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Firm investment in imperfect capital markets: A structural estimation

Listed author(s):
  • Sangeeta Pratap
  • Silvio Rendón

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.

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File URL: https://econ-papers.upf.edu/papers/274.pdf
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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 274.

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Date of creation: Sep 1996
Date of revision: Mar 1998
Handle: RePEc:upf:upfgen:274
Contact details of provider: Web page: http://www.econ.upf.edu/

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