exterior finance

exterior finance

The Importance of Exterior Finance

1. Introduction to Exterior Finance

This sheer ubiquity of the result makes it both important and, I think, attractive. But it also makes it, in a way, less interesting. In this paper, we show that the exterior finance premium can be more muted than sometimes thought; for some firms (very small ones), there are important exceptions. And it becomes more significant as exchanges intermediation becomes inferior. These regular patterns seem to conform more with a financial friction emerging from intermediation costs, the tradeoff between what Huberman and Stambaugh (1985) call non-diversifiable-wealth-based direct stock financing costs and returns to a consensus-intermediated financial sector. Consistent with this interpretation, the anomaly is strongest among the smallest firms, the ones for which trading directly in financial markets should be the most costly. This interpretation integrates results of this paper with the literature in risk management.

The importance of “exterior finance,” that is, raising funds from the financial markets, is one of the best-established facts in modern corporate finance. The key finding on this is usually associated with Rajan and Zingales (1998), who showed that among those firms with a higher likelihood of facing tight internal funding (precisely when cash flow prospects are worse), those firms take much worse financing decisions. But this effect of making more mistakes in financing decisions when internal funds are short (and, as importantly, having worse cash flow prospects in bad times) is not just a feature of financial practices for the poor, the young, or small businesses. This is a well-established feature of firms, big or small, old or young, and in general in all kinds of institutional and intellectual environments. Subsequent papers have found similar regularities when examining how shifts in financing ownership affect financing decisions across countries, industries, and firms.

2. Benefits of Exterior Finance

When capital markets can provide entrepreneurs with access to cash without forcing the limited partners who are buying the shares access to it, the trading market for shares and risk becomes much more efficient. This is critical because it helps ensure that risk capital does not “dry up” when it is most needed, namely during economic downturns. An owner or sponsor of a project with some wealth who wants to preserve their ownership share in a project could otherwise need to commit more funds to the project now, which will cause them to hold a smaller fraction of the project’s equity or to have a smaller ownership over the project at its delayed initial public offering. In turn, this would imply that one’s personal diversifiable risk would grow.

The use of exterior finance can provide both borrowers and lenders with many benefits. Here are some of them: allowing you to invest in new assets with the borrowings, which you would not be able to do otherwise. Once you have borrowed the funds you plan to use, you do not need to raise funds via putting your limited partners in a position of giving you their hard-earned money, which may imply that you will be diluting their ownership interest in the firm. Moreover, an issuer of debt in the capital markets can raise all the money they need in one fell swoop rather than in a number of smaller amounts over time, required by drawing on a line of credit with a bank or raising every dollar of borrowed funds with a new issue of securities.

3. Strategies for Obtaining Exterior Finance

Several studies have emphasized the importance of financing for the family firm. If the family firm receives sufficient financing – also known as financial slack – the family firm can strategically operate because it will have access to the resources that are necessary for implementing growth activities or for capturing attractive investment opportunities, also in difficult times. It might be that the family firm does not possess appropriate (own) resources or that other activities may also become under pressure from the limited resources, or that the availability of its resources may worsen during a financial downturn. If the family firm comes to have this problem, the family firm could experience the following disadvantages. When resources become scarce, other activities could become under pressure. If the family firm also operates with various financial claims, pressure can build up from the side of these claims, thereby sharpening the attention of these claims’ holders. If the family firm operates in a strongly competitive sector, the family firm will have to make higher efforts in creating an operational reality that is more stable as compared to the reality for firms that do not experience financial constraints.

The strategizing process should have an industrious and focused side. Obtaining exterior finance at the various stages of the lifecycle of the family firm seems to be highly motivating. In an ideal case, family firms confront neither any financial constraint nor a lack of resources. Nevertheless, a number of advantages can arise from obtaining exterior finance at the different stages of the life-span. A first reason could be a better alignment of the goals of both the family and the firm. Moreover, financial planning can offer more flexibility and asymmetrical information can be circumvented.

4. Risks and Challenges in Exterior Finance

The demand for external financing affects social welfare by stimulating economic growth and by smoothing the life-cycle consumption of households in the absence of insurance. Principal-agency problems and exogenous constraints on borrowing create frictions that impede flexibility in the allocation of resources and can reduce the future consumption of good-inflationary products – resulting in inefficient investments in inflationary insurance. The circumstances leading to inferior risk sharing coincide with the clearer worsening of investment opportunities in which risks must be absorbed. In more macro terms, this means that the cost of capital increases and real economic activities are reduced by not allowing investors/borrowers to aim for the best possible asset assignment.

The growth and stability of economies, in developed and developing countries, are closely linked to the behavior of money, credit, and the interest rates that result from them. This process responds to factors that are both endogenous, linked to the behavior of the agents, and exogenous, associated with the business cycle. Such specificity in the behavior of finance implies that the transmission of these effects will depend on the structure of the financial sector and characteristics of the economy. Nonetheless, it is well established that the conjunction of increases in the basic interest rate and abundance in liquidity imply asset inflation and thus a consequent increase in the systemic risk. Among other things, this implies that the presentation of banking affects macroeconomic developments as the economy area braces itself for an interest increase that has been advertised either explicitly or implicitly. But those narrower relations that are traditionally associated with the existence of the credit market, particularly its acceleration, can also have more distant consequences.

5. Conclusion: Maximizing the Potential of Exterior Finance

Much of the positive potential, in an economy which accelerates its balanced growth path by inhabiting these new technologies, turns out to be endogenous, conditional on decisions made by agents along the way. We have been arguing that the availability of finance determines how intensely such complementarity materializes in the economy as a whole. Moreover, access to said finance allows the economy to support a larger number of entrepreneurs and so channel technological growth, also supported with free general equilibrium relationships for the general stock of wealth for these (eventually as capital income flows backwards through many networks of residual claimants). Controlling many features of these models, adding leverage in parts and toying with equal and unequal prior distributions of net-worth, we are able to inquire on the role of asset price dynamics and personal wealth inequality on the micro-founded dynamics of diffusion, technology engagement, and access.

The role of external finance in technology adoption and diffusion has been a growing topic of inquiry in recent years. While the initial emphasis was directed at the immediate impact of severe credit market distress on the availability of credit and consequently the corporations’ capacity to invest in and employ new technologies, more recent work highlights a more subtle but systematic consideration on how the availability of external funds shapes the characteristics of investment in technology at any point in time. Technology is a key driver for sustained productivity and output growth well after the direct input of the latest machines and software are produced, and capturing the dynamics of aggregate technology purchase and assisted human capital accumulation is the latest concern of researchers. Equipping the organizational infrastructure with, for example, new technologies integral to the hiring of a new set of employees ultimately changes the state of technology that this efficient collection of human capital has access to at dawn. The latter links directly to the overall capacity of the economy and so eventually to the price of output, its fraction delivered in services, the demands for other factor inputs and so on.