2. Corporate investment theory
Neoclassical investment models show that, when capital markets are assumed to be perfect, the financial structure of the firm is irrelevant to corporate investment
decisions Miller and Modigliani, 1958. More specifically, in the standard Q model, firms should invest until marginal Q is one. In the Euler equation model, financial
factors such as debt limits and liquidity are not included when determining the firm’s cost of capital.
However, asymmetric information and incentive problems may modify corporate investment behavior in two ways. First, providers of external finance may reduce
the availability or increase the cost of debt for corporations whose profitability cannot be assessed Myers and Majluf, 1984. As a consequence, companies with
limited access to external finance often make sub-optimal investment decisions based on the availability of internal funds. Agency problems can also lead to
inefficient investment behavior. As Jensen 1986 notes, management may act against the best interests of shareholders by investing the firm’s free cash flow in
sub-optimal projects. The value-maximization goals of stockholders also conflict with those of debt-holders.
Shareholders favor riskier projects, since limited liability means they do not have to bear the full cost of negative outcomes Jensen and Meckling, 1976. Further,
equity holders can appropriate wealth by distributing dividends instead of investing in projects whose returns would have to be shared with debt-holders. Therefore, a
firm’s access to external funds may be limited by creditors who seek to reduce the scope for wealth transferring activities.
Institutional ownership, especially from banks, can mitigate incentive conflicts and information asymmetries. First, because banks are more involved in the
day-to-day activities of the company, they have better information on the firm’s investment policy and profitability. Second, they can also control managers’
consumption of perquisites and investment decisions. Finally, as both shareholders and debt-holders, banks can increase the firm’s leverage without being concerned
about the owners’ incentives to appropriate wealth at the expense of creditors.
2
.
1
. Tobin
’
s Q models with financing constraints Empirical specifications of Tobin’s Q models use market valuation of capital to
control for investment opportunities. The impact of financial constraints is then measured by including measures of the firm’s liquidity. Fazzari et al. 1988 classify
US corporations in terms of their payout ratios. Low payout firms are assumed to be financially constrained and show greater sensitivity of investment to cash flow.
However, the empirical results of this study do not distinguish information prob- lems from agency conflicts. Using the same panel of firms, Oliner and Rudebusch
1992 try to distinguish between possible sources of financial constraints. They proxy for the severity of information problems using data on the firm’s age,
exchange listing, pattern of insider trading, and distribution of equity ownership. The potential for agency conflicts is measured by the proportion of shares held by
the board of directors and the largest outside shareholders. Their results provide support for information asymmetries as a source of the finance hierarchy favoring
internal funds. In their study of Japanese firms, Hoshi et al. 1991 investigate the role of bank ownership in facilitating access to debt. They demonstrate that firms
belonging to keiretzu, Japanese industrial groups centered around banks, have higher debt ratios and depend less on internal liquidity to make investment
decisions. Prowse 1990 also shows that Japanese banks mitigate agency conflicts by increasing their equity holdings.
2
.
2
. Euler equation models with borrowing constraints Another way of testing the link between internal funds and investment is to
modify the Euler equation model to include borrowing constraints. Hubbard et al. 1994 show that the neoclassical model without capital markets frictions is
accepted for a sample of US manufacturing companies with high dividend payout. However, low payout firms, which are more likely to be financially constrained,
reject the standard model but accept the augmented version with borrowing constraints. These results remain valid when the characterization of information
asymmetries is modified: financially constrained firms can be defined as having higher interest coverage ratios, higher debt-to-asset ratios, or no bond rating
Whited, 1992. Access to external funds can also change over the lifetime of a corporation and modify the role of liquidity. Petersen and Rajan 1994 explain
that smaller US firms rely on internal funds in their initial years. As a consequence, for such firms, higher debt levels are a sign of better credit availability, rather than
that they have borrowed up to their credit limits. Changes in domestic capital markets can also modify the sources of external finance. Hoshi et al. 1990 study
the deregulation of Japanese debt markets in the 1980s. They find that, during this period, mature and successful companies switched from bank loans to public debt
in order to avoid the monitoring cost of bank financing. However, these firms also became increasingly sensitive to cash flows for their capital expenditures. In
contrast, liquidity remained unimportant for companies that had maintained bank ties.
3. Capital markets and corporate financing in France
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