Is investment: Cashflow sensitivity a good measure of financial constraints?

Since Fazzari et al. (1988), investment-cashflow sensitivity has been one of the most important indicators for testing and measuring the external financial constraints of corporations. This study analyzes the effect of changes in the relative cost of internal and external financing on investment decisions in response to tax changes. China's 2004 VAT reform decreased companies' effective tax rates, leading to an increase in operating cashflow. This, in turn, reduced the internal cost of financing and the value of the tax shield and increased the cost of debt financing. This study shows that in the case of the VAT reform, investment-cashflow sensitivity increased significantly, whereas cash holdings-cashflow sensitivity and borrowing-slack sensitivity did not significantly change. We conclude that investment-cashflow sensitivity is not an effective measure of financial constraints under information asymmetry, but cash-cashflow sensitivity and borrowing-slack sensitivity may be useful alternatives.