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The U-shaped Investment Curve: Theory and Evidence

Author

Listed:
  • Sean Cleary

    (St. Mary's University)

  • Paul Povel

    (University of Minnesota)

  • Michael Raith

    (University of Rochester)

Abstract
This paper examines how the investment of financially constrained firms varies with their level of internal funds. We develop a theoretical model of optimal investment under financial constraints. Our model endogenizes the costs of external funds and allows for negative levels of internal funds. We show that the resulting relationship between internal funds and investment is U-shaped. In particular, when a firm's internal funds are negative and sufficiently low, a further decrease leads to an increase in investment. This effect is driven by the investor's participation constraint: when part of any loan must be used to close a financing gap, the investor will provide funds only if the firm invests at a scale large enough to generate the revenue that enables the firm to repay. We test our theory using a data set with close to 100,000 firm-year observations. The data strongly support our predictions. Among other results, we find a negative relationship between measures of internal funds and investment for a substantial share of financially constrained firms. Our results also help to explain some contrasting findings in the empirical investment literature.

Suggested Citation

  • Sean Cleary & Paul Povel & Michael Raith, 2003. "The U-shaped Investment Curve: Theory and Evidence," Finance 0311010, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0311010
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Financial constraints; capital market imperfections; financial contracts; investment; internal funds; investment-cash flow sensitivity;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets

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