The Role of Non-Convex Costs in Firm’S Financial Dynamics

Abstract:     
In the standard investment models, the financing of investment is a frictionless activity. However, empirical studies suggest that financial market participation is costly. This paper focuses on the quantitative relevance of one type of financial frictions: non-convex costs of financial adjustment. It first shows that financial activity is not only lumpy, but it is more so than firm’s investment activity. It then describes a financing and real investment model of a firm with a realistic financial setup including debt, equity, cash and endogenous interest rates and bankruptcy. It compares two estimated versions of the model, a full version and one restricted from having non-convex financing frictions. Only the full model produces dynamics akin to those of US firms in the sense of generating more lumpiness in finance than in investment. The paper also shows that the full model rationalizes an empirical feature of investment behavior: a region of convexity in the estimated response of investment to productivity shocks. This analysis demonstrates that non-convex financial frictions explain features of firms’ financial and real dynamics.

Number of Pages in PDF File: 38

Keywords: Financial Dynamics, Financial Frictions, Costs of External Financing, Transaction Costs, Dynamic Trade-Off Model, Investment, Non-Convex Costs of Adjustment

JEL Classification: G31, G32, G33

working papers series