The Economic Freedom Measurement

Firm Investment

The Economic Freedom Measurement

“Firm Investment and Financial Leverage” is a white paper by William D. Foster and Albert Perrie, which has been accepted for publication in the Journal of Finance. The paper uncovers that increasing financial leverage is negative and significantly so in relation to firm investment. Also it is seen that the effect of increased financial Leverage on firm investment is very small for large information asymmetric companies. But no such significant relationship can be found between increased financial Leverage and investment for mid-sized and large-scale companies. In fact there is a negative correlation between the two for these companies. This paper then goes on to state that there are three important lessons to be learnt from the foregoing that should be applied by Manager’s in allocating resources amongst different investment opportunities.

Firstly, it is seen that with respect to firm investment, the effect of leverage increases the risk free discount at which a particular firm can borrow funds. With respect to bank lending, an increase in leverage reduces the discount at which banks lend. Secondly, the effects of leverage are not consistent across firms and are therefore influenced by differences in internal rates of return across firms. Finally, while it is seen that increases in firm investment are correlated with changes in credit quality and credit Baileye ratios, there is no direct relationship between credit quality and investment.

The paper then goes on to analyse the implications of increased domestic credit interest rates on firm investment decisions. It is found that there is a marginal increase in firm investment due to higher returns from assets and lower financing costs but this increases risk by introducing greater external financing costs. Also, the benefits of increased corporate income through better credit terms are offset by the increased taxation of dividends and capital gains and hence, offsetting the savings from lower rates of interest. However, the benefits of better economic freedom through lower domestic borrowing costs are offset by the loss of social trust in financial institutions and banks. The analysis thus, does not suggest that higher interest rates would necessarily lead to higher investment in plant and equipment or create more jobs, as has been argued by some of the critics of optimum investment theory.

Finally, the paper concludes that optimal allocation of capital between capital requirements and consumption should take into account imperfect information about future production and income and so, imperfect allocation should be kept as an assumption. However, if desired effects of optimal allocation are achieved, then the distribution of income should be based on current distributional objectives. That said, if the aim of the investment policy is to increase national growth, then a higher consumption-side policy may be adopted. On the other hand, if the primary aim is domestic growth, then the cash flow problem should be solved by means of higher production, with a smaller number of factories.

In conclusion, the present period is a period of great economic expansion with high level of unemployment and with the global economic slowdown having only limited impact on overall economic performance. There are many reasons why capital budgeting of large firms should be done through a cash flow perspective. These include the fact that most firms are cash poor and so do not have adequate spare cash for investments in fixed assets or long-term productive assets. Also, there is a limit to the rate at which capital can be reinvested, especially when the funds are invested in non-productive enterprises such as rent, plant and machinery.

Therefore, optimal allocation of capital between fixed assets and long-term investment goals may be achieved by means of a detailed cash flow analysis that takes into account all the relevant factors affecting the allocation process. The process should be made as transparent as possible and the results reported on a regular basis. It should be the object of constant and timely study to ensure the consistent measurement of the economic freedom index across the whole range of economic policies.