Payback criterion,hurdle rates and the gain of waiting

In the standard literature on investment decisions, commonly observed instruments, namely the payback criterion and the use of hurdle rates, are criticised as they do not lead to a maximization of expected profits.By using the real option approach to investment under uncertainty, we show that it can be rational for the investor to use the payback criterion as a rule of thumb, because a shorter payback period indicates lower gains of waiting.In addition, we claim that the use of hurdle rates can serve a similar purpose: It allows to distinguish between projects with different values of waiting.An explicit expression for the optimal payback period and the optimal hurdle rate is given.     

Do Private Firms Invest Differently than Public Firms? Taking Cues from the Natural Gas Industry

We study how listing status affects investment behavior. Theory offers competing hypotheses on how listing‐related frictions affect investment decisions. We use detailed data on 74,670 individual projects in the U.S. natural gas industry to show that private firms respond less than public firms to changes in investment opportunities. Private firms adjust drilling activity for low capital‐intensity investments. However, they do not increase drilling in response to new capital‐intensive growth opportunities. Instead, they sell these projects to public firms. Our evidence suggests that differences in access to external capital are important in explaining the investment behavior of public and private firms.     

SIMPLE RESOURCE ALLOCATION RULES: A NOTE ON A GENERALISATION

A stream of literature exists on the ability to pick payback hurdles such that use of the payback method replicates decisions based on net present value (NPV) analysis under circumstances where the basic shape of the cash inflow pattern associated with the investment opportunity facing the firm is assumed known. The literature has derived such payback hurdles for specific cash inflow pattern shapes (e.g., level, exponentially increasing/decreasing, arithmetic growth, etc.) The main concern of this note is to identify an expression for a general class of cash inflow pattern shapes (of which the specific shapes in the previous literature are examples) from which can be derived the payback hurdle corresponding to any specific shape belonging to the general class.     

THE ROLE OF THE PAYBACK PERIOD IN THE THEORY AND APPLICATION OF DURATION TO CAPITAL BUDGETING

The payback period has been a widely used capital budgeting tool in the analysis of capital projects. It has come under criticism for its inablility to consider all the project's flows in a present valued context. The purpose of this article is to present the duration measure in a capital budgeting framework and show how it is related to the payback period. The relationship is shown analytically and empirically. As a result, the payback period assumes a new identity which goes far to overcome the objections historically levied against it.     

VALUATION OF EVENT‐CONTINGENT OPTIONS

I study a new class of investment options, event‐contingent options. These are options to invest and divest in projects that are dependent on other projects of the same firm or that are conditioned by projects of other firms in its value chain. I construct payoff functions and derive closed‐form solutions for the value of options to invest contingent on investment (OICI), options to invest contingent on divestment (OICD), options to divest contingent on divestment (ODCD), and options to divest contingent on investment (ODCI). I also derive analytical comparative statics for these option valuation equations and examine their implications on the firm's wealth. I offer examples of event‐contingent options in a global context.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Alumina plc: A case study of the post-audit of capital investment expenditure

The case examines investment expenditures made by a major Australian manufacturer involved in the mining of bauxite ore and its refinement into alumina. The expenditures, around which the case revolves, are intended to increase the efficiency of operations of one West Australian refinery, consistent with corporate goals of cost reduction and profit improvement. The investment evaluation processes then in place at Alumina plc permitted the joint evaluation of multiple projects, even where the relationship between the projects might be tenuous. The case details one such multi-project investment and facilitates an evaluation of the components in a way that suggests that the appraisal process might be flawed, or at least sub-optimal.     

Corporate financial and investment policies when future financing is not frictionless

We study a model in which future financing constraints lead firms to have a preference for investments with shorter payback periods, investments with less risk, and investments that utilize more pledgeable assets. The model also shows how investment distortions towards more liquid, safer assets vary with the marginal cost of external financing and with firm internal cash flows. Our theory helps reconcile and interpret a number of patterns reported in the empirical literature, in areas such as risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. For example, contrary to Jensen and Meckling [Jensen, M., Meckling, W., 1976. Theory of the Firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 305–360], we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to decrease the risk of their most liquid investments.     

