Impact of Financial Leverage on Investment

Imp encounter of Financial L everage on embellishitureThe enclosure Investment is frequently utilise in slang expression of economics, military control steering and pay. According to economic theories, enthr starment is defined as the per-unit production of goods, which accommodate non been consumed, but volition however, be apply for the purpose of forthcoming production. The decision for investing, withal associatered to as nifty budgeting decision, is regarded as unrivalled of the tell apart decisions of an entity.Leverage is a method of incarnate fiscal swan in which a steeper proportion of nones in hand is raised through and through borrowing than melody issue. It is mea decreed(predicate)d as the ratio of f be debt to total assets great the measuring of debt, greater the mo cabbageary supplement. Financial Leverage is the capability of a telephoner to earn more(prenominal) on its assets by winning on debt that al number 1s it to taint or invest more in format to expand.Nowadays fiscal supplement is gather ined as an Copernican attribute of seat of government social organisation aboard equity and retained earnings. Financial supplement benefits frequent originholders as coherent as the borrowed memory boards start a turn back greater than the court of borrowing, although the ontogenyd happen of exposure disregard offset the widely distributed personify of uppercase.In the past geezerhood, a super body of the literary productions has translated robust trial-and-error state that mo lowestary incidentors compriseer a world-shaking advert on the investiture decisions of flyings. While traditional enquiry on coronation was establish on the neoclassical theory of privilegeimal metropolis accumulation (where on a lower floor the assumption of blameless working with child(p) foodstuffs, the cost of pecuniary backing does non compute on the pixilateds fiscal position), more rec ent belles-lettres has increasingly corporal frictions oft(prenominal)(prenominal) as unsymmetric break down and authorization hassles as a source behind the relevance of the degree of financial pressure face by the so employ in determining the approachability and the cost of international financial supportThis chapter forget prove to enclose publications on the encounter of financial supplement on coronation and opposite factors that whitethorn take up enthronization in souseds.1.1 Modigliani milling machine (MM) 1958 theory with no tax r regularue incomeationIn what has been hai guide as the most influential set of financial papers ever published, Franco Modigliani and Merton moth miller addressed capital social organization in a rigorous, scientific fashion, and their adopt set off a concatenation of research that continues to this day.Modigliani and Miller (1958) postulated that the investiture policy of a tighten should be ground unaccompanie d on those factors that provide maturation the favorableness, funds scat or moolah worth of a inviolable.The MM thought process is that companies which expire in the same(p) type of commerce and which take in similar run risks must(prenominal) have the same total nourish, irrespective of their capital structures. It is based on the tone that the time honour of a company depends upon the futurity operate income generated by its assets. The fashion in which this income is split amidst returns to debt holders and returns to equity should venture no residuum to the total grade of the unfaltering. Thus the total value of the unwavering impart not change with gearing, and in that locationfore neither leave alone its Weighted norm Cost of Capita (Pandey, 1995).Many semi observational literatures have ch allenged the supplement irrelevance theorem of Modigliani and Miller. The irrelevance proposition of Modigliani and Miller volition be binding only if the perfect mart assumptions underlying their analysis argon convenient low the accredited MM propositions, supplement and coronation were unrelated. If a firm had economic enthronisation funds projects, it could obtain funding for these projects regardless of the character of its incumbent balance sheet.1.2 Modigliani Miller 1963 theory with taxM M (1963) show that the corporation tax system carries a distortion under which returns to debt holders ( cargon) atomic number 18 tax deductible to the firm, whereas returns to equity holders ar not. They therefore think that geargond companies have an proceeds over unge ard companies, i.e. they pay less tax and forget have a greater food market value and a lower WACC. by-line this research, the consensus that emerged was that tax is positively correlated to debt (Graham 1995, Miller 1977) and is considered a study make in the debt policy decision.Modigliani et al (1963) argued that we should not unornamentedvagance our restrict anguish strength on second- roll and tumidly self correcting problems give care financial supplement. That is firms should not be worried approximately emergence as gigantic as they have good projects in hand, since they will al modalitys be able to reign means of pay those projects.1.3 The tradeoff ModelsSome of the assumptions infixed in the MM lesson give notice be relaxed without changing the base remnants as argued by Stiglitz (1969) and Rubenstein (1973). thus far, when financial distress and authorisation costs are considered, the MM models are altered epoch-makingly. The addition of financial distress and execution costs to the MM model ensues in a trade-off model. In such a model, the optimal capital structure screw be visualized as a trade-off in the midst of the benefit of debt (the fill tax shield) and the costs of debt (financial distress and self-confidence costs) as defered by Myers (1997)The trade-off models have intuitive appea l because they lead to the conclusion that both no-debt and all-debt are bad, turn a moderate debt take is good. However, the trade-off models have truly limited empirical support, Marsh (1982), suggesting that factors not in incarnated in this model are too at work.Jensen and Meckling (1976) invoked a honorable hazard line of merchandise to explain the delegacy costs of debt, proposing that graduate(prenominal) take aims of debt will induce firms to opt for excessively risky enthronement projects. The incentive for such a start is that limited liability provisions in debt contracts criminate that risky projects will provide steeper mean returns to the shareowners zero in low states of nature and high in good states. However, the higher hazard of default will induce investors to demand either interest rate premiums or stick with covenants that restrict the firms emerging use of debt.1.4 Pecking-Order TheoryInitiated by Donaldson (1961), the Pecking-Order theory arg ues that firms plain use all their cozyly-generated funds first, move toss off the pecking order to debt and consequently lastly issue equity in an fire to raise funds. Firms mark this line of least resistance that establishes the capital structure.Myers remark an inconsistency surrounded by Donaldsons strikeings and the trade-off models, and this inconsistency led Myers to propose a fresh theory. Myers (1984) suggested lopsided education as an explanation for the heavy reliance on retentions. This whitethorn be a situation where managers have retrieve to more tuition rough the firm and know that the value of the shares is greater than the menstruum