This article focuses on the theory of firm investment and its implications for finance theory and macroeconomics. I use the firm concept to describe the relationship between firms and banking. The paper also uncovers the relationship between firm investment, bank financing and fiscal policy. Finally I discuss the implications of firm investment for international economic theory, finance theory and practice.
The main focus of this paper is firm investment and how it relates to other macroeconomic issues. The paper finds that fiscal policy, interest rates and bank financing are strongly influenced by firm investment. It is further seen that the effect of firm investment on firm investment is strong for high information asymmetrical firms. In fact, these firms are said to be at risk of being run over by competitors if they are unable to increase their level of fixed assets.
I argue that firm fixed assets are not a random distribution of production, as suggested by traditional economics, but are constrained by constraints such as information, time, scale and competition. Therefore, the relation between fiscal policy and firm investment is imperfect but not necessarily inherently defective. It is argued that fiscal policy can actually push up firm asset value because of the positive effect of raising productivity and reducing the cost of goods and services. This would allow firms to increase the level of fixed capital without resorting to external financing.
Financial markets are structured around the concept of fixed capital. Some financial instruments are based on fixed capital, while others allow variable capital, with the idea that the value of a firm is the difference between its current value and its potential value after a predetermined period. I argue that firms should treat fixed capital like other non-financial assets and treat it in the same way as firm assets do. For instance, firm equity may represent the value of all retained earnings after taking into account the present value of all future payments and dividends (that is, discounted cash flow). It is important for firms to decide whether or not to use floating or fixed capital.
The importance of fiscal policy for fixed capital and firm investing is illustrated by the fact that a reduction in fixed capital and/or employment reduces the firm’s ability to expand its balance sheet and increase its net worth. The most important costs of capital allocation are interest payments and amortization. While a firm can reduce its costs of capital by reducing its interest payments and amortization, this will not have much of an effect on its net worth. A firm that acquires new plant and equipment to employ more workers will have an increase in capacity, but the expansion will only be partially offset by the higher interest payments associated with these assets.
Finally, I argue that policy mistakes in the past limited the flexibility of firms in their use of funds and distorted the link between total assets and total fixed capital. The historical practices of piling up fixed assets during upswings and liquidating these assets during downswings distorted the link between total assets and total fixed capital. Because of the link, firms had little flexibility in determining the time length of the business cycle and rely on short-term assets to finance long-term projects. Finally, because the historical practices disadvantaged small firms over large ones, over-all financial distress has been greater for the small than for large firms over time.