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Policy,
Re.earch,
andExtemal
Affairs

WORKING PAPERS
FinancialPolicyandSystems

CountryEconomicsDepartment
The WorldBank
April1990
WPS409
Public Disclosure Authorized

Financial Policy
and Corporate Investment
in Imperfect
Capital Markets
Public Disclosure Authorized

The Case of Korea

MansoorDailami
Public Disclosure Authorized

The vigorous expansionof corporate real investment in Korea in

the 1980sdespite high real interest rates owes much to the rapid
growth of the stock market and its increasinglyimportant role in
supplying equity capital to the corporate sector.

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 rPoMay,Resoroh,and Extmal Alhir

FinancialPolicyandSystems

This paper -- a product ot' thc Financial Policy and Systems Division, Country Economics Departmcnt
- is pan of a larger cf'fort in PRE to understand the role of capital markets in the growth and adjustment
process of developing countrics. Copies of this paper are available frec from the Wurld Bank, 1818 H
Strect NW, Washington DC 20433. Pleasc contact Maria Raggambi, rrm N9-041, extension 37657 (47
pages with tables).

Dailamni'seconometric findings support three
conclusions about the relationship between cor-
porate finance and real investmenEin Korea:
First, assuming that debt capital has been
subsidized through both taxation and regulatory
intercst ratc policy, corporations have drawn on
the stock market to finance their marginal
investment projects.
This reliance on new share issues as the
marginal source of financial capital is consistent
with the observed relationship between stock
market price movements and corporate invest-
inent behavior. It also explains Daiiami's
inability to establish a statistically meaningful
relationship bctwccn corporate investments and
profits - which would have been thc case had
corporations funded their investments at thc
margin through retained earnings.
The marginal profitability of investment in
Korca is higi, or has been shifting upward.
Otherwise it would be ditlicult to justify corpo-
rate reliance on relatively costly extemal equity
as a marginal sourcc of funds.
Second, the real aggregate stock market
price, rather than the average q, or even the
average rate of profit, is the preferred proxy for
the theoretically appropriate - but unobserved
marginal q in explaining corporatc invest-
ment behavior. The link between stock market
and real cconomic activity' has been particularly
evident in the 1980s, when rapid growth of the
market has becn accompanied by vigorous
economic growth and a boom in corporate
business investment.
Third, corporations in Korea have used low-
cost debt to finance investments in financial
assets as well as in physical and productive
assets. These financial assets - liquid assets
(cash, bank deposits, and govemment securi-
ties), other companies' shares, and accounts
receivable -- are known to account for relatively'
more (42 6 pcrccnt) of total corporate assets in
Korea than in the United States (24.3 percent) or
the United Kingdom (37.8 percent).
To the extent that extemal equity is the
corporate sector's marginal source ol' funds,
what is relevant in determining incentives for
new investmcnt is what determines the cost of
equity (such as taxation of dividcnds and capital
gains) plus the procedure for pricing new share
issues.
Policy should cater increasingly to the
requirement of developing equity markets,
including measures to change the mcthod of'
pricing new share issues from the prevailing par-
value based system (or premiums thercol) to a
system based on market forces. The existing
par-value pricing procedure has evident!y becn
an important factor behind the high cost of
external equity capital in Korea and a potential
source of speculation.

The PRE Working Paper Series disscminates the findings of work under way in the Bank's Policy, Research, and External
Affairs Complex. An ohjective of the series is to get these findings out quickly, even if presentations are less than fully
polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced at the PRE Dissemination Center

 la of Contanra

I. Introduction . 2

II. TheoreticalFramework.. 2
1. The Model 2
2. Corporate Investment and Marginal Source of Funds 14

III. 1. Empirical Results.17

2. Specificationand Data .17
IV. Conclusionand Policy Implications.23
Data Appendix.26
References.30

List of Figures and Tabl

Figure 1 .15
Table 1: Maximum-LikelihoodEstimatesof the Parametersof Equations
(15. a) and (15. b) .22
Table A. 1 .29

I would like to thank Gerard Caprio,Marcelo Giugale and Patrick Honohan for
helpful comments and suggestions,and Inbom Choi for expert researchassis-
tance.
 I. Tntr6dua tion

Central to the effectivenessof financialpoliciea geared towards promot-

ing real business investmentis the interactionbetween corporations'financ-
ing and irvestmentdecisions. The analysisof this interactionand its
implicationsfor the role of finance in real economy has long been debated in
the field of both corporate financeand investmenttheory.' In the former,
the debate has centered on the determinantsof optimal capital structurein
the capital market environmentof industrializedcountries where the existence
of well developed securitiesmarkets for pricing of various debt and equity
claims on corporateassets are taken for granted. Within this context,one
importantgoal of researchhas been to modify the implicationsof the original
Modigliani-Miller(1958) leverage irrelevancetheorem,by taking explicit
account of the influencesof taxes and costs of bankruptcy (Kraus and Litzen-
berger (1973), Scott (1976),Kim (1978)],the agency cost of debt (Jensen and
Meckling (1976)] and the potential loss of non-debt tax shields, such as
depreciationallowances,(De Angelo and Masulis (1980)]on the determination
2 These studies have generally treated the cor-
of optimal financial leverage.
porate real investmentdecisionsas exogenousand have focused on the financ-
ing aspects of corporateinvestmentbehavior. In contrast, there is the
importantstrand of researchon the neoclassicaltheory of private investment
behaviorwhich, either in its originalcontext [Jorgenson(1963),Jorgenson
and Hall (1971)] or in its modified cost of adjustmentcontext [Lucas (1967),

I See, for example,Vickers (1970),Khu and Meyer (1963),Coen (1971),Dhrymes

and Kurz (1967), and Ciccolo and Fromm (1979, 1980).
2 For recent empiricalevidenceon the simultaneousinfluenceof these attrib-
utes on optimal corporatecapital structure in the U.S., see Bradley,Jarrell
and Kim (1984);Titman and Wessels (1988).
 -3 -