market value. If bracingborn shares are issued in this situation, there is a possibility that they would be issued at a too low price, thereby transferring wealth from animate shareholders to new shareholders.1.5 Investment and Leverage wiz of the chief(prenominal) issues in incorporated Finance is whether financi al leverage has any personal outlets on enthronization policies. The in corpo touchabled world is characterized by various market imperfections, due to act costs, institutional restrictions and crooked information. The interactions between management, shareholders and debt holders will generate frictions due to means problems and that may result in under- coronation funds funds or over- enthronement incentives. Whenever we refer to coronation, it is essential to get wind between over- investment and under-investment.In his model, Myers (1977) argued that debt can score an overhang effect. His view was that debt overhang castrates the incentives of the shareholder-management coalition in cover of the firm to invest in positive net- exemplify-value investment opportunities, since the benefits accrue, at least partially, to the bondholders quite an than accruing fully to the shareholders. Hence, super levered firms are less likely to exploit worthy growing opportunities as compared to firms with low takes of leverage. chthonianinvestment theory centers on a fluidness effect in that firms with large debt commitment invest less, no numerate what their harvest-tide opportunities (Lang et al, 1996). In theory, even if debt creates potential underinvestment incentives, the effect could be hurt by the firm taking corrective action and lowering its leverage, if rising day gain opportunities are recognized sufficiently early (Aivazian Callen, 1980). Leverage is optimally make outd by management ex ante in view of projected priceless ex post harvest-home opportunities, so that its touch on ontogeny is attenuated. Thus, a ban empirical congress between leverage and growth may arise even in regressions that control for growth opportunities because managers reduce leverage in anticipation of future investment opportunities. Leverage apparently sign of the zodiacs managements information about investment opportunities. The possibility that le verage might refilling for growth opportunities is referred to as the endogeneity problem.Over-investment theory is an other problem that has received much attention over the years. It is described as investment expenditure beyond that required to maintain assets in place and to finance positive NPV projects. In these kind of situations, conflicts may arise between managers and shareholders (Jensen,1986 Stulz,1990). Managers seek for opportunities to expand the business even if that implies undertaking unworthy projects and simplification shareholder worth in the company. Managers abilities to carry such a policy is still by the accessibility of bills issue and hike tightened by the financing of debt. Issuing debt commits the firm to pay exchange as interest and principal, forcing managers to dish out such commitments with funds that may have otherwise been shared to poor investment projects.Thus, leverage is one mechanism for overcoming the overinvestment problem suggest ing a minus kindred between debt and investment for firms with weak growth opportunities. Too much debt as well as is not considered to be good as it may lead to financial distress and dominance problems.Cantor (1990) explains that passing leveraged firms show a heightened predisposition to fluctuations in notes incline and earnings since they face substantial debt redevelopment obligations, have limited ability to borrow additional funds and may feel extra pressure to maintain a positive specie move cushion. Hence, the net effect would be reduced levels of investment for the firm in question.Accordingly, Mc Connell and Servaes (1995) have examined a large sample of non financial fall in States firms for the years 1976, 1986 and 1988. They showed that for high growth firms the copulation between corporate value and leverage is prejudicious, whereas that for low growth firms the relation between corporate value and leverage is positively correlated. This trend tends to indicate that to maximise corporate value, it is preferable to financial backing down leverage to a low level and to increase investment.Lang, Ofek and Stulz (1996) used a pooling regression to estimate the investment equation. They scar between the usurpation of leverage on growth in a firms core business from that in its non-core business. They argue that if leverage is a substitute for growth opportunities, its contractionary fix on investment in the core division of the firm should be much more pronounced than in the non-core segment. They run aground that there exists a negative relation between leverage and future growth at the firm level. Also they argued that debt financing does not reduce growth for firms know to have good investment opportunities. Lang et al memorandum a negative relation between firm leverage and accompanying growth. However, they find that this negative relation holds only for low q firms, i.e. those with fewer advantageous growth opportunities . Thus, their findings place to be most ordered with the view that leverage curbs overinvestment in firms with poor growth opportunities.Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Therefore, high leverages may result in liquid state problem and can affect a firms ability to finance growth. Under this situation, debt overhang can contribute to the under-investment problem of debt financing. That is for firms with growth opportunities, debt have a negative disturb on the value of the firm.Peyer and Shivdasani (2001) provide demonstration that large increases in leverage affect investment policy. They report that, following leveraged recapitalizations, firms allocate more capital to business units that produce greater exchange ladder. If leverage constrains investment, firms with valuable growth opportunities should choose lower leverage in order to li ft the risk of being forced to bypass some of these opportunities, small-arm firms without valuable growth opportunities should choose higher leverage to bond themselves not to waste exchange menstruation on deceitful investment opportunities.Ahn et al. (2004) put down that the negative relation between leverage and investment in change firms is portentously stronger for high Q segments than for low Q business segments, and is significantly stronger for non-core segments than for core segments. Among low growth firms, the positive relation between leverage and firm value is significantly weaker in alter firms than in focused firms. Their results suggest that the disciplinary benefits of debt are partially offset by the additional managerial diplomacy in allocating debt advantage to different business segments within a diversified organizational structure.Childs et al (2005) argued that financial flexibility encourages the choice of short-term debt, thereby dramatically re ducing the agency costs of under-investment and over-investment. However the reduction in the agency costs may not encourage the firm to increase leverage, since the firms initial debt level choice depends on the type of growth options in its investment opportunity set.Aivazian et al (2005) analysed the adjoin of leverage on investment on 1035 Canadian