Recent models of firm investment decisions stressing informational
imperfections in capital markets provide a foundation for interpreting evidence
that movements in internal finance can predict investment opportunities. While
such evidence is suggestive, it is often open to other interpretations.
We present new evidence in favor of these models that addresses this gap
in two ways. First, we focus on the U.S. agricultural sector; the sector has
experienced large fluctuations in net worth and the profitability of
investment, and reasonable measures of net worth can be constructed. Second,
rather than relying on investment function representations (e.g., the q-theory
approach), we make use of predictions generated by firms' Euler equation for
capital accumulation. Intuitively, during periods in which net worth is high,
the Euler equation should hold across adjacent periods; the equation will not
hold for periods in which the shadow price of external finance is high because
of low net worth. Such an approach offers an alternative model for periods in
which internal net worth is low (holding constant investment opportunities),
and generates a link between internal net worth and investment spending during
periods of significant deflation in the value of net worth.
Our empirical evidence is presented in three parts. First, the
neoclassical, perfect-capital-markets model for investment is rejected by the
data. Omitting periods during which there were substantial negative shocks to
farmers' net equity positions, the model's overidentifying restrictions can no
longer be rejected. Second, allowing for movements in net equity positions
contributes importantly to explaining investment. Third, the effect of changes
in net worth on investment is significantly more important during the
deflationary periods than during "boom" periods. Taken together, these
findings provide support for a class of "internal funds" models of investment
under asymmetric information.
*Published:
Journal of Political Economy, Vol. 100, June 1992, pp. 506-534
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