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We extend prior literature by showing that societal trust is a significant determinant of corporate investment policy. Firms in countries with a higher level of societal trust are less prone to underinvestment. We posit that the a...
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We extend prior literature by showing that societal trust is a significant determinant of corporate investment policy. Firms in countries with a higher level of societal trust are less prone to underinvestment. We posit that the association between trust and underinvestment relates to a reduction of financial constraints. However, when we split our sample using different proxies for the level of financial constraints, we document that trust has an additional effect on underinvestment beyond enhanced access to capital. Consistent with the view that trust and conventional forms of governance are substitutes, we demonstrate that the effect of trust on underinvestment is reduced for firms in countries with strong investor protection.
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Although underinvestment phenomena are the rationale for government subsidization of research and development (R&D), the concept is poorly defined and its impact is seldom quantified. Conceptually, underinvestment in industrial R&D can take the form of either a wrong amount or a subop-timal composition of R&D investment. In both cases, R&D policy has not adequately modeled the relevant economic phenomena and thus is unable to characterize, explain, and measure the underinvestment. Four factors can cause systematic underinvestment in R&D-intensive industries: complexity, timing, existence of economies of scale and scope, and spillovers. The impacts of these factors vary in intensity over the typical technology life cycle, so government policy responses must be managed dynamically. In addition to understanding the causes of underinvestment in R&D, the magnitude of the deficiency relative to some "optimum" must be estimated to enable a ranking of technology areas with respect to expected net economic benefits from a government subsidy. Project selection criteria must therefore be based on quantitative and qualitative indicators that represent the nature and the magnitude of identified market failures. The major requirement for management of R&D policy therefore is a methodology that regularly assesses long-term expected benefits and risks from current and proposed R&D portfolios. To this end, a three-stage process is proposed to effectively carry out R&D policy analysis. The three stages are (1) identify and explain the causes of the underinvestment, (2) characterize and assess the investment trends and their impacts, and (3) estimate the magnitude of the underinvestment relative to a perceived optimum in terms of its cost to the economy. Only after all three stages of analysis have been completed can the underinvestment pattern be matched with the appropriate policy response....
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Although underinvestment phenomena are the rationale for government subsidization of research and development (R&D), the concept is poorly defined and its impact is seldom quantified. Conceptually, underinvestment in industrial R&D can take the form of either a wrong amount or a subop-timal composition of R&D investment. In both cases, R&D policy has not adequately modeled the relevant economic phenomena and thus is unable to characterize, explain, and measure the underinvestment. Four factors can cause systematic underinvestment in R&D-intensive industries: complexity, timing, existence of economies of scale and scope, and spillovers. The impacts of these factors vary in intensity over the typical technology life cycle, so government policy responses must be managed dynamically. In addition to understanding the causes of underinvestment in R&D, the magnitude of the deficiency relative to some "optimum" must be estimated to enable a ranking of technology areas with respect to expected net economic benefits from a government subsidy. Project selection criteria must therefore be based on quantitative and qualitative indicators that represent the nature and the magnitude of identified market failures. The major requirement for management of R&D policy therefore is a methodology that regularly assesses long-term expected benefits and risks from current and proposed R&D portfolios. To this end, a three-stage process is proposed to effectively carry out R&D policy analysis. The three stages are (1) identify and explain the causes of the underinvestment, (2) characterize and assess the investment trends and their impacts, and (3) estimate the magnitude of the underinvestment relative to a perceived optimum in terms of its cost to the economy. Only after all three stages of analysis have been completed can the underinvestment pattern be matched with the appropriate policy response.
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Informational asymmetries between a firm and investors may lead to adverse selection in capital markets. This paper demonstrates that when the market obtains noisy information about a firm over time, this adverse selection problem...
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Informational asymmetries between a firm and investors may lead to adverse selection in capital markets. This paper demonstrates that when the market obtains noisy information about a firm over time, this adverse selection problem can be costlessly solved by issuing callable convertible bonds with restrictive call provisions. Such securities can be designed to make the payoff to new claimholders independent of the private information of the manager. This eliminates the possibility of any dilution of equity or underinvestment and implements the symmetric information outcome in either a pooling or a separating equilibrium. The same first-best efficient outcome can also be implemented by issuing floating-price and mandatory convertibles.
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This paper investigates how ownership affects the investment-cash flow sensitivity by taking into account the non-linearities of ownership with respect to firm value, and using a free cash flow index and a criterion for financial ...