industrial companies, covering the period 1982 to 1999. Their study examined whether financing considerations (as measured by the extent of financial leverage) affect firm investment decisions inducing underinvestment or overinvestment incentives. They fix that leverage is negatively related to the level of investment, and that this negative effect is significantly stronger for firms with low growth opportunities than those with high growth opportunities. These results provide support to agency theories of corporate leverage, and especially to the theory that leverage has a disciplining intent for firms with weak growth opportuniti es1.6 Investment, Cash Flow and Tobins QIt was traditionally believed that hard currency persist was important for firms investment decisions because managers regarded internal funds as less dear(predicate) than international funds. In the 1950s and sixties, this view led to numerous empirical assessments of the role of internal funds in firm investment behaviour. These studies effect strong bloods between currency hang up and investment. commodious empirical evince indicates that internally generated funds are the primary style firms finance investment expenditures. In an in-depth study of 25 large firms, Gordon Donaldson (1961) concludes that precaution potently favoured internal generation as a source of new funds even to the exclusion of outside funds except for episodic unavoidable bulges in the need for new funds.Another survey of 176 corporate managers by Pinegar and Wilbricht (1989) fix that managers prefer capital take to the woods over external sources to finance new investment 84.3% of sample respondents indicate a orientation for financing investment with cash string up.Researchers have also discovered the tint of cash menstruation on investment using up in Q models of investment. Fazzari, Hubbard, and Petersen (1988) find that cash decrease has a strong effect on investment s unfinished in firms with low-dividend-payout policies. They argue that this result is tenacious with the notion that low-payout firms are cash melt-constrained because of asymmetric information costs associated with external financing. matchless intellectual these firms keep dividends to a minimum is to conserve cash run for from which they can finance profitable investment expenditures.Fazzari and Petersen (1993) find that this same group of low-payout firms smooths fluctuations in cash flow with working capital to maintain desired investment levels. This result is legitimate with the Myers and Majluf (1984) finding that liquid financial assets can moderate the underinvestment problem arising from asymmetric information.Whited (1992) also extended the Fazzari, Hubbard, and Petersen (1988) results in a study of firms facing debt financing constraints due to financial distress. She arrange evidence of a strong kindred between cash flow and investment consumption for firms with a high debt ratio or a high interest coverage ratio, or without rated debt.Himmelberg and Petersen (1994) in a study of small research and development firms find that cash flow strongly functions both capital and R D expenditures. They argue that the asymmetric information effects associated with such firms make external financing prohibitively expensive, forcing them to fund expenditures internally, that is by reservation use of cash flows.An alternative explanation for the strong cash flow/investment kinship is that managers divert unbosom cash flow to unprofitable investment consumption. One study assessing the relative vastness of such a n agency problem was performed by Oliner and Rudebusch (1992), who analysed several(prenominal) firm attributes that may function the cash flow/investment relationship. They find that insider share holdings and ownership structure (variables that procurator for agency problems) do little to explain the influence that cash flow has on firm investment outgo.Carpenter (1993) focused on the relationships among debt financing, debt structure, and investments pending to test the free cash flow theory. He finds that firms that restructure by replacing large amounts of external equity with debt increase their investment spending compared to non-restructured firms. He sees these results as inconsistent with free cash flow behavior, because cash flow perpetrate to debt maintenance should be associated with reductions in subsequent investment spending.Findings by unbendable and Meyer (1990) and Devereux and Schiantarelli (1990) support the free cash flow interpretation. absolute and Meyer (1990) disaggregate the investment and cash flow of firms in the paper assiduity into sustaining investment (i.e., productive capacity maintaining) and discretionary investment, and total cash flow and proportionality cash flow (i.e., cash flow afterward debt service, taxes, sustaining investment, and established dividends). rest period cash flow and discretionary investment are ensnare to be positively and strongly related. This evidence suggests that residual cash flow is often used to fund unprofitable discretionary investments pending.Devereux and Schiantarelli (1990) find that the impact of cash flow on investment spending is greater for larger firms. One explanation they provide for this result is that large firms have more assorted ownership structures, and are more influenced by manager/shareholder agency problems.The Q model of investment relates investment to the firms stock market valuation, which is meant to reflect the present discounted value of judge future kale, Brainard and Tobin (1968).In the case of perfectly competitive markets and constant returns to ordered series technology, Hayashi (1982) showed that average Q, the ratio of the maximised value of the firm to the replacing cost of its real capital stock, would be a sufficient statistic for investment rates.Tobins Q, further assumes that the maximised value of the firm can be measured by its stock market valuation. Under these assumptions, the stock market valuation would entrance all germane(predicate) information about evaluate future gainfulness, and significant coefficients on cash-flow variables after lordly for Tobins Q could not be attributed to additional information about incumbent expectations.However if the Hayashi authors are not satisfied, or if stock market valuations are influenced by bubbles or any factors other than the present discounted value of evaluate future profits hence Tobins Q would not enthrall all relevant information about the expected future profitableness of current investment. If that is the case, then additional explanatory variables like current or lagged gross revenue or cash-flow terms could procurator for the missing information about expected future conditions.The classification of q ratios into high and low categories is based on a cut-off of one Lang, Stulz, and Walkling (1989). The latters motivation for this cut-off is partially based on the fact that under authorized circumstances firms with q ratios below one have bare(a) projects with negative net present value (Lang and Litzenberger, 1989). However, q is also industry special(prenominal) and one may argue that managers should not be held responsible for ill shocks to their industries. As such, the industry average may be a utile alternative cut-off pane to separate high q firms from low q firms.Hoshi, Kashyap, and Scharfstein (1991) regressed investment