The U-Shaped Investment Curve: Theory and Evidence

52 Pages Posted: 10 Feb 2004

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: October 2004

Abstract

This Paper examines how the investment of financially constrained firms varies with their level of internal funds. We develop a theoretical model of optimal investment under financial constraints. Our model endogenizes the costs of external funds and allows for negative levels of internal funds. We show that the resulting relationship between internal funds and investment is U-shaped. In particular, when a firm's internal funds are negative and sufficiently low, a further decrease leads to an increase in investment. This effect is driven by the investor's participation constraint: when part of any loan must be used to close a financing gap, the investor will provide funds only if the firm invests at a scale large enough to generate the revenue that enables the firm to repay. We test our theory using a dataset with close to 100,000 firm-year observations. The data strongly support our predictions. Among other results, we find a negative relationship between measures of internal funds and investment for a substantial share of financially constrained firms. Our results also help to explain some contrasting findings in the empirical investment literature.

JEL Classification: G32, G33, L13

Suggested Citation

Povel, Paul and Cleary, W. Sean and Raith, Michael, The U-Shaped Investment Curve: Theory and Evidence (October 2004). Available at SSRN: https://ssrn.com/abstract=501541

Paul Povel

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 (Contact Author)

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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