Optimal Investment Under Financial Constraints: the Roles of Internal Funds and Asymmetric Information∗

Abstract

This paper studies how the investment of a financially constrained firm responds to changes in the constraints it faces. We distinguish between changes in the firm’s internal funds and changes in the extent of asymmetric information between the firm and an outside investor. The financial contract between firm and investor, and thus the cost of raising external funds, are derived endogenously. We show that changes in internal funds and informational asymmetry have different effects on the marginal cost of external funds and therefore the firm’s optimal investment. More asymmetric information generally leads to lower investment and a greater sensitivity of investment to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firm’s internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our predictions are supported by empirical evidence and explain seemingly contradictory findings in the recent empirical literature.

4 Figures and Tables

Cite this paper

@inproceedings{Povel2002OptimalIU, title={Optimal Investment Under Financial Constraints: the Roles of Internal Funds and Asymmetric Information∗}, author={Paul Povel and Michael Raith and Sean Cleary and Steven Fazzari and Allison Garrett}, year={2002} }