Gould (1968),Treadway (1969),Hayashi (1982)],assumes perfect capital mar-

kets and no uncertainty.3 In this case, it follows that the firm's real
investmentpolicy is independentof how it is financed.
An importantpoint of co- ergence between these separate areas of
research activityon the theory of investmentand finance is the recent
advances in the theory of imperfectcapital markets associatedwith, among
others, Greenwald,Stiglitzand Weiss (1984),Myers and Majluf (1984), Ber-
nanke and Gertler (1989), Fazzari,Hubbard ard Petersen (1988);Grossman and
Hart (1982). In an importantdeparturefrom the traditionalperfect capital
market/fullinformationassumptionsunderlyingthe Modigliani-Miller(1958)
theorem--orthe Jorgenson Investmentmodel (1963)--thisncw strand of litera-
ture emphasizesthe imperfectionsin capital markets arising not only from
taxes, but also from asymmetryof informationbetween users and suppliersof
finance,and shows how these imperfectionsmay create sndogenousfinancing
constraintspreventingfirms from investing in projects with positive net
present values. This possibilityarises because of the additionalpremium
imposed on the supply of externalfinance,both debt and equity, when inves-
tors are less informedabout the firm's investmentopportunitiesor its asset
characteristicsthan insiders,i.e. managers or stockholders. As a
consequence,the firm cannot costlesslysubstituteexternal for internalfunds
in order to finance its desired levels of investmentor dividendpayments.
The upshot is that firms' financing,dividend and investmentdecisionsare
inzerdependent,and the nature of this interdependenceis influencedby the
institutionaland structuralfeaturesof underlyingcapital market environ-
ment.

3 For an extensionof the neoclassicaltheory of investmentto include uncer-

tainty, see Lucas and Prescott (1971),Hartman (1972);Pindyck (1982);and
Abel (1983).
 .4-

ConsideringLiperfectionsin capital markets, the experienceof develop-

ing countriespresentsa germane ground. In almost all these countrlescapl-
tal markets are characterizedby a high degree of segmentation,severe
informationalasymmetry,incompletemarkets, weak prudentialsupervision,and
above all by pervasive governrontinterventionsin the form of direct alloca-
tion of credit, official setting of interestrates and tlght regulatory
restrictionson companies'pricing and offeringsof new equity share issues.4
These imperfectionsare, to a large extent, structural,ln the sense that they
lmpose a hlgher degree of stringencyon firas' financlngand investmentceci-
sions than are Lipliedby pure informationalasymetry presumed to exist ln
developedcountries'capitalmarkets. The reform of these structural
imperfectionsis currently the focus of liberalizatlonmeasuresadvocated by
the internationalfinancialorganizations[see, Cho (1986), Gelb and Honohan
(1988),World Bank (1989)].
The objectivesof this paper are two-fold: flrst, to develop an inte-
grated approacn towards the problem of optima) corporatereal investmentand
finance in the context of a financialmodel oE a developingeconomy
characterizedby credit rationing,a controlledbanking sector, and an orga-
nized equity market; and second, to apply the model to the non-financialcor-
porate sector of the Korean economy. Korea presentsan interestingexample
for a number of reasons, includingthe government'straditionallyactive use
of credit, interestrate and tax policy to stimulateinvestment;the existence
of relativelywell-developedand broad based equity markets; and the large
size of the corporatesector, accountingfor about 60 percent of total domes-
tic capital formation (see Data Annex for backgroundinformation on these
featuresof the Korean economy]. In addltion,the tax treatmentof income
from capital in Korea, particularlyat the personallevel, is very different

4 See, for example,Gelb (1989);Tybout (1984);Nabi (1989);Kim (1989¼, and

the World Bank (1989).
 - 5-

from that in the United States, 5 thereby providingan opportunityto analyze

the relationshilbet ien capital taxation,corporate finance and investment,
issues whic;hhave so far been exploredonly in the context of industrialized
countrieswith mature securitiesmarkets Miller (1977),Poterba and Summers
(1983, 1985); Bradley,Jarrell and Kim (1984)].
The remainderof the paper is organizedas follows. In Section I we
describeour theoreticalmodel of companies'optimal investmentand financing
behavior,which is based on the familiar'Tobin'sQ" approach to the theory of
investment,
but extendedto incorporatesome importanttax and financialfea-
tures of Korean economy. Specifically,in the model, there are three sources
of funds: (i) retainedearnings; (ii) debt capital;and (iii, external
equity. Firms raise external equity in the form of both initial public offer-
ings (IPO's)4and seasoned issuesof stocks,while debt is placed only with
the financialinstitutionsincludingboth domesticand foreignbanks and
non-bankfinancial institutions. There exists a well-functioningtrading mar-
ket in equity shares which price equity claims competitively,but the interest
rate on bank loans is administrativelyset and is treated as a policy
variable. Capital gains are exempt from personal taxes, but dividend incomes

5 While there are importantsimilaritiesin the prevailingtax codes in Korea

and the United States in terms of corporatetaxation,there are important
differencesin personal taxation. One such difference,for example, is the
much lighter taxationof interestincome relativeto equity income in Korea
than in the United States. Thanks to various exemptions,the effective maxi-
mum tax rate on interest income (includingdefense,educationand residence
taxes) in Korea is 18 percent comparedto 28 percent in the United States
(after the tax reform of 1986). But income from stocks is taxed much more
heavily in Korea; although capital gains are not subject to personal taxation
there, dividend income is taxed at a rate as high as 70 percent for wealthy
individuals,once the defense and residence taxes are taken into account. See
data Annex, Table A.1 for details.
6 The amount of capital raised through IPO's depends of course on the number
of companiesgoing public, and this has varied considerablyduring the past
two decades. In 1987, for instance,there were 35 new listingsand one delis-
ting. See Socuriti.. Market in Korea, the Korea SecuritiesDealers Associ-
ation, 1988, for details.
 *6-

are sUkjO- to high marginalporsonaltax rates. Given thesetax and finan-

the firm'soptimalrateof real investmentLs derivedas a
cial constraints,
functionof wTobin'smarginalQ," (the ratio between the market's valuationof
an incrementalunit of capital to its c;at of replacement),tax, and financial
parameters
characterizing
the fLrm'smarglnalsourceof funds.
SectionIII discussesthe estimation
of the model,wlth annualdata from
1963 to 1986. UsLngboth capitalmarketand balancesheetdata,several
measures of the valuatlon ratio are providedand their relovance and limXta-
tion for explainingcorporate real investmentbehavior in the Korean economy
are discussed. Finally,Section IV concludesthe paper with a brief
discussionof some relevantpolicy implicationsand lessons.

