Investment Under Capital Inflexibility and Collateral Constraints

In recent empirical literature, investment-cash flow (ICF) sensitivity can increase or decrease with the tightness of financing constraints. Earlier critiques suggesting that cash flow reflects expected productivity cannot explain the mixed results. Theories of financing constraints, however, predict only the decreasing effect where tighter constraints reduce firms’ borrowing capacity using capital as collateral. I propose a model in which stronger constraints can further decrease the real option value caused by capital inflexibility, thereby accelerating investment. This novel channel increases ICF sensitivity and reconciles the mixed empirical findings. I explore the model’s implications with a large panel of firms