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Firm size and the impact of profit-margin uncertainty on investment: do financing constraints play a role?

  • Vivek Ghosal
  • Prakash Loungani

We study the response of investment to changes in uncertainty about future profits. We find that in industries dominated by small firms, an increase in uncertainty about future profits depresses investment; in all other industries, increased uncertainty has virtually no effect (or has a positive effect) on investment. The data set from which these findings emerge is a balanced panel, consisting of annual data from 1958 to 1991 for 252 manufacturing industries in the United States. The theoretical work on this topic points to uncertainty about future profit flows as one of the important actors that determines the ease with which firms can access external credit. The prediction made by the theory is that an increase in uncertainty exacerbates informational asymmetries, and hence makes lenders reduce the flow of credit; this in turn lowers investment in credit-constrained firms. If one is willing to accept firm size as a proxy for access to external credit, then our finding that greater uncertainty lowers investment in small-firm-dominated industries is consistent with the theoretical prediction.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 557.

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Date of creation: 1996
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Handle: RePEc:fip:fedgif:557
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  22. Michael Devereux & Fabio Schiantarelli, 1990. "Investment, Financial Factors, and Cash Flow: Evidence from U.K. Panel Data," NBER Chapters, in: Asymmetric Information, Corporate Finance, and Investment, pages 279-306 National Bureau of Economic Research, Inc.
  23. Steven M. Fazzari & Bruce C. Petersen, 1993. "Working Capital and Fixed Investment: New Evidence on Financing Constraints," RAND Journal of Economics, The RAND Corporation, vol. 24(3), pages 328-342, Autumn.
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  26. Ghosal, Vivek, 1996. "Does uncertainty influence the number of firms in an industry?," Economics Letters, Elsevier, vol. 50(2), pages 229-236, February.
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  28. Jason G. Cummins & Kevin A. Hassett & R. Glenn Hubbard, 1994. "A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 1-74.
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