II. Theorptieal FrAmovprk

1. The Modal
We begin our analysiswith a descriptionof the objectivesthat a firm's
managersmay pursue in formulatingtheir investmentand financingplans in the
tax and financialenvironmentof Korean economy.
Given the family-basedstructureof corporateownershipand control in
Korea, it seems plausible to assume that managers act in the interestof
existing shareholdersano seek to maximize the value of equity subject to a
7 These ccnstraintsare set by technolo& by imperfec-
set of constraints.
tions in capitalmarkets, by tax provisions,and by 4nvestors'required return
on equity. The returns requiredby equity holders depend on returns on
alternativeinvestmentopportunities,which in Korea (where capital markets
have until quite recentlybeen virtually closed),are taken to be yields on
governmerst
bonds.

7 This assumptionalso applies to corporationswith diffused shareholding

bases under the conditionsthat managershave a share ownershipstake in the
firm [Jensenand Heckling (1976),or when the firm is leveragedwith potential
threat of bankruptcy (see Grossman and Hart (1982)].
 We, thus, posit, p-(I- )R, where p - requiredreturn oii equity; R -

averageyield on governmentbonds, and xi - effectivepersona, tax rate on

intereston governmentbonds. Similarly,lettinga to be marginal personal
tax rate on dividend income,and noting that capital gains in Korea are exempt
from personal taxation,the firm's objectivecan be stated formally as:

maxE.-f exp (-p1) [(1-m)d(t)-u(t)] dt (I)

where d(t) and v(t) denote, respectively,the firm's dividend payment and new
share issues at time t, and E. is the present value of future stream of after
tax dividen' payments net of new stock issues.
The firm solves the maximization problem (1), subject to a set of con-
straints. The first constraintstems from the legal requirementmandatedby
law [The Capital Market Act of 19681, which obliges
Promotior. companies to
maintain a defined minimum stream of dividend payments regardless of their
cash flow or tax consequences.' Thus, we have

d(t) > di vtjme 2

whete d is an exogenouslygiven stream of dividendpayments.

Likewise,we constrainnew share issues to be non-negativeor:

u(t) 2 0 Vtimn (3)

8 Note that such tax consequencesare very severe in Korea where capital gains
are not subject to personal taxation,while dividend income is taxed at a
relativelyhigh rate. In spite of that, companieshave distributeda sizeable
portion of their earningsas dividendsto shareholders,averaging 28 pe cent
for the corporate sector as a whole over the 1975-1986period. The tax cost
associatedwith this pay-out ratio, computedat an average dividend income tax
rate of 58 percent, amounts to 16.2 percent of corporateearnings or about 3.4
percent of corporate fixed investment.
 a8-

While there is no legal restrictionon companiesrepurchasingtheir shares,

the strong need for funds inducedby robust expans.onof corporate investment
effectivelyprecludes this option.
The third constraintrefers to the firm's access to the officialcredit
market, which is assumed to be limited. Specifically,we assume that banks
are willing to lend only a fractionof each enterprise'snew investmentneeds.
This fraction is assumed to depend negativelyon the company dAbt/capital
ratio. A linear version of this restrictionis expressed as,
b(t) S hP(t) l(t) + I P(t) K(t) - I, 8(t) (4)
whereb(t) is the maximum lezel of bank credit extended at time t, B(t) is the
stock of corporate debt outstanding,K(t) is the stock of real capital,I(t)
is gross corporate real iiavesLment,
P(t) in the price of capital goods, and h,
P and P2 are non-negativeparametersof the underlyingsupply function of
bank credit,
The fourth constraintrefers to the equalitybetween the use and sources
of funds. The firm's sources of funds consist of three items: (a) after tax
operatingprofits; net of interestpaymkent
but includingdepreciationl
allow-
ances; (b) net borrowing;and (c) net proceeds from new share issues. On the
use side, there are two main items: (a) paymentsof dividends and (b)
expenditureson new capital goods includingcosts of installationand adjust-
ment. Under these conditions,cash flow available for distributionto exis-
ting share holders at time t are given by

d(t) - (I-Ti) [it(K(t)) - r B(t)] + b(t) - B(L) + (I-u) v(t)

- P(t) C(I(t), K(t)) - P(t)( l- rz(t))l(t) (5)

where n(.) - before interestand tax profit, taken to be an increasingand

concave functionof K, i.e. " > 0 ,, 5 0, r - interestrate, p - amortiza-
tion rate on debt, v - new share issues,u - the average cost, consistingof
 .9-

both transactionand underpricingcosts, per unit of capital raised through

external equity issues, % - the corporateprofit tax rate, and C (.) - an
adjustment-costfunction assumed to be an increasingfunctionof I and K and
z - present value of depreciationallowanceallowed for tax purposeson one
unit of new investment.'
The cash flow constraint (5) is straightforward,
although three features
require coomnt. First, it is noted that interestpaymeatsare treated as tax
ceductible. This conforms to the prevailingtax regulationin many countries
includingKorea, where tax allowancesare made for corporate interestpay-
ments. This, in effect, lowers the cost of borrowing and thus induces firms
to substitutedebt for equity financing. The limit to this process of
substitutionis determinedeither by some legal >%adinstitutionalrestraints
on the debt finance available,or through considerationof varioas leverage-
related costs such as bankruptcycosts, costs due to agency and asymmetrical
informationproblemsor a loss of non-debt tax shiel.ds(see De Angelo and
Masulis (1980);Kim (1982);Ross (1985)]. Second, it is assumed that external
equity financing is costly, and the cost is proportionalto the gross proceeds
from new share issuance, i.e. uu(1).10Thus, the net proceeds from external
equity capital are equal to (l-u)v,which is included in equation (5) as an
addition to the firm's cash flows. Third, we have includeda cost of adjust-
ment item, C(I, K) in equation (5) to capture the additionalinstallation

