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Firm investment in imperfect capital markets: A structural estimation

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  • Sangeeta Pratap
  • Silvio Rendón

Abstract

We set up a dynamic model of firm investment in which liquidity constraints enter explicity into the firm's maximization problem. The optimal policy rules are incorporated into a maximum likelihood procedure which estimates the structural parameters of the model. Investment is positively related to the firm's internal financial position when the firm is relatively poor. This relationship disappears for wealthy firms, which can reach their desired level of investment. Borrowing is an increasing function of financial position for poor firms. This relationship is reversed as a firm's financial position improves, and large firms hold little debt. Liquidity constrained firms may be unused credits lines and the capacity to invest further if they desire. However the fear that liquidity constraints will become binding in the future induces them to invest only when internal resources increase. We estimate the structural parameters of the model and use them to quantify the importance of liquidity constraints on firms' investment. We find that liquidity constraints matter significantly for the investment decisions of firms. If firms can finance investment by issuing fresh equity, rather than with internal funds or debt, average capital stock is almost 35% higher over a period of 20 years. Transitory shocks to internal funds have a sustained effect on the capital stock. This effect lasts for several periods and is more persistent for small firms than for large firms. A 10% negative shock to firm fundamentals reduces the capital stock of firms which face liquidity constraints by almost 8% over a period as opposed to only 3.5% for firms which do not face these constraints.

Suggested Citation

  • Sangeeta Pratap & Silvio Rendón, 1996. "Firm investment in imperfect capital markets: A structural estimation," Economics Working Papers 274, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 1998.
  • Handle: RePEc:upf:upfgen:274
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    Cited by:

    1. Francisco Covas & Wouter J. Den Haan, 2012. "The Role of Debt and Equity Finance Over the Business Cycle," Economic Journal, Royal Economic Society, vol. 122(565), pages 1262-1286, December.
    2. Pratap, Sangeeta & Urrutia, Carlos, 2004. "Firm dynamics, investment and debt portfolio: balance sheet effects of the Mexican crisis of 1994," Journal of Development Economics, Elsevier, vol. 75(2), pages 535-563, December.
    3. Sangeeta Pratap & Silvio Rendon, 2003. "Firm Investment in Imperfect Capital Markets: A Structural Estimation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(3), pages 513-545, July.
    4. Ono, Masanori, 2003. "A computational approach to liquidity-constrained firms over an infinite horizon," Journal of Economic Dynamics and Control, Elsevier, vol. 28(1), pages 189-205, October.
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    6. Francesc Obiols-Homs, 2011. "On borrowing limits and welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 279-294, April.
    7. Silvio Rendón, 2000. "Job creation under liquidity constraints: The Spanish case," Economics Working Papers 488, Department of Economics and Business, Universitat Pompeu Fabra.
    8. Rodrigo A. Cerda & Diego Saravia, 2009. "Corporate Tax, Firm Destruction and Capital Stock Accumulation: Evidence From Chilean Plants, 1979-2004," Working Papers Central Bank of Chile 521, Central Bank of Chile.
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    10. Strebulaev, Ilya A. & Whited, Toni M., 2012. "Dynamic Models and Structural Estimation in Corporate Finance," Foundations and Trends(R) in Finance, now publishers, vol. 6(1–2), pages 1-163, November.
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    More about this item

    Keywords

    Investment; liquidity constraints; Tobin's q; estimation of dynamic structural models; financial accelerator;

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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