Internal Finance as a Source of Investment: Managerial/Principal Agent or Asymmetric Information Approach?

Abstract

Although there is evidence of a strong relationship between investment and internal finance, the reasons behind this relationship remain subject to controversy. So far, the literature has identified at least two approaches to the underlying cash flow theory of investment which influence this relationship: specifically, the managerial/principal agent framework and the asymmetric information approach. A dominant theory in corporate financing patterns for many years has been a firm’s preference for internal over external finance to fund investments. Baumol clearly articulated this idea which would be called a ‘financing hierarchy’ by later researchers, stating:
[i]t would appear that the bulk of business enterprise should finance its investment insofar as possible entirely out of retained earnings because that is, characteristically, the cheapest way to raise additional funds. Only when it becomes impossible to provide enough money from internal sources should the firm turn to the stock market or to borrowing for resources. (Baumol, 1965)