Types of Financing and Investment-Cash Flow Relationship

Types of Financing and Investment-Cash Flow Relationship -...

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Unformatted text preview: Types of Financing and Investment-Cash Flow Relationship * Achmad Tohirin and Abdul Ghafar B. Ismail Abstract: Through the credit channel, a change in monetary policy turns into a corresponding change in the amount of funds available to a firm, thereby affecting its investment. Underlying the functioning of this channel is the assumption of imperfect capital markets due to asymmetric information between borrowers and lenders, from which it follows that there is a wedge in costs between internal and external funds – each firm faces a different interest rate depending on its risk premium. Economists have centred their discussions on theoretical insights into comparative advantage of bank-based or market-based financial systems in promoting long-run economic growth. As far as we know, there has been no investigation of whether these differences between financial systems may be related to differences in the impact of financial factors/constraints on investment. At the same time, current research on Islamically oriented financial systems concentrate on the scope of activities permissible to Islamic banks and other Islamic depository financial intermediaries. These activities are mainly determined by rules that dictate the abolition of interest rate in the financial system. This paper aims to construct an investment model, which rests mainly on a comparison of results for the same investment models across different financial systems (and also different types of financing) – as opposed to a comparison of ‘competing’ models within the same country. JEL Classification: G 11 , G 21 , G 31 . Achmad Tohirin , Lecturer in Islamic Economics, Centre for Islamic Economics Development and Studies, Faculty of Economics, Islamic University of Indonésia, Yogyakarta, Indonésia. Abdul Ghafar B. Ismail , Professor of banking and financial economics, Islamic Economics and Finance Research Center, Universiti Kebangsaan Malaysia, School of Economics, Universiti Kebangsaan Malaysia, Selangor D.E., Malaysia. * The authors are grateful for research grant provided by Ministry of Higher Education for this research, under Fundamental Research Grant Scheme No: UKM-EP- 04-FRGS 0001- 2006 . © 2010 , international association for islamic economics Review of Islamic Economics , Vol. 13 , No. 2 , 2010 , pp. 49 – 63 . 50 Review of Islamic Economics, Vol. 13 , No. 2, 2010 I. Introduction Both interest rate and credit channels are often regarded as essential to mon- etary transmission. Through the interest rate channel, a change in monetary policy is expressed as a change in the risk-free interest rate, which affects eco- nomic activities such as firm investment. Behind this lies the conventional investment theory that a firm adjusts the level of its capital stock so that the marginal productivity of capital equals the cost of funds under perfect capital markets....
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