Various studies have shown that firm investment diversification increases the returns for investors. These studies suggest that the value of a firm is highly dependent on its financial structure, rather than its assets. The authors of this paper also point out that the effect of firm investment diversification is largely irrelevant in a capital market that is perfectly efficient. The results of these studies suggest that firms with high-quality financial structures are the most likely to have a higher return on investment than companies with low-quality ones.
In recent years, researchers have focused on the relationship between capital market equilibrium and firm financial policy. They have come to the conclusion that firms must diversify their investments in order to offset underdeveloped legal and financial systems. Their work has been exemplified by the Modigliani and Miller (LSM) model and the Sharpe-Lintner model. However, the LSM model fails to provide a convincing alternative explanation for the mismatch between debt policy and firm value.
The relationship between financial leverage and firm investment has been widely studied and discussed. The LSM model of financial policy shows a negative relationship between financial leverage and firm investment. In contrast, the relationship is positive for high-growth firms with asymmetric information. The LSM model explains the negative relationship between financial leverage and firm growth. In addition to the asymmetric information, Mossin’s model also accounts for the asymmetric information that exists between investors and firms.
In contrast to the LSM model, Mossin finds that the value of a firm is largely independent of the level of debt that it bears. For small firms, financial leverage has no influence on the amount of money they invest. Moreover, the LSM model does not account for other sources of income. For a small firm, this gap is not filled by other sources of finance. In fact, it even reduces the investment of smaller firms.
The LSM model shows that financial leverage influences the value of a firm’s capital. For smaller firms, this relationship is positive, but the LSM model has the opposite effect. In general, the LSM model predicts that firm investment is negatively related to financial leverage. Thus, the LSM model has a negative impact on firm investment. Nevertheless, it identifies that the relationship between financial leverage and firm investment is not a negative one.
In contrast, the LSM model predicts the amount of new investment in a firm. The LSM model includes the riskless rate borrowing model, the LSM model, and the LSM model with no taxes. It shows that the impact of financial leverage on firm investment depends on the type of company. In both cases, financial leverage increases the value of a firm. The LSM model is a better fit for the LSM model of capital markets.