The Dynamics of Financing Constraints and Investor Protection
نویسنده
چکیده
This paper provides a theory to analyze the consequences of financing constraints for firm characteristics such as investment, profitability, leverage, the fraction of external equity, the probability of default and the cost of capital. This theory is based on the effects of future investment opportunities and the legal protection of investors on entrepreneurs’ incentives to divert funds to themselves at the expense of investors. In the (benchmark) one period setting, it is shown that the optimal financial contract is debt, however, in the dynamic setting, the optimal (short-term) financial contract is a combination of debt and external equity. The optimality of equity stems from entrepreneurs’ concerns regarding the financing of future investment opportunities. It is shown that future investment opportunities either discipline entrepreneurs and relax current financing constraints, or encourage entrepreneurs to divert funds and tighten current financing constraints. When financing constraints are mitigated, investment is larger, profitability is higher, a larger fraction of investment is externally financed, leverage is higher, the fraction of external equity is larger and the probability of default is higher. The analysis also has implications for the dynamics of firm characteristics over entrepreneurs’ life cycles. Household and firm level data from two independent surveys conducted in the U.S. lend empirical support to the model’s predictions. ∗I am grateful to Michael Fishman for numerous insightful discussions. I would also like to thank Kathleen Hagerty, Arvind Krishnamurthy, Deborah Lucas, Mitchell Petersen, Adriano Rampini, Artur Raviv, William Rogerson, Paola Sapienza and Annette Vissing-Jørgensen for their invaluable comments, as well as Ran Abramitzky and Daniel Cohen for their great help. †Finance department, Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 602082001. Phone(home): 847-328-2712, (office): 847-467-4551, (cellular): 847-644-2338. Email: [email protected]
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