Law, finance, and firm growth

TLDR: Demirgut-Kunt and Maksimovic as mentioned in this paper investigated how differences in legal and financial systems affect firms' use of external financing to fund growth and found that firms in countries with well-functioning institutions have lower profit rates.

Abstract: We investigate how differences in legal and financial systems affect firms' use of external financing to fund growth. We show that in countries whose legal systems score high on an efficiency index, a greater proportion of firms use long-term external financing. An active, though not necessarily large, stock market and a large banking sector are also associated with externally financed firm growth. The increased reliance on external financing occurs in part because established firms in countries with well-functioning institutions have lower profit rates. Government subsidies to industry do not increase the proportion of firms relying on external financing. THE CORPORATE FINANCE LITERATURE suggests that market imperfections, caused by conflicts of interest and informational asymmetries between corporate insiders and investors, constrain firms in their ability to fund investment projects. The magnitude of these imperfections depends in part on the effectiveness of the legal and financial systems. Because these systems differ across countries, the literature implies that there should exist systematic cross-country differences in firms' ability to obtain external capital to finance investment. In this paper, we examine whether the underdevelopment of legal and financial systems does prevent firms in some countries from investing in potentially profitable growth opportunities. In particular, we focus on the use of long-term debt or external equity to fund growth (see our earlier work, Demirgut-Kunt and Maksimovic (1996a), which compares firms' financial structures in developed and developing countries and finds the greatest difference to be in the provision of long-term credit). We estimate a financial planning model to obtain the maximum growth rate that each firm in our thirty-country sample could attain without access to long-term financing. We then compare these predicted growth rates to growth rates realized by firms in countries with differing degrees of development in their legal and financial systems. Our approach enables us to identify specific characteristics of the legal and financial systems that are associated with long-term financing of firm growth. Thus, we provide a micro-level test of the hypoth