Determinants of individual investment decisions in investment‐based crowdfunding

We investigate determinants of investment decisions in investment‐based (equity and bond) crowdfunding campaigns, using a novel investment‐, investor‐ and campaign‐level database, where equity refers to investments in entrepreneurial start‐ups and bonds to large real estate projects. We find that investors who have higher social interactions invest more. Social interactions are important in an equity crowdfunding context but do not affect participation in bond investments. This is consistent with the view that investors' social networks help reduce information asymmetry. Women invest less in the riskiest (equity) investments but more in safer ones (bonds). These findings are better explained by differences in risk aversion than differences in overconfidence between men and women. Overall, the findings contribute to the understanding of how investment‐based crowdfunding can be a viable source of entrepreneurial finance and how entrepreneurs' campaign decisions affect investor participation in this new form of entrepreneurial finance.     

Why is Convertible Debt Subordinated? An Investment‐Based Agency Theory

This paper offers an agency‐based explanation for the junior priority status of convertible bonds. Using a simple economic model, I show that when convertible and straight debt have equal priority, shareholders can prefer value‐decreasing projects, which results in wealth transfers from bondholders to shareholders; and I prove that this problem is solved when convertible debt is subordinated. Empirical evidence supports the theory. I find that firms with greater potential for investment‐based agency conflicts are more likely to issue subordinated convertible debt, and firms with senior convertible debt are more likely to deviate from the optimal investment policy.     

Family Control and Financing Decisions

This study uses a comprehensive European dataset to investigate the role of family control in corporate financing decisions during the period 1998–2008. We find that family firms have a preference for debt financing, a non‐control‐diluting security, and are more reluctant than non‐family firms to raise capital through equity offerings. We also find that credit markets are prone to provide long‐term debt to family firms, indicating that they view their investment decisions as less risky. In fact, our empirical results demonstrate that family firms invest less than non‐family firms in high‐risk, research and development (R&D) projects, but not in low‐risk, fixed‐asset capital expenditure (CAPEX) projects, suggesting that fear of control loss in family firms deters risk‐taking. Overall, our findings reveal that the external financing (and investment) decisions of family firms are in greater (lesser) conflict with the interests of minority shareholders (bondholders).     

The Impact of Ambiguity on Managerial Investment and Cash Holdings

Standard finance theory suggests that managers invest in projects that, in expectation, produce returns that justify the use of capital. An underlying assumption is that managers have the information necessary to understand the distributional properties of the pay‐offs underlying the decision. This paper examines firm investment behavior when managers are likely to find it more challenging to develop expectations of pay‐offs, namely during periods of increased macroeconomic ambiguity. In particular, we examine how macroeconomic ambiguity – proxied by the variance premium (Drechsler, 2010 ) and the dispersion in forecasts of corporate profits from the Survey of Professional Forecasters (Anderson et al., 2009 ) – impacts managerial capital investment and cash holdings. Consistent with ambiguity theory, we find that macroeconomic ambiguity is negatively associated with capital investment and positively associated with cash holdings. These results are robust to alternative explanations related to risk, investor sentiment and economic conditions. Moreover, consistent with recent theoretical real options literature, we find that ambiguity reduces the value of investment opportunities, while risk increases the value of such opportunities. Overall, these findings provide initial empirical evidence on the economic distinction between ambiguity and risk with respect to managerial investment and cash holdings.     

What is an Investment Project's Implied Rate of Return?

How to measure a project's implied rate of return has long been an unresolved problem, except for some special cases. This paper derives return on present cost (ROPC) as the correct measure of an investment project's implied rate of return. The IRR is a biased measure except for projects classified as simple projects, and this bias is likely to be substantial in many real‐world applications. Thus while net present values should be used to determine whether to accept/reject projects, I recommend that analysts use ROPC in place of the IRR as a measure of a project's true rate of return.     

