Corporate Financial and Investment Policies when Future Financing is Not Frictionless
University of Illinois at Urbana-Champaign; National Bureau of Economic Research (NBER)
Cornell University; National Bureau of Economic Research (NBER)
Michael S. Weisbach
Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER)
September 17, 2008
Charles A. Dice Center Working Paper No. 2008-16 and Fisher College of Business Working Paper No. 2008-03-015
We study a model in which future financing constraints leas firms to have a preference for investments with sorter payback periods, investments with less risk, and investments that utilize more pledgeable assets. The model also shows how investment distortions towards more liquid, safer assets vary with the marginal cost of external financing and with firm internal cash flows. Our theory helps reconcile and interpret a number of patterns reported in the empirical literature, in areas such as risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. For example, contrary to Jensen and Meckling (1976), we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to decrease the risk of their most liquid investments.
Number of Pages in PDF File: 37
Keywords: financial constraints, types of investment, capital budgeting, risk shifting
JEL Classification: D90, G31, G32, M40, M41, M46
Date posted: November 15, 2006 ; Last revised: September 27, 2010
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