Corporate Investment and Financing Constraints; A Case of Nepalese

Manufacturing Sector
Kapil Deb Subedi
Head- Department of Management
Saptagandaki Multiple Campus
1.1General Background
An efficient selection of investment projects is essential for sustained economic
growth of any country. In market economy, the decision process about investment can be
characterized as bottom to top process. In other words, investment is carried out by individual
firm and the firm itself decides whether to invest or not. The variation of firm investment
behavior in a perfect capital market is fully explained by the market opportunity and expected
profitability of the proposed project. Therefore, adjusting capital expenditure in response to
changes in expected future demand represents rational economic behavior at the firm level
that reduces inefficient investment outlays and lead to optimal investment at the aggregate
level.
In case of perfect capital market, the firm's financial structure is irrelevant since the market
value of the firm depends only on the expected profit stream from the investment project and
not on the financial structure. Firms are thus indifferent between the various (internal or
external) means to finance their investment. Investment project will be carried out if their
expected return exceeds the (given) cost of capital which is thought to be the same for all
firms. In this neo-classical view of financial markets internal and external funds are perfect
substitutes and investment can never be constrained by a lack of internal finance.
However, it is widely accepted that there does not exist perfect capital markets in real world.
Therefore, the other factors affecting corporate investment patterns has been identified as the
existence of capital market imperfections that restrict access to or increases the cost of funds
necessary to maintain, otherwise desirable investment level. As a result, capital expenditure
reduction will be accelerated during tough times and opposite results hold during period of
strong economic growth. Therefore, the corporate investment changes due to the existence of
financial constraint has been the subject of much attention by researchers and policy makers
for the study of investment pattern and behavior at corporate level capital market
imperfections lead to firms into different financing hierarchies facing different financing
constraints. When firms face financing constraints, investment spending will vary with the
availability of internal funds, rather than just with the availability of positive Net Present
Value (NPV) projects.
Existence of incomplete asymmetric information between the borrowers and lenders
of external funds leads to problem of adverse selection and moral hazard. These problems of
asymmetric information lead to a difference between the cost of internal and external funds.
The providers of external finance will require a (firm specific) premium because they are
unable to monitor or screen all the aspects of investment projects. The size of external finance
premium depends on firm characteristics, like firm size or net worth which provide an
imperfect indication for the lender of the creditworthiness of the borrowing firms.1 Due to
external finance premium, firms will albeit to a different degree; prefer to finance their
investment by internal funds. The upshot is that internal or external finance are no longer
perfect substitute
Considerable empirical evidence Myers and Majluf (1984) indicates that internal
funds play an important role in financing investment projects under asymmetric information.
What matters to the present purpose is that these problems of asymmetric information lead to
a difference between the cost of internal and external and external funds. As a consequence
investment by firms facing high information cost is not only determined by expected profits
but also potentially by the availability of internal funds. Investments by those firms expected
to face higher information cost are thought to be more constrained by the availability of
internal finance and vice versa. Therefore, the present study derives a theoretical investment-
liquidity constraint model to test the hypothesis that the investment decisions of more
financially constrained firm will be more sensitive to their internal funds as compared to the
less financially constrained firms. The basic idea to this notion underlies various empirical
studies on the severity of liquidity constraints for investment (e.g. Fazzari et al., 1988; Kaplan
& Zingales, 1997).

1. It is off course also possible that information problems lead to quantity rationing of external
funds for firms, see Stiglitz and Weiss (1981)
 This study is directed to resolve the following issues in the context of Nepal
• Whether the internal funds are the dominant source of financing for all enterprises or
there are any significant differences on financing decisions of the firms under
different liquidity constraints?
• Whether the firm investment is sensitive to the investment opportunities of Nepalese
enterprises?
• Whether the managers choose to rely primarily upon internal cash flow for investment
despite the availability of additional low cost external funds or they ignore the cost of
internal or external funds?
• Whether the investment decisions of the smaller firms (according to assets size group)
are more sensitive to their liquidity than the investment decision of larger firms?
• Are there any differences in investment coefficient of Nepalese enterprises across
different groups of firms formed according to their financial status?

1.3 Objectives of the Study:

The major objective of this study is “to measure the relationship of the liquidity
sensitivity to firm's investment behavior and to make comparison of investment-liquidity
sensitivities across different groups of enterprises in Nepal”. Another facet of the study is
to examine the investment opportunity as proxies by difference in sales scaled by net
fixed investment of the Nepalese enterprises and establishes their relationship to the firm
investment behavior. Specifically, the study objectives can be broken down into
following parts;
1. To measure the relationship of investment-liquidity sensitivities of Nepalese
enterprises.
2. To make comparison of investment-liquidity sensitivities across different groups of
enterprises in Nepal.
3. To re-examine the firm investment decision in the presence of financial constraints.
4. To examine the firm sensitivity to investment opportunity as proxied by difference in
sales scaled by net fixed investment of the Nepalese enterprises.

1.4 Organization of the Study:

The remainder of this study will be organized as follows. The next section reviews the
literature and global findings on relationship between firm investment and firm financial
status. The section that follows describes the methodology utilized for the study. The
empirical analysis and results will be considered in next section followed by summary and
conclusions in the final section.
Research Methodology:
Research Design:
The research methodology to this study more or less follows the approach of the study
by Kaplan and Zingales (1997). The 14 listed enterprises in NEPSE Ltd. from manufacturing;
hotel and trading sectors are chosen by using non-random judgmental sampling. The study is
based on secondary data. The firms are classified into financially constrained and not
financially constrained groups using first the subjective criterion but later they are objectively
supported and classified according to discriminant analysis using equation (1). The regression
equation for this study has been estimated (Eq.-2) to test the hypothesis that whether the
financial constraints have significant impact on the investment decisions of the firms. The
basic idea underlies various empirical studies on the severity of liquidity constraints for
investment (e.g., Fazzari, Hubhard and Peterson, 1988; Kaplan and Zingales, 1997; etc.).

