What Is Firms’ Working Paper and Why Does It Matter?

Firm investment has been a matter of debate and confusion among economists. A recent study by Garyorno and Hirose (eds), “Firm Investment and Its Effects on Company Innovation”, Journal of Corporate Finance, 11(2): pp. 401-459. This research was done to shed some light on the issue of firm investment. The study finds that the effect of financial leverage on firm investment over the long run is important for large information asymmetric companies.

Firm Investment

The analysis further shows that the relation between firm investment and economic growth is particularly important for small-scale firms in emerging markets. But no such strong relationship is found for large-scale companies in developed countries either. Instead, for these firms, the effect of leveraged investments seems to be temporary. Eventually, the investment costs may outweigh the benefits.

Further analysis of the firm investment literature suggests that there are many reasons why firms make the decisions to invest in stock market shares. Chief among them is the need for short-term profits. Since dividends are unlikely to be paid for many years, firms have little motivation to accumulate long-term savings. In addition, most firms purchase their stocks through brokers, who use the proceeds to finance the purchase of long-term securities. The logic is that unless the funds generated from the stock market are used immediately, they will not earn any interest.

Analysis of the literature suggests that firms tend to behave like investors, focusing on potential gain over the short term rather than long term viability. Many firms buy and sell shares on the basis of the stock market trends. But analysis also shows that they are not very good at forecasting the long-term profitability of their investment decisions.

Probably the most common rationale offered by firms for making investments is that they believe that they can control risk better than other people can. As pointed out above, European institutions have been successful in avoiding financial crises because they have adhered to proper money management discipline. This discipline in fact involves the use of supervisory architecture – the combination of effective internal control and external supervisory architecture. Supervisory architecture refers to the overall approach to firm investment decisions. External architecture refers to management processes and the supervision exercised by regulatory authorities such as the European Central Bank.

Another commonly cited reason why firms make proactive decisions regarding investment involves the need to comply with banking Union rules. Supervision is exercised by the European Central Bank (ECB). Supervisory architecture refers to the overall approach to firm investment decisions. Finally, analysis of the literature reveals that the major obstacle to banking union supervision has been the reluctance of banking supervisors to assume direct control over financial activities. This reluctance seems to be weakening, although support for greater banking supervision is likely to increase as new bank failures are less frequent and bank regulators become more knowledgeable about the risks that their actions will cause.