Investment, Capital Structure, and Complementarities between Debt and New Equity Author(s): Rune Stenbacka and Mihkel

Tombak Reviewed work(s): Source: Management Science, Vol. 48, No. 2 (Feb., 2002), pp. 257-272 Published by: INFORMS Stable URL: http://www.jstor.org/stable/822662 . Accessed: 05/07/2012 04:32
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Investment,

Capital

Structure,

and

Between Complementarities Debt and New Equity

Rune Stenbacka * Mihkel Tombak
Swedish School of Economicsand Business Administration,Helsinki, Finland Queen's School of Business, Queen's University, Kingston, Ontario, Canada,K7L 3N6 * rune.stenbacka@shh.fi mtombak@business.queensu.ca

e study simultaneous investment and financing decisions made by incumbent owners in the presence of capital market imperfections. We present a theory for how the optimal combination of debt and equity financing depends on the firm's internal funds. We identify complementarities between the two financial instruments. We test these predictions empirically with panel data on 3,119 corporations in the COMPUSTAT database. Our estimates using instrumental variable techniques support our theoretical predictions regarding the link between internal funds and capital investments, as well as the interaction effects between debt and new equity. We explore implications for managers, financiers, and policy makers. (Investments; Financial Constraints;Capital Structure;Complementarities)
W

1. Introduction
There is overwhelming evidence for the importance of investments as an engine for economic growth.1 In 1998, U.S. nonfarm, nonfinancial corporations made capital expenditures of $707 billion (increased from $430 billion in 1993) (Department of Commerce 1999). Research in a variety of fields such as macroeconomics, public economics, industrial organization, and financial economics has generated insights concerning the foundations for the investment decisions of firms. A robust finding from a wide spectrum of
DeLong and Summers (1991) find that an extra percent of gross domestic product (GDP) invested in equipment is associated with an increase in GDP growth of one-third of a percent per year and argue that investment causes growth. Other studies also empirically found a (positive) relationship between investment and economic growth (see, for example, Barro 1991). Indeed, the endogenous growth literature is based on such a relationship. Levine and Renelt (1992) find the GDP investment share to be one of only a few variables that provide a robust positive correlation to growth in cross-country regressions. 0025-1909/02/4802/0257$5.00 1526-5501 electronic ISSN

empirical studies is that financial constraints play an important role in determining investment behavior (Hubbard 1998). Also, Rajan and Zingales (1998) offer empirical evidence of the impact of financial market imperfections on investment and firm growth. In the current study, our main objective is to demonstrate, both theoretically and empirically, that there are important interactions between different instruments of external financing and to characterize the impact of these interactions on the investments of financially constrained firms. Our study holds a number of implications for investment managers in the presence of financial constraints. Our analysis suggests that firms should initially acquire debt when the enterprise is small and leverage that debt to create retained earnings. Then, as retained earnings accumulate, managers should simultaneously acquire both new equity and debt to take advantage of the complementarities identified between these two financial instruments. Exploitation of these complementarities generates an acceleration
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STENBACKA AND TOMBAK and Investment, Structure, Complementarities Capital

of the investment-based growth of financially constrained firms. Our study also addresses the strategies of lenders. The analysis suggests that the monitoring activities of banks should be directed particularly to debtors with low levels of retained earnings as the investment programs of such projectholders involves the highest default probability. Finally, our research speaks to industrial policy makers. This study suggests that policy makers, particularly those in emerging markets, should emphasize the simultaneous development of the two types of financial markets (debt and equity). In light of the complementarities identified, the simultaneous development of the two types of markets would be preferred to a specialized focus on any one type of financial instrument in isolation. The literature in corporate finance addressing capital structure typically takes the magnitude of the investment project as given and it focuses on the combination of debt and equity as if investment is a cause of the debt and equity ratio. The investment theory literature distinguishes between internal and external financing, but seldom pays attention to different instruments of external financing. We shall argue that both capital structure and investment are endogenous and that they both depend on more basic ingredients such as the nature of the capital markets, the characteristics of the investment opportunities available to the firm, and the internal funds the firm has available. In the current analysis, we focus on the simultaneous determination of investment and capital structure of financially constrained firms with access to both debt and equity markets.2 As long as the conditions of perfect capital markets are satisfied, we know from the Modigliani-Miller irrelevance theorem that the investment programs of firms would be unaffected by financial constraints. As the survey by Harris and Raviv (1991) shows, past decades of research established how capital market
2 In their

empiricalstudy,Kovenockand Phillips(1997)also emphaand investment decisions are endogesized that recapitalizations nous. They examine whether capital structuredecisions interact with investment decisions after controlling for product market characteristics.

