Optimal Investment Under Financial Constraints: The Roles of Internal Funds and Asymmetric Information

Abstract

We study how a firm's optimal investment varies with two different measures of financial constraints: the firm's internal funds and the extent of asymmetric information between the firm and outside investors. We derive the financial contract between firm and investor endogenously; in our model, a debt contract is optimal. Decreases in internal funds and more asymmetric information both worsen the financial situation of the firm. However, they differ in their effects on the firm's investment because they change the marginal cost of debt finance in different ways. More asymmetric information generally leads to lower investment, and investment becomes more sensitive to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firm's internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our results explain seemingly contradictory findings in the recent empirical literature.

Keywords: Financial constraints, capital market imperfections, financial contracts, investment, net worth, investment-cash flow sensitivities

JEL Classification: G32, G33, L13