The relationship between financial constraints and investment efficiency

Abstract This study examines how financial constraints relate to firm‐level investment efficiency. Prior research theorizes that corporate borrowing by issue of risky debt induces suboptimal capital investment spending. We extend this research to examine whether firm‐level financial constraints and internal investment efficiency are significantly related. We measure firms’ degree of overall financial constraint following the procedure developed by Whited and Wu. Our results indicate that among highly financially constrained firms, overall financial constraints are positively associated with investment, and higher financial constraints are more likely to result in greater investment inefficiency. Furthermore, we find that this relationship is more prominent for companies with high free cash flow, high bankruptcy likelihood, and high growth potential. Our findings that financial constraints have significant influence on corporate investment efficiency should be of interest to company managers, investors, and regulators alike.