The U-Shaped Investment Curve: Theory and Evidence

Abstract

We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.

Stock Market Liquidity: Financially Constrained Firms and Share Repurchase

“…In general, unconstrained firms are more liquid than constrained firms. This is consistent with Cleary, Povel, and Raith (2007), who suggest information asymmetry between firms and uninformed investors is a primary root cause of financial constraint.…”

Corporate efficiency, credit status and investment

“…Most interestingly, investment cash flow sensitivity for financially constrained firms is found to be decreasing with corporate efficiency as opposed to increasing in the unconstrained regime. Such contrasting behavior between the two groups of firms may be explicated by the cost and revenue effect suggested by Cleary et al (2007). This along with the perceived effect of efficiency on firms' credit status suggest important implication.…”

“…More recently, Moyen (2004) argues that it is hard to identify firms with financial constraints and finds evidence in support of both Fazzari et al (1988) and Kaplan and Zingales (1997) using two different unconstrained and constrained firm models. Cleary, Povel, and Raith (2007) try to explain this contrasting behavior by showing that the relationship between the firm's internal funds and investment is not monotonic, but U-shaped. Lyandres (2007) complements this U-shaped relationship by examining the effects of costly external financing on the optimal timing of a firm's investment and Guariglia (2008) finds varying investment cash flow sensitivity for internally and externally financial constrained firms.…”

Finance and R&D Investment: A Panel Study of Italian Manufacturing Firms

“…Data indicate that both external funds and internal funds are, on average, slightly lower among small and medium sized firms. INTF can also take negative values, which is a common proxy for characterizing firms that are in financially distressed situations (Cleary et al, 2007;. To ensure that all the companies are in normal operations and to avoid classification problems related to possible bankruptcy procedures reported in the Aida database, we restrict the study to positive levels of internal funds, thus we exclude from the study financially distressed firms which represent around 6% of the sample (6.19% of large firms; 6.061% of SMEs).…”

“…Note that, with some exceptions Cleary et al, 2007), previous studies mainly examine the investment cash-flow relationship or focus on the impact of either internal or external funding on innovation. However, excluding measures of external or internal finance from regressions can lead to biased estimates because external and internal channels are not mutually independent and it is reasonable to assume that, in making investments, firms take account of all the sources of funding.…”