Article

FINANCING CONSTRAINTS IN SOME SELECTED MANUFACTURING FIRMS: AN APPLICATION OF STOCHASTIC FRONTIER APPROACH

Apr 24, 2016

DOI:

Published in: The Journal of Developing Areas Special Issue on Dubai Conference

Publisher: Western Illinois Publisher

/ Abureza Islam

Stochastic Frontier Approach (SFA) provides both cross-sectional and inter-temporal comparisons of the effects of financing constraints. SFA besides inferring the strength of financing constraints based on the sign and significance of cash flow variable, measures the constraints for each individual firm and at each point in time. It measures directly not only the marginal impact of firm characteristics, such as size & leverage on financial constraint but also at different levels of firm characteristics in a continuum, enabling the firm to decide to either a required minimum or maximum level of cash holding to significantly reduce the financing constraint. SFA used in this study asserts that financing constraints have a symmetric effect on a frictionless level of investment forcing the realized investment to be lower than the frictionless outcome. Therefore, SFA helps to estimate this unobserved investment frontier and any discrepancy of actual investment from the frontier due to financial factors. Closer the actual investment to the frontier, more investment efficiency gain a firm enjoys. So, the error term in regression model is a combination of two parts: (i) two sided noise terms and (ii) one sided (non-negative) technical inefficiency term. SFA estimates financially constrained investment by taking cognizance of modeling one sided deviation from the investment frontier as a function of firm characteristics (such as cash flow, leverage ratio, size and retention ratio of firms). Financing constraints are identified by imposing one-sided distributional assumption on the effect of financing constraints. We examine the financial constraint of some listed firms in Bangladesh following the SFA approach and find that they are under severe financial constraint. The estimated investment efficiency index (IEI) demonstrates a loss of almost 80% of the rate of investment due to financing constraints. The effects of internal financing and external financing on firms’ investment activities are different. It is found that increase in international financing (cash flow) can ease the financing constraints in addition to reduce the uncertainty of the company's follow-up financing. However, using external financing, firm is likely to increase the uncertainty of future financing. These results suggest that firms in Bangladesh should rely more on internal financing to secure investment opportunities and improve the investment efficiency.

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