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

This paper provides a generalization of the linear quadratic inventory model, which includes capital market imperfections. In particular, the model allows both for a cost of borrowing which increases with the degree of leverage, and for a ceiling on the latter. A panel of UK manufacturing firms is used to test how these imperfections affect firms with different financial characteristics. The results suggest that financial constraints play an important role in the determination of inventory decisions for firms with high short-term debt to inventories ratios or low coverage ratios, but not for firms with stronger balance sheet positions.