Modigliani and Miller 1958 assumption that investment and financing decisions

Modigliani and miller 1958 assumption that investment

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Modigliani and Miller ( 1958 ) assumption that investment and financing decisions are independent by assuming that the assets of the firm are exogenously given. This allows them to focus solely on the liability side of the balance sheet (see for example Fan and Sundaresan ( 2000 ), Duffie and Lando ( 2001 ), Hackbarth, Miao, and Morellec ( 2006 ), Gorbenko and Strebulaev ( 2010 ), Glover ( 2016 ), or DeMarzo and He ( 2018 )). Our paper ad- vances this literature by endogenizing not only firms’ capital structure choices but also their investment policy. In line with the evidence in Chava and Roberts ( 2008 ), Giroud, Mueller, Stomper, and Westerkamp ( 2012 ), and Favara, Morellec, Schroth, and Valta ( 2017 ), we find that debt financing has a negative effect on innovation and investment at the firm level, due to debt overhang ( Myers ( 1977 )). The distortions in investment due to debt financing are large and imply important feedback effects of (endogenous) investment on capital structure 5 Another departure from Klette and Kortum ( 2004 ) is that we introduce heterogeneity in the quality of innovations, which is key to match the patterns in Figure 1 . 6 Electronic copy available at:
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choice. A key contribution with respect to this literature is that we embed the individual firm choices into a Schumpeterian industry equilibrium. We show that while debt leads to underinvestment by incumbents, it increases creative destruction and growth by stimulating entry. This result goes against standard economic intuition. Third, our paper relates to the literature on debt in industry equilibrium. In a closely related paper, Miao ( 2005 ) builds a competitive equilibrium model in which firms face id- iosyncratic technology shocks and can issue debt at the time of entry before observing their profitability. In this model, all firms have the same debt level. However, the model has heterogeneity in firm size because firms are allowed to invest after entry. An important assumption in Miao ( 2005 ) is that there are no costs of adjusting capital. As a result, there is no debt overhang in the sense of Myers ( 1977 ) because the absence of adjustment costs or frictions make investment independent of financing ( Manso ( 2008 )). 6 By contrast, firms have different (endogenous) debt levels in our model and can adjust capital structure after entry as profitability evolves. In addition, investment and financing decisions interact, lead- ing to debt overhang and underinvestment by incumbents. 7 Other important contributions to this literature include Fries, Miller, and Perraudin ( 1997 ) and Zhdanov ( 2007 ), which respectively study static and dynamic capital structure choices in the Leahy ( 1993 ) model. In these models, incumbent firms are exposed to a single industry shock. They all have the same assets and the same debt level and there is no investment. Lastly, our paper relates to the literature initiated by Mello and Parsons ( 1992 ) and Parrino and Weisbach ( 1999 ) on the effects of debt financing on corporate investment in dynamic models of the firm. Our study departs from prior work by endogenizing capital
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