The U-Shaped Investment Curve: Theory and Evidence

57 Pages Posted: 25 Nov 2003

See all articles by Paul Povel

Paul Povel

University of Houston - Department of Finance, C.T. Bauer College of Business

W. Sean Cleary

Saint Mary's University, Canada - Department of Finance, Information Systems & Management Science; York University - Schulich School of Business

Michael Raith

University of Rochester - Simon Business School

Multiple version iconThere are 2 versions of this paper

Date Written: July 2004

Abstract

We analyze how the availability of internal funds affects a firm's investment in the presence of capital market imperfections. Using a model that endogenizes the cost of external funds and allows for negative levels of internal funds, we show that under otherwise standard assumptions, investment is a U-shaped function of internal funds. As internal funds decrease, the cost of maintaining a given investment increases, which makes a smaller investment more attractive. For low internal funds, however, the firm will be induced to invest more, not less: a larger investment generates more revenue, which makes it easier to repay the lender and therefore benefits the firm. We test our theory using an unusually comprehensive data set, and find strong support for our predictions. In particular, we find a negative relation between internal funds and investment for a sizable fraction of firms with low (negative) levels of internal funds. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.

Keywords: Financial constraints, capital market imperfections, financial contracts, investment, internal funds, investment-cash flow sensitivity

JEL Classification: G31, G32, G33, D21

Suggested Citation

Povel, Paul and Cleary, W. Sean and Raith, Michael, The U-Shaped Investment Curve: Theory and Evidence (July 2004). Simon Business School Working Paper No. FR 03-32, Available at SSRN: https://ssrn.com/abstract=470921 or http://dx.doi.org/10.2139/ssrn.470921

Paul Povel (Contact Author)

University of Houston - Department of Finance, C.T. Bauer College of Business ( email )

University of Houston
334 Melcher Hall
Houston, TX 77204
United States
713-743-4759 (Phone)

HOME PAGE: http://www.bauer.uh.edu/povel

W. Sean Cleary

Saint Mary's University, Canada - Department of Finance, Information Systems & Management Science ( email )

Halifax, Nova Scotia B3H 3C3
Canada

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 (Phone)
416-736-5687 (Fax)

Michael Raith

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-8380 (Phone)
585-273-1140 (Fax)

HOME PAGE: http://works.bepress.com/michael_raith/

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