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Research
BPEA | 1988 No. 11988, No. 1
EMPIRICAL models of business investment rely generally on the assumption
of a “representative firm” that responds to prices set in centralized
securities markets. Indeed, if all firms have equal access to capital
markets, firms’ responses to changes in the cost of capital or tax-based
investment incentives differ only because of differences in investment
demand. A firm’s financial structure is irrelevant to investment because
external funds provide a perfect substitute for internal capital. In general,
with perfect capital markets, a firm’s investment decisions are independent
of its financial condition.