imperfections in the form of tax distortions, asymmetric information generating problems of adverse selection and moral hazard, interactions with imperfectly competitive product markets, or contests for corporate control will make a significant difference for capital structure and investment behavior. In particular, in exploring the consequences of informational asymmetries, an influential stream of microoriented research established how financial constraints will restrict and distort the investment programs of firms once these have to be based on external financing through the debt or equity markets. A recent more macrooriented approach, surveyed by Bernanke et al. (2000), studied how credit market imperfections can generate cyclical economy-wide fluctuations. Furthermore, they investigate how financial accelerator effects can explain why cyclical movements in investment will exceed the magnitude of fluctuations in expected future profitability or in the user cost of capital. One could view the firm's added value as generated by investment projects characterized by uncertainty. In our model of firm investment, we make a distinction between incumbent and new shareholders (see for example, Blanchard et al. 1993). We focus on existing owners maximizing the value for the incumbent shareholder by determining the capital structure simultaneously with the magnitude of the investment program. Initially, we characterize theoretically how the optimal combination of debt and equity financing will depend on the firm's internal funds available for investment. This optimal combination of debt and equity reflects a tradeoff between the bankruptcy risk associated with debt and the dilution cost to incumbent shareholders of new equity. Our theory identifies complementarities between these two financial instruments. Such complementarities would then be a source of financial accelerator effects at the firm level. Subsequently, we test these predictions empirically on financial data on 3,119 publicly traded manufacturing and telecommunications corporations in the Standard and Poor's COMPUSTAT database for the years 1982-1992. Our empirical analysis lends support to our theoretical predictions regarding the link between internal funds and capital investments and evidence regarding the interaction effects between debt and new equity. An implication of this study is that when
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there are financial market imperfections, it is important that there be several financial instruments as the complementarities between them may mitigate some of the adverse effects on investment of the imperfections. This paper is organized as follows. In the next section, we present the theoretical model underlying our study. It begins with a description of the firm's investment opportunities and we examine the investment decision of a financially constrained firm. Initially we analyze the case where the outside financing is solely debt, then the case where new equity is the only source of financing, and finally, the case where these financial instruments are optimally combined. In ?3, we present the empirical part of the study by describing the data, the econometric models, and the estimation technique. The results of the estimation are then reported and interpreted. Finally, we summarize and discuss the conclusions and present avenues for further study.

first-order stochastic dominance and thereby satisfying the following assumptions: For every investment level it holds that4
ASSUMPTION 1.

Fx(y/X) < Ofor all 0 < y < M.

ASSUMPTION2.

Fxx(y/X) > Oforall 0 < y < M.

Assumption 1 captures the idea that an increase in investment shifts the probability density to higher returns. Assumption 2 means that the shifting process takes place at a decreasing rate and it is needed to make sure that the sufficient second-order conditions of the underlying maximization problem are satisfied.5 A financially unrestricted firm would choose its investment to maximize +(X)= f (ir/X)d
-RoX,

where RoX is the opportunity cost of capital. Integration by parts transforms this objective function into = M(X) M M F(Xr/X) d7- RoX.

2. Firm Net Worth and Investment-The Theory

2.1. The Basic Model In this section, we initially depict a model where the firm is unrestricted in its use of capital and we describe some of the main assumptions underlying the investment technology under consideration. Our analysis is focused on a firm operating in the absence of strategic considerations regarding the product market.3 A firm invests the volume X that generates random project returns r(X). The conditional probability distribution of project returns is described by the density function f(rrIX) with a support on the interval [0, M]. The corresponding distribution function is denoted by F(Tr/X) = fo f(y/X) dy. We concentrate our analysis on investment technologies displaying
3 Brander and Lewis (1986), Maksimovic (1990), Showalter (1995), and Faure-Grimaud (2000) have examined the relationship between financial structure and imperfect product market competition along several dimensions.

The necessary first-order condition for a profit maximizing investment, X = X*, is

M

-Jo

Fx(iT/X*)dT = Ro,

(1)

so that, in this unconstrained case, the marginal return on investment equals the opportunity capital cost. This is illustrated in Figure 1, where X* denotes the investment in the absence of financial constraints. The sufficient second-order condition for optimal investment is
M

-F

Fxx(X/X)dr

< 0,

which holds by Assumption 2. The investment technology characterized in this subsection will now be used as a benchmark in our subsequent analysis.
4 In Fx(y/X), the subscript denotes the partial derivative of the distribution function F(y/X) with respect to investments. 5A related set of technological assumptions was introduced in Koskela and Stenbacka (2000) to study the relationship between market structure, risk taking, and social welfare in lending markets.

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STENBACKA AND TOMBAK and Investment, Structure, Complementarities Capital

1 Figure

Constraints Investments Financial Under

Costof Capital

Ro

W' X x"'

X'

Investment

2.2. Capital Structure and the Impact of Financial Constraints In this section, we examine a situation where the firm's internal capital or net worth is insufficient relative to the optimal scale of the investment project. This could be seen as a reflection of our model being primarily concerned with growing firms that have sufficiently attractive investment opportunities relative to the available financial resources. The firm uses all of its available internal capital, to which we refer as the firm's net worth (W), as a primary source of finance and it can complement its investment program with external financing in the form of debt (D) and/or outside equity (K). In the subsequent analysis, we thus focus on firms that are financially constrained so that W < X*, where X* denotes the first-best investment level characterized in Equation (1). We focus on capital markets characterized by imperfections implying that we are outside of the Modigliani-Miller framework. Because of informational asymmetries, the debt and equity markets face problems associated with adverse selection and moral hazard. The market imperfections in the capital market lead to a gap between the cost of external and

internal financing as illustrated in Figure 1 and in the survey by Hubbard (1998). Bond and Meghir (1994) present empirical support for internally generated finance being available at a lower cost than external finance. Thus, with capital market imperfections, the firm's investment is systematically related to changes in the firm's available internal capital. Our analysis proceeds by first examining the case where the firm's outside financing of its investment is restricted to debt. We then proceed to analyze the case with new equity as the instrument for outside financing. Subsequently, we investigate combinations of debt and outside equity to understand how these sources of funding interact. 2.2.1. Debt Financing. With debt as the only instrument for outside financing, a firm with net worth W will decide on its debt level D to maximize M (T - DR(D, W))f (T/D + W)dr - RoW, (D, W) =

where -r = DR(D, W) represents the cost of servicing the debt, while the interest rate factor on the debt, R(D, W) = 1 + r(D, W) (where r(D, W) is the interest rate), is a function that satisfies RD > 0, Rw < 0,
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STENBACKA AND TOMBAK

