1. CENTER FOR FINANCIAL & MANAGEMENT STUDIES - UNIVERSITY OF LONDON
Financial Hierarchy Theory and the Quantity of Finance
Carlos Eduardo Guice, Sr.
2. Firm-Level Investment Demand C225
1. Conventional Investment Theory
Conventional investment theory of the firm1
describes a general equilibrium framework
whereby firms maximize profits under the conditions of perfect competition. A major behavioral
relationship in this model is the impact of interest rates2
on the cost of funds and subsequently on
real investment spending. The neoclassical model views investment as a decreasing function of
the real interest rate. It is a simple yet fundamental premise. When real interest rates are high the
demand for non-financial, investment goods is low; when real interest rates are low investment
demand is high. Firms finance much of their investment expenditure with borrowed capital.
Consequently, when interest rates change, firms change their investment behavior.
This relationship between real interest rates and investment spending can be illustrated by
the economic concept of marginal efficiency of capital (“MEC”). It defines the firm’s investment
threshold as the highest interest rate at which investment projects are expected to breakeven. If
investments are ranked in descending order by their MEC, conventional theory supports accepting
all investment projects with an MEC higher than the interest rate3
. Conversely, projects with
MEC below the interest rate will should be rejected.
Similarly, corporate capital budgeting theory provides an analogous decision rule to use
when evaluating investment opportunities. The rule instructs firms to accept investment projects
if the return4
from the proposed investment is greater than the opportunity cost of providing the
Also referred to as the neoclassical theory of investment
The terms real interest rate and interest rate will be used interchangeably. The term nominal interest rate will be
used if we are not referring to the real interest rate
Plus the appropriate risk premium
Investment return is affected by three factors: the initial capital outlay, the economic life of the investment, and the
net cash flows over time.
3. Firm-Level Investment Demand C225
The framework for evaluating investment opportunities under the aforementioned decision
rules serve to underscore the fundamental role of the interest rate in conventional investment
theory. It is granted considerable explanatory powers when considering the firm’s demand for
2. Alternate Theories
A survey of the literature reveals extensive research that enriched the analysis of
investment demand; it focuses on potential relationships between demand for investment capital
and the quantity and source of finance.
The Modigliani and Miller theory (Modigliani & Miller, 1958), which predates the non-
neoclassical research agenda, contends that the financing structure utilized to fund investment
projects is irrelevant and does not alter the value of the firm. To that point, Myers offered the
following analogy “in a perfect-market super market, the value of a pizza does not depend on how
it is sliced [Myers 2001, 84].” This theorem holds when firms operate under perfect capital market
conditions where the borrowing and lending rates are arbitrage free5
, where there is perfect
information, and where the user cost of capital is unaffected by the amount borrowed or loaned6
Here, capital structure is irrelevant because external funds are a perfect substitute for internal
Alternate theories challenge these assumptions by exploring the possible impact financial
may have on real investment (Fazzari, Hubbard, & Peterson, 1988) (Bernanke, 2007).
Empirical studies examine the interdependent relationship between finance and real investment
This maintains that debt and equity are perfect substitutes.
The marginal cost of funds is horizontal on the investment demand curve
The factors include internal funds, debt, equity, and credit supply.
4. Firm-Level Investment Demand C225
(Fazzari, Hubbard, & Peterson, 1988) and uncover non-neoclassical determinants of investment
spending (Bernanke & Gertler, 1995). Some make the case that external capital is not a perfect
substitute for internal capital which creates financing constraints that impact real investment
spending (Fazzari, Hubbard, & Peterson, 1988). The various theories within this body of
knowledge address different facets of imperfect capital markets such as asymmetric information,
agency costs, transaction costs, (Oliner & Rudenbusch, 1992), tradeoff, (Myers, 2001), and costs
of financial distress (Fazzari, Hubbard, & Peterson, 1988).
The “information effect” embedded in a firm’s capital structure can affect the price of
external finance because changes in a firm’s balance sheet convey information to investors (Myers,
The Capital Structure Puzzle, 1984). Returning to Myers pizza refrain, “after all, the value of
pizzas does depend on how they are sliced (Myers, 2001).”
3. The External Finance Premium
The price of external finance should generally exceed the opportunity cost of capital for
internally generated funds. If for no other reason than the fact that transaction costs are incurred
when procuring external funds. Moreover, the corporate tax system in some countries provides a
cost advantage to internal funds due to tax a differential between dividend payments and capital
gains (Fazzari, Hubbard, & Peterson, 1988). This wedge between the price of internal and external
funds is referred to in the literature the as external finance premium or the lemons premium
(Fazzari, Hubbard, & Peterson, 1988) (Gertler & Gilchrist, 1993). It represents the marginal cost
The empirical literature cannot explain the magnitude or movement of the external finance
premium by transaction costs and taxes alone. Information problems and agency costs have been
5. Firm-Level Investment Demand C225
cited as contributory factors to the cost premium (Oliner & Rudenbusch, 1992) (Fazzari, Hubbard,
& Peterson, 1988) (Carpenter & Peterson, 2002) (Myers, 2001) . We will limit our discussion to
imperfect information in the capital markets.
