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June 30, 1989

Corporate Investment
There is currently widespread belief that the level
of economic activity in the U.S. has outstripped
productive capacity and risks an acceleration in
inflation. To reduce inflationary pressures, many
argue, some slackening in the pace of economic
activity is necessary. In this regard, recent signs
of a slowing economy could prove beneficial.
But there is a debate concerning just how much
slowing is necessary.
The rate of corporate investment plays a critical
role in this debate. Corporate investment is an
important determinant of the economy's productive capacity. In recent years, the rate of corporate investment has been more rapid than most
traditional models had forecast, suggesting perhaps that the economy's productive capacity has
reached a higher level.
This Letter discusses the traditional model of
investment, as well as some recent research that
assumes corporations face financial market incentives (or disincentives) to invest that are not
considered in the traditional analysis. Empirical
evidence suggests that these financial market
incentives are significant and, when included in
a model of corporate investment, raise predicted
rates of investment.

Traditional investment theory
In most traditional models of corporate investment, individual firms undertake capital spending to maximize the value of their equity shares.
Whenever new investment will raise the market
value of a firm's equity, it has an incentive to
proceed with the project.
Whether new investment will increase a firm's
value, however, depends on the costs of the
capital goods themselves and any additional
costs associated with installing new equipment
and building new plants. These additional costs
include lost output from disrupting production
lines, retraining workers, and/or adopting new
management procedures. By balancing the benefits of new investment against these costs, this
traditional framework describes investment as a

gradual response over time to changes in the
stimulus to invest.
This framework is the basis for two popular
models of corporate investment. The first, the
neoclassical model, describes investment as a
function of the "user cost" of new capital equipment. This cost includes the price of the equipment, taxes that affect that price, and a measure
of the opportunity cost of funds in the form of a
market interest rate.
The second popular investment model is called
the "q-theory" of investment. In this model,
investment depends on the value the market
places on the expected stream of earnings generated by new capital equipment. If the discounted
expected value of this stream of earnings exceeds
the cost of installing the new equipment, the firm
will choose to invest. Since the market value of
this new stream of earnings is not observable,
empirical applications of this model describe
investment as a function of the ratio of a given
firm's total market value to the replacement cost
of its existing capital stock. This ratio of market
value to replacement cost was dubbed "q" by
James Tobin, who developed the theory, and provides a proxy for the premium that markets place
on newly-installed equipment. Investment will
take place when this ratio exceeds one.

Financial factors
In both of these models, the decision to invest in
a given project typically is determined separately
from the choice of how to finance that project.
Although some of these models include the mar=
ket interest rate among their explanatory variables, the yields required by a firm's creditors and
shareholders do not depend on the individual
firm's investment and financing policies.
The main reason for this separation is the
assumption that financial markets are perfect.
A perfect capital market is one in which information is costlessly available to all market participants and in which there are no transactions
costs or other factors that might cause the costs

of various financing methods to differ. In this
setting, all financing alternatives entail the same
costs; that is, the choice of raising funds through
retaining earnings, issuing new equity, or borrowing is irrelevant as far as investment decisions are

chooses both its level of investment and how it
will finance that investment, either through retained earnings or increased borrowing. Because
increasing leverage poses increasing risk of loss
for investors, the interest rate at which the firm
can borrow depends positively on firm lev~rage.

If, however, information is costly to obtain, or
is only available to certain agents, or if taxes or
transactions costs drive a wedge between the
costs of different methods of finance, then investment and financing decisions may interact.
As a result, factors that create financial market
imperfections may influence the level of corporate investment in ways that are not captured by
traditional models.

At the same time, because lenders may find it
relatively less costly to monitor larger firms, the
interest rate also will depend negatively on firm
size, which, in turn, depends on current and past
investment. These larger firms are rewarded with
lower interest rates. Reduced costs of borrowing
then feed back as an additional, financial
stimulus to investment.

One important line of research suggests that
information may not be readily available to all
marketparticipants. Forexample, a borrowing
firm may have better information than do potential creditors concerning the expected payoffs of
different investment projects. Faced with such
information "asymmetries;' lenders may write
restrictive covenants. into debt contracts to prevent borrowers from engaging in behavior that
diminishes the lenders' chances of being repaid.
The costs of complying and monitoring compliance with these covenants represent "agency
costs;' which tend to reduce the investment
choices available to firms and lead them to
forego certai n projects that otherwise would .be
Other financial market imperfections are introduced by the U.S. tax code, which treats debt
and equity finance differently, making interest
payments tax deductible, but double taxing divi·
dend payments. As a result, the after-tax cost of
an investment project depends on how that
project is financed.
These are merely two examples of the way
financing decisions might affect real investment
decisions. It is likely that many firms face financial constraints that arise from such market
imperfections. Economists only recently have
begun to explore the interaction between real
investment and corp~ratefinancingbehavior.

