. Estimation Technique
4.3. Empirical Results
4.4. Post Reform Changes in ICFS

5.1. Summary of Findings
5.2. Policy Implications
5.3. Suggestion for Future Research



This book contains, first, a broad study of Indian Manufacturing sector, its contribution in Indian national income, employment and role in industrial output and growth. Second, by using CMIE industrial panel data and latest econometric methodology, an attempt has been made to empirically investigate the investment cash flow sensitivity in the non-government manufacturing sector of India after economic reforms of 1991. This book is most suited for advanced under graduates, post graduate and research students who are pursuing research in Indian economic development and investment analysis.

Another feature of this book is the frequent presentation of statistical data in tables or graphs. These serve not only to give readers a sense of comparative analysis but also to acquaint them with possible sources for any research they may wish to undertake in Indian industrial sector themselves. Finally, this book also provides some of the short and long term problems faced by this sector which is necessary for an intelligent perusal of the Indian economic development issues.

Abdul Rahim Ansari

(Assistant Professor)

Department of Economics

Hindu College,

University of Delhi

December 2018


I am grateful to the many people who helped me by providing their valuable feedback and inspiration from time to time during book writing.

I also owe a debt of gratitude to those authors and their literature writings from which I derived many ideas. These literatures provided me a valuable insight in the current issues of manufacturing sector and its development after independence.




Manufacturing sector is treated as the core of overall industrial sector and regarded as backbone for any economy. It accelerates Gross Domestic Product (G.D.P.) growth rate, generates more employment opportunities and strengthens agriculture and service sector through inter linkage effects. It is specifically much more important for transitional economies (under developed and developing countries) since it is expected to be an engine for the growth and major absorber of labour force which would ultimately helpful in elimination of poverty levels rapidly.

In Indian economy, it holds a key position, accounting for nearly 17 per cent to Gross Value Added in 2015-161 and employing nearly 12% of India’s labour force. Historically, Indian manufacturers had a world-wide market for their products even before the rise of modern industrial system in Europe. But the impact of industrial revolution and British rule of nearly 200 years in India, led the decay of Indian handicrafts. The policy of British government forced India to engage in the export of raw materials at much lower cost to British industries and simultaneously providing market for their machine made final products. India in the recent years has emerged as a global manufacturing hub due to its efficient and skilled labour force, cost competitiveness in production, improved research and development and favourable government policies. Furthermore, the most fundamental factor fostering growth in the sector is the presence of strong consumer market domestically. The Consumer trend in the country coupled with liberalisation measures, enabled domestic players to flourish and also attracting international players to participate. The role of this sector has become more important particularly in the present globalised era because, on the one hand, there is an opportunity to take benefits of low waged workforce and enlarged markets for final products and, on the other hand, there are challenges to withstand in foreign competition and international shocks.

Many empirical studies show that the policy of widespread industrialization since second five year plan (1956-61) inhibited internal and external competition and has not been successful as regards to the generation of employment. Moreover, the growth in this sector has also been very volatile over the period of time. Government long term policy of protection to domestic industries and substantial inward orientation resulted into a comparatively higher cost of production in the manufacturing sector, sub-standard quality of products and lack of competitiveness of its exports by the end of 1970s. According to Ahluwalia (1991), it is no surprise that the regulatory framework of the pre-1980s, inter alia, has been held responsible for low growth rate of output and productivity of India’s manufacturing sector.

The period of 1980s and 1990s saw the adoption of market friendly reforms in most of the developing countries. One of the basic objectives of such reforms was to unshackle industrial sector from restrictive policy barriers and make them competitive in the world market. The Indian economy has also undergone similar reforms since the mid-eighties and especially during the early nineties. The early measures to liberalize India’s industrial policy framework included deregulation and de-licensing in certain industries, a greater role to the private sector, and a gradual shift from direct physical controls to indirect controls (Chandrasekhar, 1988; Ahluwalia, 1991). A wide ranging and comprehensive economic reforms have been initiated in India since 1991-92 which covered almost every important sector of the economy including capital market, external sector, banking sector and the industrial sector. These reform measures constituted deregulation, liberalization of the external trade and payment system and partial privatization of some of the state sector enterprises. According to Ahluwalia (1995), the changes that the reforms after 1991 brought in were “fundamental” in nature compared to the “marginal” changes only in the previous decade. It was hypothesized that these measures would improve overall economic performance and lead to a greater opportunities for growth.

After economic reforms of 1991 there is greater flexibility and autonomy in the operation and management of the private and government owned firms. The average performance of the manufacturing sector has improved in terms of growth. Presently, after globalisation, India has a big market for its product. Opportunities are there to take advantage of low waged labour as its basic input. It is interesting to look how Indian manufacturing sector is behaving after economic reforms of 1991. There are two aspects of studying impact of reform measures on industrial performance. First one is related with the manufacturing sector performances in terms of growth, its consistency, employment generation and contribution to exports. Second aspect of study is associated with the impact of financial sector reforms on this sector in terms of availability of low cost, timely and sufficient funds for investment purposes. The objective of this book is to analyse second aspect leaving aside first one for further study. It means to analyse whether the financing constraints of Indian manufacturing firms have been reduced or not specifically after economic reforms.


Firms are considered as the engines of growth in any economy. Investments by these firms act as a fuel to run these engines. When there is need for investment and expansion, firms are in need of finance. A firm can choose whether to finance its activities with internally generated funds, like retained profits, or externally managed funds, like debt, equity or a combination of these. The various means of financing investment represent the financial structure of an enterprise. According to Franco Modigliani and Merton Miller (hereafter, M.M.-1958), capital structure is irrelevant under perfect capital markets and internal and external finance are perfect substitutes of each other. Therefore it does not matter whether investment is financed by debt, equity or internal funds. They demonstrated that in a world without market frictions, value of the firm and also its overall costs of capital are independent of its choice of capital structure. Working on this line of reasoning, they propounded a well-known theorem, popularly known as “Financial Irrelevance Theorem” of firms’ capital structure in 1958 and for their path breaking paper they won Nobel prize later on.