Management Compensation and Payback Method in Capital Budgeting: A Path Analysis

While discounted cash flow techniques, such as net present value, are the primary normative models of capital budgeting recommended by finance theory, our survey suggests that one of the so-called ‘naive methods’, the payback (PB) criterion, is widely used in practice. About 85% of the responding firms make some use of the payback criterion. Almost 50% of the responding firms indicate that the payback method plays a relatively important role in capital budgeting decisions, and the degree of the importance varies among firms. This study uses path analysis to empirically identify links between the use of payback and management compensation contracts. Controlling for uncertainty in estimating future cash flows and firm size, we find that the use of the payback method is positively related to the degree to which management compensation depends on accounting earnings. Furthermore, this study finds two indirect links between management compensation and the use of payback. The more management compensation depends on accounting earnings: the more important management perceives the earnings objective and, consequently, the greater the use of the payback method; and the less important management perceives the shareholder wealth objective and, consequently, the greater the use of the payback method. We conclude that owner-management conflict and management's self-interest behaviour induced by employment contracts are factors that promote the use of payback method.     

Diversification of infrastructure projects for emergent and unknown non‐systematic risks

Allocating resources to competing large‐scale infrastructure projects involves multiple objectives. Traditional decision‐aiding methodologies focus on the trade‐offs among performance and resource objectives. Existing methodologies may fail to account for unknown and emergent risks that are typical of large‐scale infrastructure investment allocation problems. In modern portfolio theory, it is well known that a diversified portfolio can be very effective to reduce non‐systematic risks. The approach of diversification is equally important in choosing robust portfolios of infrastructure projects that may be subject to emergent and unknown risks. In this paper, we demonstrate a methodology to analyze and compare the diversification of portfolios of large‐scale infrastructure projects. We classify and explore several metrics of diversification and integrate them with risk and other performance objectives in a multiobjective approach. We test the new metrics and the methodology in a case study of hundreds of millions of dollars of infrastructure investments. The results suggest that the solutions that consider diversification are more robust to emergent risks, thus, identifying an opportunity to incorporate diversification‐based optimization methodologies to support a variety of problems involving large‐scale infrastructure investments.     

CEO Overconfidence and Corporate Investment

We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company‐specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity‐dependent firms.     

Are Overconfident CEOs Better Innovators?

Previous empirical work on adverse consequences of CEO overconfidence raises the question of why firms hire overconfident managers. Theoretical research suggests a reason: overconfidence can benefit shareholders by increasing investment in risky projects. Using options‐ and press‐based proxies for CEO overconfidence, we find that over the 1993–2003 period, firms with overconfident CEOs have greater return volatility, invest more in innovation, obtain more patents and patent citations, and achieve greater innovative success for given research and development expenditures. However, overconfident managers achieve greater innovation only in innovative industries. Our findings suggest that overconfidence helps CEOs exploit innovative growth opportunities.     

Sequential procurement auctions and their effect on investment decisions

We characterize the optimal mechanism and investment level in an environment where (i) two projects of independent costs are purchased sequentially, (ii) the buyer can commit to a two‐period mechanism, and (iii) the winner of the first project can invest in a cost‐reducing technology between auctions. We show that, in an attempt to induce more competition in the first period, the optimal mechanism gives an advantage to the first‐period winner in the second auction. As a result of this advantage, the first‐period winner invests more than the socially efficient level. Optimal advantages, therefore, create two different channels for cost minimization in buyer‐supplier relationships.     

Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process*

Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company‐wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the “influence costs” that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm‐wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project‐specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating.     

The Impact of Dividend Covenants on Investment and Operating Performance

This paper examines the influence of dividend covenants in corporate bonds on investment and operating performance. Prior literature analytically demonstrates that by limiting dividend distribution to shareholders, dividend restrictions effectively place a minimum on investment expenditures. This suggests a positive relation between dividend covenants and investment. The literature also conjectures that the influence of dividend covenants on investment (1) mitigates the under‐investment problem associated with debt financing; or (2) exacerbates over‐investment. We empirically document that the presence of dividend covenants is associated with a higher level of investment and poorer future performance. Further analyses confirm that the higher level of investment is consistent with dividend covenants exacerbating over‐investment, not mitigating under‐investment. Our results shed light on the cost aspect of dividend covenants proposed in prior literature.