Determinants of corporate investment decisions the case study of vietnam

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM- NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DETERMINANTS OF CORPORATE
INVESTMENT DECISIONS:
THE CASE STUDY OF VIETNAM
..

A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

PHAN THI ANH DONG

Academic Supervisor:

PHAN DINH NGUYEN

HO CHI MINH CITY, May 2012


Certification

"I certificate that the substance of the thesis has not already been submitted for any
degree and is not currently submitted for any other degree.
I certify that to the best of my knowledge and help received in preparing the thesis and
all sources used have been acknowledged in the thesis."
Signature

Phan Thi Anh Dong
Date:

I

I 2012


Acknowledgements
This thesis marks the completion of my Master degree in Development Economics at
Vietnam-Netherlands project.
I am truly grateful to my supervisor, Dr. Phan Dinh Nguyen, for his help and support
over the period of my thesis. Without his help in constructive follow-up, insightful and
helpful comments, I would not have been successful in completing this master thesis.
I would like to express my deepest gratitude to all people and organizations that
supported, provided assistance and information in order to make this thesis.
Furthermore, I deeply appreciate the lecturers and staff of the project, who helped
improve my knowledge and fulfill the program. I am also grateful to my close friends
for their warm encouragement.
Finally, I further wish to thank my family members who have greatly supported me
during my study. Their love and support mean a great deal to me. I would like to
reserve the pleasure of the graduate for them. Thank you very much to all of you!

ii

Table of Contents

Certification .......................................................................................................................... i
Acknowledgements ............................................................................................................. .ii
Table of Contents .. :............................................................................................................ iii
List of Tables ....................................................................................................................... v
' List of Abbreviations .......................................................................................................... vi
Abstract .............................................................................................................................. vii
CHAPTER 1: INTRODUCTION .................................................................................... 1
1.1 Problem statement ...................................................................................................... 1
1.2 Research Objectives ................................................................................................... 4
1.3 Research questions ..................................................................................................... 4
1.4 Scope and Methodology of Research ......................................................................... 5
1.5 Research structure ...................................................................................................... 5
CHAPTER 2: LITERATURE REVIEW ........................................................................ 6
2.1 Theoretical literature .................................................................................................. 6
2.1.1 Irving Fisher's Theory oflnvestment .................................................................. 6
2.1.2 J.M. Keynes theory: Marginal Efficiency oflnvestment.. ................................... 8
2.1.3 Jorgenson's Optimal Theory .............................................................................. 10
2.1.4 James Tobin's q theory oflnvestment.. ............................................................. 12
2.2 Empirical literature ............................................................... ·...... ···· .. ······················ .13
CHAPTER 3: RESEARCH METHODOLOGY .......................................................... 21
3.1 Data sources .............................................................................................................. 21

iii


3.2 Variables ................................................................................................................... 21

3.2.1 Dependent variable ............................................................................................ 22
3.2.2 Independent variables ........................................................................................ 22
3.3 Modeling specification ............................................................................................. 28
3.4 Methods of estimation .............................................................................................. 29
3.5 Conclusion ................................................................................................................ 32

CHAPTER 4: EMPIRICAL RESULTS AND DISCUSSION ..................................... 33
4.1. Descriptive Statistics of dependent and independent variables .............................. 33
4.2. Correlation analysis ................................................................................................. 34
4.3. Empirical Results .................................................................................................... 36
4.3.1 Examining the determinants of corporate investment decisions using FEM
estimators .................................................................................................................... 3 7
4.3.2 Examining the determinants of corporate investment decisions using GMM
estimator ...................................................................................................................... 42

CHAPTER 5: CONCLUSION, RECOMMENDATION AND LIMITATION ........ 47
5.1 Conclusion ................................................................................................................ 47
5.2 Policy Recommendation ........................................................................................... 50
5.3 Limitation ................................................................................................................ ·51
References ......................................................................................................................... 52
Appendix ........................................................................................................................... 58

iv


List of Tables
Table 2.1: Empirical Studies about Determinants of Corporate Investment Decisions .... 59
Table 3.1: A Set of Dependent and Independent Variables ............................................... 23
Table 4.1: Basic Statistics of the Key Variables ................................................................ 34
Table 4.2: Correlation Coefficients ofthe Explanatory Variables .................................... 35