and Investment, Structure, Complementarities Capital

RDD> 0, Rww 0, and RDW < 0. The lending rate factor is assumed to have an intercept greater than or equal to the opportunity cost of capital (R(O, W) > Ro). In light of Assumptions 1 and 2, we assume that the interest rate factor is an increasing and convex function of debt. To simplify the expressions below, we will not display the argument for the interest rate function. We can think of 7- as the break-even state of project returns above which the projectholder remains solvent. The objective function reflects that the projectholder operates with limited liability being concerned only with those states of nature where the profit exceeds the cost of debt servicing, i.e., rT> 7 = DR. Thus, the projectholder faces a probability of bankruptcy equal to F(7 ID + W). The term RoW represents the opportunity cost of capital for the debt-financed firm. Note that D can be rewritten as X-W so that there is a one-to-one correspondence between the investment and the debt. As W is exogeneous, the optimal investment level will depend on the debt cost. The first-order condition for optimal debt (D*) is M -(D*R + R)(1 - F(*/XD)) - | Fx(7T/XD)d7 = O, (2)

to Equation (1). Under such circumstances, the source of financing would be irrelevant (as in the ModiglianiMiller model). By complementing the mean-shifting Assumptions 1 and 2 with the additional6 Assumption 3, it is guaranteed that the firm's debt-financed investment problem is a concave program.7
ASSUMPTION3. (RD D + R) F,(rq/X) + Fx('q/X) < 0.

How does the firm's net worth constrain the firm's investment with debt as the instrument for external financing? As XD = W + D* it follows that
dXD

=1+ aW 1+

dD*

By totally differentiating Equation (2) with respect to W we obtain

ad2q dD* ad2 + =0. aD2 aW dDdW

Combining the two expressions above, we find that
aXD (da2i/,
a2i a2_/

dW

RdD2-dDdW
R -R .D

dD2
D- 2R)(1 - F(n/X))

= ((RW D +
+ (R

+ R)2F,(7)/X)

where 7r*denotes the break-even state of nature associated with optimal debt and where XD = W + D*. Initially, the left-hand side (L.H.S.) of Equation (2) is positive capturing that the investment return is high for low levels of investment. As the lending rate increases with debt and as the returns decrease with the investment volume, the L.H.S. of Equation (2) decreases to zero at the investment equilibrium. The debt-financed equilibrium defined by Equation (2) will be reached as debt is expanded until the lending rate factor is equal to the conditional marginal revenue from an additional unit of investment in those states of nature that keep the projectholder solvent. As an additional consideration Equation (2) takes into account that a debt increase will increase the interest rate and thereby shift the break-even state of nature. It can be seen from Equation (2) that if the interest rate factor were not a function of debt and equal to that of internal capital (R = Ro) and if there were no limited liability effect (7 = 0), then Equation (2) would be equivalent
MANAGEMENTSCIENCE/Vol. 48, No. 2, February 2002

+ (RD. D + R)Fx(71/X))/fDD. Our assumptions on the lending rate function make the first term in the numerator negative, while Assumption 3 implies that the last two terms are
6 For the special case when R(D, W) is constant, this assumption can be shown to be equivalent to the ratio

dTr _M FX(TlX) 1-F(7IX)

being decreasing as a function of q7. Such an Assumption is analogous to the monotone likelihood ratio-condition frequently employed in the principal-agent literature. 7It can be verified by straightforward calculations that '0D,(D, W) = -(2R + D*RDD)( - F(l* IX ))

+ (D*RD+ R)2F, (7* XD) +2(D*RD + R)Fx(XI*IXD) The combination

%DD(D, W) <0.

f
17*

Fxx(rIlXD)dr.

of Assumptions

1, 2, and 3 implies that

261

STENBACKA AND TOMBAK and Investment, Structure, Complementarities Capital

2a Figure

Investment Debt-Financed X
cX*

xD

Internal financing region

w negative. Consequently, with an increase in equity, investment will increase. Furthermore, a comparison of the numerator with the second-order condition in the denominator yields a condition under which debt will also increase with an increase in net worth. More precisely, we find that
aXD

<1 >1

if Condition 1 holds, otherwise,

aW

where Condition 1 is given by

(RDW. D + Rw)(1 -F('q/X))

>(D*RD+ R)F(*

IXD)-

Fxx(lXD) dT.

We can see that if R is not a function of the net worth, Condition 1 will always hold. In such a case, the L.H.S. of Condition 1 would be zero, while the right-hand side (R.H.S.) would be negative. Thus, in the absence of an effect (or with a small effect) of W on the interest rate function, the optimal debtfinanced investment would be as illustrated in Figure 2a by XD. With a sufficiently strong effect of W reducing the interest rate function and the rate of growth thereof, the investments will initially grow at a rate faster than the growth of W as illustrated in Figure 2b. In both cases, the optimal debt-financed
262

investment functions would be concave due to the declining returns on investment. In the second case, the effect of the declining returns is augmented by the declining effect of W on the interest rate function (Rww > 0). Thus, even in the presence of an effect of W on the interest rate function, Condition 1 will eventually hold and the growth of the optimal debtfinanced investment will be slower than the growth of net worth. The optimal investment with debt as the only instrument of external financing, XD, is illustrated in Figures 2a and 2b. At W = 0, one would expect a positive intercept of the debt-financed investment function. That is, an entrepreneur equipped with an idea (that can be represented by our investment technology) but with no money, will find it optimal to carry out the investment as a fully debt-financed project. Otherwise, the available investment opportunity would not be worthwhile for the entrepreneur to undertake. This intercept could be interpreted as the value of the business idea among other factors. This also reflects the typical feature of neoclassical production functions according to which the investment return is high at low levels of investment. At the intercept, the net worth would have its largest marginal impact implying that Rw and RDw would be at their maximum in absolute values. At W = 0, the probability of solvency would be 1- F(trlD), and
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STENBACKA AND TOMBAK Investment, Capital Structure, and Complementarities

Figure2b

Investmentswith DifferentTypes of Financing X A Internal financingregion

X'

xD

w it would be at a low value as there is no equity to increase the investment, and thereby, to increase the probability that the returns are greater than the debt cost. Thus, in general, it is unclear if the slope of the debt-financed investment function is greater than one or less than one at the intercept. Furthermore, substituting D = 0 transforms Equation (2) into
M

-|

Fx(7/XD) dr = R(O, W).

