Write your text here!Financing Constraints and Corporate Investment, Fazzari, Hubbard, and Petersen 1988
When capital structure does not matter, INV decisions are independent of the financial condition. But, when internal and external capital are not perfect substitutes, INV may depend on financial factors. This study links conventional models of investment to the literature on capital market imperfections and disparities in the access of individual firms to capital markets.
Predictions: If the cost of disadvantage of external finance is small, earnings retention practices should reveal little or nothing about investment, vice a versa.
Find differences across firms in the sensitivity of investment to balance sheet variables that measure liquidity. Also, the financial effects on investment are greatest when capital market information problems are likely to be most severe for high-retention firms (high dividend firms are generally large). Also tax implications: INV are sensitive to average tax burdens and marginal tax rates
Finance and study of INV:
With MM model, previous studies claim the irrelevance of financial factors on real firm decisions. Even there is empirical support by Jorgenson and Calvin Siebert which is consistent with MM. The authors find problems: 1) econometrics issue (time-series, and serial correlation), and 2) assumption of representative firm – regardless of specifications it assumes all firms are the same. To tackle this, they have groups of firms with different financial characteristics.
Sources and Cost of Finance:
Firms with different sizes show huge heterogeneity in terms of financing. For example, the retention ratio for large firms is the smallest among the groups.
The cost of internal versus external finance:
Internal financing is cheaper due to transaction costs, tax advantages, agency problems, and asymmetric information. They focus on the information asymmetry.
SEO- discounted by underwriters. Effective tax rates on capital gain are smaller than that on dividends. In the Q sense, internal financing brings lower threshold of Q. Pecking order theory suggested by Myers and Majluf.
Debt- Increasing marginal cost of new debt due to financial distress and agency costs. Debt overhang. Firms in different size show heterogeneity in terms of accessing debt market. Large firms are able to get loans from primary banks, but small and medium sized firms use private channels that restrict the firms’ operations heavily.
Financing Hierarchies and Investment:
A model for the firm value is introduced. A value maximizing firm will issue new shares only after it exhausts internal finance and q >1.
Modified version which reflects the cost of equity is introduced. The breakeven q value for investment financed by new share issues is 1 + Omega.
Intermediate levels of investment demand will be financed by a mix of internal funds and debt. When INV demand is very high, the firm should issue more equity.
If information asymmetry is important empirically, observed q should be high relative to historical values before new share issues for limited information firms.
Differences in Firm Financing Practices:
If the cost disadvantage of external financing is large, it should have the greatest effect on firms that retain most of their income. If the cost is slight, then retention practice should reveal little about financing practices, q, or investment behavior.
Class I firms have investment demand schedule like D2 or D3, and Class III firms have that of D1. Table 3: Class 1 and 2 firms borrow up to their debt capacity and go for SEO. Table 3 on Q says firms have different degree of information asymmetry in different times (diff in Q when SEO and no SEO)
Financial Constraints in Empirical Models of Investment:
Run reduced form of investment regression. To incorporate the information asymmetry argument, the authors use the groups of firms specified earlier.
Internal Funds in a Q model of investment:
There is huge difference in the estimated coefficients across classes. Class 1 firms use a lot of cash while Class 3 firms use a little of it.
Alternative Estimation Methods and Specifications for the Q model:
To the extent the stock market is excessively volatile, Q may not reflect market fundamentals. And the replacement capital stock in Q may be measured with error. Table 5 shows the results with some adjustments.
Regardless of specifications and measures, the significant difference in Class 1 and 3 firms remains strong.
Alternative interpretation of the effect of cash flow in investment is that movements in cash flow reflect productivity shocks not captured in Q: that is, cash flow may be correlated with the disturbance in the adjustment cost function). To deal with this issue, the authors use IV, but the results remain the same qualitatively.
Sales Accelerator Investment Demand Models:
There exists an alternative empirical method rather than Q. It’s based on traditional acceleration principle which links the demand for capital goods to the level or change in a firm’s output or sales. Table 7: Generally, the explanatory power of cash flow decreases with the inclusion of sales. This indicates discrepancies between AQ and MQ, or accelerator effects. But, qualitatively the results don’t change.
Internal Finance in the Neoclassical Investment Model:
Since the accelerator model does not incorporate the relative price of capital or capital services in the empirical specification, the neoclassical investment model suggested by Jorgenson is used here. In the perfectly competitive markets, the firm’s optimal demand for capital services depend ultimately on the price of output and relative prices of various inputs, including the cost of capital. Following Jorgenson the authors have the cost of capital with the sales variables, since they together modify the accelerator model to the neoclassical model with partial adjustment assumptions.
However, the results do not change qualitatively even though the model reduces the explanatory power of cash flow on investment.
Investment Equations at the Industry Level :
Investment behavior may be different across industry categories, so the authors divide the samples with the specified classes as well as SIC 2 digit codes. The results are robust.
Balance Sheets, Internal Finance, and Investment:
Precautionary saving: If managers know they will have to pay a premium for external funds, they should accumulate a stock of liquid assets when cash flow is high. It will help smooth investment over downturns and spare firms the need to obtain potentially costly external sources, and provide necessary collateral to obtain new debt.
On the other hand, Class 3 firms may not see the benefits of the precautionary savings (from stocks of liquid assets).
Using cash and equivalents, which are proxies for stock of liquid assets, the authors show changes in balance sheet positions and liquidity have a significant effect on investment for the class 1 firms. The effect doesn’t exist for Class 3 firms.
Internal Finance and Investment in High-payout Firms:
Brings up the agency cost of free cash flow: due to this cost the large firms distribute the earnings. And for them if the external sources were costly, they would have cut the dividend already.