Purpose--The purpose of this paper is to empirically examine the extent at which idiosyncratic and financial market uncertainty affect the UK private manufacturing firms' investment decisions.
Design/methodology/approach--A firm-level panel data covering the period from 1999 to 2008 drawn from the Financial Analysis Made Easy database was analyzed using the system-generalized method of moments (GMM) technique to purge time-invariant unobserved firm-specific effects and to mitigate the potential endogeneity issues.
Findings--The results from the two-step robust system-GMM estimation indicate that firms significantly reduce their capital investment expenditures when uncertainty (measured by either form) increases. The findings also reveal that private firms' investment is more sensitive to idiosyncratic uncertainty than to financial market uncertainty. The results related to firm characteristics suggest that the firm-specific variables such as debt-to-assets ratio, growth of sales and cash flow-to-assets ratio are also important in the determination of private firms' investment. The sensitivity analysis confirms that the findings are robust to an alternative method of estimation as well as to an alternative measure of idiosyncratic uncertainty.
Practical implications--The findings of the paper are useful for firms' investment decisions and authorities in designing effective fiscal and monetary policies.
Originality/value--The main value of this study is to investigate the effects of both idiosyncratic and financial market uncertainty on the investment decisions of private limited manufacturing firms.
Keywords Idiosyncratic uncertainty, Financial market uncertainty, Investments, Private limited firms, United Kingdom
Paper type Research paper
The existing literature on investment provides inconclusive evidence on the effects of uncertainty on investment. In Hartman (1972) and Abel (1983), uncertainty positively affects firms' investment, particularly, when the marginal profitability of capital is a convex function of stochastic variables. In contrast, Pindyck (1988) predicts a negative association between uncertainty and investment spending under the assumption of asymmetric adjustment cost function of capital. Another study by Caballero (1991) also predicts a negative impact of uncertainty on investment. In particular, Caballero (1991) explains that instead of irreversibility, the assumptions of imperfect competition and non-constant returns to scale production technology lead to produce the negative relationship between uncertainty and investment. Risk-aversion is another channel through which investment is negatively influenced by uncertainty (Nakamura, 1999).
Economic theory suggests that both macroeconomic and idiosyncratic uncertainty simultaneously play an important role in determining the value maximization level of firms' investment. However, the marginal effects of these two sets of uncertainty are very likely to be different across industries. Caballero and Pindyck (1996) find that aggregate uncertainty has a stronger impact on industry equilibrium investment as compared to idiosyncratic uncertainty. On the other hand, Bo (2002) provides evidence that firms' investment is more sensitive to idiosyncratic uncertainty rather than aggregate uncertainty that does not differentiate idiosyncratic uncertainty from other sources of uncertainty.
Brainard et at (1980) find that uncertainty measures based on a capital asset pricing model (CAPM)-based risk have mixed effects on firms' investment expenditures. Ghosal and Loungani (1996) find that there is a negative and significant association between output uncertainty and investment. Beaudry et al. (2001) use a firm-level data...