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The U-Shaped Investment Curve: Theory and Evidence

  • Sean Cleary (a1), Paul Povel (a2) and Michael Raith (a3)
Abstract

We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.

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COPYRIGHT: © School of Business Administration, University of Washington 2007
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Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
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