The relationship between interest rates and business investment is a topic of interest in macroeconomics and corporate finance alike. In frictionless capital markets, an increase in real interest rates leads to a decline in investment because firms discount new projects at a higher cost of capital. Controlling for opportunities, changes in real interest rates affect firms symmetrically.
A major shortcoming of the frictionless view is that it pays no attention to how firms actually raise capital, or have raised capital in the past. Firms with high levels of short-term debt, or with maturing long-term debt, for example, must refinance at market interest rates, while the debt service payments of firms with long-term debt are determined by interest rates at the time of issuance.
In a perfectly efficient capital market without financing constraints, Modigliani and Miller (1958) and Stiglitz (1974) prove that the source of financing is irrelevant, and changes in the cost of capital affect all firms symmetrically. They show that investment is independent of how financing is raised: it simply equates the marginal product of capital with the risk adjusted market rate of interest. However, recent research finds support for the existence of external finance constraints, even though there is some debate as to how best to identify them (see Fazzari, Hubbard and Petersen (1988), Hoshi, Kashyap and Scharfstein (1991), Whited (1992), and Kaplan and Zingales (1997, 2000)). These papers find that an important determinant of firm investment is the relative cost of different forms of financing. Related research shows that these costs have large effects on the composition of new finance (see Baker and Wurgler (2000) for evidence on equity versus debt issues, and Baker, Greenwood, and Wurgler (2002) for evidence on the maturity structure of debt issues).
This paper advances a simple theory by which changes in the cost of debt capital affect firm inventory and fixed investment, and tests the theory using annual investment data from U.S. manufacturing firms between 1953 and 2001. Holding leverage and the maturity structure of debt fixed, the theory compares financing cash flows between firms with short- and long-term debt. When interest rates increase, firms with short-term debt or long-term debt about to retire refinance at higher interest rates, while firms financed with long-term debt continue to pay interest at the old rate. Those firms financed with short-term debt suffer a decline in net worth because the present value of their debt liabilities is unchanged while the present value of growth opportunities has declined. Thus, these firms see their balance sheet deteriorate, in contrast to firms financed with long-term debt or equity, which experience equal declines in the present value of assets and liabilities. If firms’ ability to borrow hinges on net worth, then firms with high levels of short-term debt reduce investment relative to the frictionless benchmark. I call the the interaction between maturity structure of debt and interest rates the debt market financing channel.
I test the theory by studying capital expenditure and inventory investment in a large panel of U.S. manufacturing firms between 1953 and 2001. Controlling for firm and industry-level investment determinants, I find that firms with debt retiring after increases in nominal interest rates tend to have lower investment than firms without short-term liabilities. Second, I find that within groups of firms with similar leverage, those with more short-term debt relative to long term debt decrease investment more.
The empirical results are subject to two general sets of explanations. Either financial structure causes the sensitivity of investment to interest rates, or financial structure and the response of investment to interest rates are jointly determined by another factor. In the latter explanation, unanticipated cash flows arising from past financing decisions have no influence on future investment. This implies that the high investment-interest rate sensitivity I detect among firms with short-term debt that I attribute to financing constraints— must be due to mismeasurement of what investment would have been if these firms had been financed in a different way in the past. It is possible, for example, that the maturity structure of debt is chosen by firms to be optimal in the face of changing business conditions. In other words, firms choose short-term debt because they anticipate reducing desired investment when interest rates go up.
In my paper, concerns about endogeneity are mitigated by a number of factors. First, I study the effect of unanticipated changes in nominal interest rates on investment. This means that differentials in cash flows arising from past maturity structure decisions are unanticipated. Second, the basic results hold when I focus on the much narrower maturity measure which excludes short-term debt and studies only the fraction of long-term debt due to retire. Thus ignoring short-term debt entirely, I find that firms with relatively large current portions of long term debt reduce investment more after increases in nominal interest rates. Third, I attempt to control for the endogeneity of maturity structure by doing two-stage regressions, in which I first estimate the determinants of corporate debt maturity (following Barclay and Smith (1995)), and then estimate the sensitivity of investment to changes in nominal interest rates, sorting firms based on deviations from optimal debt maturity. Finally, in robustness checks, I control for industry-year-level determinants of investment and maturity structure. Since most theories of maturity structure predict similar maturity schedules for firms in the same industry, these controls capture a large amount of endogenous variation in the financing variables.
The results in this paper are consistent with the well-established balance sheet channel of monetary policy (Bernanke and Blinder (1995), Bernanke, Gertler and Gilchrist (1996)). Broadly defined, this theory asserts that changes in credit market conditions arising from monetary policy may be accelerated by changes in the financial position of firms, which in turn affect firms’ investment and spending decisions. The balance sheet channel has been used to explain several features of economic activity not captured by rational business cycle models, such as differences in the performance of large and small firms during recessions. I depart from their framework because I do not attempt to identify the source of variation in interest rates and instead focus narrowly on the differential in financing cash flows between firms with different debt maturity schedules. Nevertheless, the results in this paper have implications for monetary policy and business cycle analysis.
My results also complement recent research in corporate finance that finds that fixed investment may depend on the cost of equity finance through a financing channel (Bosworth (1975), Morck, Shleifer and Vishny (1990), Blanchard, Rhee and Summers (1993) and in particular Stein (1996)). Baker, Stein and Wurgler (2002) find that the investment of firms that rely on equity finance is more sensitive to Tobin’s Q than firms without financial constraints.
The paper proceeds as follows. The next section describes a model of investment when a portion of debt is due for refinancing. Section III describes the data. Section IV analyzes firm investment and debt maturity structure during the 1982 recession, an episode during which both nominal and real interest rates were abnormally high. Section V presents the empirical results on a large panel of firms between 1953 and 2001. Section VI examines alternative hypotheses. Section VII concludes.
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