9 Note that equation (5) excludesa term for depreciationallowancesallowed

for tax purposes on the existing level of capital. This term depends on past
investmentend has no influenceon future investment[see Abel (1983);Summers
(1981) for details.]
10 We recognizetwo types of costs here: (i) transactioncosts involving
underwriters'commissionsand legal and other related expenses;and (ii) the
indirectcosts associatedwith the underpricingof new share issues due pri-
marily to the "par value" method of setting the offer pr4-e at the par value.
These indirectcosts are very serious in Korea, where ii .ialpublic offerings
(IPOs) are traditionallypriced at, or very close to, par value. IPO's how-
ever, account for only a small proportionof total equity capital raised
externally;the dominantshare comes from seasoned issuanceif stocks offered
to the existing shareholdersin the form of rights issues.
 10 -

expensesassociatedwith the process of investment. The rationale is based on

the modelsof Lucas (1967), Go.ild (1968) and Treadway (1969),where the cost
of adjustmentwas introducedin the neoclassicaltheory of investmentto
obtain an explicit solution for the firm's optimal rate of investment. Fur-
thermore,this cost function is assumed to depend positively on Land specifi-
cally to take the form:

C (1,K) - a/2 (K -n-.)) x (6)

where a a 0 is a constant parameter, and n(.) is a function to be specified

later and denotes the normal or long-term growth of fixed assets.

Two other constrai-ts %re the evolution of the firm's stocks of capital
and debt as given by:

JKt) - I(t) - 6 K(t) (7)

B(t) - b(t) - 3 B(t) (8)

where 6 is the rate of depeeciationof physicalcapital.

Equation (7) describes the familiarperpetualmethod of capital accumu-

lation,wherein real capital increasesat the rate of gross investmentless
depreciationdue to obsolescenceand wear and tear. The rate of depreciation
is further taken as a constantfractionof existingcapital stock. In equa-
tion (8) net flow of loans from the banking sector is defined as the diffe*-
ence between new loans contractedand the amortizationpayment on the existing
loans where the rate of amortizationis assumed to remain unchanged over time.
 - 11 -

The maximizationproblem facing the firm, stated formally,is to choose

b(t), I(t), and v(t)to maximizethe presentvalue of its market equity, given
by equation (1), subject to the constraints (2), (3), (4), (5), (7) and (8)
and given initialconditions,t(o) and K(o). This problem can be solved by
means of standard control techniques. Thus, we treat b(t), I(t) and v(t) as
control variablesand B(t) and K(t) as state variablesand formulate the
current-valueHamiltonian,H, as,

H - (1-m) d-v + k (I - 6K) + p (b - 3B) (9)

where k and p are the associatedshadow prices of capital and debt, respec-
tively.
Taking into account tae constraints(2), (3) and (4) and substitutingfor
d from equation (5) into (9), we define the LagrangianL as:

L - (1-m.+lW 2 ) [(I -t) (n(K)-rB) - tB + b-P(1(1-tz)+C(1,K))]

• ((1-m.+i2 ) (1-U) + I3-) V

• ip,(hPI + 1, PK -328 - b) (10)

where w,,V2 and i3 are the Lagrangian multipliers associated with constraints

(4), (2) and (3) respeccively. The necessaryconditionsfor an optimal solu-

tion are the following:

_ (p + 6) X - (1-m+e 2 )) [(I -T) an P aK]- wi' (1l a)

1i (p + 1) p + (1-m+, 2 ) CD + (1-t)r] + 12W

1 (11.b)

aL
ab (1-m.i4p 2) + p - VI 0 (I1.c)

-L (1 -m*V 2 P 1 -- rZ * C) + . * -lp 0 (11.d)

 - 12 -

d' (L -m.+)(-u) + 3 1 O (I 1)

, (10 .1)

Va (d-d) - 0 (11.g)

V3 U (ll.h)

There are, A 2riorl,

several possibleoptimll paths or regimes corre-
spondingto whether constraints(2), (3), and (4) are binding or not. To
determinethese optimal paths, we rely on the assumptionthat debt is cheaper
than equity financing in Korea, which would imply that firms have the incen-
tive to resort to the maximun level of borrowing possible. In this case,
VI > 0 and from equations (ll.b) and (ll.c) it follows that , _
which is the capitalizeddifferencein the after tax cost of debt and equity
per unit of debt capital,or the subsidy to the existing shareholdersof the
firm's having access to low cost debt. To derive formally the firm's optimal
investmentrule and its financing,we substitutefor Wi into equations (ll.d)
and obtain,

(I-m + )[I@ a/C - - z-h p + + 2]J q (12)

where q - is the familiar "Tobin'smarginalQ" defined as the ratio of the

marginalvalue of an additionalunit of capital (i.e. the shadow price of
capital),x to the price of capital goods, P. [Abel (1979), Chirinko (1987)].
Equation (12) describesthe equilibriumconditionfor the firm's optimum
level of real investment. It states that an optimizingfirm will continueto
invest until the marginalcost of an additionalunit of investmentis equal to
the marginalvalue of that investment. The marginalcost of investment
depends on the cost of the marginal source of funds as well as on the net
 - 13 -

marginalcosts of acquiringcapital. The latter terms involve the sum of

purchaseand marginaladjustmentcosts less the tax savings from depreciation
allowanceson one unit of investmentin fixed assets and less the leverage
related benefits to the existingshareholdersof the availabilityof low cost
debt. The availabilityof low cost debt impliesalso that equity is the
marginal source of financialcapital to the firm; and in this respect there
are two alternativeoptimal investmentrules, dependingon whether the firm
financesits investmentat the margin by resorting to retained earnings (i.e.
internalequity), or by issuing new shares, (i.e. external equity). These
alternativescorrespond,formally,to whether (V2 - and V3>O), which implies
!-m + 2 1 - m; or whether (*2>0 and Vs-0),which from equation (ll.e) implies
that 1-m.+42-,',. Substitutingthese alternativevalues for 1-m+W 2 in equa-
tion (12), and solving it for the firm's optimal investment rate yields:

1 I r 1 p-1-t)rl
tz
- a [(1r q _ (1- 'z-CZ)j
+ h LP-(I- J *n(.) (13.a)
which is the firm's optimal investment rate when the marginal source of funds
is retained earnings, and

