ABSTRACT
Standard neoclassical models of investment typically assume that capital markets are perfect. In recent years, however, a body of theoretical work has challenged the key assumptions required for perfect capital markets. If the firm has better information about its investment returns than potential investors, external finance may be expensive, if available at all, because of adverse selection and moral hazard problems. These problems are accentuated when assets have low collateral value. In addition to this theoretical work, a large number of recent empirical studies report evidence that investment for some firms appears to depend on their financial condition.1 There are, however, potential weaknesses in the empirical methodologies used to test for the presence of financing constraints, and some of the key evidence in the financing constraint literature has recently been challenged.2 The nature of the imperfections in capital markets, how to detect their presence, and how to measure their quantitative impact on firm investment remains controversial.
