Inventory investment and capital market imperfections: A generalization ofthe linear quadratic inventory model

This paper provides a generalization of the linear quadratic inventory mode l, which includes capital market imperfections. In particular, the model al lows both for a cost of borrowing which increases with the degree of levera ge, and for a ceiling on the latter. A panel of UK manufacturing firms is u sed to test how these imperfections affect firms with different financial c haracteristics. The results suggest that financial constraints play an impo rtant role in the determination of inventory decisions for firms with high short-term debt to inventories ratios or low coverage ratios, but not for f irms with stronger balance sheet positions.