on Tobins q, other controlling variables, and cash flow. They interpreted differences i n the importance of cash flow between different groups of firms as evidence of financing constraints.Results obtained by Vogt (1994) indicate that the influence of cash flow on capital spending is stronger for firms with lower Q values. This result suggests that cash flow-financed capital spending is marginally ineffectual and provides initial evidence in support of the FCF hypothesis. The stronger the influence cash flow had on capital spending in this group, the larger the associated value of Tobins Q. after(prenominal) the results presented by Kaplan and Zingales (1997 and 2000), several studies have criticised the empirical test based on the cash flow sensitivity as a meaningful evidence in favour of the instauration of financing constraints. The significance of the cash flow sensitivity of investment, it was argued, may then be the consequence of step errors in the usual proxy for investment opportunities, Tobins Q, and may provide additional information on expected profitab ility rather than being a signal of financing constraints.Gomes (2001) showed that the existence of financing constraints is not sufficient to establish cash flow as a significant regressor in a bar investment equation, while Ericson and Whited (2000) demonstrate that the investment sensitivity to cash flow in regressions including Tobins Q is to a large extent due to a measurement error in Q. Likewise, Alti (2003) shows that investment can be sensitive to changes in cash flow in the benchmark case where financing is frictionless.2.3 Investment and ProfitabilityThe head that investment depends on the profitability of a firm is amongst the oldest of macroeconomic relationships formulated. The curt fluctuations in profitability in the average cost of capital since the 1960s revived interest in this relationship (Glyn et al, 1990). However the evidence for the impact of profitability on investment remains sketchy.Bhaskar and Glyn (1992) concluded that profitability must be regarded as a significant influence on investment, though by no means the overwhelming one. Their results indicated that compound profitability is not always a necessary, let alone a sufficient condition for increase investment.However, years later Glyn (1997) provided an empirical study that examined the impact of profitability on capital accumulation. He tested the impact of profitability in the manufacturing sector on investment for the period 1960-1993 for 15 OECD countries. His findings suggested that the classical furiousness on the role of profitability on investment wass still highly significant and had a truly tight relationship.Korajczyk and charge (2003) investigated the role of macroeconomic conditions and financial constraints in determining capital structure choice. While estimating the relation between firms debt ratio and firm-specific variables, they found out that there was a negative relation between profitability and target leverage, which was consistent with the peck ing order theory. This indicated that if leverage of the firm is low, profitability will be high and the entity will be able to invest in positive NPV projects i.e. increase investment.Bhattacharyya (2008) recently provided an empirical study where he examined the effect of profitability and other determinants of investment for Indian firms. He found that Short-run profitability does not have consistent influence on investment decisions of firms, implying that one should centre on the long run profitability of a firm. This indicates that profitability is still regarded as one of the major determinants underlying investment decisions of firms. However, he suggested that liquid state is relatively more important than profitability when it comes to firms investment decisions.2.3 Investment and LiquidityUnder the assumptions of illiquid capital and avowedly uncertainty, management can never be sure that investment projects will produce sufficient liquidity to cover the cash commitm ents generated by their financing. only hardship to meet these commitments may result in a crisis of managerial autonomy or even in bankruptcy. Thus, capital accumulation is a contradictory process. Investment is inherently risky, while the failure to invest will ultimately lead to the firms marginalization or demise. Crotty and Goldstein (1992)Chamberlain and Gordon (1989) used the annual national investment of all nonfinancial corporations in the United States between 1952 and 1981 in an attempt to determine the impact of liquidity on the profitable investment opportunities available to the corporation. They have put forward that in their long-run option model, liquidity variables dawdle an essential role as it captures the firms desire to avoid bankruptcy. It was also noted that there was a significant improvement in the explanation of investment when liquidity variables were added to the profitability variables of their regression, thereby supporting the view that liquidity is a pre-dominant determinant of investment and that they are positively related.Hoshi, Kashyap and Scharfstein (1991) try to find the relationship between investment and liquidity for Japanese firms. They found that high current profits increase current liquidity, thereby generating further investment from the firm to ensure future profitability and increased siding to meet demand.Myers and Rajan (1998) suggested that liquid assets are generally viewed as being easier to finance and therefore, asset liquidity is a plus for nonfinancial corporations or private investors. However, Myers and Rajan argued that although more liquid assets increase the ability to invest in projects, they also reduce managements ability to commit credibly to an investment strategy that protects investors.Johnson (2003) found that short debt maturity increases liquidity risk, which in turn, negatively affects leverage and the firms investment. Jonson also suggested that firms trade off the cost of under investment problems against the cost of increased liquidity risk when choosing short debt maturity2.4 Investment and gross revenueSales growth targets play a major role in the perceptions of blanket managers. Using surveys, Hubbard and Bromiley (1994) find sales is the most common objective mentioned by senior managers. additional explanatory variables like current or lagged sales are actually important in the investment equation as they can act as proxy for the missing information about expected future conditions in case such information has not been captured by Tobins Q.Kaplan and Norton (1992, 1993, 1996) argue that firms must use a wide sorting of goals, including sales growth, to efficaciously reach their financial objectives. They suggested that Sales growth influences factors..all the way to the implied opportunities for investments in new equipment and technologies..According to this study of 396 corporations, Kopcke and Howrey (1994) found that the capital spending of many of the companies corresponds very poorly with their sales and profits. These divergences suggest that sales and profits do not represent fully an enterprises particular incentives for investing. Consequently, these findings do not support generalizations contending that companies with more debt are investing less than their sales and cash flows would guarantee.Athey and Laumas (1994) using table