“Financial Irrelevance Theorem” assumed that all firms have easy and equal access to capital market, and firms’ responses to changes in the cost of capital differ only because of difference in investment demand in a perfect capital market. Since Modigliani and Miller’s publication in 1958, many financial economists have developed a number of firms’ investment financing theories to explain the sources and pattern of firms’ investment financing decisions. The most important work based on MM’s ‘Irrelevance Theorem’ has provided by the Tobin (1969) and Jorgenson (1963, 1967, 1968, 1971). Tobin propounded the ‘Q’ Theory of Investment and the theory has been extended by others (Brainard, 1968, Hayashi, 1982). This theory postulates that, the stock market valuation will act as a good proxy for the marginal benefits of investments even though the investor’s judgements of marginal productivity of capital are unobservable. The “Tobin’s Q” refers to the ratio between two valuations of the same physical assets, namely market valuation and book value of the firms. The market value is the valuation of firm’s existing assets at current market price whereas the book value is the replacement cost or production cost indicating prices in the market for newly produced assets. If this ratio is greater than unity, then it indicates more investment opportunities in future.

As for as theoretical aspects of investment behaviour is concerned, it originating from the investment ideas expressed by John Maynard Keynes and Irving Fisher during 1930s. Since then a number of investment theories have been provided by economists from time to time. Some of the important theories to explain investment behaviour of firms are: Accelerator Theory, Profit Theory, Liquidity Theory, Neo-classical Theory and Tobin’s Q theory.

However, empirical researches usually produce results inconsistent with the notion of financial irrelevance. Studies from western developed economies signifies the presence of a “Financing Hierarchy” caused by market imperfections and friction, in which internal funds have a cost advantage over new debt or equity issuance due to the higher costs associated with external financing. In fact there are many reasons which make internal funds less costly as compared to external funds in the real world. Among the most prominent factors that led the divergence in the two types of funds are transaction costs, tax advantages, agency problems, cost of financial distress and most importantly asymmetric information. The importance of financial factors on the investment behaviour of firms’ has been emphasised as early as in late 1950s, by the work of Meyer and Kuh (1957) who demonstrated the significance of financing constraints on firm-level business investment. But the role of financial factors was undermined in those times literature and most applied works since mid-1960s followed M.M.’s (1958) ‘Irrelevance Theorem’ in firms’ real investment decisions.

One of the important contributions in the empirical investment literature is the “Agency Theory” which has been propounded by Jensen and Meckling in their 1976 publication. This theory considered debt to be a necessary factor in creating the conflict between equity holders and the managers. Jensen and Meckling recommended that, due to increasing agency costs with both the equity holders and debt-holders, there would be an optimum combination of outside debt and equity to reduce total agency costs.

“Pecking Order Theory” is another important theory developed by Steward Myers in 1984 in his paper, “Capital Structure Puzzle”. Pecking order hypothesis contends that, firms have an ordered preference for financing and there is no any prior targeted debt or equity ratio. According to Myers, firms prefer retained earnings (internal funds) as their main source of funds for investment followed by debt. The last resort sought by a firm would be external equity financing. The reason for this ranking is that internal funds are regarded as ‘cheap’ source of financing investment decisions and not influenced by any outside disturbances. External debt is ranked next to internal funds as it is cheaper and has fewer restrictions compared to issuing equity. The issuance of external equity is seen as the most expensive and dangerous as it can lead to potential loss of control of the enterprise by the original owner and manager.

Fazzari, Hubbard and Petersen (1988; hereafter FHP), led the revival of the importance of financial factors in firms investment decision making and now there exists an extensive literature that demonstrates the sensitivity of a firm’s investments to its internally generated cash flow (internal funds). They proposed that, the sensitivity of corporate investments to internal cash flow would be strongest for firms that faced the greatest wedge between the costs of internal and external funds, i.e., firms that have high financial constraints. By classifying firms into several categories on the basis of dividend payout ratio (proxy for financial constraints), they presented evidence consistent with the above hypothesis. They analysed that firms having low dividend payout (smaller firms) had higher investment-cash flow sensitivities than high dividend paying firms (larger firms). The work of FHP (1988) led to a new dimension in the firms’ investment behaviour theory and followed by a number of studies which provided supporting evidence, using data from a variety of contexts.

Empirical results from developed countries show that internal funds have an important influence on firms’ investment financing and there seems to be a positive association between the two. If the cash flow (proxy for internal funds) which is a measure of liquidity of a firm is greater, the investment spending will also be greater. It is argued that an external fund is costlier than internal fund and an increase in current cash flow directly increases the stock of low cost internal funds which may be used for current investment. Furthermore with the increase in current cash flow, the firms’ net worth also rises and it leads to higher valuation of the firms’ position in the market. The net worth of the firms also acts as its collateral in the financial market and higher valuation of the firm in turn discourages premium on external funds. Therefore, increase in the cash flow leads to an increase in the internal funds in the form of increased stocks of funds and simultaneously availability of low cost external funds due to increase in the net worth of the firm.

In the beginning, the researches on investment cash flow relationships were directed mainly on firms in the United States (Jorgenson-1967, FHP-1988). It is a well-known fact that studies based on the experience of a single country may not represent the effect of diversity of economic tradition and financial environment on corporate capital structure (Antoniou et al, 2002).

However, in the mid-1980s, research coverage widened to Europe and Japan (Nagano, 2003). To broaden the understanding of determinants of capital structure, Rajan and Zingales (1998) have attempted to find out whether capital structure choices in other G7 countries are based on the similar factors of those influencing capital structures of U.S firms.

