RDP 9402: The Influence of Financial Factors on Corporate Investment 4. Conclusion

These results provide useful insights into business investment decisions and also on how monetary policy will affect those decisions.

The structure of a firm's balance sheet and the availability of adequate internal sources of funds can influence investment. Higher leverage can discourage investment by, for example, raising the cost of obtaining further external finance. Higher cash flows will boost investment by providing more, relatively cheap, internal funds and increasing the collateral backing of the firm. While both factors are statistically significant it appears that the cash flow effect is the more economically important. The extent to which these factors influence investment does, however, appear to vary between firms. The results suggest that internal sources of funding are more important for small firms, highly leveraged firms and firms that have high retention ratios.

These results have a number of important implications for monetary policy. First, the importance of cash flows as a determinant of investment suggests that monetary policy will influence investment through cash flow as well as through influencing the discount rate applied to investment projects and to overall economic conditions. Second, the impact of monetary policy will fall unevenly across the corporate sector. Smaller firms, firms with higher leverage and firms more reliant on cash flows as a source of funding are likely to be more sensitive to changes in monetary policy than others. The results in Tables 2 to 4 show that financial variables in general, and cash flows in particular, are a significant influence on investment of these firms. Financial factors appear to be less (if at all) important for larger firms or for firms with lower gearing.