Internal financial constraints,external financial constraints,and investment choice: Evidence from a panel of UK firms

This paper uses a panel of 24,184 UK firms over the period 1993–2003 to study the extent to which the sensitivity of investment to cash flow differs at firms facing different degrees of internal and external financial constraints. Our results suggest that when the sample is split on the basis of the level of internal funds available to the firms, the relationship between investment and cash flow is U-shaped. On the other hand, the sensitivity of investment to cash flow tends to increase monotonically with the degree of external financial constraints faced by firms. Combining the internal with the external financial constraints, we find that the dependence of investment on cash flow is strongest for those externally financially constrained firms that have a relatively high level of internal funds.     

Irreversible investment,managerial discretion and optimal capital structure

We explore the significance of employee compensation and alternative (reservation) income on investment timing, endogenous default, yield spreads and capital structure. In a real-options setting, a manager’s incentive to under(over)invest in a project is associated to labor income he has to forego in order to work on the project, the manager’s salary, his stake on the project’s equity capital and his subsequent income, should he decide to terminate operations. We find that the optimal level of coupon payments decreases with managerial salary and ownership stake while it is increasing in the manager’s reservation income. Yield spreads (optimal leverage ratios) are increasing (decreasing) in the manager’s salary and ownership stake, while they are decreasing (increasing) in the manager’s reservation income. Exploring agency costs of debt as deviations from a value-maximizing investment policy, we document a U-shaped relationship between agency costs of debt and the managerial compensation parameters: the manager’s reservation income, salary and ownership share.     

Risk aversion, intertemporal substitution, and the aggregate investment-uncertainty relationship

We analyze the role of risk aversion and intertemporal substitution in a simple dynamic general equilibrium model of investment and savings. Our main finding is that risk aversion cannot by itself explain a negative relationship between aggregate investment and aggregate uncertainty, as the effect of increased uncertainty on investment also depends on the intertemporal elasticity of substitution. In particular, the relationship between aggregate investment and aggregate uncertainty is positive even if agents are very risk averse, as long as the elasticity of intertemporal substitution is low. A negative investment-uncertainty relationship requires that the relative risk aversion and the elasticity of intertemporal substitution are both relatively high or both relatively low. We also show that the implications of our model are consistent with the available empirical evidence.     

Technological innovation and real investment booms and busts

We investigate why new, high-risk technologies can attract excessive and often unprofitable investment. We develop an equilibrium model in which rational, risk-averse agents overinvest in a risky technology, possibly to the point that its expected return is negative. Overinvestment results from relative wealth concerns which arise endogenously from the imperfect tradability of future endowments. Competition over future consumption leads to an indirect utility for wealth with “keeping up with the Joneses” properties that can induce herding. Because overinvestment increases with the risk of the technology, our model can explain why new, risky technological innovations may promote investment bubbles.     

Do stock price bubbles influence corporate investment?

Dispersion in investor beliefs and short-selling constraints can lead to stock market bubbles. This paper argues that firms, unlike investors, can exploit such bubbles by issuing new shares at inflated prices. This lowers the cost of capital and increases real investment. Perhaps surprisingly, large bubbles are not eliminated in equilibrium nor do large bubbles necessarily imply large distortions. Using the variance of analysts’ earnings forecasts to proxy for the dispersion of investor beliefs, we find that increases in dispersion cause increases in new equity issuance, Tobin's Q, and real investment, as predicted by the model.     

New or used? Investment with credit constraints

Used capital is cheap up front but requires higher maintenance payments later on. We argue that the timing of these investment cash outflows makes used capital attractive to financially constrained firms, since it is cheap when evaluated using their discount factor. In contrast, it may be expensive from the vantage point of an unconstrained agent. We provide an overlapping generations model and determine the price of used capital in equilibrium. Agents with less internal funds are more credit constrained, invest in used capital, and start smaller firms. Empirically, we find that the fraction of investment in used capital is substantially higher for small firms and varies significantly with measures of financial constraints.     

Investment and financing constraints in China: Does working capital management make a difference?

We use a panel of over 116,000 Chinese firms of different ownership types over the period 2000–2007 to analyze the linkages between investment in fixed and working capital and financing constraints. We find that those firms characterized by high working capital display high sensitivities of investment in working capital to cash flow (WKS) and low sensitivities of investment in fixed capital to cash flow (FKS). We then construct and analyze firm-level FKS and WKS measures and find that, despite severe external financing constraints, those firms with low FKS and high WKS exhibit the highest fixed investment rates. This suggests that an active management of working capital may help firms to alleviate the effects of financing constraints on fixed investment.     