It has been observed from the literature that empirical studies on the corporate financing and investment behaviour are largely concentrated on the United States and other developed nations with similar institutions. The issue of investment cash flow relationship among firms in developing countries has received little attention and there are only limited studies available till now. One of the recent empirical studies concerning financial reforms and its impact on firm’s investment decisions from emerging countries has been provided by Abubakr Saeed (2012). Using a cross-industries panel of 501 Indian and Chinese non-financial firms, he attempted to analyse the impact of financial reforms introduced in the 1990s in relaxing financial constraints to investment. He found that firms from both economies face financial constraints to their domestic as well as foreign investment. Further, results show that financial constraints to overall investment in Indian market decreases with business group affiliation, while state-ownership is beneficial for Chinese firms to overcome market imperfections.

In another study Bhaduri (2005) did an empirical study of the determinants of corporate investment behaviour from the Indian perspective. He derived a balanced panel of 362 manufacturing firms from prowess database of centre of monitoring Indian economy (CMIE) for a period of 1990-1995. His investment equation consists of lagged dependent variable, cash flow, long term debt and lagged values of sales to generate acceleration. The equation was estimated by generalised methods of moments (GMM) technique and found that lagged values of investment, cash flow and sales accelerator are important determinants of investment for the total sample. The positive and significant coefficient on the change in sales value shows the importance of sales accelerator in explaining investment behaviour. He concluded that the optimal capital structure choice is influenced by factors such as growth of earnings, cash flow of the firm, size of the firm, and product and industry characteristics.

While majority results from developed countries produce a positive relationship between internal funds and investment, there are the some mixed or even conflicting findings, showing a lack of consensus about an adequate and reliable measure to capture financing constraints. Specifically, a heated debate has taken place among researchers, whether investment-cash flow sensitivities can be considered adequate or accurate indicators of financing constraints among different group of firms.


Perfect capital markets – These are the markets without any frictions (i.e. symmetric information, no taxes no transaction cost etc.). A firm's financial structure becomes irrelevant to investment decisions in these markets because external funds provide a perfect substitute for internal capital. Further there is no any additional cost of funding since buyers and lenders have symmetric information about their concerned status. It means that a firm's cost of capital is the same whether it is raised internally through retained earnings or externally through the issuance of debt or equity. Firms will only consider the net present value of the project while making investment decisions. The firm invests up to the point where the expected profit from the project equals the cost of investment at the margin. It will undertake any investment project with a positive net present value and will be financed by any combination of equity and/or debt capital.

In their seminal work, Modigliani and Miller (1958) proposed that, under a very restrictive set of assumptions, the market value of an enterprise is independent of its capital structure. This proposition implies that firm’s investment decisions will only depend on the expected rate of return of the projects, and should not be affected by how the investments are financed. Thus, under the Modigliani and Miller theorem, firm’s internal finance (retained earnings) and external funds (debt and new equity issues) are perfect substitutes to each other. But many subsequent studies reported the violation of the perfect capital markets assumption and emphasized the importance of investment decisions and financing choices.

Imperfect capital markets – The concept of perfect capital markets and financial irrelevance as discussed above is unrealistic. In practice, however, a number of capital market imperfections such as tax considerations, agency conflicts, or informational asymmetries between external investors and managers of the firm arise. These imperfections drive a wedge between the cost of external and internal finance, causing financial structure to become an important driver for ‘real’ decision making (Carpenter and Petersen, 2002). Most of the empirical works find that the availability of internal funds is an important determinant of firm’s investment and that its importance diminishes as firms enjoy better access to capital markets. In an imperfect capital market, neither the interest rate (as in Hall and Jorgenson 1967) nor Tobin's Q (as in Lucas 1967) is the determinant of investment as was earlier propounded by the neo-classical economists.

The imperfections in the capital market, compels a firm to pay an additional cost for external funds. This is the cost above the actual cost of capital which must be paid to the lender for the additional risk they bear in imperfect capital market. This drives a wedge between the cost of internal and external capital creating a financing hierarchy. This cost wedge between various sources of funds has been explained in figure 1.1 below. It can be seen that, when there is low investment demand (point D1 in figure), then, the accumulated internal funds are sufficient enough to finance the business plan. At a higher levels of investment demands (for example at D2), firms will have resort to alternate debt financing for which the marginal cost will increase with leverage. Further, the cost of debt finance varies with the size of the firms, their financial leverage or degree of financial distress and agency costs. The funding through external debt may be very costly for smaller firms since the lenders will demand a risk premium (for the default cases) over the interest rate. There may also be a financial distress cost which arises when a firm faces problem in paying its principal and interest obligations on borrowed funds. Lastly, there may be an agency costs which arise from the limited liability feature of debt contracts that creates incentives for firms managers to act counter to the interests of creditors under some circumstances. This happens due to long term nature of the debt issuance which generally leads to the problem of moral hazard and a larger ratio of debt to equity often provides incentive to the managers of the firms to diverge from the interest of creditors.

Abbildung in dieser Leseprobe nicht enthalten

Figure 1.1: Cost Wedge between Internal and External Funds

Source - Fazzari, Hubbard and Petersen (1988)

Similarly at very high levels of investment demand (for example at D3) when debt financing is exhausted, external equity will be issued at an even higher cost. It is the last option for any kind of firms since it involves a heavy cost of funding. The cost of issuing these new equity shares vary substantially by the size of offerings. The cost of a new share issue includes underwriting discounts, registration fees and taxes, and selling and administrative expenses. These costs may be substantially high for the companies which are issuing small offerings.

The financial hierarchy and existence of the cost wedge between firms implies that for some firms external funds become excessively expensive or even impossible to obtain (Carpenter and Petersen, 2002). In other word, the firm’s dependency for investment will be solely on internal funds and this might have a detrimental impact on their growth. Even some investment projects with very high net present value (NPV) might not be undertaken because internal funds are insufficient and external funds overly costly. These firms who are pushed to rely mainly on their internal funding sources are believed to be financially constrained in the sense that they are constrained by the quantity of internal finance (Bond et al., 2003).


