CORPORATE INVESTMENT, DIVIDENDS, AND FINANCE: A SIMULTANEOUS APPROACH*

Abstract

IN THIS WORK a model of corporate capital budgeting is developed and estimated. The most important feature of this model is its explicit recognition of the interdependence among the components of a capital budget. The capital budgeting decision in any period consists of choosing the level of investment for the corporation and the means of financing that investment. A fundamental accounting identity insures that the level of investment is always equal to the sum of retained earnings, debt financing, and new equity financing. Therefore, any decision that affects any one of these variables must necessarily affect at least one of the others. A great deal of empirical work has been done on the components of the capital budget, but very little has been done on the complete capital budgeting decision. A theoretical model is developed to explain the decision-making process of corporations. The assumption is made that the primary objective of corporate planners is to maximize the price of a share of common stock. A series of present value models are then developed to explain the valuation of that stock. From this the optimal capital budget for the corporation is derived. In the final step a complete partial adjustment model is proposed as a more realistic description of actual corporate decision-making. This model takes the form