Comparing this equation with Equation (1) indicates that the XD curve intersects the 45-degree line below X* as R(O, W) > R0. These features of the XD curve are exhibited in Figures 2a and 2b. We directly find that
r*

daW

D = R -ax W-x

1 <0

if Condition 1 holds,

(3)

from which we can conclude that an increase in own capital will shift the break-even state of nature to lower returns if Condition 1 holds. However, this is not equivalent to determining the impact on the probability of bankruptcy, F(q/X), which depends on both 71and X. Total differentiation of F(rq/X) with respect to W shows that ax dF('q/X) 0 F(n/x)= F,(77/X) d7o+F h(/X) 'X

where we have made use of Assumption 1 and Equation (3). Equation (4) shows that the probability of bankruptcy decreases with an increase in the net worth if Condition 1 holds. In Figure 3, we illustrate how the probability of bankruptcy depends on the firm's internal funds. In our model, there is no bankruptcy unless the firm takes on debt.8 Consequently, the probability of bankruptcy is zero for W > WH.In the case where Condition 1 always holds, an increase in W decreases the debt while increasing the investment level, thereby, monotonically decreasing the probability of bankruptcy. In the case where Condition 1 does not hold initially, the firm acquires additional debt with an increase in its net worth, and thus, the first term in Equation (4) is positive, and it could be that this positive effect is sufficiently strong so that the probability of bankruptcy initially increases with W. At the point of the maximum probability of bankruptcy, co, aF(r1/X)/dW is zero, and subsequently, the probability of bankruptcy is decreasing beyond co (until WH).Thus, an increase in the firm's internal funds available for the investment could, under the conditions described, make the
8Obviously, there are cases where an entrepreneur lacks sufficient own capital, and there could be negative returns to the investment so that bankruptcy could take place in the absence of debt. Our model does not address such cases.

if Condition 1 holds,
if Condition 1 holds,

(4)

(4)

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STENBACKA AND TOMBAK

and Investment, Structure, Complementarities Capital

3 Figure

and Funds Bankruptcy Internal

Cl alwaysholds

w equilibrium probability of bankruptcy initially higher and then lower as shown in Figure 3. In this case, an increase in the projectholder's internal capital above w will decrease the fragility of the debt market. Otherwise, an increase in the firm's internal capital will monotonically decrease the probability of bankruptcy. For firms that acquire debt, we summarize our findings so far in the following propositions: 1. (a) The debt-financedinvestment will be a positively sloped concavefunction of net worth with a positive intercept. (b) The probabilityof bankruptcyis a concavefunction that is either monotonically decreasingwith net worth or decreasingbeyonda sufficiently large net worth.
PROPOSITION

that are debt-financed: smallerfirms maintain a higher growth rate but it could take place at the expense offacing a higher bankruptcyrisk. Consequently, an industry characterized by small debt-financed firms would display a high-growth rate while being highly fragile in the sense of high bankruptcy risks. Conversely, an industry with large firms would be more stable in the sense of small bankruptcy risks while pursuing investment projects of lower relative scale. The studies by Evans (1987a, 1987b), Hall (1987), and Dunne et al. (1988, 1989) have found statistical regularities serving as empirical evidence for these hypotheses. The empirical study by Evans (1987a) supports the view that bankruptcy predominates among smaller firms. 2.2.2. Outside Equity Financing. We now consider the investment decision of a firm restricted to outside equity as the source of financing. In such a firm, the objective function of the incumbent shareholders is to maximize
M

In the framework of our model, we can formulate two hypotheses based on Proposition 1. First, Proposition 1 implies that beyond a certain net worth, increases in internal funds will always increase the probability of firm survival. Second, as investment is the sole source of firm growth in the present model, Proposition 1 predicts that the proportional rate of growth conditional on survival is decreasing in firm size (where firm size is measured by net worth) beyond a certain size. The combination of these two properties makes it possible to formulate the following tradeoff as a general principle governing the dynamics of the size distribution of firms
264

i(K, W) = SK(K, W)

Trf/(r/X)d7r-RoW

= SK(K, W)EnK -RoW. We express the return requirements held by the outside capital supplier in terms of a share of project surplus, 1- SK(K, W), conditional on the outsider's capital input K and the incumbent shareholder's input W. MANAGEMENT 48, SCIENCE/Vo1. No. 2, February2002

STENBACKA AND TOMBAK and Investment, Structure, Complementarities Capital

Thus, the share of project revenues accruing to the incumbent projectholder is SK(K, W). In this way, the ownership share 1- SK(K, W) denotes the price for raising external capital. Logically, it must hold that 0 < SK(K, W) < 1. The share of project returns offered to outside investors must provide a premium, / K(K, W), relative to the return on the market portfolio in accordance with the condition
UK(K, W)RoK = [1- SK(K, W)]EIK.

Total differentiation of Equation (5) with respect to W shows that dK* _ f dW - f + Fxx(7T/X)d7T Fxx(r /X)dr-K + Wi4Ro RKWROK RoK 2/KKR'

Making use of this condition, the objective function simplifies to

qO(K,W) = EIK - ,K(K, W)RoK - RoW.