If financial markets are perfect, then there will be no difference in external and internal financing. The funding cost through each will be equal and investment decisions will be made solely on the basis of a firm’s growth opportunities. Different studies developed different criteria to explain a firm’s growth opportunity. In the beginning many studies extensively used average q (that is the ratio of market valuation of capital over its replacement value) to measure a firm’s investment opportunities, following Tobin’s (1969) study. Cash flow and other variables such as was ignored and treated as inferior to average q in explaining investment opportunities. However, later on, many empirical studies find that cash flow (internal funds) has significant explanatory power to explain investment undertaken by firms. In other words, they advocated that capital markets are imperfect (for example, Hubbard, Kashyap, and Whited - 1995), and Gilchrist and Himmelberg - 1995). These studies, therefore, re-emphasized the importance of financial variables in investment models especially under the conditions of an imperfect and incomplete capital markets.

In 1988, Fazzari, Hubbard and Petersen (hereafter FHP) published an influential paper which had a significant methodological impact in investment literature. This study revived the interest in the interdependence between financing and investment decisions. In their seminal work FHP tried to interlink the conventional model of investment which is based on the assumption of perfect capital markets with the new studies of imperfections in capital markets. FHP observe that the presence of imperfections in capital markets lead to corporate underinvestment when internal cash is not enough to invest at the first-best level. Market imperfections in the form of transaction costs, taxes, agency problems, costs of financial distress, and most important asymmetric information make external costs more costly than the internal funds. Further they argue that firm’s rely more on their internal funds to finance their investment due to the high market premium charged by external markets. They hypothesized that the connection between cash flow and investment should be strongest for those firms that are most constrained in accessing external capital.

FHP started their empirical investigation first by utilising the Q model of investment and regressing investment, on cash flow controlling for investment opportunities by Tobin’s average q. They used the following regression model to show the investment-cash flow sensitivity of firms:

Abbildung in dieser Leseprobe nicht enthalten

Where, I denotes investment, K, capital stock, Q, tax adjusted value of Tobin’s q, CF, the cash flow, the firm specific constant, and, the error term. They estimated the above equation with fixed firm and year effects.2

In one of the earliest study, Bilsborrow (1977), investigated the relative importance of real sales accelerator and liquidity among Columbian firms, beside other things like the role of foreign exchange reserves, etc. He concluded that the explanatory power of internal funds was twice that of the accelerator in the panel data model.

Mayer (1990) examined the sources of industry finance of eight developed countries from 1970 to 1985 and presented a number of stylized facts regarding global corporate financing behaviour which support the existence of financing hierarchies. He found that: (i) retained earnings are the dominant source of financing in all countries under study; (ii) firms which are ranked as “average firm” does not raise substantial amounts of financing from security markets in the form of short-term securities, bonds, or equities in any of these countries; (iii) bank loan accounts the majority of external financing in all countries.

Oliner and Rudebusch (1992) took into account 99 NYSE-listed firms and 21 over-the-counter firms for their study during the 1977 to 1983 period. There finding shows that investment is most closely related to cash flow for firms that are young, whose stocks are traded over-the-counter, and that exhibit insider trading behaviour consistent with privately held information.

Schaller (1993) studied 212 Canadian firms over the 1973 to 1986 period. He concluded that investment for independent, young, manufacturing firms with dispersed ownership concentration is the most sensitive to cash flow.

Mills et al. (1994) presented a comprehensive analysis of the role of financial factors in corporate investment decision making . They classified firms into many sub groups and their results suggest that internal sources of funding are more important for small firms, highly leveraged firms and firms that have high retention ratio. These results have a number of important implications for monetary policy too. Cash flow play an important role in determining investment and result suggests that monetary policy will influence investment through cash flow as well as through influencing the discount rate applied to investment projects. This in turn will affect the overall economic conditions and these influences will be unevenly distributed across the corporate sector.

Gilchrist and Himmelberg (1995) found that firms with easy access to publicly traded debt have no excess investment dependency on cash flow as measured by the existence of either a debt or commercial paper rating. When small firms are compared to large firms, small firms displayed higher investment-cash flow sensitivity.

Against this backdrop, a number of studies such as Kaplan and Zingales (1997), Almeida and Campello (2002), and Cleary (1999) challenged the findings of FHP (1988) and provide conflicting evidence on the relationship between investment and cash flow.

The first challenge to the findings in FHP (1988) came from Kaplan and Zingales (1997, hereafter KZ). A heated debate followed the publication of KZ article (see Chirinko, 1997; FHP, 2000; Kaplan and Zingales, 2000; and Cleary, 1999). KZ argue that “there is not a strong theoretical reason for investment-cash flow sensitivities to increase monotonically with the degree of financial constraints.”

The KZ result finds support from Sean Cleary (1999), who used more recent data (1987-94), examined a large cross-section (1317 firms), and measures financing constraints by a discriminant score estimated from several financial variables. While it has been customary in the literature to use Tobin's Q to control for growth opportunities Cleary used the simpler substitute of equity market-to-book ratio. His results suggest that the investment decisions of firms with a stronger financial position are much more sensitive to the availability of cash flow than those that are less creditworthy.

The finding of FHP (1988) is also challenged by few recent studies. Kadapakkam et al. (1998) for example, analysed firms’ net investment activities in six OECD countries and found that smaller firms that are expected to have more financing constraints show lesser investment-cash flow sensitivity compared to larger firms. Further, Allayanis and Mozumdar (2004) proposed that investment-cash flow sensitivity of firms with severe financial constraints is not different from firms having less financial constraints. Gomes (2002) and Alti (2003) argue that firms facing financial constraints faced by firms may not be a good indicator of investment-cash flow sensitivities among firms. Using an advanced estimation technique like measurement error consistent generalized method of moments, Erickson and Whited (2000) show that significant cash flow coefficients reported by earlier studies need not represent evidence of financing constraints.

The above controversies is neutralized by the study of (Moyen, 2004) who argue that the source of this contradictory finding lies in the disagreement in identifying appropriate factors to segregate more financially constrained firms from less constrained ones. The factors largely used in prior studies (e.g. dividend payout, debt financing, financial distress, firm size) are endogenous in the sense that these are not independently determined. Moreover, these factors are time variant. A company identified as financially constrained in one year may not remain constrained in the following year.

