Financing Constraint, Over-Investment and Market-to-Book Ratio

Abstract

In a simple symmetric information continous time model, we consider leverage as way to finance a fraction of the investment cost. We show that underinvestment cannot arise while over-investment may and the room for overinvestment is negatively related with the fraction paid by equityholders. Finally, we show that our model predicts the (empirically observed) negative relation between the market-to-book ratio and the leverage ratio.

Keywords: Overinvestment, profitability, market-to-book ratio, leverage ratio, financing constraint

JEL Classification: G31, G32, G33