3.2 Nature and Source of Data:

 This study is based on secondary data. A combination of quantitative and qualitative
information extracted from company annual reports have been used to rank firms in terms of
their apparent degree of financial constraints. The quantitative data required for the study
have been extracted from the secondary sources. The company annual financial statements
and the "Financial Statements of Listed Companies", Vol. VII compiled and published by
stock exchange limited served for the secondary data required to capture the liquidity
constraints of the firm.
3.3 Selection of Companies and Sample Characteristics:
There are 106 enterprises listed in Nepal Stock Exchange Limited (NEPSE Ltd.) by
the end of FY 2004/05. The present study does not cover the enterprises in banking, finance
and insurance sectors that are listed in NEPSE Ltd. Therefore, the enterprises in
manufacturing hotel and trading sectors that are listed in NEPSE Ltd. can be regarded as size
of population for this study. The study covers a sample of 14 enterprises listed in NEPSE Ltd.
for the 1995/96 to 2004/05 periods by using judgmental non-random sampling method.
Considering the study period of 1995/96 to 2004/05, usable data could be obtained as
indicated in the Table– 3.1
Table –3.1
Name and sectors of companies selected as sample
S.N. Name of the Enterprises Years Observations
A. Trading Sectors
1. Salt Trading Corporation 1999 to 2004 6
2. Bishal Bahar Company Ltd. 1998 to 2001 4
Total: 10
B. Hotel
1. Soaltee Hotel Ltd. 1998 to 2000 3
Total: 3
C. Manufacturing & ProcessiSectors

1. Botlers Nepal Ltd. 1998 to 2001 4

2. Unilever Nepal Ltd. 1998 to 2005 8
3. Botlers Nepal (Terai) Ltd. 19996 to 2004 9
4. Bhrikuti Pulp and Paper Ltd. 2000 to 2003 4

5. Shree Ram Sugar Mills Ltd. 2000 to 2001 2

6. Necon Air Ltd. 1998 to 2001 4
7. Butwal Power Company Ltd. 2000 to 2004 5
8. Jyoti Spinning Mills Ltd. 1998 to 2001 4
9. Nepal Lube Oil Ltd. 1998 to 2001 4
`10 Nepal battery company 1995 to 2001 6
11 Arun Vanaspati Udduog Limited 2001 1
Total. 51
Table - 1 shows that there are 64 observations selected for study out of 140 population
observations (14 enterprises x 10 years). Therefore, the percentage of selected observation is
n/N (64/140 )=46 percent.

3.6 Classification Methodology:

Following the approach of Cleary (2005), in this study, firms are classified into
groups according to a beginning of period financial status index (Zfs), with classification
updated every period to reflect the fact that financial status changes continuously. The index
is determined using multiple discriminant analysis, which considers an entire profile of
characteristics shared by a particular firm and transforms them into a univariate statistic. The
sample is divided into two groups:
1. Group - 1 firms, which increase dividends or keep constant payout during the period
and are likely not financial constrained
2. Group - 2 firms, which cut dividends or do not pay dividends at all during the period
and are likely financial constrained; .
The present study uses the following beginning of period variables for the purpose of
discriminant analysis: current ratio (current), debt ratio (debt), interest coverage (int.cov.), net
income margin (nl %), and Sales growth(salgr.)
Zfs = B1 current + B2 int.cov + B3 nI % + B4 sales growth + B5 Debt……… (1)

The hypothesis is that these variables will enable us to predict if firms will increase or
decrease dividend payments in the subsequent period. Coefficient values are estimated that
best distinguish each independent variable between the two groups according to the Zfs value.

3.7 Regression Equation:

The present study estimates the following regression equation to measure the
relationship between firm investment and their financial status.
(I/K)it = bo + b1 ∆ (SAL/K)it + b2 (CF/K)i + µ it ... (2)