Whited (1992) used a sample of 325 U.S. manufacturing firms facing debt financing constraints because of financial distress for the 1972 to 1986 period. Bond and Meghir (1994) used an unbalanced panel of 626 U.K. manufacturing companies for the 1974 to 1986 period. They employ an Euler equation approach to directly test the first-order condition of an inter-temporal maximization problem, which does not require the measurement of Tobin's q. By imposing an exogenous constraint on external finance and testing whether that constraint is binding for a particular group of firms both of these studies find the exogenous finance constraint to be particularly binding for the constrained groups of firms, which supports the basic FHP (1988) result.

Nabi (1989) estimated investment-cash flow sensitivity for Pakistani firms that had unequal access to the capital market. He found that output accelerator model is the better predictor of investment behavior to those Pakistani firms which have access to the formal capital market. He again emphasized that, only the liquidity variable was significant for firms who were excluded from the capital market participation.

Budina et al. (2000) used a simple augmented accelerator approach and found that cash flows (internal funds) have a significant and positive effect on investment by the entire sample. They re-tested the model by eliminating those firms from sample which had negative cash flows and found that the cash flow variable still displays a significant and positive coefficient. By further classification of the firms in to small and large samples he find that the cash flow is significant and positive for small firms while it is insignificant for large firms. Thus their study argues that small firms are financially constrained than large firms.

Shin and Kim (2002) analyzed the investment-cash flow sensitivity on a sample of US manufacturing firms by acknowledging changes in patterns of capital expenditures on quarterly basis. Their results provide evidence that small standalone firms with small cash holdings face more investment dependency on cash flow as compared to diversified large firms with large cash holdings. Similar results are obtained by Carpenter and Guariglia (2008) on a sample of UK firms. They classified firms into more and less likely to face financial constraints using employees as a measure of size and find that small firms exhibit a positive relationship between investment and cash flow.

Almeida, Campello, and Weisbach’s (2004) model suggests that financial constraints on the part of firm increases the probability to save cash today out of incremental cash flows, which they refer to as the cash-cash flow sensitivity. However, since financially constrained firms can only finance their current investment with internal cash flows, higher cash holdings lead to a lower level of current investment. As such, financially constrained firms will derive an optimal cash policy that trades off current investments against potentially profitable future investments. In contrast, financially unconstrained firms do not incur any costs for holding cash because no current period investments are sacrificed and they derive less benefit from holding cash. To examine their model’s implication, they estimate cash-cash flow sensitivity using a sample of American manufacturing firms between 1971 and 2000 and find that constrained firms exhibit significantly positive cash flow sensitivity of cash. In contrast, financially unconstrained firms do not exhibit significant cash-cash flow sensitivities because they can easily access external capital markets is and may obtain cash without much difficulty at the moment when it is actually required.

Hovakimian (2009) examines the determinants of investment-cash flow sensitivity on a sample of US manufacturing firms without relying on an ex-ante classification of the sample into constrained and unconstrained groups. They used firm-level estimates of investment-cash flow sensitivity to classify firms into groups with high, low, and negative cash flow sensitivity.3 The results suggest that firms which are classified as negative cash flow firms have the lowest cash flows but highest growth opportunities, and appear as the most financially constrained. On the other hand cash flow insensitive firms have the highest cash flows, lowest growth opportunities, and appear the least financially constrained.

Ezzedine, Abaoub and Salma, Bejar Marsh (2007) investigated investment-cash flow sensitivity and cash-cash flow sensitivities on an unbalanced panel data for 39 non-financial Tunisian firms over the period 2000-2006. By classifying firms into two groups based on the median of the total assets and dividend pay-out ratio, they found that firms classified as financially constrained exhibits investment-cash flow sensitivity higher than that of unconstrained firms, excepting small firms for which investment to cash flow sensitivity is inferior than that of large ones. Further, they find strong evidence that financial constraints do affect Tunisian investment’s decisions, mainly in positive cash flow years. However, financial constraints are found to not affect investment’s decisions in negative cash flow years. Thus, the disparity between investment-cash flow sensitivities and cash-cash flow sensitivities is likely to be higher in positive cash flow years. This Tunisian evidence strongly supports the standard theory of FHP (1988), but is in contradiction with several prior empirical results.


Most of the studies concerning investment behavior of firms under imperfect capital markets are related to the developed countries. While problems of asymmetric information and contract enforcement are likely to be present in most, if not all, financial markets (whether in developed or developing countries), it can be argued that these problems will be more severe in developing countries. In developing countries, a greater heterogeneity among firms exist, capital markets are quite segmented (so that informational flows between suppliers of funds are limited) and there is a lack of a well-developed system of contract enforcement procedures, such as an adequate legal system and a sound bankruptcy code (Aivazian, 1998). Furthermore, there are important policy implications of this literature for developing countries: the failure of financial markets to function efficiently may provide a justification for the government to intervene in these markets in favour of certain households, firms or sectors.4

Although a large number of empirical analysis at aggregate level using time series data are available on the determinants of investment, the micro level studies that analyses the relationship between financing patterns and investment for Indian business firms are very limited in number. However, in recent years several attempts have been made to throw light on this aspect concerning Indian business firms.

The first comprehensive study on the investment behaviour of Indian firms was provided by Krishnamurty and Sastry (1975) using data provided by the RBI and the Stock Exchange Official Directory. Their study suggested that the accelerator theory was important for Indian industries. Later, Athey and Laumas (1994) using panel data over the period 1978-86, examined the relative importance of sales accelerator and alternative internal sources of liquidity in investment activities of 256 Indian manufacturing firms listed on the stock exchanges. They found that when all the selected firms in the sample were considered together, current values of changes in real net sales, net profit, and depreciation were all significant in determining capital spending of firms. The authors suggested that, because of Indian government’s policy to promote small enterprises before economic liberalization internal funds were relatively more important for large firms and firms producing luxury goods compared to smaller firms as found in the case of developed countries.

