Firm Investments: The Pitfalls
In this paper, the analysis of firm investment strategies draws insights from multiple agency theory. The analysis shows that financial leverage, by definition, is a situation whereby one firm purchases a large amount of productive assets from other firms at a much lower cost than they could otherwise buy them. As a result of this situation, the value of the net assets owned increases, allowing the firms to make larger profits. However, as this situation continues over time, it eventually leads to what is called firm underperformance.
The analysis then shows that the optimal solution to solve this problem would be to create an environment that discourages firms from taking up excessive risk. This can be done through increasing the supply of available external financing for the firms by either directly (such as through banks) or indirectly (such as through the central bank). Finally, the analysis shows that pursuing this end leads to improved firm investment strategies, which lead to better allocation of capital assets. These better allocation strategies lead to improved capital structure decisions, which lead to improved domestic credit-to-GDP ration.
The second step in this paper is to illustrate how this model can be used in practice. The basic model presented here depicts a two-stage investment process in which firms develop both long-term and short-term strategies and then execute them through a series of decisions. The analysis shows that, given a series of investment choices, the outcome of each choice will depend on the values of allocative variables. The analysis further shows that this analysis is actually accurate, since allocative variables are known to be positively correlated with the returns of investment; therefore, firms tend to make similar investment decisions, regardless of macroeconomic conditions.
To illustrate how this works in practice, consider a simple example. Suppose that Company A issues stock in the dollar stock market. Company A uses its internal funds to acquire shares from investors and then sells those same shares to retail customers in the stock market. The retail price of Company A’s stock thus increases due to the inflation of the market. Firm B, which owns the underlying shares in Company A, however, does not increase its cash inflows as a result of the stock market boom.
If Company B invested using the same logic as described above, it would predict that its profits would increase because of the boom in the share market. However, if Company B used the Phillips curve, it could find that its profits declined as the share market booms and declines, and eventually, declines more. Thus, it would conclude that firm investment decisions depend on external factors, rather than on internal factors. However, it would also follow that if firms use the Phillips Curve incorrectly, it can lead to serious errors. This example is one of many utilized in order to illustrate the various pitfalls of relying solely on estimates or models based on real-time data.
These examples show why it is so important for managers and other decision makers to rely on models that take into account external factors, such as credit and capital flows, as well as the state of the economy. It is unrealistic to expect that a manager will be able to make sound firm investments decisions without taking these external factors into consideration. These models thus play a critical role in allowing companies to realize gains or losses that are necessary in order to make profitable business decisions.