I -Ia [(I-u) q - (1 -tz)]+ h [ nF.] (13_b)

which is the correspondinginvestmentequationwhen the firm finances its

investmentat the margin through issuanceof new equity.
 14 -

2. CnMarat& Invaatm.nt And MArginI Sourte of Funds

These equations offer some importantinsightsinto the relationship

between the firm's optimal investmentand its sources of equity financing. To
highlight this relationship,it is convenientto abstract, for a moment, from
the influenceof debt subsidy and solve for the steady-statevalues of mar-
ginal q to obtain q6 1-(I-m)(I-xz) and qea-U=. These define, respectively,
the thresholdvalues of q for marginal investmentprojects that are financed
by retainedearnings and by issuingnew equity shares. For recent values of
m, c and T2 from the Korean economy, it can be shown that q2' >1> q,'which
impliesa hierarchicalorder in firms' financingbehavior, shown in Figure 1.
In this figure the horizontal lines SI and S2 correspondrespectivelyto q -
q*1 and q - q*2, and the relativelylarge distancebetween these lines
reflectsthe combined influencesof high taxationof dividend income relative
to capital gains and the direct and indirectcosts of issuing new share equity
in Korea. This high cost differentialbetween internaland external source of
equity finance implies that only firms with relativelyhigh marginal profit-
ability of investment,as shown by demand scheduleD2, resort to external
equity as their marginal source of funds. In contrast, firms with investment
projectscharacterizedby demand scheduleD1, rely on internal funds to
finance their marginal investments. This direct relationshipbetween firms'
investmentand financing decisionsprovidesa useful device to motivate the
discussionof financialpolicy. To the extent that firms finance their mar-
ginal investmentprojects through issuanceof new equity shares rather than
through retentionsof earnings, it is the stock market performancethat bears
influenceon the incentivesto invest. On the other hand, for firms that
retentionof earnings is the marginal source of funds, one expects a close
relationshipbetween corporateearningsand investment. In practice, each of
these scenariosmay apply to some firms, but which one is predominantis the
key empiricalquestion to be addressed in the next section. Given that our
 - 15 -

Figure 1

q-q 2 S2

D2

q-q I

-DI

Investment

Figure 1: Marginal Source of Funds

and Investment Schedules.
 16

data relates to the corporatesector as a whole, we take a weighted average of

equations (13.a) and (13.b) with the weight assigned to the former denoted by
e, to obtain an aggregate investmentequation:
1r I(1e \1-u+ ls
I-z hp (1n-¶)r14
l,l~
[( +l8(-uq I a I P+0+0+ I

which provides the basis for our estimation. Note that the numerical value
that e takes is critical to the identificationof the marginal sources of
funds to the corporate sector. A value of 0 - 0 implies that new share issue
is the marginal source of funds; a value of e- 1, on the other hand, implies
that the corporate sector relies on internallygeneratedfunds to finance its
marginal investmentprojects.
 - 17 -

III. EmpsircalReults

III1. SRpecificationAnd Data

In this sectionwe use annual data for the non-financialcorporatesector

of the Korean economy over the period of 1963-1986to estimate simultaneously
the system of equatiorts(14) and (4). The startingpoint is the modification
of these equations into some suitableempirical form. First, we specify
n(.), the long-tErmgrowth in fixed capital in equation (14), as a functionof
the long-termgrowth in final demand, and distinguishingbetween domesticand
external demand wo poeit: n(.) - n'X,, where i'-(rI.,n1l, n12, n,. I14. %, I1) is a
vector of parameters
and X,'-(I,xX,, x,,,1,x,U2, x2,,x2,, , 2), where xi,and
1 , x21

x2, are, respectively,growth rates of exports and domestic demand in year t.

Second, we extend equation (4) to account for the possibilitythat bank credit
may be used to finance investmentsother than those in fixed assets. Thus,
denotingcorporate investmentin financialassets by At, the basic equations
to be estimated,expressed in discrete time, are:

l_,I [( u,)q,)1
-q,+(e-O)(1 - T,Z,S)] a (2 X (15Ea)

bK_ +h - pBIA I + 133 K,2 e2 (15.b)

P, K, PK,*P,K,

where all terms in equation (15.b) are scaled by PK to conform to equation

(15.a), El E2, are disturbanceterms assumed to be normally distributedwith
definitevariance - co-variancematrix and zero means, and
 .18

S,(,)pi
, P-(l-l)rl

where a is a given value of the rate of amortizationtaken to be 10 percent

per year. Note that, for a given value of P2, St is empiricallyobservable
and thus can be used as part of the data set.
To proceed with estimation,we first obtain an unbiased estimatefor 0 2

by applying instrumentalvariables to equation (15.b),using total corporate

earningsas an instrumentfor investment,I. This procedure is needed to
overcomethe simultaneityproblem associatedwith the appearanceof investment
as an Lndependentvariable in equation (15.b). Thus, using annual data from
1964 to 1986, the instrumentalvariableestimate of A2 is given by 02 - 0.20
with standard error- 0.055 and t - statistic- 3.71. Given this estimateof
02, we next turn to the estimationof equations (15.a) and (15.b). One
obstacle,however, remains. As emphasizedoriginallyby Tobin and Brainard
(1977),and subsequentlyby Summers (1981),Hayashi (1982),and Chirinko
(1987); q ln equation (15.a) is not directlyobservableand so this equation
is not empiricallyoperational. The standardapproachadopted in the empiri-
cal work in the United States has been to use "averageq" defined as the ratio
of the market valuationof existingcapital to its replacementcost (see, for
instance,von Furstenberg(1977); Summers (1981)]. The use of average q is
appealing from a theoreticalpoint of view, since it provides a link between
securitiesmarkets performanceand corporate real investmentbehavior. The
problem resides,however,with the empiricalperformanceof average q in
explainingcorporate investment. The experiencein the United States reveals
that measures of average q are typicallyvery poor predictorsof investment,
and are statisticallyinferiorto other proxies such as the real aggregate
stock market price index [Barro (1989)]. Interestingly,our findingswith
Korean data confirmedthese findingsin the United States. Experimentingwith
 - 19 -

severalmeasures of average q11, we were not able to establish any statis-

ticallymeaningfulrelationshipbetween corporateinvestmentand average q.
Instead,the use of real aggregatestock market price index proved to be much
superior,and this provides the basis for estimationresults reportedbelow.

