Corporate managers in the US and Europe claim that maintaining "financial flexibility" is the primary objective of their firms' financial policies (see Graham and Harvey (2001) and Banceland Mittoo (2002)). Their stated policies are consistent with the goal of ensuring funding for present and future investment undertakings in a world where financing frictions force fir ms to pas sup profitable opportunities. In spite of those assertions, empirical work on capital structure often ignores much of the interplay between corporate investment and financing decisions.
Most recent papers take investment as exogenous to financial policy, and focus on issues such as the relative costs of issuing debt versus equity (e.g., Shyam-Sunder and Myers (1999) and Fa ma and French (2002, 2005)), market timing (Baker and Wurgler (2002)), security return dynamics (Welch (2004)), and the relevance of elements of the tradeoff theory; taxes and financial distress costs (Hovakimianetal. (2001)). While these issues are undoubtedly important for our understanding of corporate financial policies, the literature often abstracts from crucial aspects influencing the supply and demand for external funds across firms: capital market imperfections and real investment demand.
In this paper we study the implications of investment financing interactions for external financing decisions. To understand those interactions, we focus on one of the key stylized facts of the empirical capital structure literature, namely the finding that more profitable firms demand less external finance. In contrast to the extant literature (e.g., Myers (1993) and Fa ma and French (2002)), we argue that this finding should not be interpreted as evidence for external financing costs arising from asymmetric information (à la pecking order theory).
Our main argument is simple. If the negative relation between internal funds and the demand for external financing is due to external financing costs, then this relationship should be more strongly negative in situations in which financing costs are high. Remarkably, we show new, robust evidence that this negative relationship is concentrated among firms that are least likely to face strong financing frictions. While this finding might seem puzzling, we argue that it can be understood once we incorporate the effects of endogenous investment on external financing decisions.
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Financing Frictions and the Substitution Between Internal and External Funds