Table 4.3: Regression Analysis oflnvestment Equations ................................................. 36
Table 4.4: GMM Estimator oflnvestment Equation ........................................................ .42

v


List of Abbreviations

FE

Fixed Effects

FEM

Fixed Effects Model

GMM

Generalized Method of Moment

HET

Heteroskedasticity

IV

Instrument Variables

LM

Larange Multiplier

M&M

Modigliani and Miller

MEl

Marginal Efficiency of Investment

Pooled OLS

Pooled Ordinary Least Square

RE

Random Effects

REM

Random Effects Model

VAR

Vector Auto Regressive

WTO

World Trade Organization

vi


Abstract
The purpose of this study is to examme the impact of cash flow, investment
opportunities, and other financial factors on corporate investment decisions using panel
data for Vietnamese listed firm from 2006-2010. This research adopts static model
employing Fixed Effects which the most appropriate model in analyzing panel data
through specification tests. The findings indicate that cash flow is a key determinant of
corporate investment decisions. However, investment opportunities are positive and
insignificant related to investment decisions. Other financial factors such as fixed
capital intensity, business risk, firm size, leverage are all significant in predicting
corporate investment decision. Moreover, the study also adopts dynamic model
utilizing Generalized Method of Moments. The results confirm that cash flow is a main
element in making corporate investment decisions. Nevertheless, investment
opportunities are not significant in determining enterprises investment decisions.
Besides, the lagged level of investment is negative and statistically significant
correlated with investment decisions at firm level. Other financial factors, namely fixed
capital intensity, sales growth, firm size and leverage are all significant in influencing
corporate investment decisions.

Keywords: Corporate Investment, Cash Flow, Tobin's q, Financial Constraint

vii


CHAPTER 1: INTRODUCTION
1.1 Problem statement
The goal of any enterprises when operating as a business is oriented towards
maximizing the value of the firm, which in tum increases the return of investment for

shareholders. In order to achieve this goal, companies must implement a variety of
measures, including the selection of an appropriate financial structure. This is the most
important finance function amongst the modem items. It implicates decisions to
commit sources of financing to total assets of the firms. Capital expenditure or
investment decision has significant importance to the firm because of the following
reasons:
(1) it impacts not only growth of firms in long run but also influences firm's
risks;
(2) it involves liability of a large amount of capital;
(3) it is unalterable, or alterable at heavy financial loss; and
(4) it is one of the most difficult decisions to be taken by the firm.
Because of its role in the firm value, many researchers have studied this issue. For
instance, Modigliani and Miller theorem (1958) documented that there has been no
relation between the financial structure and financial policy for real investment
decisions under certain conditions, because the financial structure would not influence
the investment costs. According to the q-theory of Tobin (1969) and extended into a
proposed model by Hayashi (1982), investment demand could be predicted by the ratio
of the market value of the firm's capital stock to its replacement cost under perfect
market assumptions; and its market value could also explain further investment
opportunities.


Nonetheless, the results of previous studies in different countries using the q-theory of
investment are mixed. In particular, Hall et al. (1998) studied the key factors which
affect investment in scientific firms for the United States, France and Japan during the
period 1979-1989, and found that the profit, sales, cash flow and investment have
connections, but differs for each country. Aquino (2000) found contrary results that
there was no significant relationship between investment rate and q. He also showed
that there is an insignificant relationship between the investment rate and cash flow.
The Vietnamese government has implemented a series of policies aimed at improving

