Financial constraints, hurdle rates, and investment activity : implications from a multi-period model

When a firm is financially constrained, an increase in its liquid balances (or net worth) is supposed to have a positive impact on its investment (equivalently, lower the hurdle rate for its projects). However, in a multi-period setting, an increase in liquid balances may make a firm more conservative in its choice of current projects. A firm with higher liquid balances today can carry its liquid balance to the next period. Thus, the firm is more willing to pass up a project today because it faces a lower risk of being constrained next period, and not being able to invest profitably. In a two-period setting, there is a critical level of liquid balances such that the firm’s hurdle rate initially decreases in its liquid balances up to this level, then increases, before decreasing again. The non-monotonic behavior of the hurdle rate is also possible in a more general multi-period setting. For some special cases, the hurdle rate is non-monotonic every period in the level of liquid balances. These results are consistent with a variety of empirical evidence, such as the non-monotonic behavior of the cash flow sensitivity of investment with respect to the liquidity position of firms (Kaplan and Zingales (1997), Cleary (1999, 2002)), or the failure of Japanese small firms to set up their investment in spite of a steady build up of liquidity since the mid-nineties. The results also suggest that monetary policy may not be very effective in stimulating aggregate demand through the balance sheet channel, and may in fact have perverse effects, if firms have already accumulated cash balances