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Posted on Jul 4, 2023 in Other subjects
Write your text here!Financing Constraints and
Corporate Investment, Fazzari, Hubbard, and Petersen 1988
Intro:
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.