Michael Raith

The U-Shaped Investment Curve: Theory and Evidence

This paper examines how the investment of financially constrained firms varies with their level of internal funds. We develop a theoretical model of optimal investment under financial constraints. Our model endogenizes the costs of external funds and allows for negative levels of internal funds. We show that the resulting relationship between internal funds and investment is U-shaped. In particular, when a firms internal funds are negative and sufficiently low, a further decrease leads to an increase in investment. This effect is driven by the investors participation constraint: when part of any loan must be used to close a financing gap, the investor will provide funds only if the firm invests at a scale large enough to generate the revenue that enables the firm to repay. We test our theory using a data set with close to 100,000 firm-year observations. The data strongly support our predictions. Among other results, we find a negative relationship between measures of internal funds and investment for a substantial share of financially constrained firms. Our results also help to explain some contrasting findings in the empirical investment literature.

Financial Constraints and Product Market Competition: Ex-ante vs. Ex-post Incentives

This paper analyzes the interaction of financing and output market decisions in a duopoly in which one firm is financially constrained and can borrow funds to finance production costs. Two ideas have been separately analyzed in previous work: Some authors argue that debt strategically affects a firm’s output market decisions, typically making it more aggressive; others argue that the threat of bankruptcy makes debt financing costly, typically making a firm less aggressive. Our model integrates both ideas; moreover, unlike most previous work, we derive debt as an optimal contract. Compared with a situation in which both firms are unconstrained, the constrained firm produces less, while its unconstrained rival produces more; prices are higher for both firms. Both firms’ outputs depend on the constrained firm’s internal funds; the relationship is U-shaped for the constrained firm and inversely U-shaped for its unconstrained rival. The unconstrained rival has a higher market share, not because of predation but because of the cost disadvantage of the financially constrained firm. D 2004 Elsevier B.V. All rights reserved.

Optimal Investment under Financial Constraints: The Roles of Internal Funds and Asymmetric Information

We study how a firms optimal investment varies with two different measures of financial constraints: the firms internal funds and the extent of asymmetric information between the firm and outside investors. We derive the financial contract between firm and investor endogenously; in our model, a debt contract is optimal. Decreases in internal funds and more asymmetric information both worsen the financial situation of the firm. However, they differ in their effects on the firms investment because they change the marginal cost of debt finance in different ways. More asymmetric information generally leads to lower investment, and investment becomes more sensitive to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firms internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our results explain seemingly contradictory findings in the recent empirical literature.

Optimal Incentives and the Time Dimension of Performance Measurement

I study optimal incentive contracting in a two-period model in which an agentʼs action generates an output with delay, and a noisy signal of output early. Under very general conditions, the optimal contract depends on the early signal as well as on output even if the signal is uninformative of effort, given output, and even if the agent has access to credit. An important characteristic of any performance measure, therefore, is the time at which it is generated. The results shed light on the use of forward-looking performance measures such as stock returns or earnings with accruals for accounts receivable.

What Are We Really Good At? Product Strategy with Uncertain Capabilities

Firms often learn about their own capabilities through their products’ successes and failures. This paper explores the interaction between learning about capabilities and product strategy in a formal model. We consider a firm that can launch a sequence of products, where each product’s success probability depends on the fit between the firm’s capabilities and the product. A successful new product always causes the firm to become more optimistic about the capability most relevant for that product; however, it can also cause the firm to become less optimistic about some of its other capabilities, including capabilities the new product does not use. The firm’s optimal forward-looking product strategy accounts for short-run expected profits as well as for the information value of learning for future decisions. We find that a product sharing few or even no capabilities with potential future products can have a greater information value than a product that shares more capabilities with future products and that ...