Internal Finance and Investment: Another Look

Firms rely on internal finance for capital expenditures because of managerial considerations instead of information-theoretic considerations. That is, rather than maximizing the market value of the firm, managers seem more interested in objectives like sales maximization, size of the firm, and perquisites. One of the best documented empirical facts in economic research has been the positive relationship between internal finance and cash flows - the sum of retained earnings and depreciation - and capital expenditures and investment. But disputes about the analytical basis for the cash flow theory have been largely unresolved. There are two distinct approaches to the cash flow theory of investment: the managerial and information-theoretic approaches. The premise of the managerial approach is that managers are primarily interested in maximizing the growth rate of the firm. The premise of the information-theoretic approach is that managers try to maximize shareholder value. Using a panel of U.S. manufacturing firms (1972­90), Samuel tries to distinguish between these two approaches on the basis of observed firm characteristics. The results suggest that firms rely on internal finance for capital expenditures because of managerial considerations rather than information-theoretic considerations. The principal shortcoming of the information-theoretic approach is its reliance on dividend practices as the decisive criterion for studying firm heterogeneity. But dividend practices are incapable of distinguishing between managerial and information-theoretic approaches since both approaches predict a negative relationship between dividend payout ratios and capital expenditures. But one can distinguish between managerial and information-theoretic approaches using such variables as size, exchange listings, and the ratio of R&D to sales and make contrasting p...