Investment and financial constraints in Indian firms: Does working capital smoothen fixed investment?

Abstract

The purpose of this paper is twofold, first to examine the investment-cash flow sensitivity in fixed and working capital investments and second to determine the role played by working capital in smoothing fixed investment. The study is based on secondary financial data of 254 Indian manufacturing firms obtained from CAPITALINE database, pertaining to a period of 10 years. This study employs two-step AB difference GMM estimator proposed by Arellano and Bond (Rev Econ Stud 58(2):277–297, 1991) to arrive at results. Results of the study confirm that working capital investment is excessively sensitive to cash flow shocks. Further we found that both fixed and working capital investment in constrained firms are more sensitive to cash flow shocks when compared to unconstrained firm. Furthermore, the fixed investment smoothing is higher in case of constrained firms. The study is a pioneer in testing whether fixed and working capital investments are sensitive to cash flow shocks and how investment-cash flow sensitivity changes with financial constraints of Indian firms. In addition, this study tends to examine the role of working capital in smoothing the fixed investment. Furthermore, this study explains this phenomenon in more detail by focusing on investment smoothing across constrained and unconstrained firms.