Internal funds and the investment function
An extensive and increasingly persuasive body of empirical evidence has linked a firm's fixed investment expenditure to its supply of internally generated funds. The central concerns of this paper are (1) the theoretical justifiability of such empirically-based investment functions, particularly those where internal funds affect only the speed of adjustment, and (2) the dynamic properties of this latter class of investment functions. A class of models is explored featuring intertemporal profit maximization under conditions of increasing costs of external finance (attributable to bankruptcy or agency costs). The paper shows that, for a major part of the optimal investment path, the function implied by the theory is remarkably close to the most promising variant found empirically: the supply of internal funds affects the speed of adjustment, but not the level of the optimal capital stock. Such investment functions possess the unusual dynamic property that the speed of adjustment increases monotonically along the optimal path.
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