Financial Constraints, Investment and Capital Structure: Implications from a Multi-Period Model
53 Pages Posted: 30 Jan 2002
Date Written: January, 2002
Abstract
Intertemporal considerations have been largely ignored in the theory of capital structure. We provide a dynamic model that integrates firms' investment, financing and cash holding decisions in the presence of moral hazard. The distinguishing feature of this model is that it takes into account financially constrained firms' incentives to intertemporally allocate their liquidity between current and future projects. The incentive to intertemporally allocate liquidity comes from the concavity of a payoff function similar to that considered by Froot, Scharfstein and Stein (1993), which causes firms to behave as though they are risk averse when financially constrained. We show that once intertemporal considerations are brought in, stylized relationships that are often associated with models based on information asymmetry could be modified significantly, making it difficult to accept or reject such models empirically. Three such relationships that we examine are: (i) the relation between cash flows (or changes in liquidity) and investment, (ii) the relation between profitability and leverage, and (iii) the relation between future investment opportunities and leverage. As regards the first, we show that there is a critical level of liquid balances such that firms below this level exhibit greater cash flow sensitivity of investment than those above; however, the cash flow sensitivity of investment can be non-monotonic over a particular range of liquid balances (equivalently, firms' hurdle rates for projects can increase in the level of liquid balances). These results reconcile recent empirical evidence in Fazzari, Hubbard and Petersen (1988, 2000), Kaplan and Zingales (1995, 2000) and Cleary (1999). Second, we show that in a dynamic framework, firm's debt level could be positively related to profitability - contrary to the conventional wisdom of one-period models (but consistent with recent empirical evidence in MacKay and Phillips (2001)). Finally, an improvement in future growth opportunities can either cause the firm to increase or decrease its current leverage, depending on the nature of this improvement.
Keywords: Financial Constraints, Investment-Cashflow Sensitivity, Capital Structure, Corporate Cash Holdings
JEL Classification: G3, G31, G32, G35
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Financing Constraints and Corporate Investment
By Steven M. Fazzari, Bruce C. Petersen, ...
-
Measurement Error and the Relationship between Investment and Q
By Timothy Erickson and Toni M. Whited
-
Inflation, Taxation, and Corporate Investment: A Q-Theory Approach
-
The Stock Market, Profit and Investment
By Olivier J. Blanchard, Changyong Rhee, ...
-
Investment-Cash Flow Sensitivities are Not Valid Measures of Financing Constraints
By Steven N. Kaplan and Luigi Zingales
-
The Present Value of Profits and Cyclical Movements in Investment