The premium satisfies /K > 1 (again, suppressing the argument for /xK)capturing the idea of imperfections in the capital market. If there were no premium for
outside equity
(uxK = 1), then it would

The denominator of this expression is the secondorder condition and is thereby negative. Contrary to the case of debt financing, and as can be seen in Figure 2b, axK> 1 is a necessary feature for new equity to be sought if the intercept of the XK function is zero or negative. This intercept implies that an entrepreneur equipped with an idea, which can be represented by our investment technology, but with no money would not find it optimal to carry out the investment as a project fully financed by outside equity. Thus, the firm will not employ the outside equity instrument until it has reached a certain size. It must
subsequently hold that aXK/3W > 1 (dK/3W > 0) so

be irrelevant

whether the investments were financed by internal or external capital (as per the Modigliani-Miller model). We assume that AK is an increasing and convex function of K and a decreasing function of W (i.e., / > 0, /UK > 0, /KW<0). The first-order condition for the optimal injection of outside capital can be expressed as M f

F(?rT/X )d1

- R(

KK*+LK) = 0.

(5)

The first term in Equation (5) represents the incumbent's share of the increased project value from one more unit of investment, while the second term is the cost of obtaining one more unit of outside equity. Comparing Equation (5) with the unconstrained optimum defined in Equation (1) shows how the premium required by the outside capital market will contract investment as the cost of capital is increased by a factor of I/KK* + /K. The sufficient second-order condition associated with optimal outside equity is assumed to hold throughout our analysis.9
9This second-orderconditionis
- fMF(TdRK <0.

that the XK curve intersects the 45-degree line from below. As XK expands, additional investments will exhibit diminishing returns. Consequently, the XK curve bends back toward the 45-degree line (dXK/oW becomes < 1). Also, it must hold that the XK function must intersect the 45-degree line before the first best X* level as the cost of capital is greater due to capital market imperfections. Thus, we can conclude > 1 and subsequently < 1 for the that initially where outside equity financing is observable. range For firms that acquire outside equity, the following proposition holds:
PROPOSITION 2. The optimal amount of outside equity is initially an increasing function, and subsequently, a decreasingfunction of a firm's net worth. The optimal investment program is a concavefunction of a firm's net worth.

It directly follows that an entrepreneur with no equity (W = 0) would not carry out any investment project if SK(W= 0, K) = 0. This means an investment level of zero in the absence of incumbent equity. Furthermore, for outside equity to be sought, it must hold that > 1, which in turn is equivalent to K > 0, because the region to the right of the 45-degree line in Figure 2b corresponds to cases in which the investment is fully self-financed. However, as decreasing
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returns set in K < 0 and X < 1. These features are illustrated in Figure 2b. Comparing Proposition 2 with Proposition 1, we see how outside equity differs from debt as an instrument for external financing. Investments based on either instrument are initially sensitive to the firm's net worth. As debt-financed investment has a positive intercept, it immediately follows that debt financing will be utilized at a smaller net worth than outside equity financing. This feature is consistent with the pecking order theory of Myers (1984), which means that debt is initially less expensive than equity. 2.2.3. Optimal Capital Structure. We now turn to the more general situation where the firm has access to both debt and equity markets as feasible instruments to finance its investment. Then, the objective of the firm is generalized to that of selecting the optimal combination of debt and outside equity to maximize i(D, K, W) = M (r - R(D, K, W) . D)f (T/X) dir (D, K, W)RoK- RoW (D, K, W)RoK- RoW,

In the presence of outside capital, the first-order condition for the optimal debt level (D**) is
= EHD - PoDROK -(RD
-

** + R)(1 - F(r**/X))

M FX(Ir/X) d7r-

=0. DROK

(6)

We observe that the first two terms are formally identical to the L.H.S. of Equation (1). Thus, D** = D* is equivalent to /AD = 0. The condition IgD = 0 would mean that the cost of new equity was independent of the amount of debt. Furthermore, it must hold that D** > D* if and only if AD < 0. Such a feature would be consistent with the pecking order theory of Myers (1984). The condition /D < 0 is, in fact, less restrictive than the conditions underlying the pecking order theory. In other words, access to the outside capital market will increase the projectholder's demand for debt if and only if the premium to new equityholders was decreasing in debt. With access to the debt instrument the first-order condition for the optimal injection of outside equity is
EIK -- KRoK - Ro = -RKD(1-F(l[lX))

= EH -

-f
=0.

-M

FxXKK

FX(7r/X)d7r-Ro(~KK+x)
(7)

where the interest rate, R(D, K, W), satisfies properties analogous to those with debt as the only instrument of financing (the relevant measure of equity is now W + K) and the premium to new equityholders, 4t(D, K, W), is an increasing and convex function of K and a decreasing and convex function of W and D. As before, we suppress the arguments for the functions capturing the lending rate and capital market premium. In this objective function, the projectholder operates with limited liability and the costs of expanded debt financing are associated with an increased bankruptcy risk and increased interest expenditures. As in the previous section, the costs to incumbent shareholders of attracting outside equity are measured by the premium on the return on equity /u. In the presence of debt, this factor has to be generalized to capture the dependence on debt and on W and K.

