The independence of investment and finance decisions

The Keynsian Model

The Keynsian model emphasized two variable as determinants of Investment: [1]

1. Current cash flow (with profits as a major component)

2. The firm’s current holdings of liquid assets

A Change in Thinking

With time, the second point began to be questioned. It became evident that shareholders will not in fact alter their investment position, even if there is a spike in debt [2]. Rather they will simply get a greater return on their bonds. This is due to the assumption that they will feel that since the company has recovered from all previous debt, they will most likely recover again.

This was later coined q-theory, and can be summed up as the mantra:

Firms should invest up to the point where the marginal cost of a new unit of capital is the valuation of such a unit of capital in the stock market.

-valuation is the market value of the firm’s shares divided by its capital stock, called the q-ratio.

On the side of cash flows, we see some similarities between consumption and investment functions, but there is one major difference. The current thinking is that the interests of the shareholders and the interests of the managers are viewed as different [1]. The manager's are only the "agents" of the owners, and therefore naturally look for what benefits themselves the most first.

This has been referred to as "empire-building" [3], and manifests itself in two ways:

1. The manager simply cares about how he/she can bring home the most money, and therefore is in support of investment which directly benefits is realm of authority, and therefore increases his own individual power.

2. As do workers, managers also have a certain set of "norms" that they feel they should be living up to, and therefore engage in empire-building purely for the sake of expectation.

These two norms coupled with a general lack of oversight within the company allows for these actions to lead to a direct corelation between investment and cash flow.

And this correlation coupled with the fact that over the past half century companies have increasingly sought the input of a Chief Financial Officer (CFO) in all major decisions, shows how the role of norms also affects investment.

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Works Cited

1. Akerlof, George A. "The Missing Motivation in Macroeconomics". http://www.aeaweb.org/annual_mtg_papers/2007/0106_1640_0101.pdf

2. Modigliani, Franco and Brumberg, Richard. "Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data"

3. Stein, Jeremy C. "Agency, Information and Corporate Investment"

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• Ricardian equivalence

• The independence of consumption and current income

• The independence of investment and finance decisions

• Inflation stability only at the natural rate of unemployment

• The ineffectiveness of macro-stabilization policy with rational expectations