Investment Frictions versus Financing Frictions

Abstract

Bertola/Caballero (1994) and Abel/Eberly (1996) extended Jor-genson's classical model of firms'optimal investment. By introducing investment frictions, they were able to capture the role of future antic-ipations in investment decisions as well as the lumpy and intermittent nature of investment dynamics. We extend Jorgenson's model to the other direction of financing frictions. We construct a model of an equity-only firm, who must pay a linear financing cost for issuing new shares. We show that the firm's optimal investment-financing is a two-trigger policy in which the firm finances investment by issuing new shares (supplementing internal funds) when the shadow price of capital hits the upper trigger value. When the shadow price hits the lower trigger value, she sells a portion of her capital stock and buys back shares (or pays dividends). Values of the shadow price of capital between the two trigger values define a range of "inaction", in which the firm does neither issue nor buy back shares and invests all of her internal funds for expansion.