COSTLY EXTERNAL FINANCE AND INVESTMENT EFFICIENCY IN A MARKET EQUILIBRIUM MODEL

Abstract

I. INTRODUCTION A large body of research has stressed the quality of a country's financial markets as an important determinant of the firms' real investments and of economic development and growth. (1) But how exactly is investment affected by financial market imperfections? A key result in the corporate finance literature says that a financially constrained firm invests less than an identical unconstrained firm and that the more financially constrained the firm is the less it invests; see, for example, Kaplan and Zingales (1997), Hubbard (1998), and Stein (2003). It seems natural to conclude from this that when external finance is associated with a deadweight cost, firms invest less than when markets are frictionless. (2) This article shows that in assessing how financing frictions distort investment, one needs to distinguish whether the external cost is idiosyncratic to a given firm or whether it affects the whole economy. In particular, the frequently used case of an otherwise identical unconstrained firm is not the appropriate first-best benchmark when the external cost affects all firms in the economy, as, for example, when it reflects the country's legal and financial institutions, its bankruptcy procedures, protection of minority shareholders, stock market regulations regarding the disclosure of information, and so on. Such common factors have market-wide effects, so the appropriate first-best benchmark is the investment level that would be chosen by the firm in an economy with perfect capital markets. It is shown here that economy-wide financial frictions can easily lead firms to invest more than under frictionless markets. Similarly, unlike in the case of idiosyncratic external costs, a higher common external cost can lead to greater levels of investment by individual firms. The argument is as follows. Suppose that new firms can be established as long as they can find enough internal or external funds to finance their operations. To make things simple, assume also that all firms in the economy are identical, so that in equilibrium, each firm earns zero expected profit. Then, if a deadweight cost is introduced into external finance, the equilibrium interest rates must fall to allow the firms to break even--otherwise, no firm would be willing to raise external finance. The decrease in the equilibrium rate of return tends to decrease the firms' marginal costs of investment, which works against the direct effect of the higher external cost. I provide simple necessary and sufficient conditions under which this indirect, market equilibrium effect prevails, so that costly external finance leads each firm to overinvest, that is, to invest more than it would in a frictionless economy. More specifically, I show the following: * When all firms are identical, then each firm overinvests if at the first-best level of investment the marginal external cost is smaller than the average external cost. Each firm underinvests if the reverse is true. * Less productive firms are more likely to overinvest than more productive firms. By the same token, more productive firms are more likely to underinvest. * Cash-rich firms and firms with relatively cheap external capital have a greater tendency to overinvest, while cash-poor firms and firms with relatively costly external capital have a greater tendency to underinvest. * Firms with free cash always overinvest compared to the first-best level. Thus, free cash causes overinvestment in the present model as in Jensen (1986), although for a different reason. * An increase in the cost of external finance can make some firms better off and also improve efficiency. All the above results hold whether the economy is closed or open to capital flows. These results suggest that while the level of capital market frictions is an important determinant of the firms' investments, so is the composition of the costs associated with these frictions. …