One implication of this approach is that changes
in tax policy may have a somewhat different impact on investment than previously assumed. For
example, a reduction in corporate tax rates generally is believed to provide an unambiguous
stimulus to investment by reducing the effective
cost of capital equipment. This tax reduction,
however, also reduces the incentive to borrow
(by reducing the value of the interest deduction).
Efforts by firms to scale back borrowing in response, then, reduce the size of the investment
stimulus that results from the tax-rate reduction.

Empirical findings
To test whether capital market imperfections
influence investment, I estimated a modified
q-theory model over the period from 1953 to
1986. This model captures the traditional explanation of investment by identifying an important role for Tobin's q ratio. But it extends
the traditional investment theory by including an
additional term that reflects the influence of capital market imperfections. The sign on this added
term depends on the relative effects of firm leverage and size on market interest rates.
The empirical results indicate that, in general,
size effects on interest rates dominate leverage
effects. That is, investing (and borrowing) firms
are rewarded relatively more for becoming larger
than they are penalized for assuming more debt.
As a result, capital market imperfections, as they
are implemented in this model, provide an additional stimulus to investment.

A new model of investment
I have developed a model which attempts to
explain investment in an environment of imperfect capital markets. In this model, a firm

Thus, this framework predicts levels of investment during the 1980s that are 10 percent higher
than the traditional model and much closer to


the actual values observed during this period.
Many economists have expressed surprise during
the last few years at the relative strength of
investment spending. This model suggests that
previously ignored financial market imperfections may explain some of the difference.
Moreover, the extended model yields significantly better predictions of investment spending
than the traditional q-theory framework. During
the sample period, prediction errors (measured
by root mean squared errors) are reduced by
one-third by incorporating capital market

After seven years of economic expansion, U.S.
and other industrial economies are approaching
historically high levels of capacity utilization.
There is widespread belief today that such intense usage of productive capacity is a signal
that the economy is approaching significant constraints on supply. Efforts to sustain rapid economic growth in the face of these constraints,
they argue, will produce an overheated economy
and lead to rising rates of inflation. Signs of rising
prices and wages are cited as evidence.
Furthermore, a number of economists have
suggested that there is a maximum rate of real
economic growth that can be sustained without
raising the rate of inflation. The number most
frequently mentioned is 2.5 percent. With the
economy currently operating at full capacity or
beyond, any rate of real growth higher than this,
analysts claim, will awaken inflationary pressures
in the econbmy.
The research described here is important
because investment spending increases the economy's productive capacity. When economists cite
2.5 percent as the maximum rate of real growth
that can be achieved without raising the rate of
inflation, they assume that investment takes place
at the historical average rate. These predictions
implicitly may rely, however, on the traditional
model of investment that ignores the influence of
financial market imperfections. The traditional

model, in particular, will fail to capture investment incentives that arise from changes in the
financial behavior of corporations.
These is evidence to suggest that corporations
have indeed altered their borrowing behavior in
the 1980s. Since the recession in 1981, corporate
leverage has increased dramatically to its highest
levels in the postwar period. The rate of change
in leverage is even more striking. Beginning in
1983, the apparent willingness of corporations to
take on additional debt increased in a statis.
tically significant way. This increased willingness
to borrow feeds through the investment equation
described here and translates into higher levels
of investment.
My research thus indicates that if current corporate financial behavior persists, investment
may respond more strongly to investment stimuli
than previously. During the 1980s, for a given
level of the traditional determinants of investment, the imperfect capital market model predicts approximately 10 percent more investment.
If spending on plant and equipment responds
more strongly to a particular investment stimulus,
then productive capacity may grow faster than
previously expected. Higher growth in capacity,
in turn, may make it possible for the economy to
sustain more rapid real output growth without
confronting major supply constraints.
While we do not yet know how fast the economy
can grow without producing a rising rate of inflation, the analysis described here suggests that
the number may be higher than the 2.5 percent
rate of growth commonly mentioned. At the very
least, considerable work remains to be done in
understanding the numerous influences that affect corporate investment and, thus, real growth.
Policies aimed at enhancing financial incentives
may prove particularly fruitful in permitting the
to continue its long-running economic expansion without experiencing higher inflation.


Jonathan A. Neuberger

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San Francisco, or of the Board of Governors of the Federal Reserve System.
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