A Working Capital Theory of the Firm with Empirical Evidence

A key assumption made in the standard theory of the firm is that there is no time difference between when costs are incurred and when revenue is received. This assumption is valid only under the assumption of perfectly functioning financial markets. However under imperfect financial markets, such as those that exist for the majority of developing economies, this assumption fails to capture the need for liquidity and therefore does not fully capture the effects of financial constraints on the dynamic behaviour of the firm. This dissertation formalizes a working capital theory of the firm that captures the effects of financial constraints on the behavior of the firm that the standard theory of the firm would otherwise not capture. The first chapter develops the working capital model of the firm and show that under very few assumptions, the dynamic model is easily tractable to a static solution. The model predicts that under financial constraints, firms would exhibit countercyclical investment behavior. Constrained firms become constrained during times when there are positive price shocks and as such, this has large implications for growth. These predictions are supported by empirical analysis using a unique panel of Bangladeshi firms. The second chapter extends the working capital theory of the firm to examine the implications of financial constraints on exports. Exporting requires greater liquidity demands due to greater transport time. As such, the model shows that the established relationship between exporting and productivity differs under financial constraints. The result shows that export status is less dependent on productivity and more dependent on the availability of working capital when firms are constrained, and this is supported by empirical analysis and results. The third chapter utilizes the difference in the behavior between financially constrained and non-constrained firms to examine the effect of bribes on firm growth. The interaction between financial constraints and bribes suggest that bribes can be distortionary even when bribes act as fixed costs. These results imply that corruption alone may not be detrimental to firm growth but when combined with limited access to finance, the cost of corruption seriously hampers the growth of firms.