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  • 08.11.2004

    Firms' Fixed Capital Investment under Restricted Capital Markets

    (Code:26)

    The determinants of firms’ fixed capital investment play an important role in growth and business cycle theories. They are crucial in designing optimal fiscal policy. Hence, study aimed at the identification of the major impediments to the optimal level of investment at firm level, has not only academic interest, but also provides practical implications for economic policy. Many previous studies acknowledged the existence of the ‘financial hierarchy’, when firms rely heavily on the internal sources of financing of capital investment (see section Literature Review).

    Asymmetric information, agency costs and transaction costs are often mentioned as the primary reasons of the financial hierarchy. This study hypothesizes that the investment behavior of any firm at a given period of time can be explained by one of the two mutually exclusive and exhaustive regimes: constrained or unconstrained. In particular, investment of a 'constrained firm' is the minimum of the optimal level and internally available funds, regardless of the source of the financial constraint. Application of the switching regression technique makes possible the estimation of the parameters for each of the regimes. This study differs from the vast literature in the field in several dimensions. First of all, in contrast to the widely used Tobin’s Q models of investment equations our methodology does not require extensive stock market data. Therefore this approach has potential applicability to a large set of countries and industries, in many of which stock market data may be unavailable or unreliable. Second, the model is not related to a particular type of financial constraint (e.g. source of external financing, capital intensity, growth rates, age, etc.) in contrast to some of the empirical models1. Thus, it is possible to model a wide range of different situations without making specific assumptions about the source of the constraint itself. This although comes at a cost of some simplifications, which might be strong in some cases.

    Third, proposed methodology allows exact (to the extent of the precision of the estimation procedure itself) identification of the constrained and unconstrained firms, that is, it estimates how the sample is separated into constrained and unconstrained firms. Thus, it is possible not only to make inferences about the presence of financial constraints, but also to identify firms that are subject to such constraints. Finally, although in the present study we used a number of simplifying assumptions to derive the investment equation in a traditional way, this should in no way be seen as a weakness of the approach itself. Indeed, more realistic settings (e.g. monopolistic competition, stochastic environment, different adjustment cost functions, etc.) can be used to construct alternative (probably more complicated) models with better fit and explanatory power.

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