Imperfect information and agency cost models: Further empirical tests

Abstract

The theory of agency costs and imperfect information suggests that some types of firms may prefer to finance investment with internal funds. Fazzari, Hubbard, and Petersen (1988) and other researchers reported differences across groups of firms in the sensitivity of investment to cash flow that appear to be caused by market imperfections. Previous researchers used a fixed-effects regression model that implicitly assumed investment behavior was the same for all firms with common financial characteristics. This paper provides evidence of substantial intragroup heterogeneity in fixed-effects estimates of investment behavior and a Random Coefficients Regression model is shown to display less intragroup variability. A formal statistical test rejects the hypothesis that firms with similar characteristics have fixed and identical regression coefficients. Some of the evidence supports the existence of intergroup differences in cash-flow coefficients; however, the large intragroup variability of the fixed-effects cash-flow coefficients may be evidence of an incorrectly specified model.