Effects of Financial Market Imperfections and Non-convex Adjustment Costs in the Capital Adjustment Process

In this paper, a model with both convex and non-convex capital adjustment costs is improved by incorporating financial characteristics of firms into their investment decision process. The structural parameters of this model are solved by the indirect inference method reproducing the coefficients of a reduced form investment equation where profitability shocks and the cash-flow-to-capital ratio are independent variables. The findings show that the mixed model is more successful in reproducing the coefficients of the investment equation compared to the alternative models in the investment literature. While financially unconstrained firms follow fundamentals more closely in their investment decisions, investment of financially constrained firms is highly affected by changes in their internal funds. ∗Correspondence: Department of Economics, University of Maryland, College Park, MD 20742. E-mail: [email protected]. †I am grateful to John Haltiwanger for his generous support and advice, and Plutarchos Sakellaris and to John Shea for numerous comments and suggestions. I also would like to thank Prof. Haltiwanger for sharing his simulation programs used in Cooper and Haltiwanger (2002) with me. Any errors are my own.