An Empirical Study: Financial-Market Imperfections and Investment

Korean economy undergoes pre-modernized corporate governance. Financial-market imperfections assumed to be incorporated in equity ratio affect the sensitivity of internal funds to physical investment. Empirical analyses show that the effects of asymmetric information are significant. Theories predict that internal finance is less costly than borrowing or issuing equity. Higher cash flow from higher profits affects investment ratio. But, this marginal effect is decreased by equity ratio. If we assume that more imperfect financial market requires more equity than borrowing, we can see that agency costs change the way economic variables like cash flow affect physical investment. Cash flow plays two opposite roles for implementing investment. In the case of financial-imperfections, we can expect that firms with higher profits invest more. But, according to free cash flow hypothesis by Jensen (1986), managers with only a small ownership interest have an incentive for wasteful management. We can expect to see more wasteful activity in a firm with large cash flows. Our regression result shows that the former dominates the latter, so we get positive coefficient for cash flow variable on the physical investment.