The Effect of External Finance on the Equilibrium Allocation of Capital
University of Illinois at Urbana-Champaign; National Bureau of Economic Research (NBER)
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Journal of Financial Economics, Forthcoming
We develop an equilibrium model to understand how the efficiency of capital allocation depends on outside investor protection and the external financing needs of firms. We show that when capital allocation is constrained by poor investor protection, an increase in firms' external financing needs may improve allocative efficiency by fostering the reallocation of capital from low to high productivity projects. We also find novel empirical support for this prediction.
Keywords: capital reallocation, financial development, investor protection, external finance
JEL Classification: G15, G31, D92
Date posted: September 1, 2004