Capital Market Imperfections, Uncertainty, And Corporate Investment

Firm-specific investment is one of the central topics of study in economic theory. Analysis of the investment decisions of firms occupies a prominent place in research programs in macroeconomics, public economics, industrial organization, and corporate finance. The purpose of this dissertation is to explore the determinants of firm-level investment, since an understanding of this problem may shed light on the source of cyclical fluctuations of aggregate output. So the primary question that we focus on in this thesis is which factors affect the firm-level investment fluctuations.This dissertation analyzes the effects of capital market imperfections and uncertainty on firm investment, theoretically and empirically. The structure is organized as follows:Chapter one is introduction, it represents the research background, motivation, methodology and logic framework of this paper, and also its shortcomings and potential theoretical innovations.As our analytical basis, we review the existing literature that studies the relationship among capital market imperfections, uncertainty and corporate investment in chapter two.Chapter three analyzes corporate investment behavior in a credit market with asymmetrically informed lenders and borrowers and costly state verification. In a standard lending model, we replicate the results of Stiglitz and Weiss (1981) that there exist equilibrium rationing and/or redlining in credit markets. More importantly, however, we further demonstrate that equilibrium credit rationing implies that the marginal cost of funds raised externally to the entrepreneur is infinite. Henceforth, when project scale divisibility is introduced, as we do, entrepreneurs have an overpowering incentive to cut back their investment spending and thus loan demand even by one unit of currency. This action guarantees that lenders will be on the rising part of their return function. As a result, credit rationing disappears in equilibrium and the credit market clears. The similar analysis also shows that redlining is not an equilibrium phenomenon. Finally we show that the extent to which borrowers will cut their project, and therefore entrepreneurs' actual capital spending depends on the level of net worth of firms. That is, firms are financing constrained, which means a small adverse shock may generate large investment fluctuations or even big business cycles through its effects on firm's net worth and external finance premium.Chapter four tests the financial constraint hypothesis using the panel data of China mainland listed manufacturing companies and the standard Q model. Do imperfections in capital market play a role in output fluctuations? Recent research in empirical macroeconomics has directed this question to the area of investment, asking in particular whether firm with free access to capital markets have different investment behavior from those who do not. We classify the total sample into "constrained" and "unconstrained" firms by three different criteria. The ratio of state-hold shares means how much government credit is put in the firm. A company's dividend policy reveals its operating performance and future profit prospects. The asset size of a firm represents its safeness in debt financing. Estimates from sample split by state-hold shares ratio show that financial effects are generally important for investment in all firms. But the results consistently indicated a substantially less sensitivity of investment to cash flow in firms with a ratio of state-hold shares greater than 50% than that of firms with a ratio equal to or less than 50%, although the former have a relatively poor performance. This statistically and economically significant difference was robust to a wide variety of model specifications and estimation techniques. These empirically important differences across firms are consistent with financial constraints arising from capital market imperfections. Contrary to the prediction of liquidity constraints hypothesis, the high-dividend firms are more cash constrained than low-dividend firms. Although estimates from the bench empirical model imply that the investment of big firms is more sensitive to fluctuations in their cash flow than that of small firms, the robust tests reverse these results. Most important, the Wald test cannot reject the null hypothesis that the cash flow coefficient of big firms equals the corresponding coefficient of small firms. All the abovementioned empirical evidence suggests that the outside investors, including banks and other financial institutions, put more emphasis on government credit than on signals generated by market factors when they make decisions.Chapter five conducts further tests for financial constraints and its quantitative effects on firm investment by introducing the often-ignored variable——working capital investment——into Q model. In the standard reduced form Q model, cash flow effects on investment have often been criticized as proxies for factors that shift investment demand rather than as evidence of financial constraints. Working capital is current assets less current liabilities, which acts as both an input and a readily reversible store of liquidity. Developing the role of working capital leads to two empirical predictions. First, when included as an endogenous variable in a fixed investment regression, working capital investment should have a negative coefficient if firms face financing constraints. Second, the reduced form Q model may underestimate the full impact of financing constraints on investment since it neglects the fact that firms smooth fixed investment in the short run with working capital. Consistent with our predictions, the coefficient of endogenous working capital is negative in the Q model. Moreover, controlling for the smoothing role of working capital results in a much larger estimate of the impact of finance constraints than reported in chapter four and other studies. These findings address the criticism and provide new evidence on financing constraints.Chapter six investigates firm investment behavior under irreversibility. In particular, we discuss the impact of uncertainty and capital market imperfections on the dynamics of investment. We first develop a model of partial irreversibility and expandability and examine the timing of investment decisions and the sequential determination of the optimal amount invested simultaneously. By introducing the concepts of call option and put option of investment, we show that firms that make their investment decision according to the naive NPV rule would be behaving sub-optimally since it ignores the effects of the two options on the expected marginal value of capital. We also demonstrate that irreversibility, uncertainty and expandability lead to a zone of inaction, and the firm's decision to invest, disinvest or remain inactive at a point of time is affected by the probability of high demand and low demand state, but not by the shape of conditional distribution function of demand state. We next explore the effects of firm level cost uncertainty (the price of capital) and demand uncertainty on corporate investment in a model with complete irreversibility and show that a mean preserving spread in conditional distribution of demand state and the price of capital tends to depress the expected future marginal value of capital and raise the marginal endogenous adjustment cost, leading to a decrease in current investment. Finally, we consider a model of irreversible investment with uncertainty and capital market imperfections. It shows that a rise in uncertainty lowers the expected shadow value of capital and increases the marginal risk premium, thereby raising the external finance premium, which means firms have to face more severe financing constraints.Chapter seven uses a panel of China listed manufacturing companies to empirically explore the relationship between capital market imperfections, uncertainty and corporate investment, that is, we focus on whether firms that are confronted with higher degree of uncertainty will suffer more from financial constraints than those with relatively low uncertainty. In this chapter, stock price volatility is used as uncertainty measure. Firms are classified by a threshold level for uncertainty. More importantly, unlike chapter four and five, here we appeal to Hansen estimator to integrate the threshold level into the empirical model and determine the cut-off value of uncertainty simultaneously with the parameters of the model. The estimates show that the cash flow coefficient for high stock price volatility observations is substantially larger than the corresponding parameter for low volatility observations. The further test using Arellano-Bond GMM estimator obtains similar results. Therefore, we can conclude that there is a differential impact of cash flow on investment depending on the degree of uncertainty that firms are facing, suggesting that financial constraints arising from capital market imperfections are more severe for the relatively high volatility finns.