The Net Worth Trap: Investment and Output Dynamics in the Presence of Financing Constraints

Jukka Isohätälä, Alistair Milne and Donald Robertson
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Jukka Isohätälä: Institute of Operations Research and Analytics, National University of Singapore, 3 Research Link, Innovation 4.0 04-01, Singapore 117602, Singapore
Alistair Milne: School of Business and Economics, Loughborough University, Epinal Way, Loughborough LE11 3TU, UK

Mathematics, 2020, vol. 8, issue 8, 1-32

Abstract: This paper investigates investment and output dynamics in a simple continuous time setting, showing that financing constraints substantially alter the relationship between net worth and the decisions of an optimizing firm. In the absence of financing constraints, net worth is irrelevant (the 1958 Modigliani–Miller irrelevance proposition applies). When incorporating financing constraints, a decline in net worth leads to the firm reducing investment and also output (when this reduces risk exposure). This negative relationship between net worth and investment has already been examined in the literature. The contribution here is providing new intuitive insights: (i) showing how large and long lasting the resulting non-linearity of firm behaviour can be, even with linear production and preferences; and (ii) highlighting the economic mechanisms involved—the emergence of shadow prices creating both corporate prudential saving and induced risk aversion. The emergence of such pronounced non-linearity, even with linear production and preference functions, suggests that financing constraints can have a major impact on investment and output; and this should be allowed for in empirical modelling of economic and financial crises (for example, the great depression of the 1930s, the global financial crisis of 2007–2008 and the crash following the Covid-19 pandemic of 2020).

Keywords: cash flow management; corporate prudential risk; the financial accelerator; financial distress; induced risk aversion; liquidity constraints; liquidity risk; macroeconomic propagation; multiperiod financial management; non-linear macroeconomic modelling; Tobin’s q; precautionary savings (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2020
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