Ebook Investment and the Cost of Capital: New Evidence from the Corporate Bond Market
The notion that business spending on fixed capital falls when interest rates rise is a the oretically unambiguous relationship that lies at the heart of the monetary transmission mechanism. Nevertheless, the presence of a robust negative relationship between investment expenditures and real interest rates or the user cost of capital more generally has been surprisingly difficult to document in actual data (e.g., Abel and Blanchard [1986] and Schaller [2006]).
Similarly, the magnitude of the response of investment to changes in corporate tax policies is a key parameter that fiscal policy makers rely on when weighing the costs and benefits of altering the tax code. With the exception of Cummins, Hassett, and Hubbard [1994], whose methodology utilizes firm-level variation in investment expenditures within a context of a “natural” experiment, researchers have had a difficult time identifying the relationship between capital formation and changes in corporate tax policy (e.g., Schaller [2006] and Chirinko, Fazzari, and Meyer [1999, 2004]).
The empirical difficulties associated with estimating the effects of changes in interest rates and corporate tax policies on business fixed investment are often blamed on a lack of identification. At the macroeconomic level in particular, long-term interest rates (through monetary policy actions) and corporate tax obligations (through investment tax credits or partial expensing allowances) are often lowered when investment spending is weak. In the extreme, the endogeneity between both monetary and fiscal policy actions and the macroeconomy may result in a positive relationship between investment expenditures and the user cost of capital.
In this paper, we revisit this apparent and long-standing empirical anomaly. We do so by constructing a new data set that links income and balance sheet information for about 900 large U.S. nonfinancial corporations to interest rates on their publicly-traded debt. Covering the last three decades, this new data set enables us to evaluate and to quantify empirically the relationship between firms’ investment decisions and fluctuations in the firm-specific user cost of capital based on marginal financing costs as measured by the changes in secondary market prices of firms’ outstanding bonds. Our results indicate that investment spending is highly sensitive both economically and statistically to movements in the firm specific measure of the user cost of capital. The sensitivity of capital formation to changes in the user cost is robust to the inclusion of various measures of investment opportunities emphasized by frictionless neoclassical models and to an estimation approach that controls for the potential endogeneity between investment and financial policy at the firm level.
The remainder of the paper is organized as follows. In Section 2, we provide a brief overview of the user cost framework and review the evidence at both the macro and micro levels on the link between financing costs and investment spending. Section 3 describes our new data set and highlights its key feature. Section 4 outlines our panel-data econometric methodology, and Section 5 presents our benchmark results. In Section 6, we consider an alternative estimation approach that addresses the potential endogeneity between interest rates and investment decisions at the firm level. This approach involves constructing an instrument for the user cost of capital that explicitly controls for firm-specific expected default risk using both option-theoretic measures of default probabilities and external credit ratings of firms’ debt. Section 7 concludes.
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