where, i denotes the ith firm, Iit is investment in plant and equipment during period t, k is the
beginning of period book value for net property, plant and equipment, CF represents current
period cash flow to the firm as measured by net income plus depreciation; ∆ SAL/K denotes
the change in sales scaled by fixed assets and proxies for investment opportunities of the
firms and uit is the error term. The liquidity variables are assumed to be uncorrelated with the
investment opportunity. A positive and significant coefficient of the liquidity variable, b2
(CF/K), is thought to indicate that liquidity constraints matter to the extent that investment is
sensitive to fluctuations in internal finance (in case of perfect capital markets, our bench mark
the liquidity co-efficient would be insignificantly different from zero). This is the basic
equation estimated by Kaplan and Zingales (1997) and Cleary (1999) among other, with
market to book ratio used in place of marginal Q as a proxy for growth opportunities, and
current period cashflow (CF) scaled by K, used to measure the availability of internally
generated funds. But in this study, the first difference of sales scaled by fixed assets as a
proxy for the investment opportunities of the firm has been used. This proxy is also used in
other studies on transition and developing economies (see e.g.; Lensink and Sterken, 1998)
where tradition of share market trading is not regular and only limited number companies are
listed. Similar to previous evidence, the reported regression results are estimated using fixed
effects to control for firm and time specific influences.
The equation mentioned above is estimated for different categories (for example;
predicted group 1, predicted group 2, FC, PFC, NFC group.. The basic test is to see whether
the liquidity coefficient is significantly higher/lower for the given more or less financially
constrained group of firms.
Presentation and Analysis of Secondary Data:
4.1 Introduction:
. This paper forms different portfolios of Nepalese enterprises under different
financial status groups as characterized by assets size, discriminant score etc. and it
estimates the investment liquidity constraint model for different portfolios using least square
regression estimate.
4.2. Firms Classification Methodology and Classification Result:
In present paper, firms are classified into groups according to a beginning of period
financial status index (Zfs), with classification model updated every period to reflect the fact
that financial status changes continuously. The index is determined using multiple
discriminant analysis, which considers an entire profile of characteristics shared by a
particular firm and transforms them into a univariate statistic. The multiple discriminant
analysis requires establishing two or more mutually exclusive groups according to some
explicit group classification. It is difficult to categorize explicitly which firms are financially
constrained without considering to a number of firm characteristics simultaneously. However,
it is possible to establish two mutually exclusive groups by making use of the past knowledge
that firms paid dividend or not. This basis suggests us dividing the sample into two
categories; group 1 firms which increase or do not change dividend per share in period t and
are likely not financially constrained; and group 2 firms which cut dividend or do not pay
dividends in period t and are likely financially constrained.
Discriminant analysis uses a number of variables that are likely to influence
characterization of a firm in one of the two mutually exclusive groups of interest. The present
study applies the following variables that are taken as proxy for firm liquidity, leverage,
profitability and growth. The independent variables chosen for the Discriminant analysis are
current ratio, debt ratio, interest coverage ratio, net profit margin and sales growth as selected
by the of study of Sean Cleary (1999). The hypothesis is that these variables will enable us to
predict, if firms will increase or decrease dividends payments in the subsequent period.
Coefficient values are estimated that best distinguish each independent variable between the
two groups according to the equation-1 presented in section three. More importantly, firms
are classified very reasonably according to their financial status as measured by traditional
financial ratio.
Table 4.2.1 reports summary statistics of mean and median and various financial variables for
the sample period which confirm that firms likely to reducing dividends or no dividends
(Predicted group 2 or financially constrained group) exhibit lower current ratios, higher debt
ratios, lower net profit margin and lower sales growth, than the firms that are likely to
increase or no change in dividend in period t (Predicted group 1or not financially constrained
group). Univariate significance level indicates that the net profit margin and debt ratio are
significant at 1 percent level of significance where as current ratio; sales growth and interest
coverage ratio are significant at five, seventeen, and thirty three percent levels of significance
respectively.
[Insert table-4.2.1 here]
Table 4.2.2 presents the correlations among the financial variables, as well as those used in
the subsequent regression analysis. The largest positive correlation between discriminant
score (Zfs) and the independent variable are 0.843 with net profit margin and 0.473 with
current ratio. These both coefficients are significant at 5% level of significance. These
observations suggest that firms tend to increase or make constant the dividend payout during
periods of increasing profits and liquidity. At the same time, the largest negative correlation
between discriminant scores (Zfs) and debt ratio is 0.71 and the coefficient is significant at
five percent level of significance. This result suggests that the firms tend to decrease or pay
no dividends at the period when they have higher debt ratio. The correlation coefficient
between fixed assets purchase and discriminant score (Zfs) is the lowest one (i.e.0.029) among
all these variables. This observation suggests that the firms are likely to be indifferent with
dividend payout and fixed assets purchase decision.
[Insert Table –4.2.2 here]

For classification purpose, 64 firms-year observations were taken into account for the
discriminant analysis using the independent variables as mentioned above. The discriminant
function classified the 33 observation as predicted group one (likely to increase or no change
in dividend) and 31 firms-year observation were classified as predicted group two (likely to
decrease or no dividends) firms. While in the original grouped cases, the 29 firms year
observations were classified into first group (increase or no change in dividend payout) and
35 firms-year observations were classified into second group (decrease or no dividend
payout) of firms. The table 4.2.3 presents the classification result. Overall, the independent
variables do a good job of successfully predicting the firms in group one if they will increase
or do not change in dividend payout in period t and predicting the firms in group two which
cut or do not pay their dividends in period t. In aggregate, the firms are being properly
classified at 66 percent of the time. The discriminant function result suggests that firms are
classified very reasonably according to their financial status as measured by traditional
financial ratios for the purpose of this study
[Insert table-4.2.3 here]

In addition to the predicted group classification, firms are also classified into three separate
groups according to their discriminant score (Zfs) value. The firms with discriminant scores in
the top third over the entire period are categorized as not financially constrained (NFC), the
next third as partially financially constrained (PFC), and the bottom third as financially
constrained (FC).
[Insert Table-4.2.4 here]

Summary statistics for these groups presented in table 4.2.4 indicate the classification
strategy has successfully captured the desired cross-sectional properties. The financial ratios
are superior for the NFC groups, inferior for the FC groups and for the PFC groups lying
somewhere between these two groups of firms.
Firms are also classified into groups according to another additional criteria designed
to measure financial constraint by reference to their susceptibility to market imperfection, as
articulated by Fazzari et al. (2000). This criterion classifies firms according to size, similar to
the approach of Gilchrist and Himmelberg (1995), based on the notion that smaller firms will
be more financially constrained because they face higher informational asymmetry problems
and agency costs. In particular, firms are classified into three groups each year based on the
size of their reported total assets, with smallest third being classified as TA Group one, the
largest as TA Group three, and the middle groups as TA Group two.
The Table 4.2.5 reports the mean and median of various financial ratios according to different
group in firm size .The reported financial variables mean and median values indicates that the
smaller the firms have the healthier financial ratios. The financial ratios are superior for the
smaller firms, inferior for the larger firms and for the middle assets size firms lying
somewhere between these two groups of firms . (Insert Table –4.2.5 here)

