Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior

Stein, Jeremy, “Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior,” The Quarterly Journal of Economics (1989), 655-669.

Claim: Managers will invest myopically, even when they care about stock price and even when markets behave rationally.

Model:

  • Stock markets determine company valuation based on current earnings.
  • Managers have an incentive to forgo profitable investments now in order to boost earnings (cash flow) now.
  • Market are rational, so they will expect managers to do this.
  • Managers who care about stock prices will be trapped into behaving myopically, since they will be penalized if they do not boost earnings now.
  • In a steady-state “signal-jamming” model, managers will inflate earnings by “borrowing” from the future (i.e. not investing optimally), and markets will correctly estimate this borrowing.
  • Capital market pressure determines the strength of this phenomenon, and may take one of the following forms:
    • Threats of takeover (when a firm’s stock price is low)
    • Lack of financial slack (the ability to undertake investments without issuing new stock)
    • Distance between the firm and its creditors (creditors who are intimate with a firm will rely less on the stock price to appraise firm value)
    • The degree to which current earnings are a good signal of future earnings.

Conclusions:

  • Myopic behavior, where managers underinvest to boost short-term earnings and market rationally expect this and adjust valuations accordingly, is a Nash equilibrium.
  • This positive market reaction to announced investments is not evidence that managers do not underinvest, as argued by Jensen (1986).
    • Underinvesting managers only undertake the best projects, so markets are pleased when myopic managers invest.
  • Startups with high stock prices and high investments are not evidence that managers are not myopic.
    • For startups, current earnings have little correlation with long-run success (most startups have negative earnings). The link between stock prices and underinvestment does not yet exist.
  • Corporate divestitures and breakups are evidence supporting the signal-jamming model.
    • Markets can better interpret the investments and future earnings of stand-alone companies than of conglomerates, so breakups reduce the signal-jamming inefficiencies

Dynamic Agency and the q Theory of Investment

DeMarzo, Peter M., Michael J. Fishman, Zhiguo He, and Neng Wang, 2012, “Dynamic Agency and the q Theory of Investment,” The Journal of Finance, Vol. 67, No. 6 (2012), 2295-2340.

Purpose:  To introduce an agency problem into the standard q theory of investment; to show that cash flow is not the best predictor of investment.

Motivation:  A large body of literature uses cash flow to predict firm investment levels.  This paper argues that a better proxy is “financial slack,” which is directly related to the agency problem.

Model:

  • Productivity is a Brownian motion, and the agent controls the drift but not the volatility.
  • w = W/K is the agent’s total expected payoff per unit of capital, and must be high enough to incentivize the agent to maximize productivity.
  • The level of w depends on λ, σ, and historical firm profitability.
    • λ is a measure of the extent of the agency problem.
    • σ is the volatility of firm productivity.
    • Past productivity raises or lowers w, and the agent loses his job when w = 0.
    • A portion of w is deferred, giving the agent a stake in continued firm success.
  • Investor’s expected payoff per unit of capital, p(w), is a function of how much they pay the agent.
  • Average q is total firm value per unit of capital stock, or qa = p(w) + w.
  • Marginal q, or qm = p(w)wp’(w).
    • Firms invest when marginal q is less than 1, so investment is a function of w. It follows that investment depends upon λ, σ, and past firm performance.
  • “Financial slack” equals w/λ, and is the largest productivity shock the firm can suffer without changing agents.
  • The agent accumulates cash and available credit equal to the firm’s “financial slack,” then distributes excess income to shareholders.

Conclusions:

  • Financial slack is a better predictor of investment than cash flow.
  • Average q is higher than marginal q because an increase in capital stock K reduces w, and hence reduces the agent’s [historically determined] incentives to maximize productivity.
  • Financial slack and profitability are substitutes in determining average q.
  • When the firm is profitable, w rises, the agent’s incentives grow, and return on investment increases.
    • Investment is serially correlated.
  • The cost of incentivizing the agent leads to underinvestment in every state of the world.

Measuring investment distortions arising from stockholder-bondholder conflicts

Parrino, Robert, and Michael S. Weisbach, 1999, “Measuring investment distortions arising from stockholder-bondholder conflicts,” The Journal of Financial Economics 53, 3-42.

Purpose:  This paper calculates the expected wealth transfer between stock- and bondholders occurring when a firm begins a new project.  It also estimates how stockholder-bondholder conflict impacts investment decisions, and whether it can explain cross-sectional variation in capital structure.

Findings:

  • There will be underinvestment when the firm is faced with safe projects.
    • Stockholders demand a higher return than the CAPM rate.
      • This effect is stronger for high-leverage firms.
    • Safe projects with low returns benefit bondholders at the expense of equity holders.
  • There will be overinvestment when the firm is faced with risky projects.
    • Stockholders are willing to gamble, and will even invest in negative NPV projects if the potential payoff is high.
      • This effect is also stronger for high-leverage firms.
    • Risky projects with negative expected (but high potential) payoffs benefit equity holders at the expense of bondholders.
  • Longer debt duration is vulnerable to larger agency problems
  • Lower marginal tax rates lead to slightly larger distortions
  • The stockholder-bondholder conflict does exist and there do seem to be empirical investment distortions, but these distortions are too small to be useful in explaining most firms’ capital structure decisions.
    • The distortion is only 0.14% for a firm with 20% debt-to-capital ratio, compared with a 3% noise factor in measuring cost of capital

parrinoweisbach

Motivation:  Managers seek to maximize shareholder value, not necessarily firm value.  The “underinvestment problem” is when managers avoid a positive NPV project that would increase firm value but would lower stockholder value.  The “overinvestment problem” is when managers undertake a negative NPV project that lowers firm value but raises stockholder value.  These agency problems have been widely discussed in the literature for decades, but there is no consensus on their magnitude or on how important they really are.

Data/Methods:  Use numerical simulations to estimate the impact of debt on the investment decisions of a levered firm whose managers seek only to maximize stockholder value.  Compute the stockholder-bondholder wealth transfer accompanying projects with known characteristics.

  • Compustat data for firms from 1981-1995
  • Monte Carlo:  Assume a firm with known cash flows following a random walk without drift for 30 years, after which cash flows are static.  Assume a project financed entirely with equity, whose cash flows similarly follow a random walk without drift for 30 years.  Assume a correlation of 0.5 between firm and project cash flows, run the simulation 5,000 times, and compute the ex ante value of debt and equity each time.
    • Value of debt is the sum of discounted future cash flows to bondholders.
    • Value of equity is the discounted cash flows to stockholders plus a terminal value.

Conclusions:  Distortions in stockholder-bondholder required investment returns vary along several dimensions.  However, for the typical firm they are much smaller than the noise in cost-of-capital measurement.  The effect exists but is too small to explain cross-sectional variation in capital structure.