Political geography and corporate political strategy

We examine the relationship between political geography and corporate political strategy by considering lobbying expenditures. We find that firms increase their lobbying intensity when local politicians cannot provide a direct link to the governing elite, i.e. when firm location on the political map shifts to an area that is not closely aligned with the president. Our results indicate that firm lobbying is a means for exerting influence on political power and is primarily geared toward building valuable political capital in order to exploit short-term opportunities. Lobbying expenditures are a matter of expediency for politically active firms that tend to spend less on lobbying when there is an alignment of power and more when there is misalignment of power. We also find that more sophisticated, better informed institutional investors recognize and/or encourage corporate political strategies that involve adjusting lobbying efforts in response to changes in political geography.     

Capital Budgeting in Multidivision Firms: Information, Agency, and Incentives

We examine optimal capital allocation and managerial compensationin a firm with two investment projects (divisions) each runby a risk-neutral manager who can provide (i) (unverifiable)information about project quality and (ii) (unverifiable) accessto value-enhancing, but privately costly resources. The optimalmanagerial compensation contract offers greater performancepay and a lower salary when managers report that their projectis higher quality. The firm generally underinvests in capitaland managers underutilize resources (relative to first-best).We also derive cross-sectional predictions about the sensitivityof investment in one division to the quality of investment opportunitiesin the other division, and the relative importance of division-leveland firm-level performance-based pay in managerial compensationcontracts.     

The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment

We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of "socialism" in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.     

Agency and Internal Capital Market Inefficiency: Evidence from Banking Organizations

Using banking data, I provide evidence that agency problems are at the root of internal capital market inefficiency. I find that publicly traded bank holding companies (BHCs) are less efficient in their internal capital allocation than nonpublicly traded BHCs. This suggests that the divergence of interests between the chief executive officer and the shareholders is an important source of the internal capital misallocation. I also demonstrate that BHCs incorporating a tiered organizational structure are less efficient than nontiered BHCs, but only within a sample of BHCs that are publicly traded. These findings imply that a greater degree of rent‐seeking activity by division managers contributes to internal capital market inefficiency only if the top manager is an agent. This is consistent with theoretical models that explain internal capital misallocations through the multiple layers of agency within an organization.     

Promotion Tournaments and Capital Rationing

We analyze capital allocation in a conglomerate where divisionalmanagers with uncertain abilities compete for promotion to CEO.A manager can sometimes gain by unobservably adding varianceto divisional performance. Capital rationing can limit thisdistortion, increase productive efficiency, and allow the ownerto make more accurate promotion decisions. Firms for which CEOtalent is more important for firm performance are more likelyto ration capital. A rationed manager is more likely to be promotedeven though all managers are identical ex ante. When the tournamentpayoff is relatively small, offering an incentive wage can bemore efficient than rationing capital; however, when tournamentincentives are paramount, rationing is more efficient.     

Allocation of Decision-making Authority

This paper addresses the question of what determines where in a firm’s hierarchy investment decisions are made. We present a simple model of a CEO and a division manager to analyze when the CEO will choose to allocate decision-making authority over an investment decision to a division manager. Both the CEO and the division manager have private information regarding the profit maximizing investment level. Because the division manager is assumed to have a preference for “empire”, neither manager will communicate her information fully to the other. We show that the probability of delegation increases with the importance of the division manager’s information and decreases with the importance of the CEO’s information. A somewhat counterintuitive result is that, in some circumstances, increases in agency problems result in increased willingness of the CEO to delegate the decision. We also characterize situations in which the CEO prefers to commit to an allocation of authority ex ante, instead of deciding based on her private information. Finally, even though the division manager is biased toward larger investments, we show that under certain conditions, the average investment will be smaller when the decision is delegated. These results help explain some findings in the empirical literature. A number of other empirical implications are developed.We thank Sudipto Dasgupta, Wouter Dessein, Jeff Ely, Mike Fishman, Ehud Kalai, John Matsusaka, Canice Prendergast, Chester Spatt, Lars Stole, Jan Zabojnik, two anonymous referees, participants at the 2002 Utah Winter Finance Conference, the 2002 European Finance Association Annual Meetings, the Harvard/MIT Organizational Economics Workshop, the 2002 University of Illinois Bear Markets Conference, and workshops at the University of Chicago and USC for helpful comments. Financial support from the Center for Research in Security Prices at the University of Chicago Graduate School of Business is gratefully acknowledged.     