the business environment for enterprises in the country. This comes in the wake of
Vietnam's joining of the WTO in 2007, and since then, a variety of companies have
invested in multi-sectors businesses and spread-out, in order to become conglomerates.
This has conversely created a trend. These businesses have been investing in several
projects which do not relate directly to their strong main sectors such as real estate and
stocks, while the management capacity and inexperience of enterprises, the
government's institutions, and infrastructure have not developed as fast as the multisector and spreading investments.
Instead of investing directly in foundational material such as machinery, construction
and renovation of factories, research and development (R&D), and improving human
resource

managem~nt

so as to develop their businesses, they have chased the trend of

the multi-sector and spread investment so that they can obtain benefits immediately. As
a consequence, the efficiency in investment of corporate businesses lowers, and may
even be at the level of a loss. Because of this, it can cause stagnant equity, and
influence the financial situation of the firms. This could ultimately lead to bankruptcy;
as in the cases ofVINASHIN 1 and EVN2 •
1

VINASHIN is a Vietnam Shipbuilding Industry Group. This Group involved in many projects in several
different fields of economics beside its main business - shipbuilding; for instance, sea transport, ports, steels,

2


- -

--- - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Apart from this, it is not easy for enterprises to access sources of capital when real
lending interest rate is so high in recent time (normally, the real lending rate is 18% 20% per year; some cases is 23% per year). The reasons are by economic trends at the
domestic, regional and global level. This can thus affect the firms' investment
decisions and processes of production with their business operations. In other words,
investment issues affect not only the survival of the businesses, but also the levels of
unemployment and economic development of a country.
Although there are several papers that have studied on the determinants of investment
decisions at the firm level, these however are mainly focused on developed economies
and some emerging countries (e.g., the United States, the United Kingdom, Canada,
India, China, and Korea). To the best of my knowledge, only a group of researchers
have attempted to address this issue as it relates to the scenario in Vietnam, while
investment decision of the firms as become a big issue in recent years. Concretely,
Ninh L.K. et al. (2007) analyzed some factors involved with the impact on investment
decisions of private enterprises in the Mekong River Delta. Nonetheless, this research
did not determine other variables, namely investment opportunities, region, or business
risk, which might have an influence on investment decisions at the firm level. This
thesis, therefore, proposes to investigate this situation as it relates to a larger scale.

cements, beers, air services, insurance, banking, import (cars and motorbikes) and agricultures_ Because of multisector and spread investment, VINASHIN has been facing to financial problems in heavily (more than VND
80,000 billions or over USD 4 billions of debt) and facing lawsuits to be raised by foreign creditors (e.g., Elliott
Yin, Netherlands).
2

EVN is a Vietnam Electricity Group. This group invests not only in electricity- main sector, but also spreads in
hospitality, tourisms, media, real estate, etc. As a result, the group has been facing a large losses in recent years
(in 2010, the loss is VND 8,400 billions or over USD 400 millions) and facing large debts (as of June.30, 2011,
EVN has remained in debt to PetroVietnam about VND 8,860 billions or over USD 440 millions, and Vietnam
National Coal, Mineral Industries Corporation about VND 1,200 billions or over USD 50 millions).

3


1.2 Research Objectives
With investment situation of enterprises in Vietnam and the continuing importance of
c~rporate

investment decisions in mind, the overall goal of this thesis is to examine

factors which affect investment decisions at the firm level in Vietnam.
To achieve this overall goal requires meeting the following specific objectives:
(1) To determine whether cash flow affects corporate investment decisions;
(2) To determine whether investment opportunities exerts influence on investment
decisions of the firms;
(3) To test whether other financial factors impact on investment decisions at the
micro level such as leverage, sales growth, business risk, fixed capital intensity,
etc;
(4) To suggest policy recommendations for the enterprises in making decisions.

1.3 Research questions
Specifically, the research aims to address the following questions:
(1) Does cash-flow affect the investment decisions ofVietnamese firms?
(2) Do investment opportunities influence corporate investment decisions in
Vietnam?
(3) Can corporate investment decisions be explained by other financial factors in
Vietnam?

