Morgan Stanly Case Study

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Is the Growth of Small Firms Constrained by Internal Finance? Robert E. Carpenter UMBC Bruce C. Petersen Washington University First Version: December 4, 1998 Second Version: June 18, 2000 This Version: January 22, 2001 Abstract This paper examines the long-standing theory that small firm growth is often constrained by the quantity of internal finance. Under plausible assumptions, when financing constraints are binding, an additional dollar of internal finance should generate slightly more than an additional dollar of growth in assets. This quantitative prediction should not hold for the relatively small number of firms with access to external equity. We test these predictions with a panel of over 1600 small firms and find that…show more content…
To test these predictions, we examine a large panel containing over 1600 small manufacturing firms. We find that the typical firm retains all of its income, raises relatively little external finance, and has an average growth of assets similar to its cash-flow-to-asset ratio. For firms that make little use of external equity finance, our regressions indicate a slightly greater than a dollar-for-dollar relationship between growth and internal finance. In contrast, the small fraction of firms that make heavy use of new share issues exhibit a much weaker relationship between growth and internal finance. Overall, our results indicate that the growth of most small firms is constrained by the availability of internal finance. 3 This paper also brings new evidence to bear on an important outstanding issue in the financing constraint literature. The literature has wrestled with the problem of sorting out the reasons why cash flow is positively correlated with firm investment. While many researchers have argued that the correlation is due to financing constraints, an alternative interpretation is that cash flow is a proxy for investment opportunities. The methodological approach used in our study helps to address this problem. By examining the growth of the whole

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