Investment Irreversibility, Finance and the Firm’s Life Cycle
June, 17th 2020
University of East Anglia
We develop a model of a financially constrained firm’s optimal investment programme when investment is partially irreversible, which generates many of the stylised facts of a firm’s life cycle: gradual capital accumulation, growth when young followed by maturity, and retention of liquid wealth alongside reliance on borrowing during the growth phase. Investment is subject to a cash-in-advance constraint. Firms with little internal liquid wealth must therefore borrow from banks, which extend one-period loans, in order to finance investment. The risk of firm failure makes lending risky, so banks charge higher interest rates when firms do not have sufficient collateral. A reduction in the reversibility of investment – for example, a reduction in the tangibility of firms’ capital – increases aggregate corporate cash holdings as a multiple (share) of output, while reducing aggregate corporate borrowing as a multiple (share) of output, consistent with empirical evidence.