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Investment Irreversibility, Finance and the Firm’s Life Cycle

Investment Irreversibility, Finance and the Firm’s Life Cycle
Date:

June, 17th 2020

Speaker:

David Jones

Source:

University of East Anglia

Abstract

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.