Investment, capital structure, and complementarities between debt and new equity
Rune Stenbacka, Mihkel Tombak. Management Science. Linthicum: Feb
2002.Vol.48, Iss. 2; pg. 257, 16 pgs http://proquest.umi.com/pqdweb?did=111676011&sid=13&Fmt=4&clientId=68814&RQT
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Abstract (Document Summary)
Simultaneous investment and financing decisions made by incumbent owners in the presence of capital market imperfections are studied. A theory for how the optimal combination of debt and equity financing depends on the firm's internal funds is presented. Complementarities between the two financial instruments are identified.
These predictions are empirically tested with panel data on 3,119 corporations in the
COMPUSTAT database. The estimates using instrumental variable techniques support the theoretical predictions regarding the link between internal funds and capital investments, as well as the interaction effects between debt and new equity. Implications for managers, financiers, and policy makers are explored.
Full Text (1753 words)
Copyright Institute for Operations Research and the Management Sciences Feb
2002[Headnote]
We study simultaneous investment and financing decisions made by incumbent owners in the presence of capital market imperfections. We present a theory for how the optimal combination of debt and equity financing depends on the firm's internal funds. We identify complementarities between the two financial instruments. We test these predictions empirically with panel data on 3,119 corporations in the COMPUSTAT database. Our estimates using instrumental variable techniques support our theoretical predictions regarding the link between internal funds and capital investments, as well as the interaction effects between debt and new equity. We explore implications for managers, financiers, and policy makers.
(Investments; Financial Constraints; Capital Structure; Complementarities)
1. Introduction
There is overwhelming evidence for the importance of investments as an engine for economic growth.1 In 1998, U.S. nonfarm, nonfinancial corporations made capital expenditures of $707 billion (increased from $430 billion in 1993) (Department of
Commerce 1999). Research in a variety of fields such as macroeconomics, public economics, industrial organization, and financial economics has generated insights concerning the foundations for the investment decisions of firms. A robust finding from a wide spectrum of empirical studies is that financial constraints play an important role in determining investment behavior (Hubbard 1998). Also, Rajan and Zingales (1998) offer empirical evidence of the impact of financial market imperfections on investment and firm growth. In the current study, our main objective is to demonstrate, both theoretically and empirically, that there are important interactions between different instruments of external financing and to characterize the impact of these interactions on the investments of financially constrained firms.
Our study holds a number of implications for investment managers in the presence of financial constraints. Our analysis suggests that firms should initially acquire debt when

the enterprise is small and leverage that debt to create retained earnings. Then, as retained earnings accumulate, managers should simultaneously acquire both new equity and debt to take advantage of the complementarities identified between these two financial instruments. Exploitation of these complementarities generates an acceleration of the investment-based growth of financially constrained firms. Our study also addresses the strategies of lenders. The analysis suggests that the monitoring activities of banks should be directed particularly to debtors with low levels of retained earnings as the investment programs of such projectholders involves the highest default probability.
Finally, our research speaks to industrial policy makers. This study suggests that policy makers, particularly those in emerging markets, should emphasize the simultaneous development of the two types of financial markets (debt and equity). In light of the complementarities identified, the simultaneous development of the two types of markets would be preferred to a specialized focus on any one type of financial instrument in isolation.
The literature in corporate finance addressing capital structure typically takes the magnitude of the investment project as given and it focuses on the combination of debt and equity as if investment is a cause of the debt and equity ratio. The investment theory literature distinguishes between internal and external financing, but seldom pays attention to different instruments of external financing. We shall argue that both capital structure and investment are endogenous and that they both depend on more basic ingredients such as the nature of the capital markets, the characteristics of the investment opportunities available to the firm, and the internal funds the firm has available. In the current analysis, we focus on the simultaneous determination of investment and capital structure of financially constrained firms with access to both debt and equity markets.2
As long as the conditions of perfect capital markets are satisfied, we know from the
Modigliani-Miller irrelevance theorem that the investment programs of firms would be unaffected by financial constraints. As the survey by Harris and Raviv (1991) shows, past decades of research established how capital market imperfections in the form of tax distortions, asymmetric information generating problems of adverse selection and moral hazard, interactions with imperfectly competitive product markets, or contests for corporate control will make a significant difference for capital structure and investment behavior. In particular, in exploring the consequences of informational asymmetries, an influential stream of microoriented research established how financial constraints will restrict and distort the investment programs of firms once these have to be based on external financing through the debt or equity markets. A recent more macrooriented approach, surveyed by Bernanke et al. (2000), studied how credit market imperfections can generate cyclical economy-wide fluctuations. Furthermore, they investigate how financial accelerator effects can explain why cyclical movements in investment will exceed the magnitude of fluctuations in expected future profitability or in the user cost of capital.
One could view the firm's added value as generated by investment projects characterized by uncertainty. In our model of firm investment, we make a distinction between incumbent and new shareholders (see for example, Blanchard et al. 1993). We focus on existing owners maximizing the value for the incumbent shareholder by determining the capital structure simultaneously with the magnitude of the investment program. Initially, we characterize theoretically how the optimal combination of debt and equity financing will depend on the firm's internal funds available for investment. This

optimal combination of debt and equity reflects a tradeoff between the bankruptcy risk associated with debt and the dilution cost to incumbent shareholders of new equity. Our theory identifies complementarities between these two financial instruments. Such complementarities would then be a source of financial accelerator effects at the firm level. Subsequently, we test these predictions empirically on financial data on 3,119 publicly traded manufacturing and telecommunications corporations in the Standard and
Poor's COMPUSTAT database for the years 1982-1992. Our empirical analysis lends support to our theoretical predictions regarding the link between internal funds and capital investments and evidence regarding the interaction effects between debt and new equity. An implication of this study is that when there are financial market imperfections, it is important that there be several financial instruments as the complementarities between them may mitigate some of the adverse effects on investment of the imperfections.
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This paper is organized as follows. In the next section, we present the theoretical model underlying our study. It begins with a description of the firm's investment opportunities and we examine the investment decision of a financially constrained firm. Initially we analyze the case where the outside financing is solely debt, then the case where new equity is the only source of financing, and finally, the case where these financial instruments are optimally combined. In 33, we present the empirical part of the study by describing the data, the econometric models, and the estimation technique. The results of the estimation are then reported and interpreted. Finally, we summarize and discuss the conclusions and present avenues for further study.
[Footnote]
1 DeLong and Summers (1991) find that an extra percent of gross domestic product
(GDP) invested in equipment is associated with an increase in GDP growth of one-third of a percent per year and argue that investment causes growth. Other studies also empirically found a (positive) relationship between investment and economic growth
(see, for example, Barro 1991). Indeed, the endogenous growth literature is based on such a relationship. Levine and Renelt (1992) find the GDP investment share to be one of only a few variables that provide a robust positive correlation to growth in crosscountry regressions.
[Footnote]
2 In their empirical study, Kovenock and Phillips (1997) also emphasized that recapitalizations and investment decisions are endogenous. They examine whether capital structure decisions interact with investment decisions after controlling for product market characteristics.
[Reference]
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[Reference]
Accepted by Phelim P. Boyle; received April 2001. THis paper was with the authors 3 months for 2 revisions.
[Author Affiliation]
Rune Stenbacka * Mihkel Tombak
Swedish School of Economics and Business Administration, Helsinki, Finland Queen's
School of Business, Queen's University, Kingston, Ontario, Canada, K7L 3N6 rune.stenbacka@shh.fi * mtombak@business.queensu.ca