4.3. Regression Estimation:

Firms can finance their investment by external funds by equity or debt. Alternatively
the firm can also use internal funds to finance its investment projects. In the case of perfect
capital markets, the firm’s financial structure is irrelevant since the market value of the firm
depends on the expected profit stream from the investment project and not on the financial
structure. But in incomplete capital market, asymmetric information leads to problems of
adverse selection and moral hazard. What matters to our present purpose is that these
problems of asymmetric information lead to a difference between the cost of internal and
external funds. As a consequence, investments by firms facing high information costs are not
only determined by expected profits but also potentially by the availability of internal funds.
Investments by those firms expected to face higher (lower) information costs are thought to
be more (less) constrained by the availability of internal finance. This basic idea underlies
various empirical studies on the studies on the severity of liquidity constraints for investment
(e.g.; Fazzari et al., 1988; Kaplan & Zingales, 1997). The reduced form investment equation
in this type of study has the following general form (Hubbard, 1998: 202):
(I/k)it = Co + C1f (X/Kit) + C2f (L/K)it + µ it ... (1)
Where I is the net investment in fixed assets and the dependent variable in the
regression, it is obtained as the first difference of tangible fixed assets plus depreciation in
our present study. Investment opportunity (X) in equation (1) is an important explanatory
variable. Theoretically marginal Q could be used for the approximation of present and
expected future investment opportunities. Since marginal Q is unobservable, many
investment/liquidity studies for industrialized countries use average Q as a proxy. However in
order to be able to calculate average Q, the country concerned should have a well developed
stock market. In Nepal this is still not the case, and only a limited number of companies are
listed and have their market trading regularly. We therefore use the first difference of sales as
a proxy for the investment opportunities of the firm. This proxy is also used in other studies
on transition economies (see e.g.; Lensink and Sterken, 1998) and more often than not it out
performs Tobin's Q (Fazzari et al.). Cash flow is used as a proxy for the liquidity variable in
equation (1). So in our empirical study, equation (1) be comes:
(I/K)it = Co + C1 ∆ (SAL/K)it + C2 (CF/K)i + µ it ... (1')
Where it denotes the ith firm in period t, I is net investment in fixed assets, ∆ SAL
denotes the change in sales and proxies for investment opportunities, and CF represents the
cash flow variable; µ is the error term and the scalar, K is the net fixed assets at the
beginning of each year. Similar to previous evidence, the reported regression results are
estimated using fixed effects to control for firm and time specific influences.

4.4. Regression Results:

We estimated the regression equation in total sample and the results are presented in
Table – 4.4.1. Our hypothesis in liquidity constraint model is that a positive and significant
coefficient of the liquidity variable C2 is thought to indicate that liquidity constraints matter
to the extent that investment is sensitive to fluctuation in internal finance. The first column in
Table – 4.4.1 represent the full sample estimation results, where cash flow coefficient is
positive and significant. The regression results for investment-opportunity sensitivity of
Nepalese enterprises indicate that the coefficient is positive as per prior expectation but it is
very small and not significant. This result suggests that the liquidity constraints are relevant
for the Nepalese enterprises whereas, the investment sensitivity to market opportunity is not
so significant for investment decision in Nepalese enterprise in our sample.
In order to identify the regression coefficient of constrained and unconstrained firms, the
equation mentioned above is estimated for sub samples where the sub- sampling is based on
above mentioned discriminant analysis. The predicted group one (firms likely to increase
dividends or no change in dividends) firms’ regression estimation (as shown in Table – 4.4.1
column two) shows the positive and significant cash flow coefficient. But at the same
estimation, these firms showed a negative co-efficient for market opportunity as proxied by
first difference of sales to fixed assets. It also estimated the regression equation for predicted
group two, the regression result for these firms shows the small cash flow co-efficient (Table
– 4.4.1 Column - III). However it is insignificant, the co-efficient value is positive. The main
conclusion to arise from Table – 4.4.1 is that liquidity constraints are relevant for the
Nepalese enterprises whereas the firms that are financially unhealthy are relatively insensitive
to the availability of internal funds, while the opposite result holds for firms with reasonably
solid financial positions. This result supports the main findings of Kaplan and Zingales
(1997) and Cleary (1999) regarding the impact of financial health the investment decisions of
firms with stronger financial positions are much more sensitive to the availability of internal
funds
[.Insert table –4.4.1 here]

4.4.1 Regression Result for Sample Split Based on Discriminant Score

The present study also estimated the regression equation of different financial status group;
(for example FC, PFC and NFC groups) as mentioned above according to their discriminant
score and presented the result in Table – 4.4.2. They indicate that internal cash flow is the
significant determinants of investment for all three groups of firms. For all the groups, cash
flow co-efficient are positive. For PFC group, however the co-efficient being positive, it is
not significant but for rest of the group, the co-efficient are significant at the 1 percent level
of significance. The result also suggests that the market opportunity as peroxied by first
difference of sales to fixed assets is insensitive to investment decisions of FC and NFC
groups of firms. The co-efficient, as opposite to prior expectation, are negative and also
insignificant to FC and NFC groups. As regard to the PFC group, the market opportunity co-
efficient is positive as per prior expectation but it is insignificant. The adjusted R² value
ranges from 11.4 percent to 44.5 percent, which is higher than the previous studies.
The positive and significant co-efficient for liquidity variable suggests that firm’s investment
decisions are sensitive to the availability of internal funds. More importantly, the investment
outlays of the FC firms are significantly more sensitive to liquidity than that of NFC firms.
The estimated cashflow co-efficients for the NFC, PFC and FC groups are 0.404, 0.392 and
1.404 respectively. This result contradicts the main findings of Kaplan and Zingales (1997)
and Cleary (1999) regarding the impact of financial health on investment decisions of firms
with stronger financial positions are much more sensitive to the availability of internal
funds.But at the same time, it supported the main findings of Fazzari et. al. (1988) regarding
the impact of financial health on investment decisions of firms with least financially
constrained firms are much less sensitive to the availability of internal funds
[Insert table –4.4.2 here]