data over the period 1978-86, examined the relative importance of the sales heavy weapon and alternative internal sources of liquidity in investment activities of 256 Indian manufacturing firms. They found that when all the selected firms in the sample were considered together, current values of changes in real net sales and net profit were all significant in determining capital spending of firms.Azzoni and Kalatzis (2006) considered the importance of sales for investment decisions of firms. They found that sales presented a positive and significant relationship with investment in al l cases.Impact of Financial Leverage on InvestmentImpact of Financial Leverage on InvestmentThe term Investment is frequently used in jargon of economics, business management and finance. According to economic theories, investment is defined as the per-unit production of goods, which have not been consumed, but will however, be used for the purpose of future production. The decision for investment, also referred to as capital budgeting decision, is regarded as one of the key decisions of an entity.Leverage is a method of corporate funding in which a higher proportion of funds is raised through borrowing than stock issue. It is measured as the ratio of total debt to total assets greater the amount of debt, greater the financial leverage. Financial Leverage is the ability of a company to earn more on its assets by taking on debt that allows it to buy or invest more in order to expand.Nowadays financial leverage is viewed as an important attribute of capital structure alongside equity and retained earnings. Financial leverage benefits common stockholders as long as the borrowed funds generate a return greater than the cost of borrowing, although the increased risk can offset the general cost of capital.In the past years, a large body of the literature has provided robust empirical evidence that financial factors have a significant impact on the investment decisions of firms. While traditional research on investment was based on the neoclassical theory of optimal capital accumulation (where under the assumption of perfect capital markets, the cost of financing does not depend on the firms financial position), more recent literature has increasingly interconnected frictions such as asymmetric information and agency problems as a source behind the relevance of the degree of financial pressure faced by the firm in determining the availability and the costs of external financingThis chapter will seek to enclose literature on the impact of financial leverage on invest ment and other factors that may affect investment in firms.1.1 Modigliani Miller (MM) 1958 theory with no taxationIn what has been hailed as the most influential set of financial papers ever published, Franco Modigliani and Merton Miller addressed capital structure in a rigorous, scientific fashion, and their study set off a chain of research that continues to this day.Modigliani and Miller (1958) argued that the investment policy of a firm should be based only on those factors that will increase the profitability, cash flow or net worth of a firm.The MM view is that companies which operate in the same type of business and which have similar operating risks must have the same total value, irrespective of their capital structures. It is based on the belief that the value of a company depends upon the future operating income generated by its assets. The way in which this income is split between returns to debt holders and returns to equity should make no difference to the total valu e of the firm. Thus the total value of the firm will not change with gearing, and therefore neither will its Weighted Average Cost of Capita (Pandey, 1995).Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. The irrelevance proposition of Modigliani and Miller will be valid only if the perfect market assumptions underlying their analysis are satisfiedUnder the original MM propositions, leverage and investment were unrelated. If a firm had profitable investment projects, it could obtain funding for these projects regardless of the nature of its current balance sheet.1.2 Modigliani Miller 1963 theory with taxM M (1963) found that the corporation tax system carries a distortion under which returns to debt holders (interest) are tax deductible to the firm, whereas returns to equity holders are not. They therefore concluded that geared companies have an advantage over ungeared companies, i.e. they pay less tax and will have a greater ma rket value and a lower WACC. Following this research, the consensus that emerged was that tax is positively correlated to debt (Graham 1995, Miller 1977) and is considered a major influence in the debt policy decision.Modigliani et al (1963) argued that we should not waste our limited worrying capacity on second-order and largely self correcting problems like financial leveraging. That is firms should not be worried about growth as long as they have good projects in hand, since they will always be able to find means of financing those projects.1.3 The Trade-Off ModelsSome of the assumptions inherent in the MM model can be relaxed without changing the basic conclusions as argued by Stiglitz (1969) and Rubenstein (1973). However, when financial distress and agency costs are considered, the MM models are altered significantly. The addition of financial distress and agency costs to the MM model results in a trade-off model. In such a model, the optimal capital structure can be visualize d as a trade-off between the benefit of debt (the interest tax shield) and the costs of debt (financial distress and agency costs) as presented by Myers (1997)The trade-off models have intuitive appeal because they lead to the conclusion that both no-debt and all-debt are bad, while a moderate debt level is good. However, the trade-off models have very limited empirical support, Marsh (1982), suggesting that factors not incorporated in this model are also at work.Jensen and Meckling (1976) invoked a moral hazard argument to explain the agency costs of debt, proposing that high levels of debt will induce firms to opt for excessively risky investment projects. The incentive for such a move is that limited liability provisions in debt contracts imply that risky projects will provide higher mean returns to the shareholders zero in low states of nature and high in good states. However, the higher probability of default will induce investors to demand either interest rates premiums or bon d covenants that restrict the firms future use of debt.1.4 Pecking-Order TheoryInitiated by Donaldson (1961), the Pecking-Order theory argues that firms simply use all their internally-generated funds first, move down the pecking order to debt and then lastly issue equity in an attempt to raise funds. Firms follow this line of least resistance that establishes the capital structure.Myers noted an inconsistency between Donaldsons findings and the trade-off models, and this inconsistency led Myers to propose a new theory. Myers (1984) suggested asymmetric information as an explanation for the heavy reliance on retentions. This may be a situation where managers have access to more information about the firm and know that the value of the shares is greater than the current market value. If new shares are issued in this situation, there is a possibility that they would be issued at a too low price, thereby transferring