The Empirical Relationship Between Investment and Financing: A New Look

Since the publication of the work of Modigliani and Miller (MM) in the late 1950s there has been a recurrent controversy in the finance and economics literature about the interdependence of investment and financial variables. The arguments are too well known to recount at any length here. Basically MM would argue that in perfect capital markets, investment is, and should be independent of financing (which we will identify, as they would, with financial variables like dividends and new debt). The opposing view would argue that capital markets are sufficiently imperfect that the firm must consider financing in its investment decision. At least some of the proponents of this other view would argue that the firm must raise funds and allocate these scarce funds between investment and dividends. This view, then, holds that the firm's investment, dividend, and financing decisions are interdependent and must be studied in the context of a simultaneous equation model. There have been many articles discussing the MM position and many attempts to test it empirically. The first to focus directly on the question of interest here was done by Dhrymes and Kurz 1 in 1967. We will attempt to show that, despite several later studies, Dhrymes and Kurz were correct in their assertion that the investment and financing decisions are made simultaneously and must be studied in the context of a simultaneous equation model. To set the stage for our study we shall review the Dhrymes-Kurz study and subsequent related studies and show that each contained some error that affected their results.