Eastwood and Kohli (1999) analyzed unbalanced panel data of 788 Indian public limited companies selected from the eight sectors of small-scale industry during the period 1965-78. It was assumed that for an Indian firm the amount of bank credit available was fixed in supply and marginal costs of retentions and informal credit were increasing. They find that large firms with new investment opportunities could obtain additional external finance more easily as compared to small firms. Their study suggests that small firms were not only facing the problem of raising external funds for investment demands, but there were also effective constraints regarding the usage of the funds. Moreover, the evidence suggests that the rise in bank lending has raised investment spending by these firms. Finally, using instrumental variable (IV) technique their result demonstrates that small and large firms in India faced different financial environment during 1965-78.

Athey and Reeser (2000) using a firm level data of 142 Indian listed manufacturing firms from 7 industrial groups over the period 1981-96. They estimated an augmented q model of investment and found Tobin’s average q and internal funds to be important determinants of corporate investment. They proposed that internal funds are less important for the sample of smaller firms than for the sample of large firms. Further, their result indicates that internal funds are unimportant for very large, well known firms which presumably suffer less from asymmetric information. This finding is opposite to general findings and it is justified on the ground that it may be due to the specific feature of Indian industrial policy in which small firms were beneficiaries of the selective policy adopted by Indian government. However, changes in the policy regime in 1991 necessitate further analysis of determinants in the context of Indian firms taking into account the financing patterns in relatively liberalized era.

In another study Ganesh Kumar et al. (2001) attempted to investigate the presence of finance constraints among investing firms in the post liberalization period 1993-98. Using a balanced panel of 718 Indian manufacturing firms as a case study they classify their sample according to outward orientation (instead of firm size) and argue that a higher export orientation means a greater ability to compete in world markets. The authors proposed that the Indian firms’ ability to compete in the world market after economic liberalization may be an important determinant of investment project quality. In such environment these firms may face lower costs of external funds. Using a GMM approach, they estimate an investment equation with lagged sales and cash flow as regressors. The authors find that exporting firms are less financially constrained than the domestic firms which are not export oriented. The sales accelerator was significant for domestic and small firms while it was insignificant for the exporting firms.

Another important study in the Indian context is of Athukorala and Sen (2002) who examined the determinants of private corporate investment using data for the period 1954-96. These authors found lagged change in real bank credit to be an important source of external finance to Indian firms. Public investment has a strong complimentary relationship with private corporate investment in India.

Amiya Kumar Bagchi, Pranab Kumar Das, Bhaswar Moitra (2002) analysed a panel of 600 Indian firms for the period 1991-92 to 1997-98 to test the hypothesis of finance constraint. They classified firms on the basis of dividend pay-out ratio as high-cost and low-cost groups; a high dividend pay-out ratio implies a low cost of information faced by the firms and vice versa. They hypothesized that the firms in the high-cost group shows evidence of finance constraints and severity of the constraint goes down with the decrease in the cost of information. Using single as well as simultaneous equations model for each group they found that the firms with medium dividend pay-out ratios are constrained while the low dividend paying group (i. e, high information cost) and very high dividend paying group is not constrained in the loans market so far as investment in fixed capital is concerned. Further cash flow is the most important determinant of firm investment for the low dividend as well as the high dividend paying groups. But the sensitivity of investment to cash flow is higher for the high dividend paying group. This is quite a surprising result that requires careful explanation.

Rejie George, Rezaul Kabir and Jing Qian (2005) examined the reliability of using the investment – cash flow sensitivity as a good measure of financing constraints by comparing Indian business group firms with independent firms. The study also provided a separate investigation on the role played by size, age, leverage and ownership in influencing the investment – cash flow sensitivity group-affiliated firms. They derived Bombay Stock Exchange listed companies data from “Capitaline 2000” database for a period of 1995-2000. Their sample consists of a balanced panel of 339 firms and only those firms were selected for which complete data were available for all six years. The sample firms are distributed across several industries, the most important of which are chemicals, construction, metal, transport, and trade and services. The final sample comprises of 141 (42%) non-group firms and 198 (58%) group firms (a total of 2034 firm-year observations).

Two robust econometrics specifications, Tobin’s “Q” and “Euler Equation” were used to carry out analysis and these equations were estimated by means of Ordinary Least Squares and Two-Stage Least Squares (2SLS) techniques. Their result indicates that there is a positive and statistically significant relationship between investment and Q. All model specifications show almost the same magnitude of the estimated coefficient. The explanatory power of regressions is not low (varying from 13% to 17%) and consistent with prior studies. The estimated cash flow coefficient is positive and statistically significant in each model specification and it is not significantly different between group-affiliated and independent firms. The estimation by 2SLS technique shows the same result as before - that is, coefficients of Q and cash flow are found to be positive and statistically significant. This is opposite to the findings in earlier literatures. If investment – cash flow sensitivity were a good measure of financing constraints, then group-affiliated firms should have depicted significantly lower sensitivity. The Euler equation investment specification once again provides the same result - cash-flow Coefficient is positive and statistically significant, but the group interaction terms are statistically insignificant. This is inconsistent with the claim that firms belonging to business groups should depict a lower investment – cash flow relationship because these firms experience lower financing constraints relative to independent firms. Further classification of firms as group and non-group firms as large on the basis of asset size, they found that, for large firm sub-sample, the coefficient of cash flow and group dummy interaction is positive (0.097) and statistically significant (t = 2.378). It indicates that the investment – cash flow sensitivity for large group-affiliated firms is significantly higher than that for large non-group firms. Division of firms as group-affiliated and stand-alone, indicates that the investment – cash flow sensitivity for large group-affiliated firms is positive (0.098) and statistically significant (t = 1.735). It indicates that investment is more sensitive to cash flows of larger group companies and less sensitive for smaller group companies. This is in contradiction of traditional finding and supportive of the claim that the investment – cash flow relationship is not a useful measure of a firm’s financing constraints. Classification on the basis of corporate ownership shows that it does not affect the investment – cash flow sensitivity among group affiliated firms. On the other hand, it has a significant positive impact among independent firms. The interaction coefficient for corporate ownership dummy is positive (0.112) and statistically significant (t = 2.374). Thus, for unaffiliated firms with high corporate ownership, the cash flow sensitivity is significantly larger than for those with low corporate ownership. They also find that age does not influence the relationship among both group and non-group firms: young and old firms exhibit no difference in their investment – cash flow sensitivity. Overall conclusion of this study show that investment of firms that are a priori expected to be more financially constrained are not necessarily more sensitive to their cash flows.

