The assumption of perfect capital markets is least likely to be satisfied for the class of firms which devote resources towards the development of innovative products or processes. Existing tests of the impact of capital market imperfections on innovative firms cannot distinguish between two alternative hypotheses: (i) that capital markets are perfect, and that different factors drive the firm's different expenditures, and (ii) that capital markets are imperfect, and that the different expenditures of the firm respond disproportionately to a common factor, namely shocks to the supply of internal finance. However, an implication of the perfect capital markets assumption is that each of the firm's expenditures should be equally insensitive to fluctuations in internal finance. Therefore, to distinguish between these hypotheses, the sensitivity of physical investment expenditures to internal finance is compared across innovative and non-innovative firms. For robustness, several investment equations are estimated. The results support the hypothesis that innovative firms are financially constrained.
