Investment and Debt Constraints: Evidence from Dutch Panel Data

It is generally accepted that real markets are sometimes affected by imperfections and their consequences. In contrast, the functioning of financial markets is mostly assumed to be perfect and efficient. Modigliani and Miller (1958, hereafter MM) show that in the latter case the capital structure of the firm is irrelevant for the user cost of capital and does neither affect investment nor the value of the firm. Since the publication of their seminal paper a large number of studies has pointed out that the empirical relevance of the MM-proposition is small. Financial markets suffer from several (institutional) market imperfections. In the first twenty years after the MM-publication, papers showed that distortionary taxes, transaction, bankruptcy and agency costs cause the financial structure to affect investment decisions. In recent studies the focus is directed towards information asymmetries. Agents have different sets of information. Firms know more about the quality of their investment project than, for instance, a bank. It can be shown that in such a case external funds (for instance bank credit) are more expensive than internal funds, because problems like adverse selection and moral hazard may occur. This might explain the empirical phenomenon that firms preferably use internal funds to finance Investment.1