Academic journal article International Advances in Economic Research

Firm Liquidity and Investment under Uncertainty

Academic journal article International Advances in Economic Research

Firm Liquidity and Investment under Uncertainty

Article excerpt

JEL G30

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The assumption of perfect capital markets ensures that firms have access to an unlimited supply of funds at a constant cost of capital. Firm investment, in turn, depends wholly on the expected profitability of the assets in which the firm invests. Under some conditions, the separation of the firm's investment and financing decisions will persist even with market imperfections. Under other conditions, external and internal funds are not perfect substitutes, and the firm's investment and financing decisions will not be independent.

In a previous study, the author examined the impact of internal liquidity constraints on firm investment under certainty when the constraints are currently nonbinding, but will limit investment in the future. In the present paper, uncertainty is allowed, with competition imposing upper and lower bounds on output price. As with the certainty case, the analysis shows that latent liquidity constraints can affect investment policy even when current constraints are nonbinding. In an intertemporal context the firm's forward-looking behaviour anticipates future liquidity constraints, modifying investment policy for any particular period. The curve describing the evolution of the firm over time is an S-shaped Tobin's q function. It implies that a stabilizing mechanism is at work, reducing investment's sensitivity to a given change in the present value of the firm's marginal product and, hence, in internal liquidity. …

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