Abstract
Abstract There is a large theoretical and empirical literature exploring the link between corporate investment and internal funds. In the idealized world of no information asymmetries and no taxes, it is immaterial how investment is financed. If future profitability is properly controlled for, by including Tobin’s q in an equation explaining investment, investment should not be sensitive to the firm’s liquidity. There are two explanations for why investment can be excessively sensitive to the firm’s liquidity. The traditional explanation is that there is a pecking order in the source of investment finance. With taxes providing the interest deductibility for debt finance at the corporate level and preferential treatment of capital gains over dividends at the personal level, retention is the cheapest source of finance, followed by debt and then new share issues. Investment will be excessively sensitive to the firm’s liquidity because the cost of investment finance depends on the level of investment.1 The more modern explanation is the agency model featuring the incentive problem faced by managers or the information asymmetry between managers and shareholders.2
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