state.<sup>31</sup> For the working capital model, the continuously bounded stage is shorter (the average time is 2.22 periods) but firms are still vulnerable to restricting constraints on average for another 6 periods. This contributes to the prolonged effects of financial constraints on firm growth.

Long term value is the sum of profits across time and Figure 8 shows the median bands of the ratio between constrained long term value and the non constrained long term value for both the working capital model and the standard model, across different borrowing allowances. At a borrowing allowance of zero, constrained firms have only 63% of the value of non constrained firms. Even though constrained firms eventually catch up in terms of capital stock and ability to respond to positive shocks, they can never catch up to the long term value of unconstrained firms of the same age. Dynamically, financial constraints have a permanent effect on firm value in the long run.

To summarize, financial constraints restrict optimal output which results in loss of producer surplus. Inefficiencies arise not just from producing below scale (shown by cost per dollar of revenue) but also from distortions to factor composition (shown by labor to capital ratios). Financial constraints have a persisting effect over time. The value of the firm is inevitably lower as the constraints inhibit it from making the most out of profitable production opportunities. Furthermore, the predicted effects of financial constraints are much more severe in the model with working capital than in the standard model.

# **4 Empirical Analysis**

The predicted behavior of firms under financial constraints is different in the working capital model than in the standard model. The effects of financial constraints on output levels, efficiency and firm growth are much more severe in the working capital model. I test the predictions unique to the working capital model using firms level panel data from Bangladesh. First, the need to finance working capital implies that firms are more likely to become financially constrained when demand shocks increase. Second, under binding constraints, investment responds countercyclically to demand shocks. Third, the timing of when constraints bind imply that output response to positive demand shocks will differ from negative demand shocks for firms near the margin of being constrained. If these predictions are consistent with what we see in the data, this lends support for the working capital model of financial constraints and offers suggestive evidence for the simulated results of the model.

## **4.1 The Bangladesh Panel Survey**

Firms in Bangladesh have very limited access to external finance. The country ranks among the bottom quintile of developing countries in terms of its performance in attracting foreign direct investment. Bangladesh has consistently been classified as an under performer in attracting foreign direct investment by the UN Conference of Trade and Development. The Inward FDI Performance Index 2002-04 ranks Bangladesh 122 out of 140 countries. (Country Report, EIU 2005) Foreign inflows are constrained due to investor’s concerns about political instability and high levels of corruption. Domestic private investment is also low, due inter alia to the underdeveloped banking sector. The financial sector in Bangladesh is dominated by commercial banks. Four state owned commercial

> 31In the absence of permanent shocks

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