Comparing Equation (7) with Equation (5), we can see that access to a debt market will expand the equity financing if and only if RK < 0. 3. PROPOSITION (a) Access to outside equity as a financing instrument will induce incumbent shareholders investments if and only if the preto expand debt-financed mium requiredby outside investors is decreasingin debt. (b) Access to debt as a financing instrument will induce incumbent shareholdersto expand equity-financedinvestments if and only if the lending rate is decreasingin new equity. Proposition 3a means that newly issued shares would sell for a higher price ceteris paribus in the presence of a debt market. This can be seen in light of two effects. First, debt has increased the investment and the firm is thereby more valuable as long as it remains solvent. Second, in the presence of debt the
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bankruptcy risk is increased. Proposition 3a expresses that the former effect will dominate in equilibrium. Proposition 3b states that the presence of a debt market will increase the new equity issued if debtholders reduce the lending rate in response to injections of new equity. The optimal combination of debt and equity must satisfy the system of equations defined by Equations (6) and (7). Combining the first-order conditions 6 and 7, we find that the optimal combination of debt and new equity, D** and K** with the associated investment X**= W + D**+ K**,has to satisfy + (D**RD R) (1 - F(7**IX**))+ RoK**/LD = D**RK(1 F(1**IX**))+ Ro(p +K**,K).

derivatives in Equations (9) and (10) are of the same sign meaning that the financial instruments are either mutually complements or substitutes. Furthermore, any difference in magnitude of the complementarities would arise from differences in the magnitude of the denominators (the second-order conditions). The stability condition
ODD(D, W, K). qKK(D,W, K) - ODK(D, W, K). KD(D, W, K) > 0,

(8)

implies that the product of the derivatives in both Equations (9) and (10) is less than one. The following proposition describes conditions under which the numerator of Equations (9) and (10) are positive.
PROPOSITION 4. The properties

Consequently, in equilibrium, the expected marginal cost of debt financing must be equal to that of equity financing. We now further explore complementarities between the financial instruments. Total differentiation of Equation (6) with respect to K shows that
dD** -ADK(D,K,W)
-

,D < O,

JiKD< O,

RK < O,

or

RKD < O,

are necessary conditionsfor debt and equity to exhibit complementaritiesas instruments of externalfinancing. Thus, for complementarities between the instruments to exist either the cost of debt is a decreasing function of K and/or the premium for outside equity is a decreasing function of D. By decreasing the cost of one financial instrument, its utilization is increased. By the properties described in Proposition 4, such an increase in utilization would then decrease the cost of the other instrument. To demonstrate how an increase in the entrepreneur's net worth will expand the investment program due to complementarities between the financial instruments, we totally differentiate the identity X**= W + D**+ K**to find that dX** =1+ dW dD** dK** dD**dK** dK**dD** + + + dW dK dW dW dD dW (11)

dK

DD(D,K, W) + -ElIDK + LDKROK /UDRO IDD(D,K, W) M Fxx(7rTX) d7

(9)

where EIDK = RKDF(rI**IX) -

- (RDKD+ RK)(1 -F(7**IX))

+ (RDD+ R)(RKDF,(r**IX) + Fx(**IX)). Analogously, by totally differentiating Equation (7) with respect to D we find that
dK** -(KD(D,
-

K, W)

dD

KK(D,K, W) + A,DRO -EIKD + P,KDRoK

IKK K,W) (D,

where EHKD = ErDK. In both cases, the denominator is the second-order condition with respect to the decision variable in question, and thereby assumed to be negative. As the numerators are identical, the
MANAGEMENT SCIENCE/Vol. 48, No. 2, February 2002

The last two terms of Equation (11) represent the investment expansion generated by the complementarity. The optimal investment volumes under the various regimes-with no capital restrictions, with outside financing based on debt alone, with outside financing based on equity alone and with an optimal combination of debt and equity-are depicted in Figure 2b. Below the 45-degree line only internal

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and Structure, Complementarities Investment, Capital

financing would be utilized as it is cheaper. At some level of incumbent equity, the slope of the optimal investment volume using only outside equity financing instruments is greater than one and the line for XK would then approach, and subsequently intersect, the 45-degree line. The line illustrating the investment volume using both debt and outside capital, X**, would lie at or above the line for XD and above the line for XK as it is the result of a less constrained optimization problem. With complementarities, however, the investment volume using both debt and outside capital X** would lie strictly above both the line for XK and the line for XD when both forms of financing are utilized. Furthermore, with access to both instruments, the firm would employ external financing at lower levels of net worth and consequently X** will then go above the line for XD. In addition, because access to both instruments lowers the cost of external financing and expands investment, X** will intersect the 45-degree line from above at a higher W than both the curves for XD and XK. These features of the optimal investment are illustrated in Figure 2b. Our analysis suggests that the relative attractiveness of the two instruments for external financing exhibits a systematic relationship with the firm's net worth. Furthermore, the two instruments display complementarities with each other. We conclude our theoretical section by summarizing some of the most important empirically testable hypotheses in a final subsection. 2.3. Hypotheses on Investment and Capital Structure We summarize and evaluate our theoretical section by highlighting the consequences for financial management and by formulating the empirically testable implications. In light of our model, managers of financially constrained firms should initially acquire debt when the enterprise is small, and leverage that debt to create retained earnings before acquiring new equity. As the retained earnings grow, optimal investment management calls for simultaneous acquisition of new equity and more debt to exploit the complementarities between these two financial instruments. Such a management policy should then be retained until the 268

firm reaches such a financial strength that the technologically determined optimal volume of the investment activities can be internally funded. Financiers will find that smaller enterprises will initially be more interested in debt financing than in equity. This lending activity, however, will represent a particularly risky undertaking until the borrowing firm builds up internal funds and starts to acquire new equity. Our analysis so far has generated the following three classes of empirically testable predictions: (1) When restricted to debt as the only instrument for external finance, debt-financed investment is an increasing and concave function of the firm's net worth with a positive intercept. (2) When restricted to new equity as the only instrument for external financing, the firm's equityfinanced investment is an increasing and concave function of internal funds. (3) There are complementarities between new equity and debt as instruments of external financing. These complementarities are functions of the firm's incumbent equity. Furthermore, the product of these complementarities ((dD**/dK) x (dK**/dD)) is less than one. The three hypotheses together imply that as the incumbent capital of the firm grows, it would initially seek financing through the use of the debt instrument. With greater usage of debt, it would decrease the expected cost of financing based on the use of outside equity. Consequently, a feedback mechanism would be generated whereby the firm would seek even more external finance using the other instrument, thus increasing its investments in a nonlinear manner to its existing equity. These features for which we presented theoretical foundations are illustrated in Figure 2b, where X** lies above both the curve for XK and that of XD.