Optimal capital allocation using RAROC™ and EVA®

Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity infrequently but have continuous access to debt capital. In such a context this paper shows that EVA and RAROC based capital budgeting mechanisms have economic foundations. We derive optimal capital allocation under asymmetric information and in the presence of outside managerial opportunities for an institution with a risky and a riskless division. It is shown that the results extend in a consistent manner to the multidivisional case of decentralized investment decisions with a suitable redefinition of economic capital. The decentralization leads to a charge for economic capital based on the division's own realized risk. Outside managerial opportunities increase the usage of capital and lead to overinvestment in risky projects; at the same time more capital is raised but risk limits are binding in more states. An institution with a single risky division should base its hurdle rate for capital allocated on the cost of debt. In contrast, the hurdle rate tends to the cost of equity for a diversified multidivisional firm. The analysis shows that hurdle rates have a common component in contrast to the standard perfect markets result with division-specific hurdle rates.     

The Capital Budgeting Process: Incentives and Information

We study the capital allocation process within firms. Observed budgeting processes are explained as a response to decentralized information and incentive problems. It is shown that these imperfections can result in underinvestment when capital productivity is high and overinvestment when it is low. We also investigate how the budgeting process may be expected to vary with firm or division characteristics such as investment opportunities and the technology for information transfer.     

Controlling Investment Decisions: Depreciation- and Capital Charges

This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and to base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.     

The disciplinary role of debt and equity contracts: Theory and tests

We study how equity and debt contracts commit investors to discipline managers. Our model shows that the optimal allocation of debt, equity, and control rights depends on which disciplinary action is more efficient. When the efficient action is managerial replacement, then control rights should be allocated to equity holders, and capital structure should consist of equity and long-term debt. When the efficient action is liquidation, then control rights can be allocated to the manager, and capital structure should consist of equity and short-term debt. We find empirical support to the model's predictions in a sample of leveraged buyout transactions.     

Dismantling internal capital markets via spinoff: effects on capital allocation efficiency and firm valuation

We investigate the linkage between changes in firm value and changes in capital allocation efficiency resulting from dismantling internal capital markets via spinoffs. We find no evidence of wholesale misallocation of capital pre-spinoff. On the average, excess value increases following spinoffs. Furthermore, changes in excess value are positively linked to changes in capital allocational efficiency following spinoff. We find that spinoff announcement returns are greater (smaller) when the parent allocates capital to the unit to be spun off in a seemingly less (more) efficient manner. Divested division capital expenditures move toward industry levels after spinoff, regardless of their relative investment opportunities.     

Corporate fraud and investment distortions in efficient capital markets

Inefficient investment allocation induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs, has been endemic historically and has recently attracted much attention. We reconcile corporate fraud and investment distortions with efficient capital markets, building on shareholder‐manager agency conflicts and investment renegotiation in active takeover markets. Because investments that are ex post inefficient are not renegotiation proof, the optimal renegotiation‐proof contract induces overstatements by managers, accompanied by overinvestment in low return states and underinvestment in high return states by rational investors. Our framework also helps explain why easy access to external capital appears to facilitate corporate fraud.     

Corporate distress and lobbying: Evidence from the Stimulus Act

The literature on distressed firms has focused on these firms’ investment, capital structure, and labor decisions. This paper investigates a novel aspect of firm behavior in distress: how financial health affects a firm?s lobbying and, consequently, its relationship with the government. We exploit the shock to nonfinancial firms during the 2008 financial crisis and the availability of the stimulus package in the first quarter of 2009. We find that firms with weaker financial health, as measured by credit default swap spreads, lobbied more. We also show that the amount spent on lobbying was associated with a greater likelihood of receiving stimulus funds.     

SOME ECONOMIC DETERMINANTS OF MANAGEMENT LOBBYING FOR ALTERNATIVE METHODS OF ACCOUNTING: EVIDENCE FROM THE ACCOUNTING FOR INTEREST COSTS ISSUE

This paper extends the theory of management lobbying on accounting standards. Specifically, it is hypothesized that, in addition to the variables previously identified in literature, the capital structure of the firm would affect its management's lobbying position on an accounting standard. The results of an empirical investigation of the lobbying position of firms on the accounting for interest costs issue, reported in the paper, confirm the extended theory.     

On relative performance,remuneration and risk taking of asset managers

We analyze the asset management problem when the manager is remunerated through a scheme based on the performance of the fund with respect to a benchmark and his/her choices are driven by a power utility function. We show that it is not the asymmetric-fulcrum type feature of the scheme that makes the difference in preventing excessive risk taking in case of a poor performance. To prevent gambling when the performance deteriorates, it is important not to provide a fixed fee to the asset manager, and that remuneration is sensitive to a very poor relative performance as in the case of a capital stake or of a management fee with flow funds. We provide empirical evidence on the mutual fund industry showing excessive risk taking in case of a very poor performance and limited risk taking in case of overperformance with respect to the benchmark. These results agree with a remuneration scheme including a fixed fee and a cap.     

