RDP 9402: The Influence of Financial Factors on Corporate Investment 2. Finance and Investment Theory

Financial factors play a limited role in traditional models of investment. For example, in the neoclassical model, firms choose inputs of capital (and labour) so as to maximise the present discounted value of their income streams. Financial factors enter only through the cost of capital which, in turn, is independent of the way the firm finances itself. This independence arises because capital markets are assumed to be perfect. Thus, firms are able to secure external finance for a project if its expected marginal return exceeds its cost of capital. There is no shortage of funds for firms with value-increasing projects and the marginal costs of debt, equity and internal funds are equal. In this world, the availability of adequate cash flows is not a constraint on investment and the financial characteristics of the firm do not influence its cost of capital. Thus, “interactions between real and financial variables can be reduced to interactions between real variables and interest rates” (Mauskopf (1990)).

There are a number of reasons to believe that this separation of real and financial factors would not occur in practice. Some firms (particularly small firms) have limited access to external sources of funding.^[3] Cash flows will be their primary, and in some cases, only source of funds.

Even companies with access to external funding will rely more heavily on cash flows as a source of finance. There are direct costs involved in raising external funding, such as underwriting and administrative fees.^[4] There are also potential financial distress costs associated with using external finance. For example, as leverage increases, other things being equal, there may be a higher probability of the firm facing financial distress. In this case, the firm may incur direct bankruptcy costs such as legal expenses and trustee fees and indirect costs such as the disruption of operations, loss of suppliers or customers and the imposition of financial constraints. The present value of these expected costs should be reflected in current financing costs (whether or not the firm actually enters bankruptcy). Finally, there are issues of taxation, shareholder dilution, control of information, the need to maintain flexibility and liquidity that may also have an impact on a firm's financing choices. Financial factors may therefore affect the cost and availability of capital and so influence the investment decision.

Financial factors are generally introduced to standard investment models through information asymmetries or through agency costs. The introduction of these assumptions helps explain how a given level of investment will be funded and how a firm's financial position will influence its investment.

Informational asymmetries, where managers have more information about a firm than potential debt or equity holders, make it difficult for potential creditors and equity holders to evaluate the prospects of different firms. If creditors cannot distinguish between good quality and poor quality potential borrowers then the market interest rate is likely to incorporate a premium – good quality borrowers would be charged more than they would in a perfectly-informed market.^[5] Similarly, new equity issues may trade at a discount to their value implied by the underlying prospects of a firm.^[6] The firm may also incur agency costs – costs borne by owners of the firm resulting from potential conflicts between managers, debtholders and equityholders.^[7] For example, the nature of the debt contract may provide an incentive for managers, acting on behalf of equity holders, to pursue riskier investment projects than would be pursued under a different financial structure. If the investment is successful, equity holders capture most of the excess gain; if the venture is unsuccessful, both equity holders and debt holders share the burden. Because debtholders anticipate this type of behaviour, they price debt contracts accordingly.

The effect of these information problems is to boost the cost of external finance relative to internal finance. These cost differentials provide some insight into how a given level of investment will be funded – cash flows will be preferred to debt which, in turn, will be preferred to new equity issues.^[8] Recent Australian evidence (Shuetrim, Lowe, and Morling (1993)) shows that the capital structure of the firm can be explained in part by these types of informational problems.

The theoretical extent of asymmetric information problems and agency costs can be shown to be a function of the structure of a firm's balance sheet. Accordingly, the structure of a firm's balance sheet will influence its investment decision and shocks to the balance sheet will alter the evolution of investment over time.^[9] Firms can alter the cost of funding investment in a number of ways. Higher cash flows directly reduce the cost of funds because firms will be less reliant on more costly external funding. They also help reduce the costs of external funds by increasing the collateral backing of external finance.^[10] Recent evidence from the United States suggests that firms often “reliquify”, that is, build up their stock of financial assets before undertaking large investments (Whited (1991) and Eckstein and Sinai (1986)). They do this either because they have limited access to external finance or because it provides them with collateral to obtain external funding at lower cost. Shifts in cash flows, financial assets and leverage may thus influence the dynamics of investment. Indeed, Bernanke and Gertler (1989) show that shocks to balance sheets can increase the amplitude of the investment cycle in a simple neoclassical model.

Because the degree of asymmetric information and agency costs depends on firm characteristics, certain firms may be more sensitive to financial factors than others. For example, investors are likely to be less well-informed about smaller companies. This may hinder their ability to raise funds and boost the costs of external funding. Changes in cash flows may thus be a more important determinant of investment for smaller companies.^[11] Also, the investment of firms with higher leverage may be more sensitive to cash flows than that of firms with lower leverage. The increased debt servicing obligations resulting from higher leverage mean that the available cash flows of higher-geared firms are smaller and thus they have less of a buffer against disturbances.

Consideration of these links between investment and the balance sheet position of the corporate sector enriches the theoretical representation of the way that monetary policy is transmitted. In simple models, monetary policy affects corporate investment directly by altering the rate at which the expected returns to investment are discounted and indirectly through its effects on demand in the economy generally. Adding financial factors into the analysis means that monetary policy will also affect investment through its effect on the financial position of the corporate sector. A tightening in policy, for example, will increase interest payments and reduce cash flow. This will reduce the availability of relatively cheap internal funds and also increase the cost of external funds. Additionally, asset prices will fall, reducing the collateral that firms can provide to outside financiers, raising the cost of external funding. Investment may be affected through these channels in addition to the intertemporal substitution effects of standard theory. Because the importance of these factors will vary across firms depending on their size and financial structure, changes in monetary policy will be transmitted unevenly across the corporate sector.