4.4.2. The Impact of Leverage on Firm Investment:

A number of prior studies (for example Lang, Ofek and Stulz, 1996) find that future
growth and investment are negatively related to leverage; particularly for firms with low
Tobin’s q value and high debt ratio. It is very important to control the firm leverage effect on
investment liquidity constraint model. Therefore, an additional test is performed to examine
the robustness of results to the influence of firm leverage. This implies the significance of
examining whether the pattern of investment-liquidity sensitivities defected in the present
study could be attributed to a systematic tendency of the classification scheme to assign firms
to a group whose investment decisions are more sensitive to firm leverage than those of other
groups. This hypothesis is tested by running regression that include debt to total assets as an
independent variable in the regression specification, in addition to ∆ SAL/K and CF/K. The
results are reported in Table – 4.4.3 The co-efficient for debt to total assets is found to be
negative and insignificant for FC and NFC groups, hence the cashflow co-efficient virtually
remain identical for these two groups.
About the PFC groups the Debt/Total assets co-efficient is positive and virtually the cashflow
co-efficient has increased from 0.392 to 0.501 and is significant at 1 percent level of
significance. This evidence suggests that the observed pattern of investment-liquidity
sensitivity is attributable to a leverage effect for PFC groups of firms.
[Insert table- 4.4.3 here]

4.4.3 Liquidity Constraints and the Relevance of Firm's Size:

In this section; the present study used firm characteristics to classify firms that a priori
can be considered to differ in their access to external funds or, in other words, in their
liquidity constraints. There are various measures to determine firm size. This study presented
estimations based upon the total assets of each firm for each period. Table – 4.4.4. reports
result for the groups formed according to firm size. This result suggests that smaller firms are
more liquidity sensitive than larger ones. The cashflow co-efficients for all three groups of
firm are positive. The TA Group one has highest cashflow co-efficient than other two groups.
The cashflow co-efficient for largest group is positive as per prior expectation but it is not
significant.. This observation confirms the result of Gilchrist and Himmelberg (1995) but
contradicts with recent international evidence provided by Kadapakkam et al. (1988), and
Cleary (2005) who find that smaller firms are less sensitive to cashflow than the larger ones.
This result supports with prior results presented in this study and suggested the notion that
the smaller firms will be more financially constrained because they face higher informational
asymmetry problems and agency cost so they are more sensitive to internal funds than the
larger firms. This findings is incompliance with the conclusion of FHP(1988)
[Insert table- 4.4.4]

6. Summaries and Conclusions

First, the literature in this filed has tended to proffer different causal analysis for clarifying
the relationship between firm investment and financial status. Many studies supports the
existence of a strong relationship between financial factors like leverage, liquidity,
profitability and investment decision which contradicts the basic irrelevancy proposition
established by Modigliani and Miller (1958). This suggests that firms operate in imperfect
market, which leaves researchers and policy makers to deal with critical issues of how and
why these imperfections affect firm investment decisions.
Second, market imperfection is the predominant phenomena over the all countries in the
world whether they are well developed one or the country striving for development only
the difference lies in its characteristics like legal, social, geographical and economic
development stage and its degree to imperfection. A number of empirical studies (e.g.
Myers and Majluf (1984), Bernanake and Gertler (1989) provide the foundation for
market imperfection which is mainly resulted by asymmetric information problems in
capital market and the agency cost causing a premium on external finance.
Third, the theoretical argument asserted the existence of a financing hierarchy, in which
firms finance investment primarily through internal funds, and issue equity as a last resort
(as in the pecking order theory postulated by Myers, 1984). Given the existence of
imperfect financial market, this relationship should hold for all firms, even the large well-
known ones. There is ample empirical evidence to support this notion, and in fact, there
does not appear to be very much debate on this issue.
Fourth, on the observed condition of financial hierarchy the investment outlays of
constrained firms would be the most sensitive to internal funds availability. This claim
was substantiated by an overwhelming amount of empirical evidence (e.g. Fazzari et. al.:
1988, Hoshi et. al. 1991; Oliner and Rudebush: 1992; Whited; 1992, etc) based on the
studies that categorized firms according to different characteristics.
Fifth, however the existence of such a financing hierarchy also suggests the importance of
maintaining adequate financial slack as argued by Myers and Majluf (1984). In such
situation, it is reasonable to argue that firms with weaker financial positions will display
relatively low investment cash flow sensitivity, due to the necessity of using internal funds
to pay down debt and improve firm liquidity. Many empirical studies (e.g. Kaplan and
Zingales: 1997, Cleary: 1999; Kaplan and Zingales: 2000, Cleary et. al.: 2005 and Cleary:
2005) support this notion that the investment decision of firms with stronger financial
positions are much more sensitive to the availability of internal funds than those that are
less creditworthy.
Sixth, Debate over this matter as explained above has been widespread by the recent work
of Kaplan and Zingales (2000) and Fazzari et.al.(2000) who articulated two conflicting
views of this issue. This debut poses a conceptual argument questioning the
appropriateness of the measure and validity of financial constraints as explained by
Kaplan and Zingles (1997). Hence, this theoretical debate has challenged the generality of
conclusions of the either study as emanating from the seminal study conducted by Fazzari
et. al.(1988) or the study result of Kaplan and Zingales (1997).
Seventh, the conclusions of the above-explained studies relate to the investment behavior of
firms operating in well-developed economies, which may not necessarily hold for firms
operating in distinctly different environments specially in developing economies. In the
context of Nepal, only a few researches (e.g. Pradhan and Kurmi, 2004) have been conducted
in this very issue; therefore it is useful conduct the research in this issue to generalize the
behavior of investment pattern of Nepalese firms that are operating in very small, imperfect
and volatile capital markets.
In the context of Nepal, there are only a few listed companies operating in imperfect capital
market. These companies’ ownership and control is strongly concentrated. Most firms have a
controlling owner, family controlled, many large firms are members of business groups and a
numbers of firms have not yet been listed. In the context of these country specific
characteristics, the present study is primarily concerned with the testing of the conclusions of
the above-explained studies e.g, studies of Fazzari et. al. (1988) or Kaplan and Zingales
(1997) (they relate to the investment behavior of firms operating in well-developed
economies) in context of Nepal.
The estimated regression results in total sample suggested that the liquidity constraints are
relevant for the Nepalese enterprises whereas, the investment sensitivity to market
opportunity is not so significant for investment decision in Nepalese enterprise in our sample.
In order to identify the regression coefficient of constrained and unconstrained firms, the
regression was estimated for sub samples where the sub- sampling based on above mentioned
discriminant analysis. The predicted group one (firms likely to increase dividends or no
change in dividends) firms’ regression estimation showed the positive and significant cash
flow coefficient. But at the same estimation, these firms showed a negative co-efficient for
market opportunity as proxied by first difference of sales to fixed assets. The estimated the
regression cofficient for predicted group two,also gave the same results however the
coefficient was smaller than those of first group.
The present study estimated the regression equation of different financial status group; (for
example FC, PFC and NFC groups) as mentioned above according to their discriminant The
result indicated that internal cashflow is the significant determinants of investment for all
three groups. The result also suggests that the market opportunity as peroxied by first
difference of sales to fixed assets is insensitive to investment decisions of FC and NFC
groups of firms. The co-efficient, as opposite to prior expectation, were negative and also
insignificant to FC and NFC groups. As regards to the PFC group, the market opportunity co-
efficient was positive as per prior expectation but it was insignificant.
The positive and significant co-efficient for liquidity variable suggested that firm’s
investment decisions are sensitive to the availability of internal funds. More importantly, the
investment outlays of the FC firms are significantly more sensitive to liquidity than that of
NFC firms.
This result supported the main findings of Fazzari et. al. (1988) regarding the impact of
financial health on investment decisions of firms with stronger financial positions are much
less sensitive to the availability of internal funds and contradicted the findings of Kaplan and
Zingales (1997) and Cleary (1999).
The present study also estimated the regression equation of different portfolio of firms based
upon the total assets of each firm for each period. This result suggested that smaller firms are
more liquidity sensitive than larger ones. The cashflow co-efficients for all three groups of
firm were positive. The Total assets Group one firms (smaller Firms) had highest cashflow
co-efficient than other two groups. The cashflow co-efficient for largest assets group is
positive as per prior expectation but it is not significant.. This observation confirms the result
of Gilchrist and Himmelberg (1995) but contradicts with recent international evidence
provided by Kadapakkam et al. (1988), and Cleary (2005) who find that smaller firms are less
sensitive to cashflow than the larger ones. This result supports with prior results presented in
this study and suggested the notion that the smaller firms will be more financially constrained
because they face higher informational asymmetry problems and agency cost so they are
more sensitive to internal funds than the larger firms. This findings is incompliance with the
conclusion of FHP(1988)