III. 2. n Mathnd and R-eulta

atA
The system of investmentequation (15.a) and the bank credit supply func-
tion (15.b)were estimated simultaneouslyby full informationmaximum likeli-
hood method, with annual data from 1964-1986. The data has already been
defined,with details regardingmethodology,sources and constructionbeing
reported in the Data Appendix.
Table 1 contains the estimationresults under two specificationsof
parametera, i.e.; (i) when G was not g Rriori restricted;and (ii) when e was
restrictedto be zero. The table also shows the log likelihoodvalues under
these two specificationsand the implied likelihoodratio statistic for test-
ing the hypothesise- 0. This statistic is distributedX2(
1), with critical

values 3.84 (5% probabilityof type I error) and 6.63 (1%). Since these
values exceed the computedlikelihoodratio statisticof 1.902, we accept the
specification0- 0. This is an important finding,since it means that the
corporate sector in Korea financesits investmentat the margin by issuing new
equity shares, rather than by resorting to earning retention. This reliance
on externalequity as the marginal source of funds for financing investmentis
consistentwith the observationthat investmentin Korea is related to stock
market price index but not to corporateearnings. The lack of strong rela-
tionshipbetween investmentand earnings implies that investmenthas not been
constrainedby internalcorporate resources.

11 These measureswere based on the ratio of market value of equity plus book
value of debt to the replacementcost of capital,where capital was defined
either broadly to includemachinery,equipment,and inventories,or narrowly
as only the sum of machineryand equipment.
 20

Given the weight of evidencein support of the specification,e- 0, we

continue our interpretationof the results under this specification,as con-

tained in the second column of Table 1. Regarding these results, they seem
quite satisfactory,since all have the right sign and all, with the exception
of second lags of growth of exports and domestic demand, are significantly
different from zero at the 5 or 10 percent levels, as marked in the table.
The estimatedvalue for h is 0.43, indicatingthat corporationsin Korea use
about half of their low-costbank loans to finance fixed investments,and use
the rest to finance others such as financialinvestments. This estimateis
consistentwith supplementaryinformationon the observed share of fixed
assets in Korean corporatebalance sheet and its policy implicationswill be
elaboratedbelow. The estimatesof other financialparameters,i.e. 013,
and E3 are all stronglysignificant,supportingthe view that financial and
real investmentdecisions are interdependentin Korea. The impliedvalue for
the coefficientof cost of adjustmentis a,2 - 22.4, which is high, but not
12 The
unusual in the empiricalliteratureon the Q-approachto investment.
possibility,nevertheless,remains that our estimatemay contain an upward
problem arising
bias due to errors in variables,or due to a specification"3
from our use of the aggregatereal stock market price index as a proxy for the

12 Though not directlycomparable,Thirinko (1987) reports estimate for a

ranging from 536.62 to 558.7, when ;he influenceof demand is included,and
ranging from 183.7 to 209.6, when demand is excluded from his model of corpo-
rate investmentin the United States. Similarly,estimatesreportedby Fot-
erba and Summers (1983) for the United Kingdom data are much higher than our
estimate for the Korean data.
13 We also experimentedwith the use of average rate of profits as a proxy for
marginalq, but the results were not satisfactoryto warrant reporting. vi-
dently, no single proxy can capture fully the influenceon -nvastment of mar-
ginal q. Hence, attention should be given to considerationof severa'. proxies
and indicators. The methodologyfor estimatingmultiplo indicatorsin linear
structuralmodels is well developed [see, for instance,Joreskog and Gold-
berger (1975),Bentler (1983),Aigner, et. (1984) for estimationissues and
Titman and Wessels (1988), for an interestingapplicationto corporate
finance]. The extension and applicationof this methodologyto non-linear
models which are typical featuresof the Q-approachto investmentpresentsa
promising area of future research.
 21 -

theoreticallyappropriate,but not observable,marginal q. Fina ly, our

results confirm the sensLtivLtyof businesscorporate investmentin Korea to
changes in demand conditions,both internaland external. As shown in Table
1, the contemporaneousand lagged coefficientsof growth rates of both real
exports and domestic demand are estimatedat a high level of significance,and
lags of higher order do not seem to matter. Therefore,our findingslend
further support to the relevanceof acceleratorterms in Q-wodels of invest-
ment behavior.
 . 22 -

Table 1: Maximum-Likelihood Estimates of the

Parametersof Equations (15.a) and (15.b),
(StandardErrors are in Parentheses)

Parameteror Unrestricted Restricted (0-0)

Statistic

no*^l 0.12 0.10

(0.01) (0.01)
a ^^1 32.72 44.79
(7.31) (12.80)
h * 0.56 0.43
(0.23.) (0.24)
n u0.02 0.05
(0.02) (0.02)
**

q2 ^- 0.01 0.04
(0.03) (0.02)
Th -0.03 -0.03
(0.02) (0.02)
Ti4 0.33 0.31
(0.07) (0.07)
Tns 0.29 0.34
(0.06) (0.06)
n16 0.08 0.07
(0.05) (0.06)
13 * 0.05 0.07
(0.04) (0.04)
13 0.76 0.74
(0.17) (0.18)
e -0.17 0.00
(0.09)
Log L 114.865 113.914
a 1.902

Noe: Sample period is 1964-1986;Log L representsthe log likelihoodstatis-

tic; a is the likelihoodratio test statisticunder e- 0 hypothesis;
*I significantat the 5 percent level.
*I significantat the 10 percent level.
 23