4. Asymmetric Information
Imperfect information, known as information asymmetry, creates inefficiencies in the
capital markets. When parties to a market transaction have unequal knowledge of the relevant
information there is the absence of perfect information (a necessary condition for perfect capital
markets). When all market participants lack access to the information they need to make it creates
market friction. No one has full and complete information. Information is available to some but
not others; some information is private, some information is public. Thus, each participant has to
formulate unique investment strategies in order to navigate the uncertainty and ignorance created
by imperfect information.
When information asymmetry between the firm’s management and funding provider is
substantial, funders cannot accurately access the quality of a firm’s investment opportunity nor
can they confidently predict the behavior of its managers. This exposes them to significant adverse
selection (ex ante) and moral hazard (ex post) costs. Moreover, this problem may persist since due
diligence and monitoring activities aimed at reducing informational asymmetry may prove cost
prohibitive under certain circumstances. Appropriately, investors and lenders reflect compensation
for this uncertainty in their risk-adjusted rate of return. As a result, the compensating terms offered
by the less-informed funding provider can cause markets to break down due to high bid-ask spreads
(Fazzari, Hubbard, & Peterson, 1988).
6. Firm-Level Investment Demand C225
Problems of asymmetric information are not static; they may differ across industry, firm
life cycle, characteristics (Bulan & Yan, 2009), and size. Information asymmetries may be larger
for early stage, growth firms who are unknown commodities to creditors and suppliers of finances.
In contrast, mature firms are more likely to have long-term relationships with creditors and other
suppliers of finance. For example, we can assume acute information asymmetries in firm’s whose
common stock offerings are issued over the counter relative to firms whose offering are listed on
the new York Stock Exchange. In the high-tech industry information asymmetries between firms
and the suppliers of finance are like to be severe. High-tech firms undertake risky R&D project
with volatile returns and they make investments decisions on the basis of new knowledge, making
it difficult for funders to evaluate project quality (Carpenter & Peterson, 2002). Moreover, high-
tech investments generally have limited collateral value (Carpenter & Peterson, 2002).
5. Financial Hierarchy Theory
Recent empirical literature has made the case for the existence of a financing hierarchy
(Fazzari, Hubbard, & Peterson, 1988) and sought to identify its source (Oliner & Rudenbusch,
1992). Since internal funds are the least expensive relative to external financing, they are the most
preferred capital source. When the firm’s investment spending exceeds available internal funds,
external financing is obtained. Figure 1 illustrates a financing hierarchy whose external finance
premium is largely driven by informational asymmetry.
7. Firm-Level Investment Demand C225
The quantity of finance is represented by the horizontal axis and the marginal cost of funds
is shown at the left vertical axis. There are three sources of financing: internal funds (2), capital
market or institutional debt (3), and equity (6). The perfect capital market line (8) is horizontal at
the marginal cost of funds because internal and external funds would be perfect substitutes.
A move to the right on the horizontal axis represents increased investment demand. Once
we exhaust all internal funding, we begin financing our investment projects with debt. Here is
where we first encounter the external finance premium (1) and the effect of asymmetrical
New Equity SharesInternal
Maximum Financial Leverage
Marginal Cost of FundsExternalFinancePremium
Capital Market Debt
Quantity of Finance
All Funds are
2 3 6
Figure 1: Financing Hierarchy with Asymmetric Information
8. Firm-Level Investment Demand C225
information (7). As investment demand increase along the horizontal axis, the marginal cost of
borrowing (4) increases. Eventually, we reach our debt capacity (5) and want to avoid the costs of
financial distress. At this point, in order to continue our investment program, new equity shares
will be issued to finance additional investment expenditures.
As we move across the horizontal axis both informational asymmetry and the external
finance premium becomes more pronounced.
6. Pecking Order Theory of Finance
An influential theory proposed by Myers and Majluf (Myers & Majluf, 1984), known as
the pecking order theory, hypothesized that the source of the financing hierarchy was information
asymmetry between the firm’s well-informed managers and their less-informed suppliers of funds.