Social capital and capital allocation efficiency

Based on the social norms and structural theories of social capital, this study examines the relationship between community social capital and the firms’ capital allocation efficiency. We hypothesize and find that the community social capital of a firm's headquarter area has a negative and statistically significant impact on its capital allocation inefficiency, which is robust to alternative proxies for community social capital and capital allocation inefficiency, propensity score matching and instrumental variable regressions. In addition, we find that the effect of community social capital is more pronounced for firms with poor internal ethical culture and weak network connections to outside executives and directors, implying that community social capital becomes important in these situations. This finding links prior social norms and networks literature to capital allocation studies in that the norms and networks components of community social capital discipline self-interested managers’ behavior and reduce information asymmetry-two channels of capital allocation efficiency. Overall, community social capital works as a compensatory monitoring and information transfer mechanism and improves the firms’ capital allocation efficiency.     

Does Centralization Increase the Size of Government? The Effects of Separation of Powers and Lobbying

Difficulties faced by the Economic and Monetary Union have strengthened the position of those who advocate a process of (further) political integration in the European Union (EU). A widespread fear is, though, that such a process would favor powerful interest groups able to lobby the EU policymakers. Persson and Tabellini (1994) argue that political centralization will increase the size of the government through lobbying because of free-riding incentives created by federally funded programs with localized benefits. We extend their analysis by presenting a model where the budgeting process is divided into two stages, instead of one, which better captures the EU institutional framework. A federal legislator (the Council) chooses the size of the budget at one stage, while a federal agency (the Commission) chooses the allocation of the budget at the next stage. We show that separation of powers in the budgeting process restricts free riding and, therefore, reduces the incentives to lobby. The result is an unchanged budget under centralization. Moreover, it is shown that if the lobbying activity is directed to both policymakers, competitive lobbying may actually reduce the size of the public sector under centralized policymaking.     

Capital Allocation for Insurance Companies—What Good IS IT?

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A. Read Jr. propose to use a specific capital allocation method for pricing insurance contracts. We show that in their model framework no capital allocation to lines of business is needed for pricing insurance contracts. In the case of having to cover frictional costs, the suggested allocation method may even lead to inappropriate insurance prices. Beside the purpose of pricing insurance contracts, capital allocation methods proposed in the literature and used in insurance practice are typically intended to help derive capital budgeting decisions in insurance companies, such as expanding or contracting lines of business. We also show that net present value analyses provide better capital budgeting decisions than capital allocation in general.     

Identifying lobbying strategies: An analysis of public responses to the Productivity Commission Inquiry into executive remuneration in Australia

This study investigates lobbying behaviour over the two phases of the 2009 Productivity Commission Inquiry into executive remuneration within Australia. Consistent with expectations, behaviours appeared related to preference for change, the costs of regulatory change relative to those of lobbying, and the need for reputational capital. Industry participants, and those from the Representative and Professional bodies emerge as key opponents. Industry presented in a conciliatory manner during the first phase, revealing a preference for the status quo, but then directly targeted specific recommendations of concern, notably the ‘two strike’ and ‘no vacancy’ rules in the second phase. Respondents from the Representative and Professional Bodies were broadly and consistently supportive of change and the Inquiry’s final recommendations. We also find that these recommendations largely align with the views of the Representative Bodies, but conflict with those expressed by Industry in their second phase submissions. Finally, we find no evidence to suggest the motivation behind Industry lobbying related to poor remuneration practices.     

FINANCIAL CONTRACTING BETWEEN MANAGERS AND VENTURE CAPITALISTS: THE ROLE OF VALUE‐ADDED SERVICES,REPUTATION SEEKING,AND BARGAINING POWER

I analyze manager and venture capitalist bargaining over the financial contract in the face of double‐sided moral hazard problems. The allocation of cash flows depends on the combined effects of value‐added services, reputation seeking, and bargaining power. Welfare is maximized when the venture capitalist has high value‐adding capabilities, the market for reputation is informationally efficient, and the manager has bargaining power. Furthermore, I consider the effect of exit strategies on the financial agreement. I also consider bidding between venture capitalists of differing abilities. Generally, the superior venture capitalist wins with a lower bid, but in some cases the inferior venture capitalist can win.