Investment, uncertainty, and liquidity

Abstract

Despite extensive research, the exact nature of the dependence of corporate investment on firm liquidity, uncertainty, and hedging policy remains obscure. First, although it is widely recognized that external financing can be costlier than internal financing, thereby implying that the quantity of new investment can be sensitive to the availability of internal funds, the extent to which inter-firm variations in investment-cashflow sensitivities reflect differences in the severity of financing constraints is a matter of considerable debate. A number of studies (e.g., Fazzari, Hubbard and Petersen, 1988; Hoshi, Kashyap and Scharfstein, 1991; Whited, 1992) find that firms deemed likely to be financially-constrained display higher investment-cashflow sensitivities than other firms, but recent work by Kaplan and Zingales (1997, 2000) criticizes this approach and suggests that investment-cashflow sensitivities provide little information about the degree to which firms are financially constrained. Second, if firms are indeed subject to financing constraints, then Lessard (1990) and Froot, Scharfstein and Stein (1993) argue that hedging is valuable because it helps ensure that firms have sufficient internal funds to take advantage of profitable investment opportunities. Thus, hedging firms should invest more than non-hedging firms, all else equal. However, recent empirical work by Allayannis and Mozumdar (2000) and Geczy, Minton and Schrand (1997) indicates no difference in investment rates between hedgers and non-hedgers. Third, theoretical models predict that greater uncertainty reduces investment, either because of real option considerations (e.g., McDonald and Siegel, 1986) or because of financial distress costs (e.g., Stulz, 1999). But empirical research by Ghoshal and Loungani(1996, 2000) and Caballero and Pindyck (1996) finds a much weaker relationship than implied by these models. Overall, considerable gaps between theory and evidence exist in these three areas.