Surajit Bhattacharyya (2008) used corporate firm data to examine the role of accelerators and financial variables affecting business fixed investment and tried to disentangle their individual importance. He extracted data from the Profit and Loss Statements and the balance sheets of Indian corporate manufacturing firms listed in the Bombay Stock Exchange Official Directory. His study covers a 7-year period from 1991-92 to 1997-98. The author classified firms according to two broad industrial categories: Electronics, Electrical Equipment and Cables (EEEC) covering 26 firms and General Engineering (GE) covering 28 firms. GE firms were comparatively bigger group and thus have more creditworthiness in the loan market. Initially he used fixed and random effects model to estimate nominal and real net investment functions within a neoclassical framework. But Hausman (1978) specification test for Random Effects Model and the F- test for Fixed Effects Model reject both these types of model specifications, and hence they used OLS (ordinary least squares) method to estimate the empirical models with pooled cross section– time series data. He found that in post-liberalization period, the availability of internal liquidity is one of the important determinants of net investment activities of Indian manufacturing firms. In fact, it complements the role of accelerator(s) in firm investment decisions. Volume of retained earnings is more important than the retention ratio; and retention practices of firms are relatively more important than their dividend pay-out decisions. Short-run profitability does not have consistent influence on the investment decisions of the firms.

V.R. Prabhakaran Nair (2009) attempted an empirical investigation to assess the investment behaviour in India across different groups of firms using an unrestricted investment equation of the lagged augmented accelerator model. They utilised firm level manufacturing data from centre for Monitoring Indian Economy’s (CMIE) for the period of 1993-94 to 2003-04. The sample consists of an unbalanced panel of 2269 firms with 19852 observations. The investment equations in their empirical analysis have been estimated in first differences to eliminate the fixed effects in the model and Generalised method of Moments (GMM) have been used to allow for the potential endogeneity of the independent variables. The appropriate lagged values of the right hand side variables are used as instruments.

The result for the entire sample indicates positive and significant coefficient of the cash flow (0.062) variable which means cash flow strongly affects investment. This result is consistent with the existence of a financing hierarchy. After classifying firms into two groups (small and large) on the basis of gross fixed assets they examined the effect of cash flow and debt variables on investment with financial liberalization.

They found that financial liberalization has not reduced or relaxed the dependence of small firms on internal funds. The estimated coefficient of cash flow on investment has increased from 0.186 before financial liberalization to 0.237. Evidence also suggests that, with financial liberalisation, investment remains to be negatively affected by the debt-to-capital ratio (-0.019) at 5 per cent level significance. For large firms internal funds or profit was less important in augmenting investment. However, the positive coefficient of cash flow which was relatively small and insignificant for large firms (0.072) before liberalisation has increased (0.108) and became highly statistically significant in post liberalisation period. On the other hand, the debt-to capital ratio coefficient is significantly positive for large establishments even after considering the effect of financial liberalisation. In other words, unlike small firms, large firms were not credit constrained irrespective of financial liberalisation policies. One possible explanation for this is that, having obtained debt in the past may act as a signal to financial intermediaries like banks and other institutions about the firm’s credit worthiness.


Despite extensive research since the publication of M.M.’s (1958) “Financial Irrelevance Theorem” and finance led investment strategy by Meyer & Kuh (1957), the theory of firms’ investment financing remains one of the most controversial issue in modern corporate finance. The investment cash flow sensitivity of firms and determinants of investment financing under imperfect capital markets is still a puzzle for most of financial economists. Therefore, there is a strong need to conduct empirical studies on these issues brought by literature review in order to get some further evidence on the corporate finance theory. This study is an attempt to fill this gap by providing an empirical research on investment-cash flow sensitivity of Indian manufacturing firms since economic reforms. This is important, specifically, because of following reasons:

(1) Although the main objective of the financial reforms in India has been to enhance the availability of credit through reducing the cost of external finance and mitigate the constraints on the supply of funds for both domestic and foreign investment, however, the impact of such reforms on the ease of finance to firms’ investment is not well established. In India, the story is quite interesting and slightly more complex. Government’s policy of direct credit lending towards small and medium enterprises before economic reforms characterize different investment cash flow sensitivity pattern as compared to those of developed economies. Previous studies show that prevalence of a high degree of imperfection and underdevelopment of the capital market generally leads to a higher dependence on internal funds (cash flow) for investments. It is, therefore, important to study whether the financial reforms have reduced the financial constraints to firm investment decision through better allocation of funds. Again it would be interesting to investigate how Indian firms finance their investment projects and how it has a direct impact on the growth rate of industrial sector and gross domestic product of the country. This is particularly important because the growth in the industrial sector decides the pace and pattern of overall economic growth and employment in any country. Studies have found that whenever industrial sector experienced a slowdown, the overall growth of the economy collapses.

(2) The majority of the researches concerning investment behaviour of firms and cash flow sensitivities have been made by using international data and concerning the firms of developed countries. In addition, there has been a great debate among researchers whether cash flow sensitivity is a measure of the rate and level of investment. Most of the research confirms this sensitivity and advocated a positive relation between cash flow and investment. However, there is a lack of literature showing capital market imperfections and investment-cash flow relationship in India after economic reforms. The empirical question that arises, therefore, is whether corporate investment is more sensitive to cash flow with a given level of imperfections in Indian capital market or not. This is the basic objective which has been investigated in this study and an attempt has been made to provide a theoretical framework and to test empirically the investment-cash flow sensitivity in Indian manufacturing sector.