Table – 4.2.1
Sample Summary Statistics:
The followings are the reports of financial variable means for the sample of firms-year
observations of Nepalese non-financial sectors of enterprises. All financial variables are for
the beginning of period of the fiscal year except for cash flow, investment and change in
sales(dsales) which represents firm cash flow , capital expenditure and difference in sales
during period t. k is the firm's beginning of period net fixed assets value. The discriminant
score (zfs) is calculated using discriminant analysis according to equation 1. A full-
description of the variables is included in the Appendix.
Sales Interest
Debt NP growt ∆sales/ coverag
Group Statistic ratio ratio h C/R CF/K FA/K k e
NFC
Group Mean .0402 .1736 .1612 2.100 .5871 .1874 .7363 11.63
n=33
.0000 .1039 .2052 1.788 .4663 .0637 .2269 10.94
Median
FC
Group .3999 -.0178 .0216 1.476 .2278 .1524 .0277 5.334
Mean
n=31
Median .4817 .0061 .0346 1.130 .0928 .0534 .0423 1.140

Total
Mean .2144 .0809 .0936 1.798 .4131 .1704 .3931 8.584

n=64 Median .0488 .0723 .0809 1.616 .2962 .0548 .0773 5.541

Table – 4.2.2
Correlation among Variables
The followings are the reports of financial variable means and their correlation for the
sample of firms-year observations of Nepalese non-financial sectors of enterprises. All
financial variables are for the beginning of period of the fiscal year except for cash flow,
investment and change in sales(dsales) which represents firm cash flow , capital expenditure
and difference in sales during period t. k is the firm's beginning of period net fixed assets
value A full-description of the variables is included in the Appendix.
 Debt NP
C/r ratio ratio Int. cov CF/K FA/K ∆sales/k Sal.grt Dis. Scr
C/r 1
Debt ratio -.188 1
NP ratio .270* -.503** 1
Int.tcov.
.016 -.661** .416** 1
CF/k .031 -.560** .390** .623** 1
FA/K .092 -.001 .056 .156 .413** 1
∆sale/k .075 -.051 .062 .047 .379** .259* 1
Sal.grt -.095 -.026 .281* .068 .296* .136 .612** 1
Dis. Scr .473** -.719** .843** .259* .419** .029 .209 .362** 1
* Correlation is significant at the 0.05 level (2-tailed).
** Correlation is significant at the 0.01 level (2-tailed).

Table 4.2.3 Classification Results

The following are classification result of the sample of firms-year observations of Nepalese
non-financial sectors of enterprises .Firms are classified into groups according to a
beginning of period financial status index (Zfs), The index is determined using multiple
discriminant analysis considering an entire profile of characteristics shared by a particular
firm and transforming them into a univariate statistic.
Predicted groups Total
membership
Group 1 Group 2
Count Group 1 20 9 29
Original Group 2 13 22 35
% Group 1 69.0 31.0 100
Group 2 37.1 62.9 100

Table-4.2.4
Firm's financial status group-wise sample summary statistics
The followings are the reports of financial variable statistics for the sample of firms-year
observations of Nepalese non-financial sectors of enterprises. The FC, PFC and NFC groups
are formed by sorting all firms according to their discriminant scores. Every year, the firms
with the lowest discriminant scores (the bottom one-third) are categorized as financially
constrained (FC); the next one third are categorized as partially financially constrained
(PFC); and the top one-third are categorized as not financially constrained (NFC).
firms Interest Sales
Debt Covera ∆Sales/ Growt
ratio NP ratio CR ge CF/K FA/K k h
NFC Median .0000 .1056 1.8043 10.94 .4663 .0340 .7121 .2459
N=21 Mean .0318 .2145 2.2323 10.64 .6044 .1386 1.1187 .2246
PFC Median .0120 .0923 1.7100 20.00 .4435 .1081 .0081 .0075
N=22 Mean
.0647 .1010 1.7374 13.92 .5975 .2190 -.0607 .0233
FC Median .5501 -.0201 .9600 .79 .0111 .0319 .0519 .0490
N=21 Mean .5317 -.0660 1.4413 1.51 .0544 .1545 .1335 .0356