IV. Cnne1uuien Anil Poling, Impieattona

The econonometricfindingspresented in this paper support three conclu-

between corporate finance and real invest-
sions regarding the relationship
ment in Korea.
First,giventhe preomise that debt capitalhas been subsidizedthrough
both taxationand regulatoryinterestrate policy, corporationshave drawn on
the stockmarketto financetheirmarginalinvestment
projects.This reliance
on new shareissuesas the marginalsourceof financialcapitalis consistent
with the observedrelationship
betweenstockmarketpricemovementsand corpo-
behavior. It also accordswith our inabilityto establisha
rate investment
statistically
meaningfulrelationship
betweencorporateinvestment
and
profits,whichwouldhave been the casehad corporations
fundedtheirinvest-
ment at the marginthroughretainedearnings.This conclusionalsosuggests
thatthe marginalprofitability
of investment
in Korea is high,or has been
shiftingupwards. Withoutthat,it wouldbe difficultto justifycorporate
costlyexternalequityas theirmarginalsourceof
relianceon relatively
funds.
Second, the real aggregate stock market price, rather than the average q,
or even the average rate of profit, is the preferred proxy for the theoreti-
cally appropriate--but unobserved--marginal q in explaining corporate invest-
ment behavior. This conclusion is important, rot only because it supports the
findings of Barro (1989) and Fischer and Merton (1984) for the United States,
but also because it draws attention to the important link between stock market
and real economic activity in the Korean economy. Such a link has been par-
ticularly evident in the 1980s when the rapid growth of the market has been
accompaniedby a boom in corporatebusiness investmentas well as a vigorous
economic growth. The 1980s have also seen other importantmacroeconomicand
policy changes in the Korean economy ircludingmeasures to reduce inflation,a
 - 24 -

large growth in household savings and a sharp turn-aroundin the country's

balance of payment position from deficit to surplus in 1986.1 These develop-
ments highlight the macro dimensionof stock market performancein Korea, and
in that respect,the relationshipbetween stock market and investmentis
likely to be an interactiveone. Thus, our approachof treatingthe stock
market as exogenous is likely to have introducedan upward simultaneityblas
in the estimated coefficienta, due to the simultaneltybetween s*ock market
and corporatereal investmentperformances,
Third, our findingshighlight the extent to which corporationsin Korea
have used low cost debt to flnance investmentsln financialassets, as opposed
o physicaland productiveassets. These financialassets, referring to liq-
uid assets (cash, bank deposltsand governmentsecurities),other ccapanies'
shares and accountsreceivablesare known to account for a relativelylarger
share of corporate total assets in Korea than those in the United States or
the United Kingdom. Evldenceprovidedby Dailami (1989, b) on asset composi-
tion of corporatebalance sheets in Korea and in a sample of developed coun-
tries shows, for instance,that financialassets accounted in 1983, in
aggregate,for about 42.6 percent of total assets in Korea as comparedwith a
correspondIngratio of 24.3 percent in the United States and 37.8 percent in
the United Kingdom.
These conclusions,taken together,yield importantimplicationsfor the
conduct of financialpolicy in Korea. They suggest that a narrow focus on
interestrate policy is likely to be ineffective,not only because of the
importantweight of financialassets in corporatebalance sheets, but also
because of the increasinglyimportantrole that the stock market has played to

14 See Dailami (1989 a); Dornbuschand Park (1987);Corbo and Nam (1986) for
review and analysisof macro economicevaluationof Korean economy in the
1980s.
 25 -

supply equity capital to the corporate sectorIs To the extent that external
equity constitutesthe marginal source of funds to the corporate sector, it is
the considerationof the determinantof cost of equity such as taxation of
dividendsand capital g&ins, as well as the procedure for pricing new share
issues, which are relevantin determiningincentivesfor new investment.16In
this regard,policy necds to cater increasinglyto the requirementof develop-
ment of equity markets, includingmeasures to modify the prevailingmethod of
pricing of new share issues at par rather than at market value. The existing
par-valuepri'-ing
procedurehas evidentlybeen an importantfactor behind the
high cost of externalequity capital in Korea and a source of unhelthy specu-
latior..

15 For the corporatesector as a whole, equity financingaccounted during the

period 1985-1987 for 23.7 percent of total corporate externalfinancingneeds,
as compared to 34.4 percent from traditionalbank loans.
16 There is also the argumentagainst subsidizingdebt capital that lends to
distortionsin resourceallocation.
 - 26 -

Da La AppendiA

The primary source for most of the data used in this study is the Eco_-
nonIi *atiaties YaArbook (ESYB),Bank of Korse,variousissues. Two set of
flow of funds tables, i.e. the IntegratedAccountsof National Income and
FinancialTransactions,and FinancialAssets and Liabilities,contained in
this publicationwere utilized to generat. the necessarybalance sheet data
for the total non-financialcorporatesector for the years 1963.1986. These
data were supplemented,when necesryaq,by drawing on several other sources,
includingNationalAccounts (NA), Bank of Korea; KoreAn_Tax&i±Qn (KT), Minis-
try of Finance; SanuritAeu S tatnea Ymarhook (SSYB), Korea Stock Exchange;
and SecuritiesMarket in Korea (SMK),various years, The Korea Securities
DealersAssociation.
The definitionsof variables are as follows:
1. I - gross real investmentin machinery,equipment,structures,and inven-
tories, for non-residential,non-financialcorporatesector at 1980 con-
stant prices, based on (NA);
2. q - ratio of aggregatestock market price Index (Korea Composite Stock
Price Index) to implicitprice deflatorfor capital goods (SSYB) and
(NA);
3. b - gross borrowing consistingof special and commercialbank loans,
insuranceand trust loans and net foreign loans, (ESYB);
4. B - total corporatedebt consistingof total bank debt, foreign debt and
debt owned to insuranceand trust companies,(ESYB);
5. m - personal tax rate on dividend income,constructedas the weighted
average of marginal personal tax rates on dividends for differentclass
 - 27 -

of stock holders, i.e. individuals,institutions,and companies. The

source of data is (KT) for tax rates and (SSYB) for stock ownership com-
position;
6. p - average yield on governmentbonds; for the 1972-186 period and prior

to that corporatedividendyield, (SSYB);