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This paper investigates how ownership affects the investment-cash flow sensitivity by taking into account the non-linearities of ownership with respect to firm value, and using a free cash flow index and a criterion for financial constraints to disentangle underinvestment and overinvestment. Interesting results are provided by estimating using the Generalized Method of Moments to eliminate the endogeneity problem. The alignment of interests between owners and managers and the monitoring by concentrated ownership both alleviate the sensitivity of investment to cash flow both in underinvestor and overinvestor firms. However, in the presence of controlling owners, underinvestment and overinvestment are exacerbated.
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Standard theory predicts that if wages are determined by bargaining workers underinvest in human capital, as they bear all the investment costs yet receive only a share less than one of the return. I show that this result depends ...
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Standard theory predicts that if wages are determined by bargaining workers underinvest in human capital, as they bear all the investment costs yet receive only a share less than one of the return. I show that this result depends on the way the investments are financed. I introduce contingent loans, which do not accumulate interest if the borrower is unemployed. When the investments are financed by such loans, the interest payments are regarded as a (negative) part of the surplus the agents bargain over. As a result, a worker pays the same share of the interest as he receives of the return.
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Mandatory contributions to defined benefit pension plans provide a unique identification strategy to estimate the market's assessment of the value of internal resources controlling for investment opportunities. The price decrease ...
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Mandatory contributions to defined benefit pension plans provide a unique identification strategy to estimate the market's assessment of the value of internal resources controlling for investment opportunities. The price decrease following a pension-induced drop in cash is magnified for firms that appear a priori more financially constrained, suggesting a negative effect of financing frictions on investment. In contrast, low control on managerial discretion attenuates the negative price reaction to contributions consistent with empire-building theories. While overinvestment seems to be the prevalent distortion in a panel of large firms, underinvestment appears to dominate in a sample that is more representative of the cross-section of listed companies.
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We develop a Q-theoretical model for levered firms subject to environmental constraints (regulations). The model highlights the implications of environmental constraints on dynamic investment and optimal capital structure decision...
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We develop a Q-theoretical model for levered firms subject to environmental constraints (regulations). The model highlights the implications of environmental constraints on dynamic investment and optimal capital structure decisions. We find that environmental constraints can lead equityholders to become endogenously risk averse. Moreover, environmental constraints give rise to underinvestment in capital and asset sales, which is attributed to the carbon abatement effect caused by environmental constraints. In addition, firms with environmental constraints use conservative debt for low business risk and choose high leverage for high business risk relative to firms without environmental constraints, which is governed by the trade-off between abatement cost effect and risk-aversion effect caused by environmental constraints. Firms with environmental constraints have high credit spreads. Our theoretical results are consistent with some empirical findings.
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This paper studies the interaction between corporate financing decisions and investment decisions in a dynamic framework. When the production decision involves an expansion option, the firm trades off tax benefits of debt against ...
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This paper studies the interaction between corporate financing decisions and investment decisions in a dynamic framework. When the production decision involves an expansion option, the firm trades off tax benefits of debt against two costs of debt financing, namely the investment distortion related to exercise of the expansion option and the loss of a valuable expansion opportunity if the firm defaults. The optimal capital structure is all equity for firms with more value in growth options (or intangible assets) and tends to involve debt financing for firms with more value in tangible assets.
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We empirically examine whether firms make investment decisions in anticipation of recessions and subsequently perform better. Using a large quarterly dataset of fixed asset investments for U.S. firms during 1984-2012, we show that...
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We empirically examine whether firms make investment decisions in anticipation of recessions and subsequently perform better. Using a large quarterly dataset of fixed asset investments for U.S. firms during 1984-2012, we show that not all firms efficiently adjust their investment decisions in anticipation of a recession. However, we find that pre-acting firms that properly adjust their investment decisions (i.e., underinvest) before a recession outperform re-acting firms that fail to make proper investment decisions (i.e., overinvest) before a recession in subsequent returns on assets, returns on investments, and market-adjusted return measures.
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In this paper we examine a new effect of risky debt on a firm's investment strategy. We call this effect "accelerated investment". It stems from a potential loss of investment option in the event of default. The possibility of def...
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In this paper we examine a new effect of risky debt on a firm's investment strategy. We call this effect "accelerated investment". It stems from a potential loss of investment option in the event of default. The possibility of default reduces the value of the option to wait and provides equity holders with an incentive to speed up investment. As a result, in the absence of wealth expropriation by a levered firm's debt holders, its shareholders exercise their investment option earlier than the shareholders of an otherwise identical all-equity firm. This result is at odds with the generally accepted intuition that in the absence of potential wealth transfers and taxes the shareholders of a levered firm would follow the same investment policy as that of an unlevered firm. In addition to providing various illustrations of the accelerated investment effect, we relate its magnitude to the presence of competition for investment opportunities.
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