4

- - - -

-----------

-

--

1.4 Scope and Methodology of Research
The thesis will study this issue via 500 firms listed on the stock market in Vietnam
during the period of 2006 - 2010. Both static and dynamic approaches are utilized to
estimate the deterininants of corporate investment decisions through STATA 11
software. Specifically, the static econometric model specifications consist of Pooled
Ordinary Least Square (Pooled OLS), Random Effects Model (REM), and Fixed
Effects Model (FEM) to find the most appropriate model; whilst Generalized Method
of Moment (GMM) is employed in the dynamic econometric model.

1.5 Research structure
The thesis is organized in five chapters, including this introduction. Chapter 2 reviews
theories of investment and empirical studies of investment decision at the micro level.
Chapter 3 describes data collection and methodology in which the model for estimation
and method of estimation are outlined. Chapter 4 presents the results from analyzing
data and discussion. Chapter 5 briefly draws the conclusion, recommendations and
limitations of the thesis.

5


CHAPTER2: LITERATURE REVIEW

In this chapter, section 2.1 reviews key theories that are relevant for understanding
investment at the firm level. Following this, empirical researches will be also showed
in section 2.2 with the different contexts of the world in general, and of Vietnam in
specific focus.

2.1 Theoretical literature
The research introduces theories of investment in the time sequence, and begins with
the investment theory of Fisher ( 1930) in section 2.1.1. He concluded that investment
and interest rate have a negative relationship. Next, Keynesian theoty (1936) with
General Theory is discussed in section 2.1.2. He also had critiques on Fisher's works

but still having the same concept of marginal efficiency of investment. Finally,
neoclassical theories of investment are developed and reformulated by Jorgensen
(1963) and James Tobin (1968) in section 2.1.3.

2.1.1 Irving Fisher's Theory of Investment
Irving Fisher is the first person who introduced theory of investment in the Rate of
Interest in 1907, and further developed in Theory of Interest in 1930. He assumed that

all capital was used up in the process of production, called circulating capital or
investment. Given that output is related to investment, a production function can be Y
=

f(L, I) where Y, L, I denoted by output, labor, and investment respectively. Then, he

assumed that investment in any time period only produce output in the next period.
Therefore, returns from investment are defined as

1t

= Yt+I- (1 + r)lt where 1t denoted

by profits and r denoted by the rate of interest.
The formula of profit maximization of the firms can be written as:
max 1t = f(lt)- (1 + r)lt
6


------------------------------

- - - --

Hence, the optimal investment decisions will be where/'= (1 + r) or if' - 1) = r.
Fisher called if ' - 1) as "the rate of return over cosf' where both cost and return are
differences betWeen two optimal income streams. Precisely, f (11) is a concave curve,
so, when 11 increases, f' will decrease. Because interest rate increases, it leads to a
decrease in investment. Therefore, there is a negative relationship between investment
and interest rate.
Although Fisher found that investment is relevant to the rate of interest, his theory still
raises problems relating to ownership structure and financial decision. If supposing that
firms are owned by entrepreneurs, might it not be that corporate investment decisions
are influenced by the desired consumption-saving decisions of the owners? Moreover,
is there a relationship between investment decisions and financial decisions? These two
questions would be answered by reworking his full theory of investment into a "twostage" budgeting process; Hirshleifer (1958, 1970) noted these are:
(1) the firm's investment decision is separate from its owner's attitudes towards the
investment; and
(2) the investment decision is separate from the financial decision.
In addition, Keynes (1936) criticized the term 'interest rate' in Fisher's investment
theory as well. Keynes acknowledged that "Professor Fisher uses his 'rate of return

over cost' in the same sense and for precisely the same purpose as I employ 'the
marginal efficiency of capital' ..." (Keynes, 1936: p.140). Therefore, the optimal
condition for corporate investment decisions is that marginal efficiency of investment
equals to the rate of interest.
However, Keynes commented on two assumptions of Fisher which are necessary for a
determinate theory. The first assumption, savings today is consumption for future.