3. The Empirical Evidence

In this section, we empirically test the hypotheses developed in our theoretical analysis. We first describe the data and variables used in these tests. We then specify the econometric model and estimation procedure.
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STENBACKA AND TOMBAK and Investment, Structure, Complementarities Capital

3.1. The Data and Variable Descriptions The tests use financial data on 4,435 publicly traded manufacturing and telecommunications corporations in the Standard and Poor's COMPUSTAT database. This data is available on an annual basis for the years 1982-1992. Upon the elimination of missing data, we have 34,840 firm-year observations. Kaplan and Zingales (1997), using a sample of firms from the same COMPUSTAT database, found that in 85.3% of their sample's firm years there was no evidence of financing constraints that restrict investment. Among those observations were firms that announced policies of self-financing, such as the policy of Hewlett Packard that Kaplan and Zingales cite. Such firms would finance their investments from internal funds. Consequently, we limited our sample to observations from firms that did acquire additional debt or equity. Thus, the number of firms in our sample was reduced to 3,119 and the firm-year observations to 12,846. The following variables were used: K, the sale of common and preferred stock; D, the long-term debt; W, the retained earnings; /, the S&P Common Stock Ranking; and INT, the interest rate. The definitions of these variables and descriptive statistics for them are exhibited in the Appendix. 3.2. The Model and Its Estimation We estimate the following econometric model of simultaneous equations using instrumental variable techniques with the LIMDEP7 two-stage least squares estimation procedure for the fixed effects model with panel data: K = ao + aW + a2W2 +(a3+a4W
D=

Table 1

Estimates theSimultaneous for Equations D forKand (Equation 12)

Estimate -27.74** 0.0149** -0.161E-05**
0.0849** -0.612E-05** 0.223E-09** -0.0272** 156.4**

Parameter ao
a1
a2

Standard Error 5.54 0.0026 0.150E-06

0.0021 0.329E-06 0.133E-70 0.00569 59.18

a3 a4 a5 a6

go

P1
1P2
03

P4 /5
f6

0.287** -0.294E-05** 4.598** 0.125E-02** -0.306E-07**

-1074.6*

0.017 0.709E-06 0.2106 0.599E-04 0.224E-08

577.17

* Significant the 10%level. at

**Significant the 1% level. at

respectively) that are subsequently used in estimating Equation (12). The estimates for Equation (12) without group effects are reported in Table 1.10 One would expect a higher (worse) stock rating to have a negative impact on the amount of new equity and a higher interest rate to have a negative effect on the amount of debt sought. From our theoretical section, we would expect both c + a, W + a22W2 and /o +/ lW +32 W2 (the direct effect of internal funds) to be positive. Furthermore, the theory predicts that a0 is nonpositive and l0is positive, whereas a2 and 32 are negative to reflect the concavity of the functions. If there are complementarities between debt and
new equity a3 + a4W + a5W2 and
,3 + 84W + 15W2

+ a5 W2)D + a6/ + e1,

(12) 2

+031W+ PW2 o

W + (33 + 34 + 85 W2)K+ 36INT+ e2, where the es represent the error terms. The instruments
K = a0o+a,W W2 + a3CSt_1 + a4Dt_l + a5 + vl,

D = bo+ b W + bW2 + b3CSt_l+ b4Kt_l+ b5INT+ 2, where CS is the value of the common stock and the vs are the error terms, provide us with the fitted variables for D and K (with R2s of 32.8% and 85.5%,

would be positive and from the stability condition, our theory suggests that the product of these values would be less than one. The theory suggests that the complementarities are functions of W and that these functions are nonlinear. As one would expect, higher interest rates have a negative effect on the amount of debt, and a poorer stock rating has a negative impact on the amount of new equity sought. A 100 basis point increase in interest rates leads to the average firm in our sample
10The estimates with industry dummies do not significantly change

the results.

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seeking US $10.7 million less debt. Similarly, a downgrading of the stock from an average rating (,L= 16) to a below average rating (A = 17) would decrease the new equity sought on average by $27,000. Inserting the average value for W into the estimate for ao + a W +a2W2 and 30+13 W +32 W2 yields the values -18.2 and 353.8, respectively. The positive intercept for debt and the negative intercept for the new equity is consistent with the theory. This implies that the firm must have a certain level of retained earnings before new issues are floated. As the corporations in the COMPUSTAT database are primarily those listed on major stock exchanges such as the New York Stock Exchange, and given the transactions costs involved in a new share issue, this is a reasonable result. It is a result consistent with that reported by Bond and Meghir (1994) for United Kingdom firms. The expression a0 + a W + a2W2 is always negative, implying that in the absence of a complementarity with debt, new equity would not be sought by the average-sized firm of our sample. The derivatives of debt and new equity (a1 + 2a2W and3 W + 2,32W) have the average values of 0.013 and 0.283, respectively. Because the derivative of new equity and debt with respect to firm retained earnings is positive, indicates that the average firm in our sample is still in the size range where an increase in net worth would increase both the new equity and debt sought. As both a2 and P2 are statistically significantly negative, the empirical evidence lends support for the concavity of the functions for both debt- and equity-financed investments. We also have empirical support for complementarities between new equity and debt. We find the values of a3+ a4W + a5W2 and P3 + 34W+ 35W2 to be on average 0.081 and 5.45, respectively. Thus, the prediction from the stability condition that the product of these complementarities be less than one holds. While debt is initially less expensive than new equity, lenders may require more equity before supplying additional debt. Such a credit limit mechanism might explain the high equity dependence of debt. Furthermore, many other factors discussed in the literature, like the role of debt as a device to discipline managers or affect corporate control contests, may be at play. In summary, we have empirical support for all three of our hypotheses. 270

