External financing

Abstract: This paper considers a firm that must issue common stock to raise cash to undertake a valuable investment opportunity. Management is assumed to know more about the firm's value than potential investors. Investors interpret the firm's actions rationally. An equilibrium model of the issue-invest decision is developed under these assumptions.The model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities.The model suggests explanations for several aspects of corporate financing behavior, including the tendency to rely on internal sources of funds, and to prefer debt to equity if external financing is required. Extensions and applications of the model are discussed.

Abstract: We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity-dependent firms.

Abstract: This paper contrasts the "static tradeoff" and "pecking order" theories of capital structure choice by corporations. In the static tradeoff theory, optimal capital structure is reached when the tax advantage to borrowing is balanced, at the margin, by costs of financial distress. In the pecking order theory, firms preferinternal to external funds, and debt to equity if external funds are needed. Thus the debt ratio reflects the cumulative requirement for external financing. Pecking order behavior follows from simple asymmetric information models. The paper closes with a review of empirical evidence relevant to the two theories.

Abstract: We investigate how differences in legal and financial systems affect firms' use of external financing to fund growth. We show that in countries whose legal systems score high on an efficiency index, a greater proportion of firms use long-term external financing. An active, though not necessarily large, stock market and a large banking sector are also associated with externally financed firm growth. The increased reliance on external financing occurs in part because established firms in countries with well-functioning institutions have lower profit rates. Government subsidies to industry do not increase the proportion of firms relying on external financing. THE CORPORATE FINANCE LITERATURE suggests that market imperfections, caused by conflicts of interest and informational asymmetries between corporate insiders and investors, constrain firms in their ability to fund investment projects. The magnitude of these imperfections depends in part on the effectiveness of the legal and financial systems. Because these systems differ across countries, the literature implies that there should exist systematic cross-country differences in firms' ability to obtain external capital to finance investment. In this paper, we examine whether the underdevelopment of legal and financial systems does prevent firms in some countries from investing in potentially profitable growth opportunities. In particular, we focus on the use of long-term debt or external equity to fund growth (see our earlier work, Demirgut-Kunt and Maksimovic (1996a), which compares firms' financial structures in developed and developing countries and finds the greatest difference to be in the provision of long-term credit). We estimate a financial planning model to obtain the maximum growth rate that each firm in our thirty-country sample could attain without access to long-term financing. We then compare these predicted growth rates to growth rates realized by firms in countries with differing degrees of development in their legal and financial systems. Our approach enables us to identify specific characteristics of the legal and financial systems that are associated with long-term financing of firm growth. Thus, we provide a micro-level test of the hypoth