Table-4.2.5
Firm’s assets size wise financial summary statistics
The followings are the reports of financial variable statistics for the sample of firms-year
observations of Nepalese non-financial sectors of enterprises. All financial variables are for
the beginning of period of the fiscal year except for cash flow, investment and change in
sales(dsales) which represents firm cash flow , capital expenditure and difference in sales
during period t. k is the firm's beginning of period net fixed assets value A full-description of
the variables is included in the Appendix. Firms are sorted into size groups according to
total assets. TA Group 1 includes the smallest third of firms according to total assets every
year, while TA Group 3 includes the largest third and TA Group 2 the middle third.
firms Debt NP Interest Sales
ratio ratio CR Cov. CF/K FA/K Sales/k Growth
TAGrp Median .5222 .0101 1.400 .9714 .167 .04 .1241 .1121
Three Mean
n=21 .3873 .0516 2.087 3.725 .239 .119 .4894 .1187
TAGrp Median .0595 .0820 1.5700 8.130 .286 .113 .0216 .0080
Two Mean
.n=22 .1783 .0468 1.6184 10.69 .343 .209 .0757 .0218
TA.Grp Median .0104 .0929 1.6310 7.417 .510 .063 .1087 .1272
One
n=21 Mean
.1194 .1155 1.6317 10.47 .682 .178 .6237 .1419

Table 4.4.1 Regression Results for the Total Sample:

Reported coefficients are the within fixed firm and year estimates over the sample
period (t-statistics and p-value are in parenthesis). Investment in fixed assets divided by the
net fixed assets is the dependent variable. The first difference in sales divided by net fixed
assets and the cash flow/net fixed assets are the independent variable. Predicted group 1
includes firm that are classified as likely to increase dividends or keep payout at constant
rate in year t according to discriminant analysis, predicted group 2 includes firms that are
classified as likely to decrease or no dividend per share in year t.
Investment-Liquidity Constraint Model Estimated for the Total Sample
Total Predicted Predicted
Sample Group 1 Group 2
C. Constant term 0.025 -0.168 0.092
T-statistic (0.395) (-1.657) (1.134)
Probability (0.69) (0.10) (0.26)
∆SAL/K, First dif. Sales to Fixed Assets 0.119 -0.058 0.074

T-statistic (0.962) (-1.212) (1.654)

Probability (0.34) (0.23) (0.10)
CF/K, Cash flow to Fixed Assets 0.367 0.679 0.254
T-statistic (2.962) (3.983) (1.538)

Probability (0.00) (.00) (0.13)

Adjusted R² 0.156 0.323 0.117
F-statistic 6.922 8.633 2.98
Number of Observation 64 33 31

Table – 4.4.2
Regression Result for Sample Split based on Discriminant Score:
Reported coefficients are the within fixed firm and year estimates over the sample period (t-
statistics are in parenthesis). Investment in fixed assets divided by the net fixed assets is the
dependent variable the first difference in sales divided by net fixed assets and the cash
flow/net fixed assets are the independent variable. The FC, PFC and NFC groups are formed
by sorting all firms according to their discriminant scores. Every year, the firms with the
lowest discriminant scores (the bottom one-third) are categorized as financially constrained
(FC); the next one third are categorized as partially financially constrained (PFC); and the
top one-third are categorized as not financially constrained (NFC).
Investment-Liquidity Constrained Model Estimated for FC, PFC, NFC Group
FC Group PFC Group NFC Group
Constant 0.138 -0.029 -0.103
T-statistic (1.566) (-0.204) (-1.482)
Probability (0.13) (0.84) (0.15)
SAL/K, First dif. Sales to -0.025 0.091 -0.025
Fixed Assets
T-statistic (-0.431) (1.043) (-0.763)
Probability (0.67) (0.30) (0.45)
CF/K, Cash flow to Fixed 1.404 0.392 0.446
Assets
T-statistic (3.574) (1.926) (3.882)
Probability (0.00) (0.06) 0.00
Adjusted R² 0.443 0.114 0.445
F-statistic 8.55 2.41 9.004
Prob. (F-Statistic) 0.00 0.11 0.00
Number of Observation 21 22 21

Table 4.4.3
Regression result for effect of firm leverage on investment-liquidity constraint model
estimated for FC, PFC and NFC group
Reported coefficients are the within fixed firm and year estimates over the sample period (t-
statistics are in parenthesis). Investment in fixed assets divided by the net fixed assets is the
dependent variable the first difference in sales divided by net fixed assets and the cash
flow/net fixed assets and long term debt/total assets are the independent variable. The FC,
PFC and NFC groups are formed by sorting all firms according to their discriminant scores.
Every year, the firms with the lowest discriminant scores (the bottom one-third) are
categorized as financially constrained (FC); the next one third are categorized as partially
financially constrained (PFC); and the top one-third are categorized as not financially
constrained (NFC).
Effect of firm leverage on investment-liquidity constraint model estimated for FC, PFC
and NFC group
Group SAL/K CF/K LTD/FA R² n
FC -0.022 (-.376) 0.1.388 -0.116 0.410 21
(3.359) (0.229)
PFC 0.046 (.496) 0.501 (2.29) 1.112 (1.26) 0.25 22
NFC -0.021 (-.586) 0.440 (3.68) -0.218(0.34) 0.504 21
 Table –4.4.4
Regression Estimate for Size group:
Reported coefficients are the within fixed firm and year estimates over the sample period (t-
statistics are in parenthesis). Investment in fixed assets divided by the net fixed assets is the
dependent variable the first difference in sales divided by net fixed assets and the cash
flow/net fixed assets are the independent variable. Firms are sorted into size groups
according to total assets. TA Group 1 includes the smallest third of firms according to total
assets every year, while TA Group 3 includes the largest third and TA Group 2 the middle
third.
Group CF/K SAL/K R² n
TA Group 1 0.656(3.205) 0.008 (0.332) 0.412 22
TA Group 2 0.526 (2.56) 0.025 (0.192) 0.299 21
TA Group 3 0.166 (0.651) 0.054 (0.247) 0.111 21
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Appendix A
WINSORIZE
A number of observations are "winsorized" (if the value of the variable exceeded
cutoff values) according to the following rules:
(i) assign a value of 50 percent (-50 percent) if growth in sales is greater (less) than 50
Percent (-50 percent)
(ii) assign a value of 2 (-2) if investment/fixed assets is greater (less) than 2 (-2).
(iii) assign a value of 20 if interest coverage ratio is greater than 20.
Appendix B
Description of Financial Ratio Calculation
Current assets
1. Current ratio =
Current liabilities

