The relationship between financial leverage and firm investment is complex. While the correlation between finance and equity is weak, it is positive for publicly traded firms. In contrast, a negative correlation between finance and equity exists for privately held firms. This suggests that private firms may be able to finance their misvaluation-induced investments with debt. This relationship may help to explain the dynamics of capital allocation. However, this finding is controversial. The findings are consistent with other evidence.
While private firms can borrow funds from government sources and development banks, they are not significantly more likely to raise money from these sources than do larger companies. This is because governments prefer to provide financing to larger companies, which have better financial and legal systems. In addition, small firms do not have adequate trade credit, so they are less likely to receive government funds. In addition, private finance for small firms often falls short of the level required to attract investment. Therefore, it is imperative to find alternative sources of finance for these companies.
Another form of finance is gearing, a process in which a firm borrows outside funds to make additional investments. The purpose of this process is to return dividends to shareholders and make a profit between dividends and repayments. The borrowed funds are typically invested in attractive stocks and long-term plans. The loans are often financed at lower rates of interest than the market rate, making them more accessible to smaller firms. As a result, the decision to engage in gearing is made by the board of directors and fund manager.
In addition to the risk and cost of misvaluation, the benefits of misvaluation-induced investment are enormous. Not only do private firms enjoy higher returns on investments, but they also benefit from the increased profitability that is a result of the overvaluation of public markets. This is particularly true in emerging economies, where the legal and financial systems are less developed. While trade credit in developing countries may not be as strong as in developed markets, it is still the best option for private firms seeking financing.
Despite the importance of trade credit for small firms, there is little evidence that it is necessary to invest in small firms. Moreover, while the availability of credit in developing countries is increasing, the availability of capital in these countries is decreasing. The lack of development means that the prevailing law and regulatory environment in the country is not compatible with the growth of small firms. The best solution is to provide capital to small companies that can be in the same country as the investor.
Moreover, small firms do not receive much government finance. This means that the amount of government money available to them is low. The same is true for the size of their business. While there are exceptions, this gap is exacerbated by a weak legal and financial system. Nonetheless, this is not an excuse for investors to refrain from investing in small firms. In fact, this gap is a problem for all firms, regardless of their size.
