International Finance Discussion Papers (IFDP)
July 1996
Firm Size and the Impact of Profit-Margin Uncertainty on Investment: Do Financing Constraints Play a Role?
Vivek Ghosal and Prakash Loungani
Abstract:
We study the response of investment to changes in uncertainty about future profits. We find that in industries dominated by small firms, an increase in uncertainty about future profits depresses investment; in all other industries, increased uncertainty has virtually no effect (or has a positive effect) on investment. The data set from which these findings emerge is a balanced panel, consisting of annual data from 1958 to 1991 for 252 manufacturing industries in the United States. The theoretical work on this topic points to uncertainty about future profit flows as one of the important actors that determines the ease with which firms can access external credit. The prediction made by the theory is that an increase in uncertainty exacerbates informational asymmetries, and hence makes lenders reduce the flow of credit; this in turn lowers investment in credit-constrained firms. If one is willing to accept firm size as a proxy for access to external credit, then our finding that greater uncertainty lowers investment in small-firm-dominated industries is consistent with the theoretical prediction.
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