A new economic book suggests that firms should use financial engineering models and not only be rigid in their attitude of the financial risks they take, but should also be flexible when it comes to the kind of investment they plan to make. The book by economists Shiv Mankara and Michael J. Weber, titled ” Firm Investment: Some Economic Theory and Practice ” describes financial engineering models that help firms to understand the relationship between firm characteristics and investment behavior. Drawing insights from financial service concepts, the book then uncovers that firm financial leveraging is negatively and significantly associated with firm investment risk. Finally it is seen that the effect of firm leverage on firm investment risk is particularly strong for high-information asymmetric firms.
The focus of the book turns to capital budgeting and asset pricing. The main idea here is to show that firms that do not adjust their capital budgets to take advantage of opportunities to invest will, over time, see diminishing returns to their capital budgets. The analysis shows that firms with large differences in net present value of their invested assets (the difference between total current value of assets and total net worth of firms) tend to be conservative in their management of business cash. By contrast, firms that have substantial deviations from the mean value of their capital budgets will tend to be more aggressive in their use of their retained earnings. This could result in greater turbulence in markets as liquidity tightens and prices rise.
The focus of the book turns to the relationship between firm investment and firm valuation. The analysis indicates that there are three major channels through which increased firm valuation can affect economic growth: first, that higher stock market prices are correlated with higher real estate values; second, that higher stock market prices are correlated with higher bond prices; third, that higher bond prices are correlated with higher real estate prices. The third channel through which firm valuation relates to economic growth is not fully established, but the research does suggest that higher stock market prices and lower bonds provide a counter-intuitive benefit to economic growth. That is, lower bond prices reduce the cost of real estate financing relative to prices of listed firms; yet, real estate prices are also positively associated with productivity. Future research will address the implications of the channel for firm valuation of fixed economic growth.
The book concludes with a case study on Wal-Mart. Wal-Mart has long been one of the most successful US firms and one of the world’s largest retailers. But even with its success, Wal-Mart has struggled with managing its enormous financial portfolio. As one of the book’s authors explains, Wal-Mart managed to grow its market share despite experiencing slower growth in its overall product lines because its core businesses were efficient and its location relative to population centers provided it with a competitive advantage. The authors explain that this ability to exploit location and efficiency to increase overall firm value is a major reason why external finance options like bank loans and equity capital are important for improving the quality of firms as a whole.
Funders look for firms that can increase their attractiveness to investors by improving their financial health through better management of their fixed costs and increasing cash flow. Identifying the importance of managing cash flow in the overall business framework requires a detailed description of cash flows and how they affect firm size, the quality of the firm, and the relationships between firm size, financial liquidity, firm growth, and investment quality. Internal funds are designed to add to a firm’s capital assets without raising additional debt. Internal funds are considered attractive to firms that are not generating strong revenue growth but are still growing in terms of size. In addition, internal funds have the ability to make investments that are not always tax deductible and do not guarantee returns in the short or long term.
The overall conclusion of the book is that external financing barriers to venture capital should be identified and defeated. To do so, managers need to understand the links between firm size, financial depth, and profitability. Also, managers should evaluate the effect of investing in fixed assets on overall financial returns. Finally, external financing barriers can be defeated if the firm identifies and plan well a strong succession plan that eliminates any perceived threats to its competitive position.
