Modeling the Effects of Financial Constraints on Firm’s Investment

Abstract

The paper develops a model of firm´s investment under uncertainty with financial market imperfections and analyzes the effects of financial constraints on firm´s investment. Firm´s investment is an increasing function of the firm´s marginal q , however the investment function is characterized by an upper bound that depends on the firm´s borrowing capabilities. The firm´s marginal q is the sum of the expected value of the marginal profitability of the physical capital stock and of a positive external finance premium. In the presence of financial market imperfections the firm forms expectations about future financial conditions and these expectations raise the firm´s current marginal q . Similarly, the shadow price of firm´s debt is the sum of the interest cost of debt repayment and of a provision for external finance that depends on the firm´s expectations over future financial conditions.