How important are financial constraints, adjustment costs and uncertainty in understanding the aggregate rate of investment in the real world?

Investment makes a great contribution to economic growth, as investment and GDP have a positive relationship (Zou, 2006). Investment can be defined as the purchase of assets with the goal to generate income in the future (Hayes, 2021). Thus, it is relevant to identify the determinants which affect  the  aggregate  rate  of  investment  in  the  economy  in  order  to  understand  the  dynamics underpinning investment and investment decisions.

This paper will examine the importance of uncertainty, adjustment costs and financial constraints in explaining the rate of investment in the real world.

Uncertainty can be divided into two distinct categories: idiosyncratic uncertainty on the one hand, which relates to the firm’s specific uncertainty and aggregate uncertainty on the other hand, referring to uncertainty on the macroeconomic level (Cassimon et al., 2002). This paper will focus on the latter, as we aim to identify the effect of uncertainty on the aggregate rate of investment.

The traditional method of assessing whether an investment should be undertaken or not is the NPV principle (Carruth et al., 2000). This principle implies that an agent will only invest if the present value of future earnings is greater or equal to the cost of investing. However, in the presence of uncertainty, this principle is no longer applicable as the size of the wedge between the cost and revenues becomes larger as the uncertainty about future returns increases (Carruth et al., 2000). This mechanism will therefore increase the threshold at which investment will be triggered (Carruth et al., 2000).

Uncertainty proxies can be constructed through a variety of different approaches, such as measures of risk, volatility of price levels or profitability of capital among others (Carruth et al., 2000). Leading to a lack of consensus about the best approach.

Cassimon et al. (2002) collected data for 462 Belgian manufacturing companies for ten years and conducted a research on the effect of uncertainty on investment by using the 4-year-variance of profitability as a proxy for uncertainty. Their findings suggest that there is a negative relationship between uncertainty and the probability to invest in a project with a higher degree of irreversibility. By irreversibility, we mean that the incurred cost may not be recovered after the investment takes place (Carruth et al., 2000).  However, surprisingly, Cassimon et al. found that  under a  reversible investment condition, the  relationship  between the amount  invested and  uncertainty is  positive. Meaning that  a  higher  level of  uncertainty will  increase the  amount  invested  by the firm  if the investment can easily be reversed. These findings go in line with the results found by Leahy and Whited (1996) who focused on the data of 600 US manufacturing firms over a 6-year period and used the variance in the daily share return as a proxy for uncertainty (Carruth et al., 2000). The similarities in findings of both researches highlight the critical role of irreversibility in the investment process.

However, the impact of uncertainty on investment differs drastically between different industries and across groups of firms due to the differences in the nature of secondary markets for capital equipment (Carruth et al., 2000). Often, capital goods can be sold below the purchasing price in these secondary markets, leading to a degree of partial irreversibility (Bigsten, 1999).

The combination of uncertainty and irreversibility often leads firms to delay their investment until further information about the future becomes available (Cassimon et al., 2002). This could be the case for example during an aggregate demand shock, where firms would delay their investment to figure out if the shock is transitory or permanent (Carruth et al., 2000).

Irreversibility can also be considered as a form of adjustment cost (Carruth et al., 2000) as it contributes to delaying investments which implies risk and foregone profits.

We can distinguish two different forms of adjustment costs:  (i)  Fixed disruption costs, which are related to the downtime in the production process when new capital is added, leading to a loss of output and (ii) Quadratic adjustment costs, which relate to the higher costs associated with rapid changes (Bloom et al., 2006). But opportunity costs and forgone outputs are likely to account for the largest share of adjustment costs (Bigsten, 1999).

On a firm’s microeconomic level, these costs could be incurred by the instalment of new capital stock, training of employees or research about pieces of equipment. However, one could argue that these adjustment costs differ significantly between countries. Indeed, according to Bigsten, these costs are drastically higher for developing countries as they face a different cost structure than firms located in industrialized countries (Bigsten, 1999).

The traditional model of investment was developed by Tobin and implies a positive linear relationship between investment and the Q ratio (Carruth et al., 2000). This ratio considers the firm’s market value of installed capital over the replacement cost of this installed capital (Schiantarelli, 1996). Meaning that when Q is above 1, the firm should invest and vice versa.

However, when we account for adjustment costs, the assumption that the  relationship  between investment and Q is linear will no longer hold (Carruth et al., 2000). This is because firms do not immediately adjust their investment levels for small changes in Q, which leads to a range where the optimal rate of investment is zero due to an insensitivity to changes in Q (Carruth et al., 2000). This occurs  because  returns  are too  small to trigger  either  investment  or  disinvestment  (Ibid).  Such conclusions suggest that firms will wait before adjusting to exogeneous shocks, leading to lumpy and infrequent investments (Bigsten, 1999). This statement goes in line with Doms’s and Dunne’s findings (1997), who  used  a  17-year data of  13,000  US  manufacturing firms to test this  relationship and empirically found that a large portion of a firm’s investment over the 17-year period is concentrated in a single year (Bigsten, 1999). Moreover, a majority of the 13,000 firms experiences a minimum capital growth of 37% in a single year (Ibid).

Furthermore, financial constraints can also impact the rate of aggregate investment. While it is widely assumed that in corporate finance, external finance is more expensive than internal finance, due to the interest rate of borrowing (Bond & Meghir, 1994). We shall see through which mechanisms this cost affects aggregate investment.

Data from US and UK companies shows that internal finance is to a wide extent preferred, as around 70% of investments are financed from retained earnings (Bond & Meghir, 1994). This is because firms have  access to  external  finance  but  at  a  higher  cost  and  this  cost  of  borrowing  has  a  positive relationship with the level of borrowing, to protect the lender against a risk of default (Ibid). This is the result of asymmetric information between insiders and outside investors, who consequently ask for a premium to compensate for the risk (Ibid). The level of internal finance can be measured by the firm’s cash flow, as it is made of the firm’s after-tax profit and depreciation (Guariglia, 2008).

In order to test this relationship, Guariglia (2008) undertook research to measure the firms’ sensitivity of investment to cash flow using a panel data of 24184 UK unquoted firms between 1993 and 2003. The standard Q model being criticised for not taking into account constraints and associated costs (Schiantarelli, 1996), Guariglia used an error-correction specification to overcome these criticisms. She argues that using unquoted firms’ data will produce more relevant findings as they tend to face greater constraints than large firms quoted on the stock market (Ibid). The research’s findings suggest that an increase of 10% in cash flow increases the investment by 1.21%, which also means that a drop in cash flow leads to a drop in investment (Ibid). This research also revealed a U-shaped relationship between investment and cash flow. Guariglia suggests that this relationship could be due to firms wanting to avoid an increase in costs associated with borrowing, repayment or higher risk if the investments were unchanged.

In addition, when considering both internal and external financial constraints, firms that have a high level of internal finance but are externally constrained, are those which face the highest levels of sensitivity to cash flow (Ibid). Financial constraints could only be eliminated if debts would be a perfect substitute for retained earnings (Bond & Meghir, 1994).

To conclude, this paper went through three determinants that affect the level of aggregate investment.  Uncertainty,  when  combined  with  irreversibility,  has  a  negative  relationship  with investment as it increases the threshold at which investment will be triggered. Moreover, adjustment costs lead to a non-linear relationship between Q and investment, which leads to a range where the optimal investment rate is zero despite variations in Q. Lastly, we saw how the level of cash flow is relevant to the investment decisions when firms face external financial constraints. If the debate is to be moved further, one could identify and analyse additional determinants which affect the rate of aggregate investment in the real world.