7


Keynes illustrated the first assumption "it does not necessitate a decision to have a
dinner or to buy a pair of boots a week or a year hence or to consume any specified
thing at any specified date" (Keynes, 1936: p.21 0). The second assumption looks at the
effect of interest rate in its regulation of the degree of impatience. Set capacities would
limit the output, as it compared with one of Fisher's "ineligible" options. The bottom
line for profit lies in the tally of the complete income derived from the investment, and
ex ante saving with all projects.
In brief, the first theory of investment is displayed by Irving Fisher in 1930. He
concluded that investment and the rate of interest have a negative connection.
Nevertheless, Keynes debated the nature and source of interest in Fisher's theory and
find another invest111ent theory reviewed in the next section.

2.1.2 J.M. Keynes theory: Marginal Efficiency of Investment
In General Theory, Keynes (1936) emphasized the central role of investment in the
theory of aggregate output and employment. His view differed from traditional views
in two fundamental ways. First of all, the importance of investment did not result only
from its long-run effect on capital stock growth, but also on driving force of aggregate
demand and short-run fluctuations in economic activity.
Secondly, he rejected the micro-foundations of investment that were based exclusively
on technological conditions of capital productivity by stressing uncertainty, finance,

and monetary factors as fundamental determinants of investment. This theory provided
a rich source of theoretical and empirical literature, which supported for financial
influence on investment through significant effects of liquidity and profits in a variety
of empirical investment functions.
In the General Theory, he also put forward the relationship between investment
decisions and interest rate in an investment function, namely I= I0 + I(r). He assumed
8


that firms got series investment projects that depended on their internal rate of return.
Firms needed to choose one or some of them to undertake. Consequently, which
projects would be chosen? He concluded that given a rate of interest, firms would
choose projects whose the interest rate was below marginal efficiency of investment
(MEl) or internal rate of return.
In other words, given available projects, firms will invest until their internal rate of
return is equal to the interest rate.

3

This means that a decrease in interest rates should

reduce the investment costs relative to the potential yield. Consequently, the marginal
capital investment of projects might be worthy. Therefore, firms would invest until the
discounted yield exceeds the projects' costs; or, the relationship between investment
and the interest rate becomes negative.
However, there were several critiques on Keynes's theory. Firstly, Alchian (1955) and
Hirshleifer (1970)

~riticized

the view that when it came to interest rates, ranking or

priority projects may not be unaffected. Keynesian theory specifically functions
consistently when there is the maximization of the standard present value provided that
at least one investment project and one outside option exist. In a scenario where
multiple investment projects were present, they Keynesian ranking would differ
specifically in the value maximization as the interest rates affect the ranking.
Secondly, Asimakopulos (1971, 1991) and Garegnani (1978) criticized on the
possibility of a downward-sloping MEl function in the presence of unemployment.
Specifically, the multiplier issue of Keynes refers that output and aggregate demand
would increase when investment is performed by the multiplier. However, considering
3

J.M. Keynes definited the internal rate of return as the marginal efficiency of capital, which Abba Lerner ( 1944,
1953) renamed as the marginal efficiency of investment. "I define the marginal efficiency of capital as being
equal to the rate of disco~nt which would make the present value of the series of annuities given by the returns
expected from the capital asset during its life equal its supply price (or replacement cost)" (Keynes, 1936: p.l35)

9


the dependency of the MEl function on future returns, could an increased level of
income and profit imply that the multiplier would make a prediction of higher returns
possible?
If this is in fact the case, then the MEl functions have no other option but to shift
outwards to the right. It means that an increase in investment leads to another increase
in aggregate demand; and, hence the MEl curve would shift outward once again,
increasing investment, and so on. As a result, investment is not determinate in
circumstances of unemployment in which the multiplier works its marvelous. This
could be interpreted that if the MEl curve was in fact continuously shifting, then all of

the investment projects would be eventually given the capacity to be undertaken, not
just the ones whose level of profitability determine their viability. The problem of
interest rate movement will always affect the level of profit gained by individual
projects, as well as total demand for the project across the broad sector of the
population.
In short, in his theory, Keynes made much of investment decision but was quite about
the underlying fixed capital. He proposed a negative link between investment and
internal rate of return or MEl. Alternatively, a firm will invest in a project if MEl is
greater than or equal to interest rate. Nevertheless, some researchers debated about the
assumption of rank in various investment projects depending on their MEl; and, the
MEl concept of Keynes and "rate of return over cost" of Fisher is not the same if
having an unemployment situation.