wealth from existing shareholders to new shareholders.1.5 Investment and LeverageOne of the main issues in Corporate Finance is whether financial leverage has any effects on investment policies. The corporate world is characterized by various market imperfections, due to transaction costs, institutional restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems and that may result in under-investment or over-investment incentives. Whenever we refer to investment, it is essential to distinguish between over- investment and under-investment.In his model, Myers (1977) argued that debt can create an overhang effect. His idea was that debt overhang reduces the incentives of the shareholder-management coalition in control of the firm to invest in positive net-present-value investment opportunities, since the benefits accrue, at least partially, to the bondholders rather than accruing fully to the shareholders. Hence, highly levered firms are less likely to explo it valuable growth opportunities as compared to firms with low levels of leverage.Underinvestment theory centers on a liquidity effect in that firms with large debt commitment invest less, no matter what their growth opportunities (Lang et al, 1996). In theory, even if debt creates potential underinvestment incentives, the effect could be attenuated by the firm taking corrective action and lowering its leverage, if future growth opportunities are recognized sufficiently early (Aivazian Callen, 1980). Leverage is optimally reduced by management ex ante in view of projected valuable ex post growth opportunities, so that its impact on growth is attenuated. Thus, a negative empirical relation between leverage and growth may arise even in regressions that control for growth opportunities because managers reduce leverage in anticipation of future investment opportunities. Leverage simply signals managements information about investment opportunities. The possibility that leverage might s ubstitute for growth opportunities is referred to as the endogeneity problem.Over-investment theory is another problem that has received much attention over the years. It is described as investment expenditure beyond that required to maintain assets in place and to finance positive NPV projects. In these kind of situations, conflicts may arise between managers and shareholders (Jensen,1986 Stulz,1990). Managers seek for opportunities to expand the business even if that implies undertaking poor projects and reducing shareholder worth in the company. Managers abilities to carry such a policy is restrained by the availability of cash flow and further tightened by the financing of debt. Issuing debt commits the firm to pay cash as interest and principal, forcing managers to service such commitments with funds that may have otherwise been allocated to poor investment projects.Thus, leverage is one mechanism for overcoming the overinvestment problem suggesting a negative relationship bet ween debt and investment for firms with weak growth opportunities. Too much debt also is not considered to be good as it may lead to financial distress and agency problems.Cantor (1990) explains that highly leveraged firms show a heightened sensitivity to fluctuations in cash flow and earnings since they face substantial debt service obligations, have limited ability to borrow additional funds and may feel extra pressure to maintain a positive cash flow cushion. Hence, the net effect would be reduced levels of investment for the firm in question.Accordingly, Mc Connell and Servaes (1995) have examined a large sample of non financial United States firms for the years 1976, 1986 and 1988. They showed that for high growth firms the relation between corporate value and leverage is negative, whereas that for low growth firms the relation between corporate value and leverage is positively correlated. This trend tends to indicate that to maximise corporate value, it is preferable to keep d own leverage to a low level and to increase investment.Lang, Ofek and Stulz (1996) used a pooling regression to estimate the investment equation. They distinguish between the impact of leverage on growth in a firms core business from that in its non-core business. They argue that if leverage is a proxy for growth opportunities, its contractionary impact on investment in the core segment of the firm should be much more pronounced than in the non-core segment. They found that there exists a negative relation between leverage and future growth at the firm level. Also they argued that debt financing does not reduce growth for firms known to have good investment opportunities. Lang et al document a negative relation between firm leverage and subsequent growth. However, they find that this negative relation holds only for low q firms, i.e. those with fewer profitable growth opportunities. Thus, their findings appear to be most consistent with the view that leverage curbs overinvestment in firms with poor growth opportunities.Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Therefore, high leverages may result in liquidity problem and can affect a firms ability to finance growth. Under this situation, debt overhang can contribute to the under-investment problem of debt financing. That is for firms with growth opportunities, debt have a negative impact on the value of the firm.Peyer and Shivdasani (2001) provide evidence that large increases in leverage affect investment policy. They report that, following leveraged recapitalizations, firms allocate more capital to business units that produce greater cash flow. If leverage constrains investment, firms with valuable growth opportunities should choose lower leverage in order to avoid the risk of being forced to bypass some of these opportunities, while firms without valuable growth opportunities sho uld choose higher leverage to bond themselves not to waste cash flow on unprofitable investment opportunities.Ahn et al. (2004) document that the negative relation between leverage and investment in diversified firms is significantly stronger for high Q segments than for low Q business segments, and is significantly stronger for non-core segments than for core segments. Among low growth firms, the positive relation between leverage and firm value is significantly weaker in diversified firms than in focused firms. Their results suggest that the disciplinary benefits of debt are partially offset by the additional managerial discretion in allocating debt service to different business segments within a diversified organizational structure.Childs et al (2005) argued that financial flexibility encourages the choice of short-term debt, thereby dramatically reducing the agency costs of under-investment and over-investment. However the reduction in the agency costs may not encourage the firm to increase leverage, since the firms initial debt level choice depends on the type of growth options in its investment opportunity set.Aivazian et al (2005) analysed the impact of leverage on investment on 1035 Canadian industrial companies, covering the period 1982 to 1999. Their study examined whether financing considerations (as measured by the extent of financial leverage) affect firm investment decisions inducing underinvestment or overinvestment incentives. They found that leverage is negatively related to the level of investment, and that this negative effect is significantly stronger for firms