7. r - nominal lending rate, constructedas the simple average of rates on
general bank loans, export loans, loans from the Machinery IndustryPro-
motion rund; and loans from the National InvestmentFund, (NA);
8. c - corporate income tax rate. includingdefense and residence tax, (KT);
9. z - present value of standarddepreciationallowanceson new investment
in fixed assets (machineryand equipmentand structures)allowed for tax
purposes and calculatedunder a straight-linedepreciationformula and
based on an asset lifetimeof 42.5 years for structuresand 10 years for
machineryand equipment,(KT).
10. u - average cost per unit of gross proceeds from issuingnew equity
shares, calculatedas: u - (UPC + tc) (RIPOS)+ (1-RIPOS) (tc),
where UPC - underpricingcost associatedwith IPOS, taken from Kim and
Lee (1989); tc - transactioncost, taken from (SMK); RIPOS - ratio of
capital raised through IPOS relative to total capital raised by issuance
of new equity shares, (SMK).
11. K - net capital stock, where capital is defined broadly to include
machineryand equipment,structuresand inventories;fixed assets were
calculatedat replacementcost value, based on perpetual inventoryvalue,
using an average depreciationrate of 0.091; and bench mark value for
1962 obtained from Pyo (1988). Inventorieswere measured at market
value, after adjustmentsfor inflationand inventoryturnover are taken
into account (NA) and (ESYB).
12. A - corporate investmentin non-fixedassets, (ESYB).
13. x - Annual growth rate of export volume (NA).
 - 28 -

14. x2 - Annual growth rate of real domesticdemand (NA).

 - 29 -

Tnvastment,Financialand Tax DAtas Korean Non-financialCorporate Sector

(Annual Average. for Selected Periods)
(Percentage, unless indicated)

1963-69 70-74 75-78 79-81 82-86

1. Cor:prta- Fixed Invent-
an
a. growth rate 25.7 10.5 21.3 -1.1 11.7
b. percent of GDP 12.6 14.5 17.4 19.0 19.0
2. Iaon of TWCz,=
fro Ca2ta
a. corporate income 29.4 26.7 35.4 41.1 40.5
b. dividend income 11.3 15.8 57.i 61.6 57.6
c. income earned on
interest on bank
deposits 13.5 19.0 6.3 10.2 17.8
d. income earned on
interest from govern-
ment bonds 0 0 0 4.3 17.8
3. ReaI Tnterent Rate -0.2 -5.8 -7.7 -3.5 6.4
4. Stock Market
a. Market Capitalization/
GDP 2.7 5.5 11.1 7.1 8.4
b. Real Aggregate Price
Index(1980-100) 166.8 230.0 216.5 117.4 121.8
5. Corporate Investment/
Total Domestic Investment 65.1 62.3 65.4 62.4 60.3

Noce and Sources: See previous section on definition and source of data.
 * 30 -

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WPS388 The DistortionaryEffects of Tariff FaezehForoutan March 1990 S. Fallon
Exemptins in Argentina 38009

WPS389 MonetaryCooperationin the CFA PatrickHonohan March1990 Wilai Pitayato-

Zone nakam
37666

WPS390 Price and MonetaryConvergence PatrickHonohan March1990 Wilai Pitayato-

in CurrencyUnions: The Francand nakarn
RandZones 37666

WPS391 Wealth Effectsof VoluntaryDebt DanielOks April 1090 S. King-Watson

Reductionill LatinAmerica 31047

WPS392 InstitutionalDevelopmentin World SamuelPaul April 1990 E. Madrona

Bank Projects: A Cross-Sectional 37489
Review

WPS393 Debt-for-NatureSwaps MichaelOcchiolini March1990 S. Kiing-Watson

31047

WPS394 ThresholdEffects in International Mark M. Spiegel April 1990 S. King-Watson

Lending 31047

WPS395 HowGambiansSave- and What Parker Shipton April 1990 C. Spooner

Their StrategiesImplyfor International 30464
Aid

WPS396 StrategicTrade Policy: How New? Max Corden

How Sensible?

WPS397 AntidumpingRegulationsor PatrickA. Messerlin April 1990 S. Torrijos

ProcartelLaw? The EC Chemical 33709
Cases

WPS398 AgriculturalExtensionfor Women KatrineA. Saito April 1990 M. Villar

Farmersin Africa C. leanWeidemann 33752

WPS399 MacroeconomicAdjustment, AndresSolimano April 1990 E. Khine

Stabilization,and Growthin 39361
ReformingSocialistEconomies:
Analyticaland Policy Issues

WPS400 MacroeconomicConstraintsfor Andr6sSolimano April 1990 E. Khine

Medium-TermGrowth and Distribution: 39361
A Model for Chile

WPS401 PolicingUnfair Imports: The J.S. J. MichaelFinger March1990 N. Artis

Example Tracy Murray 38010
 PREWorki pner Serbs

Contact
I~a A~bAA e&or for

WPS402 The GATT as InternationalDisciplineJ. MichaelFinger March1990 Ik.Artis

Over TradeRestrictions:A Public 38010
Choice Approach

WPS403 InnovativeAgriculturalExtension S. Tjip Walker

for Women: A Case Studyof
Cameroon

WPS404 LaborMarketsin an Era of Luis A. Riveros

Adjustment:The ChileanCase

WPS405 Investmentsin Soiid Waste Carl Bartone April 1990 S. Cumine

Management:Opportunitiesfor JanisBernstein 13735
EnvironmentalImprovement FrederickWright

WPS406 Township,Villaga,and Private WilliamByrd

Industryin Chiia's Economric AlanGelb
Reform

WPS407 PublicEnterpriseReform: AhmedGalal April 1990 G. Orraca-Tetten

A Challengefor the WorldBank 37646

WPS408 Methodo'ogicalIssuesin Evaluating Stijn Claessens

Debt-ReducingDeals IshacDiwan

WPS409 FinancialPolicy and Corporate MansoorDailami April 1990 M. Raggambi

Investmentin ImperfectCapital 37657
Markets: The Case of Korea

WPS410 The Cost of Capitaland Investment AlanAuerbach April 1990 A. Bhalla

in DevelopingCountries 37699

WPS411 InstitutionalDimensionsof Poverty LawrenceF. Salmen

Reduction

WPS412 ExchangeRate Policy in Developing W. Max Corden

Countries

WPS413 Supporting Safe Motherhood: L. M. Howard

A Reviewof FinancialTrends

WPS414 SupportingSafe Motherhood:A L. M. Howard

Reviewof FinancialTrends,
ExecutiveSummary

WPS415 How Good (or Bad)are Country NormanHicks April 1990 IA. Berg
Projections? MichelVaugeois 31058

WPS416 World Bank Effortsat Poverty Paul Glewwe

Measurementin the Third World: The
Living StandardsMeasurementStudy