On the Interaction of Financial Frictions and Fixed Capital Adjustment Costs: Evidence from a Panel of German Firms

This paper analyzes the interaction of financial frictions and non- convex adjustment costs. With non-convex adjustment costs firms infrequently carry out discrete investment projects. Therefore, financial variables may influence investment in two ways. Theoretically, they can alter the frequency at which investment projects are undertaken, or they can influence the size of the stock of capital a company wishes to hold in the long run. Empirically, finance has nearly no long-run influence on the stock of capital in the sample of German companies which this paper analyzes. By contrast, the influence of finance on investment decisions is substantial. Consequently, finance primarily affects investment frequencies and accordingly, financial factors and fundamental capital productivity strongly interact in the determination of investment.Investment; imperfect capital markets; debt constraints; adjustment costs; nonlinear panel cointegration

The Other Side of Limited Liability: Predatory Behavior and Investment Timing

This paper investigates the interplay of investment irreversibility, predatory behavior, and limited liability in a duopoly with aggregate demand uncertainty. We find that limited liability and investment irreversibility is likely to produce predatory behavior in very competitive industries in which prices react strongly to changes in quantity and capacity increases are not too costly. The rationale for this may be summarized as follows: Under limited liability, the owners of a firm have to decide whether they are willing to finance losses from private funds, or whether they rather default on the firms obligations in adverse states. However, market conditions themselves become endogenous in a duopoly since the quantity decisions of all competitors determine the market price. If now investment is irreversible, it is a strong commitment. It hence becomes a device to force others to leave early and allows oneself to commit to leave late. If the ability to promote the exit of a competitor is strong, it may then even result in firms investing only to prey, i.e. firms invest only to consequently monopolize the market. Therefore, the model of this paper explains predatory behavior in a duopoly without invoking reputational, network- or learning-effects. Moreover, this paper's model also does not define predatory behavior as deviations from tacit collusion.Real Options, Duopoly, Predatory Behavior, Timing Game

Aggregate investment dynamics when firms face fixed investment cost and capital market imperfections

This paper analyzes a model of investment with fixed investment costs and capital market imperfections. In this model finance influences the level of capital firms hold, as well as the frequency at which they invest. In consequence investment reacts nonlinearly with respect to shocks to productivity and liquidity. Liquidity and productivity shocks are complements and the influence of finance is strongest if a firm wishes to significantly adjust capital for fundamental reasons. This theoretical model is confronted with UK company data in a two-step estimation that first identifies the long-run relationship of productivity, capital and liquidity. Here we find no significant influence of finance on the capital decision of a firm. However, when the short-run investment function is estimated, liquidity has a significant impact, which is also strongest for strong fundamental investment incentives. Moreover, the investment function is strongly convex in the fundamentals themselves, indicating fixed costs of capital adjustment.Investment, non-convex adjustment cost, imperfect capital markets, nonlinear error-correction, panel data

A closer look at the gap. A comment on Cooper and Willis' 'mind the gap' paper

Recently, there has been a lively debate between Cooper and Willis (2001,2002,2003a, 2003b) and Caballero and Engel (2004) about the apropriateness of the so-called 'gap approach' to labor adjustment. Cooper and Willis claim that the gap approach is unable to identify non- convex adjustment costs because of a measurement error under the alternative hypothesis of convex costs. This comment assesses the validity of Cooper and Willis' claim by providing evidence from a number of Monte-Carlo experiments. In contrast to Cooper and Willis findings from single simulations, the experiments reveal no tendency to falsely reject the convex-cost hypothesis if one uses the correct one-sided test for non-convexities. In fact, the parameter estimates are typically biased against the hypothesis of non-convex costs. Consequently, there is no tendency to falsely reject although the estimates show substantial excess dispersion as a result of a spurious regression problem.Employment Adjustment, Non-Convex Adjustment Costs, Monte- Carlo Experiments

Aggregate investment dynamics when firms face fixed investment cost and capital market imperfections

In this paper a model of aggregate investment is derived which incorporates fixed investment costs and capital market imperfections on the micro-level. Aggregate investment reacts nonlinearily with respect to aggregate shocks to productivity and liquidity of firms. Employing non-parametric kernel estimation methods to analyze a sample of annual account data of UK companies, these nonlinearities also show up empirically. Furthermore a difference in strength between the long- and the short-run effect of liquidity on investment is found, which is inconsistent with models that explain the empirical correlation of investment and liquidity solely as the result of some long-run relationship like liquidity-dependent costs-of-capital. Moreover, as a side-result when imposing a linear structure, we find, as reported in previous studies, that financially constrained firms appear to be less influenced by liquidity than unconstrained ones. However, this finding disappears when the investment function is estimated without any restrictions on the functional form and thus has to be attributed to a misspecification error, which is avoided by the estimation strategy of this paper.

Firm-specific productivity risk over the business cycle: facts and aggregate implications

Is time-varying firm-level uncertainty a major cause or amplifier of the business cycle? This paper investigates this question in the context of a heterogeneousfirm RBC model with persistent firm-level productivity shocks and lumpy capital adjustment, where cyclical changes in uncertainty correspond naturally to cyclical changes in the cross-sectional dispersion of firm-specific Solow residual innovations. We use a unique German firm-level data set to investigate the extent to which firm-level uncertainty varies over the cycle. This allows us to put empirical discipline on our numerical simulations. We find that, while firm-level uncertainty is indeed countercyclical, it does not fluctuate enough to significantly alter the dynamics of an RBC model with only first moment shocks. The mild changes we do find are mainly caused by a bad news effect: higher uncertainty today predicts lower aggregate Solow residuals tomorrow. This effect dominates the real option value effect of time-varying uncertainty, highlighted in the literature. --Ss model,RBC model,lumpy investment,countercyclical risk,aggregate shocks,idiosyncratic shocks,heterogeneous firms,news shocks,uncertainty shocks.