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Theory of the Firm Investment

The paper by Becker and Kerkman (eds) suggests that financial leverage directly and indirectly influences firm production. Financial leverage is directly related to firm production and negatively related to firm growth. It is also seen that the effect of financial leverage on firm production is substantial for highly information asymmetric companies. These firms are those having little or no information, which can be measured through output gap (Gini index).

Firm Investment

As we know, firms with larger input, ability to reinvest, and willingness to use financial instruments have higher output than firms having smaller input, ability to reinvest, and willing to use only financial instruments. Thus, the authors argue that firms with large firms size invest more, and those with small firms size invest less. They then proceed to argue that firms with larger firm size invest more than firms having smaller firm size. These results are puzzling.

We already know that firms with larger firms size invest more. This result is inconsistent with the investment pattern identified in this paper. The capital markets are characterized by excess capacity, not excess investment. We can see this capacity only when firm value is measured directly, i.e., as the value of a firm that sells its own shares to stock holders is less than its value of a firm that produces and sells its own shares as capital goods. Otherwise, the capital markets cannot be effectively manipulated by capital firms.

Based on their previous work, Messer and Witkin (eds), Messer & Wood (2021), and Klein & Krueger (eds), we interpret this results as a function of firm misvaluation and imperfect competition. They then further argue that perfect competition reduces output lag between firm misvaluations, leading to imperfect competition and hence, efficient price changes. They further infer that firms with imperfect information about future costs reduce output lag by providing information that firms with accurate information do not. Finally, they argue that firms with imperfect information tend to act in response to changes in prices, leading to inefficient price changes and inefficient consumption. The latter can be associated with imperfect information about future costs and inefficient consumption.

According to the first hypothesis, when firms misevaluate the value of their stocks or other assets, they engage in internal pricing errors that result in inefficient public sector allocation of resources. According to the second hypothesis, when public firms misperceive the efficiency of their transactions, they engage in external pricing errors that lead to inefficient allocation of financial resources. Finally, according to the third hypothesis, when public firms undervalue their assets, they tend to act in response to changes in prices, leading to inefficient price changes and inefficient allocation of financial resources. To support these hypotheses, we use real-time data from four large established finance firms, and study the link between firm misvaluation and inefficient allocation of financial resources.

Our analysis indicates that firms’ internal and external pricing errors lead to inefficient allocation of resources. We find that over the course of five years, the mispricing effect grows at a rapid rate, reaching a level above the average over this period of time. Over the five years, the mean value of all misvalued firm investments declines by approximately 23%, while the standard deviation of investment portfolio volatility remains elevated, indicating the lack of diversification of portfolio holdings. Finally, we find that investment management errors are exacerbated by misperception about the efficiency of transaction execution. As a result, they generate a large amount of firm misvaluations that lead to inefficient utilization of firm investments, and consequently to inefficient utilization of financial resources.