Fixed investment/fundamental sensitivities under financial constraints

• Investment/fundamental sensitivity of firms with/without financial problems.
• New fundamentals are used: profitability shocks and mandated investment rate.
• Investment is regressed on fundamentals and financial variables for two groups.
• Financially constrained firms are found to be more responsive to fundamentals.
• Results support expectations of contracting models of financial market imperfections.

While most models with financial market imperfections predict investment by financially constrained firms to be more sensitive to financial variables, contracting models argue that investment by such firms should be more sensitive to fundamental determinants of investment because fundamentals capture both investment opportunities and changes in the financial position. By first grouping U.S. manufacturing firms as either financially constrained or unconstrained, this paper examines systematic differences in investment/fundamental sensitivities. The findings show that, as expected of contracting models, investment by financially constrained firms is more responsive to fundamentals. These fundamentals are captured by two prominent empirical measures: profitability shocks and mandated investment rate.