Financing constraints, irreversibility, and investment dynamics

We develop a model of an industry with many heterogeneous firms that face both financing constraints and irreversibility constraints. We use this model to examine the cyclical behavior of aggregate fixed investment, variable capital investment, and output in the presence of persistent idiosyncratic and aggregate shocks. Our model yields three main results. First, the effect of the irreversibility constraint on fixed capital investment is reinforced by the financing constraint. Second, the effect of the financing constraint on variable capital investment is reinforced by the irreversibility constraint. Finally, the interaction between the two constraints is key for explaining why input inventories and material deliveries of US manufacturing firms are so volatile and procyclical, and also why they are highly asymmetrical over the business cycle.     

Dynamic risk management

Both financing and risk management involve promises to pay that need to be collateralized, resulting in a financing versus risk management trade-off. We study this trade-off in a dynamic model of commodity price risk management and show that risk management is limited and that more financially constrained firms hedge less or not at all. We show that these predictions are consistent with the evidence using panel data for fuel price risk management by airlines. More constrained airlines hedge less both in the cross section and within airlines over time. Risk management drops substantially as airlines approach distress and recovers only slowly after airlines enter distress.     

Firm survival and financial development: Evidence from a panel of emerging Asian economies

Using a panel of five Asian economies - Indonesia, Korea, Malaysia, Singapore and Thailand - over the period 1995-2007 we analyze the links between firm survival and financial development. We find that traditionally used measures of financial development play an important role in influencing firm survival. When stock markets become larger or more liquid firms’ survival chances improve. On the contrary, we show that higher levels of financial intermediation can increase firm failures. We also find that the beneficial effects of stock market development are more pronounced during the later years of our sample, while the adverse effects of bank intermediation have declined over time. Finally, large firms are more likely to benefit from developments in financial markets compared to small firms.     

Market timing,investment, and risk management

The 2008 financial crisis exemplifies significant uncertainties in corporate financing conditions. We develop a unified dynamic q-theoretic framework where firms have both a precautionary-savings motive and a market-timing motive for external financing and payout decisions, induced by stochastic financing conditions. The model predicts (1) cuts in investment and payouts in bad times and equity issues in good times even without immediate financing needs; (2) a positive correlation between equity issuance and stock repurchase waves. We show quantitatively that real effects of financing shocks may be substantially smoothed out as a result of firms' adjustments in anticipation of future financial crises.     

Stated and revealed investment decisions concerning retail structured products

We analyze the investment behavior of private clients with regard to retail structured products. To ascertain their stated and revealed preferences, we use a questionnaire and a field experiment. The real product issued in the field experiment is comparable to the hypothetical product in the questionnaire in terms of both payoff and communication. We find that a product described in simple words strongly motivates people to invest in structured products for the first time, and also eliminates gender differences. However, the real product attracts far fewer first-time buyers than we expected from the questionnaire results.     

Insurance and opportunities: A welfare analysis of labor market risk

Using a model with constant relative risk-aversion preferences, endogenous labor supply and partial insurance against idiosyncratic wage risk, this paper provides an analytical characterization of three welfare effects: (a) the welfare effect of a rise in wage dispersion, (b) the welfare gain from completing markets, and (c) the welfare effect from eliminating risk. The analysis reveals an important trade-off for these welfare calculations. On the one hand, higher wage uncertainty increases the cost associated with missing insurance markets. On the other hand, greater wage dispersion presents opportunities to raise aggregate productivity by concentrating market work among more productive workers. Welfare effects can be expressed in terms of the underlying parameters defining preferences and wage risk or, alternatively, in terms of changes in observable second moments of the joint distribution over individual wages, consumption and hours.     

Bank connections,corporate investment and crisis

Against the backdrop of a severe financial crisis and extensive restructuring of the financial sector, we investigate the evolution and determinants of connections between firms and banks, and the impact of bank connections on corporate investment. Our study examines Thai non-financial companies during 1995–2000, a period straddling the East Asian Financial Crisis of 1997–1998. Before the crisis, bank-connections are common and associated with significantly lower sensitivity of corporate investment to internal cash flow. After the crisis, and following substantial changes in bank ownership and governance due to financial-sector reforms and restructuring, far fewer firms are bank-connected and connections no longer affect investment–cash flow sensitivity.     

