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Title: Do Measures of Financial Constraints Measure Financial Constraints?

Author(s): Joan Farre-Mensa and Alexander P. Ljungqvist

Publication Date: January 2015

Keyword(s): Financial constraints

Programme Area(s): Financial Economics

Abstract: Financial constraints are fundamental to empirical research in finance and economics. We propose two novel tests to evaluate how well measures of financial constraints actually capture constraints. We find that firms classified as constrained according to five popular measures do not in fact behave as if they were constrained: they have no trouble raising debt when their demand for debt increases exogenously and they use the proceeds of equity issues to increase payouts to shareholders. We propose an alternative proxy for financial constraints, based on Merton?s (1974) distance-to-default measure, which successfully identifies firms whose behavior is consistent with being constrained.

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Bibliographic Reference

Farre-Mensa, J and Ljungqvist, A. 2015. 'Do Measures of Financial Constraints Measure Financial Constraints?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10326