Firm Investment Growth During Credit Crunch Periods

Firm Investment

Firm Investment Growth During Credit Crunch Periods

The term firm investment refers to an investment in a company or a project which is considered as low risk. A venture is the most common example of firm investment. There are several categories under which such investments are classified. These include public equity, venture capital, small/growing business, mid-size business and large/complex business. A new investment can be made in a variety of fields depending upon the needs and the profitability of the project. It is always advisable to first consult with experts in the related fields before proceeding with the investment.

The level of risk exposure of a firm is defined as the net difference between its liabilities and assets. The relationship between firm investment decisions and firm risk therefore is a crucial area of research in the finance field. Further, it has long been observed that the effect of external financing on firm investment decisions is majorly important for mid-size and high data asymmetric firms. Thus it has been seen that firms based in the SME segment tend to use more financial engineering tools such as venture capital, angel investors and venture capital firms for their funding requirements. On the other hand firms based in the EME (economically advanced) segment tend to adopt financial instruments which are less sensitive to market fluctuations. Hence the overall tendency is that EME firms tend to adopt external financing more often than their SME counterparts.

The reasons for this are not clearly understood but it is believed that the major reason lies in government intervention. Since the government intervention comes into play here due to the adverse effects of market turbulence and inflation, it is believed that these policies act as a constraint for investment efficiency. Thus as the economy becomes more dependent on external financing, these constraints become more serious. However it should also be kept in mind that a higher level of government regulation often results in more efficient utilization of resources by the firms concerned.

So does the presence of a significant amount of government stimulus package or a large scale fiscal stimulus policy encourage firms to make higher investment? To understand this one has to understand why the firms are required to invest so much during a particular recession period. It is important to note that during the normal economic cycle, apart from a few exceptions, companies tend to invest in resources that yield them some return-generating potential over a long term period. Therefore it is difficult to justify investing heavily in any single area during a recession period.

This is where the presence of a significant amount of fiscal and structural government intervention comes in. While the fiscal stimulus package and the housing bubble investment are the best known of all the fiscal interventions, the presence of a large scale financial crisis also acts as a strong motivation for firms to make higher investment. In fact research suggests that during the financial crisis period, firms tend to divert their attention towards short-term benefits rather than concentrating on their long term viability. Thus investment during recession is seen as being optimal only if the firm is able to secure some long-term value addition through effective management of its resources. However, this can be easier said than done.

One reason why firms do not make such investment calls despite having a reasonable expectation of positive returns is that firms cannot easily distinguish between the good opportunities and bad ones. Good opportunities come and go, while bad ones remain on the table for a long time. Moreover, firms’ investment decisions depend on a number of external factors including market friction and relative valuation of the firm by various other firms. While market price volatility and relative valuation are relatively easy to measure, market friction is much more difficult to define objectively given the fact that firms often act in different ways and have different motives.