Internal finance and investment: another look

Cherian Samuel

No 1663, Policy Research Working Paper Series from The World Bank

Abstract: One of the best documented empirical facts in economic research has been the positive relationship between internal finance and cash flows and capital expenditures and investment. But disputes about the analytical basis for the cash flow theory have been largely unresolved. There are two distinct approaches to the cash flow theory of investments: the managerial (managers are primarily interested in maximizing the firm's growth rate) and information theoretic (managers try to maximize shareholder value). Using a panel of US manufacturing firms (1972-90), the author tries to distinguish between the approaches. The results suggest that firms rely on internal finance for capital expenditures because of managerial considerations. The principal shortcoming of the information-theoretic approach is its reliance on dividend practices as a decisive criterion for studying firm heterogeneity. Dividend practices are incapable of distinguishing between managerial and information-theoretic approaches. But one can distinguish between managerial and information-theoretic approaches using such variables as size, exchange listings and the ratio of R&D to sales and make contrasting predictions about the firm's reliance on internal finance for capital expenditures. The evidence shows that the firm's observed reliance of capital expenditures on internal finance is driven by managerial rather than information-theoretic considerations. While no current research directly distinguishes between managerial and information theoretic approaches, preliminary evidence seems to favor the managerial approach. And even though the stock market may play a limited role as a source of finance, policy initiatives to reform the financial sector and develop capital markets are likely to enhance the overall efficiency of the resources allocation process in the economy.

Keywords: Financial Intermediation; Decentralization; Labor Policies; Payment Systems&Infrastructure; International Terrorism&Counterterrorism; Banks&Banking Reform; Economic Theory&Research; Financial Intermediation; Environmental Economics&Policies; International Terrorism&Counterterrorism (search for similar items in EconPapers)
Date: 1996-10-31
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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