In the pecking order theory, it is assumed that the firm’s management has information advantage
regarding the project returns, information that is unavailable to investors. As a result, investors
cannot distinquish bad from good projects. Seeking returns consistent with average project
outcomes, they discount the value of quality investment (Oliner & Rudenbusch, 1992). With the
exception of asymmetrical information, the theory assumes all other conditions of a perfect capital
Myers (Myers, 1984) illustrates the theory in his article; the essential points are as follows:
A firm requires N funds inorder to pursue an investment opportunity it believes will realize a
positive net present value benefit. Assume ϒ is the project’s net present value (NPV) and β is the
value of the firm if it forgoes the new project. Only the firm management knows the true value of
both ϒ and β; investors do not. Investors will underwrite the new project anticipating a distribution
of possible outcomes of good and bad investments in the relevant market. The motivation for
9. Firm-Level Investment Demand C225
issuing securities is the prospect of realizing ϒ, the NPV of the investment opportunity. If the firm
issues securities with an aggregate market value of N and, based on an informational advantage,
the manager knows that the new shares are worth N1; the manager will issue share and invest only
when the following condition holds: ϒ ≤ ∆N where ∆N ≡ N1- N. Otherwise the firm may forgo
a positive net present value investment. This opportunity cost is an important component of the
external finance premium.
The theory anticipates a potential underinvestment problem as a consequence of funders
discounting invesment opportunities. To avoid this, firms adopt a strategy to preference rank
financing sources: they prefer internal funds and if there is a financing deficit and external funds
are needed they prefer debt over equity (Myers, Capital Structure, 2001). Furthermore, the theory
predicts that firms with the highest adverse selection costs adhere most strictly to the pecking order
(Bulan & Yan, 2009).
Do constraints on the quantity of finance effect the real economy? Financing constraints
can negatively impact real investment expenditure, especially for firms facing substantial cost
premiums for external funds due to severe informational asymmetry problems.
According to the financing hierarchy, some firms will generally be more bank-dependent
for financing needs once internal funds are depleted which would make these firms
disproportionally exposed to the effects of a tight credit market. Their bank-dependent relationship
is a propagation mechanism, serving as a financial accelerator that amplifies cyclical fluctuations
in investment spending (Bernanke, 2007) (Gertler & Gilchrist, 1993). Shocks to the credit market
10. Firm-Level Investment Demand C225
that tighten bank credit and reduce collateral assets values expose firms following the pecking
order theory to severe liquidity constraints8
Are there firms that follow the pecking order theory? Empirical data supports the existence
of a financing hierarchy and supports the notion that the quantity and source of financing effect
real investment decisions. With regard to the source of the hierarchy, the empirical data is mixed
(Bulan & Yan, 2009) (Oliner & Rudenbusch, 1992) (Leary & Roberts, 2005) (Carpenter &
Peterson, 2002) (de Medeiros & Daher, 2001).
Liquidity effects real investment spending (Fazzari, Hubbard, & Peterson, 1988).
11. Firm-Level Investment Demand C225
Bernanke, B. S. (2007, June 15). The Financial Accelerator and the Credit Channel. The Credit Channel
of Monetary Policy in the Twenty-first Century Conference. Altanta: Board of Governors of the
Bernanke, B. S., & Gertler, M. (1995). Inside the Black Box: The Credit Channel of Monetary Policy
Transmission. Journal of Economic Perspectives, 9(4), 27-48.
Bulan, L., & Yan, Z. (2009). The Pecking Order Theory and the Firm's Life Cycle.
Carpenter, R. E., & Peterson, B. C. (2002, February). Capital Market Imperfections, High-Tech
Investment, and New Equity Financing. The Economic Journal, 112(477), pp. F54-F72.
Fazzari, S. M., Hubbard, R. G., & Peterson, B. C. (1988). Financing Constraints and Corporate
Investment. 1988(1), pp. 141-195.
Gertler, M., & Gilchrist, S. (1993, March). The Role of Credit Market Imperfections in the Monetary
Transmission Mechanism: Arguments and Evidence. The Scandinavian Journal of Economics,
Kochhar, R. (1996, November). Explaining Firm Capital Structure: The Role of Agency Theory vs.
Transaction Cost Economics. Strategic Management Journal, pp. 713-728.
Leary, M. T., & Roberts, M. R. (2005). The Pecking Order, Debt Capacity, and Information Asymmetry.
Modigliani, F., & Miller, M. H. (1958, June). The Cost of Capital, Corporate Finance, and the Theory of
Investment. American Economic Review, 48(4), pp. 261-297.
Myers, S. C. (1984, July). The Capital Structure Puzzle. The Journal of Finance, 39(3), 575-592.
Myers, S. C. (2001, Spring). Capital Structure. The Journal of Economic Perspectives, 15(2), 81-102.
Myers, S. C., & Majluf, N. S. (1984). Corporate Financing and Investment Decisions When Firms Have
Information That Investors Do Not Have. Journal of Finance, pp. 187-221.
Oliner, S. D., & Rudenbusch, G. D. (1992, November). Sources of the Financing Hierarchy for Business
Investment. The Review of Economic and Statistics, 74(4), 643-654.