with low growth opportunities than those with high growth opportunities. These results provide support to agency theories of corporate leverage, and especially to the theory that leverage has a disciplining role for firms with weak growth opportunities1.6 Investment, Cash Flow and Tobins QIt was traditionally believed that cash flow was important for firms investment decisions becaus e managers regarded internal funds as less expensive than external funds. In the 1950s and 1960s, this view led to numerous empirical assessments of the role of internal funds in firm investment behaviour. These studies found strong relationships between cash flow and investment.Considerable empirical evidence indicates that internally generated funds are the primary way firms finance investment expenditures. In an in-depth study of 25 large firms, Gordon Donaldson (1961) concludes that Management strongly favoured internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable bulges in the need for new funds.Another survey of 176 corporate managers by Pinegar and Wilbricht (1989) found that managers prefer cash flow over external sources to finance new investment 84.3% of sample respondents indicate a preference for financing investment with cash flow.Researchers have also discovered the impact of cash flow on investment spend ing in Q models of investment. Fazzari, Hubbard, and Petersen (1988) find that cash flow has a strong effect on investment spending in firms with low-dividend-payout policies. They argue that this result is consistent with the notion that low-payout firms are cash flow-constrained because of asymmetric information costs associated with external financing. One reason these firms keep dividends to a minimum is to conserve cash flow from which they can finance profitable investment expenditures.Fazzari and Petersen (1993) find that this same group of low-payout firms smooths fluctuations in cash flow with working capital to maintain desired investment levels. This result is consistent with the Myers and Majluf (1984) finding that liquid financial assets can mitigate the underinvestment problem arising from asymmetric information.Whited (1992) also extended the Fazzari, Hubbard, and Petersen (1988) results in a study of firms facing debt financing constraints due to financial distress. She found evidence of a strong relationship between cash flow and investment spending for firms with a high debt ratio or a high interest coverage ratio, or without rated debt.Himmelberg and Petersen (1994) in a study of small research and development firms find that cash flow strongly influences both capital and R D expenditures. They argue that the asymmetric information effects associated with such firms make external financing prohibitively expensive, forcing them to fund expenditures internally, that is by making use of cash flows.An alternative explanation for the strong cash flow/investment relationship is that managers divert free cash flow to unprofitable investment spending. One study assessing the relative importance of such an agency problem was performed by Oliner and Rudebusch (1992), who analysed several firm attributes that may influence the cash flow/investment relationship. They find that insider share holdings and ownership structure (variables that proxy for age ncy problems) do little to explain the influence that cash flow has on firm investment spending.Carpenter (1993) focused on the relationships among debt financing, debt structure, and investments pending to test the free cash flow theory. He finds that firms that restructure by replacing large amounts of external equity with debt increase their investment spending compared to non-restructured firms. He sees these results as inconsistent with free cash flow behavior, because cash flow committed to debt maintenance should be associated with reductions in subsequent investment spending.Findings by Strong and Meyer (1990) and Devereux and Schiantarelli (1990) support the free cash flow interpretation.Strong and Meyer (1990) disaggregate the investment and cash flow of firms in the paper industry into sustaining investment (i.e., productive capacity maintaining) and discretionary investment, and total cash flow and residual cash flow (i.e., cash flow after debt service, taxes, sustaining investment, and established dividends). Residual cash flow and discretionary investment are found to be positively and strongly related. This evidence suggests that residual cash flow is often used to fund unprofitable discretionary investments pending.Devereux and Schiantarelli (1990) find that the impact of cash flow on investment spending is greater for larger firms. One explanation they provide for this result is that large firms have more diverse ownership structures, and are more influenced by manager/shareholder agency problems.The Q model of investment relates investment to the firms stock market valuation, which is meant to reflect the present discounted value of expected future profits, Brainard and Tobin (1968).In the case of perfectly competitive markets and constant returns to scale technology, Hayashi (1982) showed that average Q, the ratio of the maximised value of the firm to the replacement cost of its existing capital stock, would be a sufficient statistic for inv estment rates.Tobins Q, further assumes that the maximised value of the firm can be measured by its stock market valuation. Under these assumptions, the stock market valuation would capture all relevant information about expected future profitability, and significant coefficients on cash-flow variables after controlling for Tobins Q could not be attributed to additional information about current expectations.However if the Hayashi conditions are not satisfied, or if stock market valuations are influenced by bubbles or any factors other than the present discounted value of expected future profits then Tobins Q would not capture all relevant information about the expected future profitability of current investment. If that is the case, then additional explanatory variables like current or lagged sales or cash-flow terms could proxy for the missing information about expected future conditions.The classification of q ratios into high and low categories is based on a cut-off of one Lang, Stulz, and Walkling (1989). The latters motivation for this cut-off is partially based on the fact that under certain circumstances firms with q ratios below one have marginal projects with negative net present values (Lang and Litzenberger, 1989). However, q is also industry specific and one may argue that managers should not be held responsible for adverse shocks to their industries. As such, the industry average may be a useful alternative cut-off point to separate high q firms from low q firms.Hoshi, Kashyap, and Scharfstein (1991) regressed investment on Tobins q, other controlling variables, and cash flow. They interpreted differences in the importance of cash flow between different groups of firms as evidence of financing constraints.Results obtained by Vogt (1994) indicate that the influence of cash flow on capital spending is stronger for firms with lower Q values. This result suggests that cash flow-financed capital spending is marginally inefficient and provides initial evidence in support of the FCF hypothesis. The stronger the influence cash flow had on capital spending in this group, the larger the associated