Financial Constraints and Company Investment

Stephen R. Bond · Costas Meghir

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Corporate Finance and Governance Financial Analysis and Corporate Governance Corporate Taxation and Avoidance

Abstract

The question we address in this paper is whether the investment spending of at least some firms is affected by the availability of internally generated finance (retained earnings), reflecting some constraint on the ability of these firms to raise external finance (debt or new equity) for investment. The opposing view is that the cost at which investment funds can be obtained, taken to be independent of the amount invested, is the only financial consideration that matters in the determination of investment. This is an old question in economics, which has been the subject of several official inquiries as well as a large body of academic research. The answer to this question has a number of important implications. Profits are highly cyclical, so if investment depends directly on the availability of profits then investment spending will be more sensitive to fluctuations in economic activity than would otherwise be the case. This could be an important factor in the propagation of business cycles. If post-tax profits help to determine investment spending then the impact of company taxes on investment will be more complicated than is often assumed. In particular, the average tax rate will influence the level of investment spending, in addition to the impact of taxes on the cost of capital, and any increase in the total revenue raised from corporation tax could have a directly adverse impact on business investment. There may also be an incentive for firms with available internal funds to take over firms whose investment spending is constrained, resulting in take-over activity that would otherwise be inefficient. To the extent that financial constraints on investment spending are attributable to imperfections in capital markets or to market failures, there may also be some motivation for policy measures designed to reduce these impacts, if financial constraints are found to be pervasive.

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References

1984Corporate financing and investment decisions when firms have information that investors do not have 1958The Cost of Capital, Corporation Finance and the Theory of Investment 1981Credit Rationing in Markets with Imperfect Information 2008The cost of capital, corporation finance and the theory of investment 1988Financing Constraints and Corporate Investment 1987Financing Constraints and Corporate Investment 1980Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?1978Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence

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