In this study, we develop a model of simultaneous investment and financing decisions made by incumbent owners of firms in the presence of capital market imperfections. In the model, the firm's added value is generated by investment projects characterized by uncertainty. We make a distinction between incumbent and new shareholders. The incumbent owners maximize their value by determining the capital structure simultaneously with the magnitude of the investment program. Initially, we characterize theoretically how the optimal combination of debt and equity financing will depend on the firm's internal funds available for investment. This optimal combination of debt and equity depends on a tradeoff between the bankruptcy risk associated with debt and the dilution cost to incumbent shareholders of new equity. Our theory identifies conditions under which there would be complementarities between debt and new equity. Subsequently, we test these predictions empirically on financial data for the years 1982-1992 on 3,119 publicly traded manufacturing and telecommunications corporations in the Standard and Poor's COMPUSTAT database. Our empirical analysis lends support to our theoretical predictions regarding the link between internal funds and capital investments and the interaction effects between debt and new equity. There are a number of policy implications that arise from the conclusions of this study. In the presence of capital market imperfections, the complementarities between debt and new equity as instruments of external finance are particularly important for small firms facing severe financial constraints in relationship to their available investment projects. Consequently, our study presents arguments for why industrial policies should target small firms to create circumstances whereby these firms would be able to adopt financing strategies, which exploit the complementarities between the financial instruments. Recall that the Modigliani-Miller irrelevance theorem implies that the form of financing is irrelevant when capital markets are perfect. Thus, we can conclude that policies enhancing the exploitation of complementarities will be more significant with the higher the degree of imperfections prevailing in the capital markets. MANAGEMENT SCIENCE/Vol. No. 2, February2002 48,

4. Concluding Discussion

STENBACKA AND TOMBAK

and Investment, Structure, Complementarities Capital

Our study also points to the importance for policy makers to simultaneously promote the efficiency of both credit and equity markets rather than focusing only on one type of financial market. This feature might be particularly relevant in emerging markets. This study can formally be (and has been) extended in a number of ways. For example, we extended the model to account for strategic interaction between the investment projects (Stenbacka and Tombak 1999). Such an extension is important to capture imperfect competition between the projectholders in settings where they can make strategic use of different financial instruments to affect the outcome of subsequent stages of investment competition. Also, we investigated a more dynamic model where the payoffs from investments in one period feed into the wealth that can be used for investments in subsequent periods. The recent study by Povel and Raith (2001) points to still another important direction for future research. They distinguish financial constraints based on a firm's insufficient level of internal funds from constraints generated by capital market imperfections in the form of asymmetric information. Within such a framework, their theoretical model argues that these two measures of financial constraints will impact differently on firms' investment behavior because internal funds and capital market imperfections will have different effects on the marginal cost of debt finance. Acknowledgments
R. Stenbacka thanks the Bank of Finland and the Academy of Finland for financial support. M. Tombak thanks NSERC, the Helsinki School of Economics, and the Academy of Finland for financial support. The authors also thank Petri Niininen for research assistance, Lars-Hendrik Roller for extensive comments, and seminar participants at INSEAD, University of Nottingham, and WZB, Berlin, for their comments.

Table 2 Variable

Statistics Descriptive Mean 28.05 473.2 692.8 9.72 Standard Deviation 252.8 2,172.3 2, 368.1 3.13

K (millions $) of D (millions $) of W (millions $) of INT(%)

D = Long-term debt. This item represents debt obligations due more than one year from the company's balance sheet date. D includes bonds and mortgages, loans, long-term lease obligations, and other obligations requiring interest payment. The stock variable is used here as it is the stock that determines the interest obligations and the corresponding probability of bankruptcy. COMPUSTAT annual data item #9. W = retained earnings. This is the cumulative earnings of the firm less the total dividend distribution to shareholders. It includes issuable stock, reaquired capital stock, reserves for self-insurance, and stock options, warrants, and rights. Observations where the firms had negative retained earnings were rejected. Again, the stock variable is used as the probability of bankruptcy is determined by the stock. COMPUSTAT annual data item #36. ,u = S&P common stock ranking. This item is generated by S&P's scoring system appraising the past performance in terms of growth and stability of a stock's earnings and dividends and the stock's relative standing. This measure can be viewed as an indicator of the attractiveness of investment opportunities facing a firm. The ranking codes range from 7 (highest), 8 (high), to 16 (average), to 21 (lowest), to 99 (bankruptcy). Observations where the firm was deemed near bankruptcy (/u > 17) were rejected as firms not likely to have sufficiently attractive investment opportunities. COMPUSTAT annual data item #282. INT = interest rate. This data was computed by taking the interest expense for the year (COMPUSTAT annual data item #15) and dividing by the long-term debt and debt in current liabilities item (COMPUSTAT annual data item #34). When that long-term debt and debt in current liabilities was zero, the observation was rejected as firms not seeking outside financing. Table 2 lists the descriptive statistics.

References Appendix. Description of the Variables

K = sale of common and preferred stock. K represents the funds received during a year from the issuance of common and preferred stock. It includes the sale of common and preferred stock, the conversion of preferred stock and/or debt into common stock, the exercise of stock options and/or warrants, and related tax benefits due to the issuance of stock. The flow variable is used as in the subsequent time periods these new equityholders would become incumbent equityholders. COMPUSTAT annual data item #108. Barro, R. J. 1991. Economic growth in a cross section of countries.

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was 3 received April2001. Thispaper with theauthors months 2 revisions. for Accepted PhelimP. Boyle; by

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