Profit sharing and investment by regulated utilities: A welfare analysis

We analyse the effects of different regulatory schemes (price cap and profit sharing) on the endogenous size of a firm's investment. Using a real option approach in continuous time, we show that profit sharing does not delay a firm's start-up investment compared to a pure price-cap scheme. Profit sharing does not necessarily affect total investment either, if the threshold for profit sharing is high enough. Only a profit sharing intervening for low profit levels could delay further investments. We also evaluate the effects of profit sharing on social welfare, determining profit level that should optimally trigger tighter regulation: profit sharing should be less stringent in sectors where there is more opportunity for larger investment.     

Hedging,financing, and investment decisions: Theory and empirical tests

In this paper we theoretically and empirically examine the interaction between hedging, financing, and investment decisions. A simple equilibrium model with costly financial distress suggests that as firms become more efficient at risky investments vis a vis low risk investments, they will borrow less, invest more in risky assets, and hedge more. The model also predicts a positive relationship between hedging and leverage – a result consistent with debt capacity arguments. We test the model empirically using a simultaneous equations framework to investigate the determinants of firm-level hedging, financing and investing decisions. The results strongly support the hypothesis that the hedging, financing and investment decisions are jointly determined. In addition, we find strong support for the central hypothesis that firms more efficient investing in risky technologies more aggressively hedge and use less debt financing in order to maximize their comparative advantage.     

Cash flow uncertainty,financial constraints and R&D investment

Based on the data from Chinese listed companies of Shanghai and Shenzhen stock markets between 2005 and 2016, we systematically examine the relationship between cash flow uncertainty and R&D investment, and further research the moderating effect of financial constraints on the association between the two. Our empirical results find that R&D investment decisions tend to be more conservative and cautious due to cash flow uncertainty, which is not conducive to innovation efficiency. Firms with higher cash flow uncertainty invest more cautiously in R&D innovation, whereas firms with lower cash flow invest more boldly in R&D innovation. Financial friction may exacerbate the negative impact of cash flow uncertainty on innovation activities. Strategic cash holding can help firms better deal with the risks caused by cash flow uncertainty. In provinces with high marketization, the market competition intensifies, resulting in more significant cash flow uncertainty.     

Collateral and capital structure

We develop a dynamic model of investment, capital structure, leasing, and risk management based on firms' need to collateralize promises to pay with tangible assets. Both financing and risk management involve promises to pay subject to collateral constraints. Leasing is strongly collateralized costly financing and permits greater leverage. More constrained firms hedge less and lease more, both cross-sectionally and dynamically. Mature firms suffering adverse cash flow shocks may cut risk management and sell and lease back assets. Persistence of productivity reduces the benefits to hedging low cash flows and can lead firms not to hedge at all.     

Time-varying risk of rare disasters,investment, and asset pricing

We extend an equilibrium business cycle/asset pricing model of production and capital accumulation by introducing a time-varying risk of rare disasters. It predicts that investment is much more volatile than output, which provides theoretical support for the empirical data. Furthermore, the model-generated stationary distribution of the investment-output ratio fits the data remarkably well. Both of them exhibit negative skewness, which means that there is a small probability that this ratio can be very low. Given the observations of the investment-output ratio, we obtain the values of the jump intensity implicit in the historical data and find those recession periods coincide with a rapid increase in the probability of a disaster. Finally, the model shows that the existence of adjustment costs generates a procyclical price of capital and contributes to resolving the equity premium puzzle.     

Inventory Dynamics and Business Cycles: What Has Changed?

To what extent can information-technology led improvements in inventory management account for the apparent moderation of economic fluctuations in the United States since the mid-1980s? We argue that changes in inventory dynamics played a reinforcing—rather than a leading—role in the reduction of output volatility. Since the mid-1980s, inventory dynamics have changed in a manner consistent with a faster resolution of inventory imbalances. However, these changes appear to be a consequence of changes in the response of industry-level sales and aggregate economic activity to monetary policy shocks. Our results suggest that it is the interaction between the changes in inventory behavior at the industry level and the macroeconomic environment—where the latter likely includes changes in the conduct of monetary policy and the responses of the economy to policy disturbances—rather than any single factor, that has contributed importantly to the observed decline in economic volatility.