RDP 9308: Balance Sheet Restructuring and Investment 2. Investment and Finance

Traditional theory has tended to treat investment and financing decisions as separable. Assuming that capital markets are perfect, firms are not liquidity constrained and their investment decisions are unaffected by their capital structure. Recent theoretical developments, however, have focused on interactions between investment and financing decisions: the investment opportunities available to a firm will influence the size and structure of its balance sheet. Also, financial factors will influence the extent to which firms can undertake potentially profitable investment.

One strand of the new literature focuses on imperfect capital markets. Capital market imperfections can have significant effects on business decision making. Liquidity constraints and the lack of perfect substitutability between internal and external financing, for example, can limit a firm's ability to obtain funds for investment or boost the cost of those funds.[4] Because of this, the availability of adequate cash flows is important for investment. One reason for this is that not all firms have effective access to external capital markets. This is particularly true of small firms. Woo and Lange (1992), for example, note that ‘limited access may arise as a result of prohibitions or barriers to entry that specifically preclude small firms from gaining funds, either through regulation or in terms of the costs involved’. For some companies internally-generated cash flows may be the primary, and in some cases the only, source of funds. If internal funds are inadequate, or if lending institutions tighten the availability of credit during periods of uncertainty, some value-increasing investment projects may not be undertaken.

Furthermore, even for firms with access to external funding, internal cash flows are a relatively cheap source of finance. Incentive problems (agency costs), financial distress costs and asymmetric information increase the cost of external relative to internal finance.[5] A financing hierarchy results, in which internally generated cash flows are relatively cheap, debt is more expensive and external equity is the most expensive form of finance.[6]

These theories have a number of important implications for capital structure and investment decisions. First, the cost of capital is in some sense endogenous. For example, maintaining adequate cash flows directly provides funds for investment and reduces a firm's need to raise higher-cost external funding. Furthermore, a rise in cash flows will strengthen a firm's balance sheet which, in turn, will reduce the cost of obtaining external funding. This is because it increases the collateral that can be used to back external finance, reducing the information risk that outside lenders face. Firms can reduce this risk in other ways by, for example, maintaining a stock of easily collateralisable assets. This is based on the idea of ‘reliquification’ described by Eckstein and Sinai (1986) and Whited (1991). Firms accumulate financial assets in order to increase their financial health prior to undertaking new investment projects. If firms do not have access to external finance, they will be forced to retain earnings and accumulate financial wealth in order to finance lumpy investment projects. If firms do have access to external finance, but at a premium, the accumulation of financial wealth reduces the agency cost of these funds. Therefore, even if investment incentives are high, firms may prefer to build up working capital balances (and reduce debt levels) before undertaking significant new investment projects.

Thus capital structure decisions can influence investment. Indeed, it can be shown that the level of investment is positively related to corporate balance sheet positions (Bernanke and Gertler (1986, 1987) and Mills, Morling and Tease (1993)).

Furthermore, the desirability of investment will influence a firm's balance sheet. The financial hierarchy implies that firms will have a preference for cash flows as a means of funding. The extent to which they take on new debt or raise new equity will be a function of the demand for investment. When expected returns on investment are high, firms will be willing to undertake new raisings of external funds up to the point where the marginal return to doing so equals the marginal cost of a unit of external finance.

Even abstracting from capital market imperfections, the sequential separation of real and financial decisions is unrealistic. In a more complete theoretical framework, real and financial decisions are determined simultaneously as part of a broader portfolio allocation decision in which expected risk-adjusted returns are compared (see Kohli and Ryan (1987)). Investment in physical capital is only one possible use of a firm's funds. It is possible that in some periods accumulation of financial assets or the repayment of debt may be the optimal use of funds.

So far we have emphasised financial market imperfections and their possible effects on business behaviour. However, there are also other characteristics of investment expenditures that are not adequately captured in the standard models. Pindyck (1991), for example, notes that investment expenditures are often irreversible and that they can generally be delayed.[7]

Pindyck likens an irreversible investment opportunity to a financial call option – a right to pay an exercise price at some time in the future and receive an asset. The ‘option’ has value because delaying a project – that is, not exercising the option – means that a firm will obtain more information about the viability of the project. Like a financial option, the more uncertain the environment, the higher the value of waiting. This uncertainty may take the form of uncertainty about future cash flows, relative prices, interest rates or institutional arrangements. When a firm exercises the option by irreversible investment, it forgoes the opportunity of waiting for new information. This lost value is part of the cost of the investment. The opportunity cost of exercising the option can be large and may be very sensitive to uncertainty.[8] When uncertainty is high, other inducements may have to be very high to offset this cost and to encourage investment expenditure.


See McKibbin and Siegloff (1987), Wizman (1992) and Whited (1989) for models incorporating liquidity constraints. For models incorporating imperfect substitutability between internal and external sources of funds see Myers and Majluf (1984), Gertler and Hubbard (1988) and Jensen and Meckling (1976). [4]

See Gertler (1988) for a survey of the issues. [5]

A number of studies confirm the existence of financing hierarchies. Chaplinsky and Niehaus (1990) and Amihud et al. (1990), for example, find evidence that firms prefer internally sourced funds to external funds. Direct management surveys such as Allen (1991) and Pinegar and Wilbricht (1989) confirm these findings. [6]

Investment is, in many cases, irreversible because the capital is industry or firm specific. A blast furnace, for example, cannot readily be adapted to an alternate use (Pindyck (1988)). [7]

McDonald and Siegel (1986), Brennan and Schwartz (1985), Majd and Pindyck (1987) and Pindyck (1988). [8]