2.1.3 Jorgenson's Optimal Theory
Based on the neoclassical theory of optimal capital accumulation, Jorgenson (1963,
1967, 1971) developed an alternative investment theory. He began with definition of
the present value of the firm.

10


Let output at any particular time be related through the production function: Y = f (L,
K)

Then, returns at any particular time are given by:
R(t) =total revenue- total costs= p.Y- w.L - q.l
Where Y, L, and I denoted by levels of output, variable input, and investment in
durable goods and p, w, and q denoted by the corresponding prices.
00

00

So that the value or"the firm is represented by: W = JR.e-ndt = J[pY -q/ -wL].e-r'dt
0

0

Gross investment is defined as: dK =I -8K, so the problem of maximizing present
dt

00

value is:

maxW = J[pY -q/ -wL]e-r'dt
0

According to Hamiltonian expression: H = pf(K, L)- ql- wL + A.(l- <>K) where A.
represents the capital's shadow price.
The first order conditions for the optimal capital are:
dH/dl = -q + A.= 0 (*);

dH/dL = pJL- w = 0;

- dH/dK = -pfK + }.() = d)Jdt- rA.;

dH/dA. =I- <>K

The second condition isJL = w/p. From(*) we have q =A., so dq/dt = d)Jdt.
Hence, dq/dt -rq = -P/K + q()

or p.fk = q[() + r- ( dq/dt)/q]

If we callfK = dY/dK, the marginal product of capital is:fK = q[<> + r- (dq/dt)/q]/p

11


Then, "real user cost of capital" defined as: c = q[o + r- (dq/dt)/q]. So, pfk =cor /K =
p/c.
Using Cobb-Doughlas function Y = KaL(a-1), we have:fK = a(YIK), then K* =paY/c.
Generally, K* = f(Y, p, r, q, o, dq/dt) = f(Y, p, c) where K* relies positively on Y and p
and negatively on c.
In terms of investment, how does one obtain investment? In order to obtain the rate of
investment determinate, Jorgensen subsequently appended a distributed lag function.
As a consequence, actual investment at any time period is the sum of the proportion of
past

desired

investment

that

will

be

delivered

at

time

t:

I,= A-oM( +A,M;_, +... +A..nb.l(_n

This pattern has proved controversial in the literature, namely, Lucas (1967), Jame
Tobin (1968). It not only leads to auto-correlated errors but also becomes almost
indistinguishable the accelerator theory of investment. Consequently, Jorgensen's
theory of investment, which depends massively on prices as independent variables,
shows that it based on ad hoc stock adjustment mechanism and is incompetent at the
level of practice.
In summary, Jorgensen's theory of investment derives the optimal capital stock under
constant returns to scale and exogenously given output (Hayashi, 1982). In order to
obtain the investment, he subsequently added controversial delivery lags. However,
this theory still has some problems, i.e., the rate of investment cannot be determined; it
is difficult to verify. in practice.

