Financial Leverage and Firm Investment

In a recent study, Kaplan and Zingales (2002) found that financial leverage negatively correlated with firm investment. This relationship was most pronounced among firms with high information asymmetry and low growth, and was not significant among high-growth firms. However, the evidence suggests that the two factors are related, with the latter having a larger impact on firm investment. These findings support the economic competition hypothesis. Moreover, the findings are robust to other alternative treatments of growth opportunities, including the shared sentiment hypothesis.

Firm Investment

Compared to larger firms, small firms receive little or no finance from government sources. As a result, these governments often focus their attention on large firms for which it is easier to secure government financing. Similarly, underdeveloped countries are not as well equipped to support small-firm finance, and thus, are less likely to attract private investment. In such circumstances, there are few options for securing funds. While trade credit is a viable alternative, it is not a sustainable solution for smaller firms.

Several studies have shown that the financial situation of smaller firms is poorer in developing countries. Nevertheless, government funding is generally more likely to reach larger firms than smaller firms. In addition, government-sponsored programs that promote small-firm finance tend to be a political “win-win” for governments. Besides, fewer resources are allocated to smaller-scale enterprises. A more equitable approach would provide more financial support for larger companies. And finally, it would enable more small businesses to thrive.

In the current research, we find no evidence of a causal relationship between the misvaluation of public firms and private firm investments. Using a panel of large firms, we find no evidence that private-sector investment increases with misvaluation. The results of our study are consistent with the shared sentiment hypothesis and are robust to alternative treatments of growth opportunities. And this study also indicates that private-sector investments are an important source of finance for small-size firms in developing countries.

Another factor that influences the capital investment of small-firms is the diversification of the controlling owners’ portfolios. In a developed country, portfolio diversification is positively affected by the number of firms owned by a single owner, and the majority of private-sector investments are concentrated in fewer than 10% of the total equity. But, in developing countries, it can be beneficial to invest in a small company. And because of the resulting dynamism and profits, it will generate a high level of employment and tax revenues.

In a developing country, there is a lack of access to financing for small firms. Development banks and governments are more likely to provide funding to large firms. But small firms cannot compensate for underdeveloped legal and financial systems by utilizing private sources of finance. Despite this, alternative sources of finance do not necessarily fill the void. Even though they are not financially strong, these companies need to raise debt to expand their operations. In this case, equity investors are more willing to invest in a firm if the latter is profitable.