Finance Constraints or Free Cash Flow? The Impact of Asymmetric Information on Investment

Two explanations characterize the nature of information asymmetries in corporate investment-financing decisions. Models based on finance constraints argue that information-driven cost differentials between internal and external finance may leave profitable investment projects unexploited. Models based on the agency costs of free cash flow suggest that managers increase their utility by wasting resources on unprofitable investments. This paper uses firm-level panel data to empirically compare a model of asymmetric information motivated by finance constraints against the free cash flow alternative by examining the response of firms' investment to changes in internal and external finance. The findings suggest that both finance constraints and agency costs are present in the capital markets.