Long-term debt
2. Debt ratio =
Total assets

Earning before interest and taxes

3. Net profit Margin =
Interest expenses
Net profit
4. Net profit margin =
Net sales
5. Cash flow = Net profit + Taxes + Depreciation
6. Investment = Net fixed assets t - 1 - Net fixed assets
7. Difference in sales (∆ sales) = Net sales t - Net sales t – 1
Difference in sales
8. Sales growth =
Net sales t - 1
9. Net fixed assets (K) = Net property, plant and machinery
Appendix D
Financial Variables for Regression Analysis (Firms and Year wise)
SN Company Year ∆ SALES/K CASHFLOW/K FA/K
1 NLL 1998 1.77008 0.52877 -0.00609
2 NLL 1999 1.50656 0.71944 0.03940
3 NLL 2000 1.17101 0.86543 -0.01234
4 NLL 2001 -1.11511 0.69127 0.28157
5 NLL 2002 -1.58131 0.40510 0.00451
 6 NLL 2003 0.05041 0.84007 -0.03153
7 ULL 2004 1.91687 1.46100 0.06370
8 ULL 2005 -0.31936 2.01260 0.07000
9 BPPL 2000 0.03449 -0.08677 0.00529
10 BPPL 2001 0.14881 0.00404 0.00027
11 BPPL 2002 -0.07405 0.18075 0.04493
12 BPPL 2003 0.12406 0.00050 -0.03272
13 BNL 1998 1.01273 1.46500 1.64741
14 BNL 1999 0.22692 0.31444 0.14895
15 BNL 2000 0.01201 0.29585 0.14917
16 BNL 2001 0.11591 0.24852 0.09062
17 NLOL 1998 1.17516 0.52547 0.05466
18 NLOL 1999 1.36206 0.86495 0.03215
19 NLOL 2000 -0.00954 0.52997 0.33719
20 NLOL 2001 -1.92143 -0.02582 0.00385
21 JSP 1998 -0.14849 -0.07183 0.04041
22 JSP 1999 -0.00849 -0.00028 0.03250
23 JSP 2000 0.25548 0.09284 0.07314
24 JSP 2001 0.03283 0.00691 0.04869
25 AVUL 2001 0.90092 0.07861 0.02224
26 BNTL 1996 4.36455 1.46432 0.65751
27 BNTL 1997 -0.81181 1.26434 0.37790
28 BNTL 1998 1.65428 1.60724 0.57300
29 BNTL 1999 0.60191 1.05062 0.24845
30 BNTL 2000 0.16633 0.90149 0.31198
31 BNTL 2001 0.73591 0.72074 0.13018

Cont…
SN Company Year ∆ SALES/K CASHFLOW/K FA/K
32 BNTL 2002 -0.58638 0.57103 0.20172
33 BNTL 2003 0.03123 0.44122 0.35252
34 BNTL 2004 -0.22474 0.32049 0.02055
35 SSM 2000 0.08899 0.01175 0.14120
36 SSM 2001 0.22610 0.05719 0.02404
37 STC 1999 2.60516 0.24217 0.11431
38 STC 2000 -6.22410 -0.30561 0.05490
39 STC 2001 3.87149 0.38101 0.06830
40 STC 2002 3.10332 0.90697 9.45582
41 STC 2003 1.31454 0.15491 0.03336
42 STC 2004 3.14295 0.22230 0.01923
43 BBCL 1998 0.06505 0.37304 -0.02297
44 BBCL 1999 0.02817 0.42210 0.24868
45 BBCL 2000 0.13765 0.45384 0.03404
46 BBCL 2001 0.07498 0.55478 0.01894
47 SHL 1998 0.05499 0.27469 0.15381
48 SHL 1999 0.00806 0.27077 0.11947
49 SHL 2000 -0.05781 0.24597 0.10811
50 NIL 1998 0.75874 0.41087 1.32183
51 NIL 1999 0.05339 0.01208 -0.08513
52 NIL 2000 -0.22304 -0.07817 -0.16701
53 NIL 2001 -0.53356 -0.80322 -0.19723
54 BPC 2001 -0.21390 0.20190 0.03003
55 BPC 2002 0.06728 0.21681 0.01097
56 BPC 2003 -0.19408 -0.00373 0.05342
57 BPC 2004 0.24469 0.39086 -0.37987
58 NBCL 1995 0.71208 1.33496 0.56934
59 NBCL 1996 1.62891 0.62242 0.13392
60 NBCL 1997 0.07966 0.52145 0.02696
61 NBCL 1998 -1.32487 0.56998 0.02393
62 NBCL 1999 4.96630 1.56445 0.13142
63 NBCL 2000 -2.19756 1.35596 0.07311
64 NBCL 2001 -0.17989 1.12362 0.27860