Investment is the nucleus of an economy. It plays a crucial role in promoting industrial and economic growth for any country. It is an essential component of aggregate demand and fluctuations in investment levels have considerable effect on production and overall economic activity. During the last few decades, many developing countries witnessed changes in economic regimes that have severely conditioned the pattern and sources of investment financing.

In the simplest economic theories, there are just two factors of production: capital and labour. The capital stock generally includes all fixed assets associated with productive capacity like factories, machinery, plant and equipment, inventories etc. The investment on these fixed physical assets is called as tangible fixed asset investment. There may be some investment in non-physical assets that does not involve the accumulation of tangible physical asset but will enhance future productive capacity. These are called intangible investment. For example investment on human capital such as staff training and some components of research and development expenditure (R&D) directly increases the efficiency and productivity of firms and become increasingly more important in these days. Besides this the investment on working capital (inventory investment), residence and financial assets (financial investment) are other types of investment.


Fixed investment is defined as the investment in fixed assets like acquisition of land and building, setting up of new plants and machinery and miscellaneous items (e.g. furniture, vehicles etc.). It is intended either to replace old capital stock or to create new capacity in a firm. There are several alternative economic theories which have been given over time to explain the determinants of firms business fixed investment. These theories are originating from the basic profit maximization problem of the firm and by their dynamic optimization in terms of cost and revenue. The standard theories that have been dealt in the literature on business fixed investment can be arranged in the following lines -

1. The Accelerator Theory
2. Profit Theory
3. Liquidity Theory
4. Neo-Classical – І and Neo-Classical – ІІ
5. Tobin’s Q Theory

The origin of modern theoretical ideas regarding investment behaviour can be traced back to the debates between John Maynard Keynes and Fisher in 1930s. The theories of Fisher and Keynes provide the backbone of later analyses of fixed asset investment. In The “Theory of Interest” (1930), Fisher emphasized that investment is determined at the point where the rate of return on investment is equal to the prevailing interest rate. With its emphasis on relative price factors and benefits versus costs, Fisher’s theory forms the basis of Neo-Classical models of fixed investment (e.g., Jorgenson’s model formulated in the 1960s).5 The theoretical development of investment literatures in the post-world-war ІІ period was dominated by Keynesian ideology and the concept of “Marginal Efficiency of Capital” (Keynes, 1936) was central to the analysis of investment. In its basic form there is much similarity between Keynes’s marginal efficiency of capital and Fisher’s internal rate of return. However, Keynes developed a theory of investment that allows a central role for expectations and unquantifiable uncertainty which is in contrast to Fisher’s approach. Due to this endemic uncertainty as formulated by Keynes’s, the monetary and financial factors have a decisive influence on fixed asset investment activity. Investment projects cannot easily be assessed using fisher’s mathematical tool since he does not include unquantifiable expectations in his model. Further Keynes proposed that while the private entrepreneurship is important, the government must also play a role in promoting investment and aggregate demand by judging the desirability of investment projects and moderating destabilizing forces, such as speculation.

John Maynard Keynes Approach

Keynes in his “General Theory of Income and Employment” (1936) argues that marginal efficiency of capital (MEC) is the key determinant of investment. MEC measures expected profitability of an investment and it is the discount rate that makes the present value of an investment’s future revenue or prospective yield just equal to its current supply price (or current replacement cost). So in Keynesian analysis MEC is a critical dynamic link that connects past, present and future. He shows that investment will take place until the MEC is equal to the current interest rate: that is to the point ‘where there is no longer any class of capital asset of which marginal efficiency exceeds the current interest rate. Keynes argued that an increase in the rate of interest makes investment less attractive by narrowing the gap between MEC and the rate of interest.

Further Keynes (1936) noted that “there is no necessity to hold idle cash balances to bridge over intervals if it can be obtained without difficulty at the moment when it is actually required.” It means that firms do not maintain cash liquidities if they have easy access to external capital markets but firm’s liquidity is significant when firms cannot easily raise funds through external financial markets. This becomes more important if liquid resources can help firms exploit potentially profitable projects. The above argument of Keynes is related with firm’s cash policies, but this is much more general because the decisions which can affect firm capacity to finance projects is affected by the distribution of financing demand and costs across the time.


1 Economic Survey, CSO, India, 2015-16

2 Fixed time effects are included to capture aggregate business-cycle influences. Fixed firm effects account for unobserved time-invariant links between investment and the explanatory variables. That is, the "within" effect of Q or cash flow on investment is captured by the above estimates.

3 A set of characteristics that reflect the severity of the firms' financial constraints, their internal liquidity, growth opportunities, and their investment and financing behaviour is examined for each investment-cash flow sensitivity category.

4 As the World Bank (1993) notes, credit directed to exporters in the East Asian countries had been an important factor behind the rapid economic growth in these countries in the past few decades. Calomiris and Himmelberg (1993) also show that directed credit programmes in Japan had a large, positive and statistically significant effect on investment.

5 MC Baddeley (2003). “Investment theories and analysis.” Gonville and Caius College Cambridge, Palgrave publication.

Excerpt out of 121 pages


Investment Financing. An Empirical Study of Indian Manufacturing Sector
University of Delhi
Catalog Number
ISBN (eBook)
ISBN (Book)
investment, financing, empirical, study, indian, manufacturing, sector
Quote paper
Abdul Ansari (Author), 2018, Investment Financing. An Empirical Study of Indian Manufacturing Sector, Munich, GRIN Verlag,


  • No comments yet.
Look inside the ebook
Title: Investment Financing. An Empirical Study of Indian Manufacturing Sector

Upload papers

Your term paper / thesis:

- Publication as eBook and book
- High royalties for the sales
- Completely free - with ISBN
- It only takes five minutes
- Every paper finds readers

Publish now - it's free