Financial Constraints and Investment Decisions
| DOI | http://doi.org/10.1111/1467-9485.00202 |
| Author | E. Saltari,G. Travaglini |
| Date | 01 August 2001 |
| Published date | 01 August 2001 |
{Journals}sjpe/48_3/c163/makeup/c163.3d
FINANCIAL CONSTRAINTS AND
INVESTMENT DECISIONS
E. Saltari and G. Travaglini *
ABSTRACT
In what follows we show that liquidity constraintscan affect a firm's investment even
when the constraints are not currently effective. This happens when, at any given
time, the firm believes that internal finance is likely to become a constraint in the
future. In these circumstances, the value of the firm becomes a non-monotonic
functional form of thefundamental. Thus, in a dynamic setting, the potential barrier
to internal liquidity expansion exerts a global effect on the firm's investment policy,
lowering its desired investment profile (Classification JEL: E22, E51).
II
NTRODUCTION
The traditional theory of investment assumes that capital markets are
frictionless and that firms have access to an infinite supply of funds at the
required interest rate. Under this assumption, external investors can replicate at
no additional cost to themselves, the financial structure of a firm's original
investment. It follows that the capital structure of the firm has no effect on its
market value (Modigliani and Miller, 1958). Obviously, if capital structure does
not change the value of the firm, ex-ante evaluation of investment plans is
simplified, the current value of a project being exclusively determined by
technology and by prevailing market prices. In this context, investment decisions
depend solely on real variables, such as expected profits, while financial
decisions assume a secondary role in the firm's activities. These assumptions
inform both the intertemporal optimizing model of investment with (or without)
adjustment costs (Eisner and Strotz, 1963; Lucas, 1967), and the neoclassical
interpretation of Tobin's q(Tobin, 1969; Hayashi, 1982).
The most interesting(and realistic) case, however, is when external and internal
resources are not perfect substitutes. If, for example, asymmetric information
makes it difficult for external lenders to evaluate the profitability of the firm's
investment plans, the market interest rate for external funds may be substantially
higher than the opportunity cost of the corresponding internal resources. In these
circumstances investment decisions will depend on the financial structure of the
firm and, in particular, on the internal liquidity generated by current profits
Scottish Journal of Political Economy,Vol.48,No.3,August2001
#Scottish Economic Society 2001, Published by Blackwell PublishersLtd, 108 Cowley Road, Oxford OX4 1JF, UK and
350 Main Street, Malden, MA 02148, USA
330
*Universita
Ádi Urbino, Italy
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