We examine the role of a country‟s institutional framework for investment and financing activities. A country‟s financial structure, investor rights, and legal environment are important determinants of the relation between cash flow and firms‟ investment and financing behavior. Firms from countries with a strong institutional framework exhibit higher financing-cash flow sensitivities. These firms are more likely to substitute a cash flow shortfall with issuing equity. Conversely, investment-cash flow sensitivities are higher for firms in countries with a weaker institutional framework.

Introduction

A large strand of literature suggests that the efficient allocation of capital is of major importance for economic growth, and that the best way to achieve an efficient capital allocation is through financial and legal development. Formal financial markets and associated institutions improve the capital allocation process and contribute to economic growth. For example, Levine and Zervos (1998) find that both the size of the banking sector and the extent of stock market activity are related to future economic growth. Wurgler (2000) shows that financial markets improve the real economy by better allocating investment. Relative to countries with small financial markets, financially developed countries boost investment more in their growing industries, and cut it more in declining industries. Love (2003) notes that financial development affects economic growth by reducing financial constraints. Similarly, Ayyagari et al. (2008, 2011) document that constrained access to finance hinders innovation, and obstacles to raise external finance restrain firm growth. Beck et al. (2005) and Beck et al. (2006) conclude that the financial and institutional development weakens the constraining effects of financial and legal obstacles on capital allocation efficiency. We provide a deeper understanding of the effect a country‟s economic, financial, and legal development has on firms‟ access to finance. Access to finance is examined by comparing how different institutional frameworks affect the sensitivities of firms‟ investment and financing decisions to cash flow, with particular emphasis on financing-cash flow sensitivities. This approach is in contrast to the prior literature on cash flow-sensitivities, which has mainly focused on the relation between investment and cash flow. Fazzari et al. (1988) were the first to report that investment spending of U.S. firms is positively related to their cash flow, which has usually been interpreted as an indication of constrained access to capital. Their results have been challenged methodologically (Erickson and Whited, 2000, 2012; Chen and Chen, 2012). We argue that another main critique is that single-equation models, by focusing exclusively on the investment-cash flow sensitivity but neglecting the financing-cash flow sensitivities, only provide an indirect test of financial constraints.