The U-Shaped Investment Curve: Theory and Evidence
57 Pages Posted: 25 Nov 2003
Date Written: July 2004
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: Suggested Citation