2.1.4 James Tobin's q theory of Investment
Tobin's q theory of investment was presented in 1969. This theory resolved the
problem of Jorgensen's theory of investment, undetermined investment rate. It is a
12


function of q,

whic~

is a ratio of the value of the firm to the replacement cost of the

firm's capital stock.
Tobin's idea is that if market evaluates a firm which is higher than its physical capital,
it is a signal that the market suggests that this company has the potential for growth.
Moreover, Tobin's q theory proposed that when q is more than or equal to 1, a firm
will promote investment for growth. Otherwise, when q is less than 1, the firm will
disinvest by selling physical capital or reducing the investment lower than depreciation
in order to decrease physical capital automatically.
However, Hayashi (1982) noted that with a certain assumption (homogeneity, linear
costs), Tobin's q is shadow marginal benefit of capital. It means that Tobin's q is more
than or equal to 1, the firm will invest $1 in machinery and equipment and profit will
be more than $1 in the future. In fact, this seems like a rather obvious truth but it marks
an advance in the ·economic world. From that, they can endogenize the investment
function in the model rather than using an ad hoc investment function as before, i.e.,
Keynesian investment.

2.2 Empirical literature
The relationship between investment and finance is popular with the matter that
financial structure is relevant to corporate investment decisions since imperfect capital
markets exist. Meyer and Kuh (1957) emphasized the role of financial variables in
firms' investment decisions and existence for internal source of funds. Studies
investigated how financial choice of a corporation impacted on its investment delayed
in 1960s, following the work by Modigliani and Miller (1958), hereafter M&M, who
identified the link between financial structure and financial policy for real investment
decisions under four certain conditions; and extended this to neoclassical models of
investment; for instance, Jorgenson (1963); Hall and Jorgenson (1967).
13

Tobin (1969) and Hayashi (1982) explored q-theory4 of investment as a reformulation
of the neoclassical theory and developed it assuming a perfect capital market and
convex costs of adjusting the capital stock. According to the q-theory, the ratio of
market value of the firm's capital stock to its replacement cost could demonstrate for
investment demand. In other words, the central method which creates an impact on
financial policies and events on aggregate demand is by altering the assessment of
physical asset relative to its replacement cost.
M&M (1958) postulated that the financing and real investment decisions of the
companies made separately from each other. Furthermore, this theorem claimed that
the enterprises' ·investment should be embarked upon only according to those factors
which would enlarge the profitability, cash flow or net worth of the firm and there was
no connection between financial markets and corporate real investment decisions.
Nevertheless, this theorem will only be correct in a world of perfect capital markets
(symmetric information, no transaction costs, no default risk, and no taxation).
M&M theorem cannot interpret investment decisions at the micro level if having
asymmetric information in the market. Concretely, imperfect markets exist in
developing countries, firms have more information about the profitability and risks of
investment projects than the suppliers of funds have. Besides, corporate finance theory
also suggests that market imperfections may repress the capacity of the corporate to
fund investments and would perpetually influence the investment decisions of the
firms.
Moreover, the theoretical models of asymmetric information also referred to the
magnitude of investment decision. For instance, Akerlofs (1970) examined the role of
4

The second version of the neoclassical approach suggested by Tobin and Hayashi is that the rate ofinvestment
is a function of q, the ratio of the market value of an additional unit of capital or of existing capital to its
replacement cost. (Hayashi, 1982, p.214)

14

asymmetric information in the market for lemons. He built an economic theory and
proved how markets fail when buyers have less information than sellers which leads to
an adverse selection, moral hazard or both. This is other corollaries of informational
asymmetry. The cost of higher interest rate might lead to nearly good companies with
safer projects so as to leave the applicant pool. It might also cause enterprises to take
on riskier projects with higher expected returns. Thus, if there are adverse selection and
moral hazard, the ratio of 'lemon' in the applicant pool and the probability of default
will increase. He then illustrated through some applications that later researchers could
put this theory into the firms' seeking funds from lenders; for instance, Stiglitz and
Weiss (1984) with similar arguments 5 •
Fazzari et al. (1988) investigated the effect of financing constraints on the investmentto -cash-flow sensitivity. After controlling for investment opportunities with Tobin's q,
they employed the dividend rate so as to distinguish firms which were facing financial
constraints or not. They found that cash flow could impact investment because of the
capital market imperfection, the asymmetric information and the lemon problem.
Alternatively, the effect of investment on cash flow considered as a policy problem of
welfare reduction, a capital market failure or an inefficient fund that is similar to
problems mentioned in previous researches (e.g., Akerlof, 1970; Stiglitz and Weiss,
1981 ). In addition, Fazzari et al. (1988) also observed that internal sources of funds are
less costly than external sources of funds in the capital market imperfection, which is
suitable for Myers and Majluf(1984) 6 •

