Abstract
The purpose of this study is to examine the role of liquidity variables in explaining firm investment. Based on goodness of fit criteria, the study finds a model incorporating both liquidity and profitability variables performs better than the leading profitability-based models used in empirical research. In turn, liquidity flow measures perform better than do measures of liquidity stock. To investigate the impact of liquidity on investment, this study utilizes a model where the firm’s goal is maximizing the probability of its long run survival (PLRS). Chamberlain (International Review of Financial Analysis, 1996) described the investment decision maximizing the PLRS for a portfolio investor. Under reasonable assumptions, this investment decision reduces to the allocation of wealth between risky and risk-free assets. For a firm, the liquidity stock variable influencing its PLRS is the debt–equity ratio. The important difference between an investor and a firm is the nature of their risky assets. A portfolio investor holds financial assets which are readily traded and offer rates of return independent of the quantity held. In contrast, a firm holds tangible productive assets, which lack these properties. As a result, an investor is able to move at will at the start of each period to any desired allocation of wealth, while a firm is only able to move toward its desired debt–equity ratio over the period. Thus, a firm maximizes its PLRS by making the growth rate in capital in each period equal to the expected rate of growth of its net worth plus some fraction of the difference between its actual and desired debt–equity ratios. The role of liquidity is examined by estimating the PLRS model for each of the twenty-five large non-financial U.S. corporations studied. The performance of the model is compared with the three most common interpretations of the value maximization theory used in empirical research: the accelerator (capacity utilization), Int Adv Econ Res (2008) 14:350–351 DOI 10.1007/s11294-008-9152-0
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