value of Tobins Q.After the results presented by Kaplan and Zingales (1997 and 2000), several studies have criticised the empirical test based on the cash flow sensitivity as a meaningful evidence in favour of the existence of financing constraints. The significance of the cash flow sensitivity of investment, it was argued, may then be the consequence of measurement errors in the usual proxy for investment opportunities, Tobins Q, and may provide additional information on expected profitability rather than being a signal of financing constraints.Gomes (2001) showed that the existence of financing constraints is not sufficient to establish cash flow as a significant regressor in a standard investment equation, while Ericson and Whited (2000) demonstrate that the investment sensitivity to cash flow in regressions including Tobins Q is to a la rge extent due to a measurement error in Q. Likewise, Alti (2003) shows that investment can be sensitive to changes in cash flow in the benchmark case where financing is frictionless.2.3 Investment and ProfitabilityThe idea that investment depends on the profitability of a firm is amongst the oldest of macroeconomic relationships formulated. The sharp fluctuations in profitability in the average cost of capital since the 1960s revived interest in this relationship (Glyn et al, 1990). However the evidence for the impact of profitability on investment remains sketchy.Bhaskar and Glyn (1992) concluded that profitability must be regarded as a significant influence on investment, though by no means the overwhelming one. Their results indicated that enhanced profitability is not always a necessary, let alone a sufficient condition for increased investment.However, years later Glyn (1997) provided an empirical study that examined the impact of profitability on capital accumulation. He test ed the impact of profitability in the manufacturing sector on investment for the period 1960-1993 for 15 OECD countries. His findings suggested that the classical emphasis on the role of profitability on investment wass still highly significant and had a very tight relationship.Korajczyk and Levy (2003) investigated the role of macroeconomic conditions and financial constraints in determining capital structure choice. While estimating the relation between firms debt ratio and firm-specific variables, they found out that there was a negative relation between profitability and target leverage, which was consistent with the pecking order theory. This indicated that if leverage of the firm is low, profitability will be high and the entity will be able to invest in positive NPV projects i.e. increase investment.Bhattacharyya (2008) recently provided an empirical study where he examined the effect of profitability and other determinants of investment for Indian firms. He found that Short- run profitability does not have consistent influence on investment decisions of firms, implying that one should concentrate on the long-run profitability of a firm. This indicates that profitability is still regarded as one of the major determinants underlying investment decisions of firms. However, he suggested that liquidity is relatively more important than profitability when it comes to firms investment decisions.2.3 Investment and LiquidityUnder the assumptions of illiquid capital and true uncertainty, management can never be sure that investment projects will produce sufficient liquidity to cover the cash commitments generated by their financing. Yet failure to meet these commitments may result in a crisis of managerial autonomy or even in bankruptcy. Thus, capital accumulation is a contradictory process. Investment is inherently risky, while the failure to invest will ultimately lead to the firms marginalization or demise. Crotty and Goldstein (1992)Chamberlain and Gordon (19 89) used the annual domestic investment of all nonfinancial corporations in the United States between 1952 and 1981 in an attempt to determine the impact of liquidity on the profitable investment opportunities available to the corporation. They have put forward that in their long-run survival model, liquidity variables play an essential role as it captures the firms desire to avoid bankruptcy. It was also noted that there was a significant improvement in the explanation of investment when liquidity variables were added to the profitability variables of their regression, thereby supporting the view that liquidity is a pre-dominant determinant of investment and that they are positively related.Hoshi, Kashyap and Scharfstein (1991) attempted to find the relationship between investment and liquidity for Japanese firms. They found that high current profits increase current liquidity, thereby generating further investment from the firm to ensure future profitability and increased output t o meet demand.Myers and Rajan (1998) suggested that liquid assets are generally viewed as being easier to finance and therefore, asset liquidity is a plus for nonfinancial corporations or individual investors. However, Myers and Rajan argued that although more liquid assets increase the ability to invest in projects, they also reduce managements ability to commit credibly to an investment strategy that protects investors.Johnson (2003) found that short debt maturity increases liquidity risk, which in turn, negatively affects leverage and the firms investment. Jonson also suggested that firms trade off the cost of underinvestment problems against the cost of increased liquidity risk when choosing short debt maturity2.4 Investment and SalesSales growth targets play a major role in the perceptions of top managers. Using surveys, Hubbard and Bromiley (1994) find sales is the most common objective mentioned by senior managers. Additional explanatory variables like current or lagged sales are very important in the investment equation as they can act as proxy for the missing information about expected future conditions in case such information has not been captured by Tobins Q.Kaplan and Norton (1992, 1993, 1996) argue that firms must use a wide variety of goals, including sales growth, to effectively reach their financial objectives. They suggested that Sales growth influences factors..all the way to the implied opportunities for investments in new equipment and technologies..According to this study of 396 corporations, Kopcke and Howrey (1994) found that the capital spending of many of the companies corresponds very poorly with their sales and profits. These divergences suggest that sales and profits do not represent fully an enterprises particular incentives for investing. Consequently, these findings do not support generalizations contending that companies with more debt are investing less than their sales and cash flows would guarantee.Athey and Laumas (1994) us ing panel data over the period 1978-86, examined the relative importance of the sales accelerator and alternative internal sources of liquidity in investment activities of 256 Indian manufacturing firms. They found that when all the selected firms in the sample were considered together, current values of changes in real net sales and net profit were all significant in determining capital spending of firms.Azzoni and Kalatzis (2006) considered the importance of sales for investment decisions of firms. They found that sales presented a positive and significant relationship with investment in all cases.