With perfect capital markets a firm can always raise external funds to finance all the projects with a positive expected net present value. This is not possible if some imperfections are present in the financial markets. Under asymmetric information or contract incompleteness (imperfect enforceability) the moral hazard problem limits the availability of debt (Stiglitz and Weiss, 1981; Besanko and Thakor, 1986; Milde and Riley, 1988; Hart and Moore, 1998). In addition adverse selection increases equity financing costs so that they overcome expected profits of feasible investment projects (Myers and Majluf, 1984).
These theories predict that financing constraints should influence real activity both at individual and aggregate level. At the individual level, if external finance is limited, retained earnings become the main source of funds, and firm investment is a function of internal finance availability rather than of expected productivity of capital. At the aggregate level financing constraints can amplify and propagate the effects of initial real and monetary shocks, through three channels: the financial accelerator effect: constrained firms can only invest if internal finance is available. Hence at the beginning of a downturn the reduction in cash flow depresses investment (Bernanke Gertler and Gilchrist, 1996); the asset price effect: when the borrowing capacity of a firm depends on the collateral value of its assets, at the beginning of a downturn the drop in asset prices reduces borrowing and investment (Kiyotaki and Moore, 1997; Ortalo Magne’, 1997; Bernanke, Gertler and Gilchrist, 1998); the flight to quality effect: during a downturn banks increase collateral requirements, thereby reducing loans to borrowers facing financing constraints. All three effects have opposite direction during an upturn.
Recent empirical work produced a considerable evidence supporting this view. At the aggregate level, using size as a proxy for access to credit markets, it has found that small manufacturing firms experience more procyclical variation in sales, inventories, and short term debt than larger firms do (Bernanke, Gertler and Gilchrist, 1996). At the microeconomic level, empirical work is based mainly on panel data estimation technique. It shows that investment is excessively sensitive to internal finance: cash flow influences investment more than its informational content about firm’s fundamentals would predict, according to the neoclassical model with quadratic adjustment costs (Among many others see Whited (1992); Hubbard, Kashayap and Whited (1995); Jaramillo, Schiantarelli and Weiss (1996) and Gilchrist and Himmelberg (1998)).
The limit of this literature is the absence of a theoretical framework able to explain both microeconomic and aggregate evidence. On the one hand empirical work on the aggregate effects of financing constraints is based on generic considerations on which firms are more likely to be constrained and what are the likely effects of constraints. The assumption that dimension is a proxy for financing constraints is imposed rather than founded on a theory of firm behaviour at the micro level. On the other hand microeconomic analysis is based on reduced form estimation, and does not explicitly solve the dynamic investment problem of a constrained firm to derive its aggregate implications.
This paper aims to fill this gap in the literature, with a model that analyses the way financing constraints affect the choice between consumption, investment and precautionary saving for the entrepreneur of a small/medium firm. The model is solved using a numerical method, and the simulation of the investment and saving path of the firm is shown to be consistent with microeconomic empirical evidence
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