5

they showed that the key issue that the lenders confront with the existence of informational asymmetry (a
consequences of informational asymmetry).
6

They demonstrated that the cost of internal funds is lower than that of external funds due to asymmetric

information between lenders and borrowers.

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Added to this, there are also two further issues - agency costs and transaction costs that
can explain fluctuations in the investment. Firstly, agency costs theory developed by
Jensen and Meckling (1976) can answer the problem that why a firm that is
confronting the costs of higher interest rate does not try to get money from other
sources (i.e., debt, equity market). Agency problems arise when having a conflict of
interests between managers, creditors, and shareholders because of differing goals.
Secondly, the costs of a transaction combined with the issue of debt and equity issue
might increase the cost of external financing. It is supposed that debt is the only
channel of external. funds available to the firm. Debt financing allows the creditors to
be entitled to the interest payment, and have their principals at the expiry date. If not
making scheduled payments, then the physical assets of firm will be sold in order to
raise funds. This depends on the firm's ability and its degree to which it can redeploy
its assets. There are usually non-redeployable durable assets (i.e., a building, a ship, or
a factory) in a high specified investment project; thus, it is quite difficult to recover
funds from liquidation. In this circumstance, in order to protect the creditors' interests,
they will create disadvantages for the debtors with higher interest payments, restricting
the size of loans and so forth.
A large level of empirical literatures followed, namely Hall et al. ( 1998) and used the
Panel Data version of the Vector Auto Regressive (VAR) methodology to examine the
determinants of investment in scientific firms for the United States, France, and Japan
during the period 1979-1989. They found that there were tighter relations between
investments on the one hand, and profits, sales, and cash flow on the other hand differs
for each country. Hubbard (1998) analyzed various factors (e.g., inventory investment,
research and development (R&D), employment, business formation and survival,
pricing, and corporate risk management) which determine the link between cash flow

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and investment decisions by using the U.S. data. Hubbard's results strongly support
that there was a significant relationship between investment and changes in net worth.
Furthermore, Carpenter and Guariglia (2008) estimated investment regressions
distinguishing the firms' abilities to the face financial constrain in the UK firms over
the period 1983-2000. They observed that cash flow could not explain the sensitive
nature of investment decision for large firms; however, its explanatory power was still
the same for small firms. It implies that the significance of a cash-flow variable in
investment equation could be caused by information asymmetries in the capital market.
In addition, there were several researchers who afforded an opportunity to analyze the
link between investment and imperfect capital market without employing q as a proxy
for investment opportunities, but applying different measures of investment
fundamentals that also supported the findings' Fazzari et al. (1988). In particular,
Gilchrist and Himmelberg (1995) used VAR methodology to examine an available
information database relating to firms from the period 1979-1989 in the United States.
They afterward estimated a linear expectation of the present discounted value of
marginal profits, as a measure of corporations' investment opportunities; then
estimated regressions of investment on the latter variable and cash flow. Finally, they
concluded that the neoclassical model without cash flow only holds for firms less
likely to face financial constraints (Carpenter and Guariglia, 2008, p.1896).
Nevertheless, Kaplan and Zingales (1997) disclaimed results of Fazzari et al. (1988).
They investigated that accustomed use of the sensitivity of investment to cash flow like
a measurement of financial constraint. They then implied that the less financial
constraints the firms face in corporate investment decisions, the more sensitive to the
availability of cash·flow they are. In the same way, Erickson and Whited (2000) also
argued that the link between cash flow and investment will not appear once explaining
investment on a measurement error in q and cash flow.

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