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The U-Shaped Investment Curve: Theory and Evidence

Published online by Cambridge University Press:  06 April 2009

Sean Cleary ,
Paul Povel  and
Michael Raith
Sean Cleary
Affiliation:
[email protected], Saint Mary's University, Sobey School of Business, Halifax, Nova Scotia, Canada B3H 3C3
Paul Povel
Affiliation:
[email protected], University of Minnesota, Carlson School of Management, Minneapolis, MN 55455
Michael Raith
Affiliation:
[email protected], University of Rochester, William E. Simon Graduate School of Business Administration, Rochester, NY 14627
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Abstract

We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 42 , Issue 1 , March 2007 , pp. 1 - 39
Copyright
Copyright © School of Business Administration, University of Washington 2007

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