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.     

Innovation,endogenous overinvestment,and incentive pay

We analyze how two key managerial tasks interact: that of growing the business through creating new investment opportunities and that of providing accurate information about these opportunities in the corporate budgeting process. We show how this interaction endogenously biases managers toward overinvesting in their own projects. This bias is exacerbated if managers compete for limited resources in an internal capital market, which provides us with a novel theory of the boundaries of the firm. Finally, managers of more risky and less profitable divisions should obtain steeper incentives to facilitate efficient investment decisions.     

Beyond Panglossian theory: strategic capital investing in a complex adaptive world

Traditional capital budgeting theory (as an extension of financial economics) is characterized as Panglossian because of its suggestion that rational market outcomes produce the best of all possible worlds. During the last two decades, practice-oriented theorists have increasingly been moving from algorithmic capital budgeting techniques to a focus on capital investment strategy. Also, during the last twelve years, economics researchers at the Santa Fe Institute (SFI) have scrapped the dubious assumptions of neoclassical economics and have turned to complex adaptive systems theory for a more realistic portrayal of the economy. This paper explores various SFI studies and their implications for capital investment theory and capital investment strategy. Brian Arthur's theory of increasing returns undermines the notion that capital budgeting techniques can be counted on to generate economic efficiency. His theory further suggests that the high tech, knowledge-based sectors of the economy inherently produce outcomes that are too unpredictable for the meaningful application of traditional capital budgeting techniques. Studies by David Lane and his colleagues suggest that the identity of agents, the attributes of artifacts and the possibilities for action tend to be emergent phenomena that are generated by the interactions of agents. These considerations suggest a form of strategic action that focuses on process. Finally, it is argued that the artificial life and other SFI types of computer simulation models are potentially useful tools for the study of strategic capital investment decisions.     

The Contributions of Stewart Myers to the Theory and Practice of Corporate Finance*

In a 40‐plus year career notable for path‐breaking work on capital structure and innovations in capital budgeting and valuation, MIT finance professor Stewart Myers has had a remarkable influence on both the theory and practice of corporate finance. In this article, two of his former students, a colleague, and a co‐author offer a brief survey of Professor Myers's accomplishments, along with an assessment of their relevance for the current financial environment. These contributions are seen as falling into three main categories:

• ? Work on “debt overhang” and the financial “pecking order” that not only provided plausible explanations for much corporate financing behavior, but can also be used to shed light on recent developments, including the reluctance of highly leveraged U.S. financial institutions to raise equity and the recent “mandatory” infusions of capital by the U.S. Treasury.
• ? Contributions to capital budgeting that complement and reinforce his research on capital structure. By providing a simple and intuitive way to capture the tax benefits of debt when capital structure changes over time, his adjusted present value (or APV) approach has not only become the standard in LBO and venture capital firms, but accomplishes in practice what theorists like M&M had urged finance practitioners to do some 30 years earlier: separate the real operating profitability of a company or project from the “second‐order” effects of financing. And his real options valuation method, by recognizing the “option‐like” character of many corporate assets, has provided not only a new way of valuing “growth” assets, but a method and, indeed, a language for bringing together the disciplines of corporate strategy and finance.
• ? Starting with work on estimating fair rates of return for public utilities, he has gone on to develop a cost‐of‐capital and capital allocation framework for insurance companies, as well as a persuasive explanation for why the rate‐setting process for railroads in the U.S. and U.K. has created problems for those industries.

     

The impact of strategy communications, incentives and national culture on balanced scorecard implementation

Professionals are challenged daily with difficult decisions. Capital budgeting decisions are one type of difficult decision, especially in firms that embrace a Balanced Scorecard management philosophy. In these firms, the decision maker frequently must choose among multiple options on the basis of multiple criteria with no one option dominating across all criteria. Not only must the decision maker evaluate each option on each criteria, the decision maker also must weigh the relative importance of each criteria when making a final judgment. When faced with difficult decisions, decision makers will resort to various coping behaviors, such as decision avoidance or delay, status quo bias, deferral to others' preferences, or reliance on decision aids. In a Balanced Scorecard environment, one important type of decision aid is the strategy map. The ambiguity introduced by multiple options and multiple criteria also creates a condition in which the subjective biases of the decision-maker can easily manifest in the absence or despite decision aids. Among those potential biases are self-interests and national culture. In this study we examine the effects on capital budgeting decisions of two common types of strategy maps as well as incentive effects and national culture. An objective of Balanced Scorecard management practices is to overcome a common North American fixation on short-term financial outcomes. Recent research submits that an appropriate strategy map will facilitate that end by overcoming certain other cognitive limitations (such as fixation on common metrics). Our inquiry will examine whether biases related to self-interests and national culture persist in the presence of two common strategy maps. A behavioral experiment was conducted in which 140 MBA students from Spain and the U.S. with average work experience of 10 years participated. Findings were that significant fixation on short-term financial outcomes persists in the presence of one common strategy map, but not in the presence of an alternate common strategy map, and that incentive and national culture biases persist in the presence of both. In addition, all three experimental variables exhibited significance and equivalent influence, although prior research has only addressed the influence of incentives.     

A NEW APPROACH TO CAPITAL BUDGETING FOR FINANCIAL INSTITUTIONS

The classic approach to capital budgeting based on the standard Capital Asset Pricing Model (CAPM) says that the hurdle rate (or cost of capital) for any new project or investment should depend only on the riskiness of that investment. Thus, the hurdle rate, and hence the expected value of the investment, should not be affected by the financial policy of the company evaluating the project. Nor should the hurdle rate be influenced by the company's risk management policy, or by the kind of assets it already has on the balance sheet. This article argues that such a “singlefactor” model may be inappropriate for banks and other financial institutions for two main reasons:

• ? it is especially costly for banks to raise new external funds on short notice;
• ? it is costly for banks to hold a buffer stock of equity capital on the balance sheet, even if this equity is accumulated over time through retained earnings.

The single-factor CAPM ignores such costs and, in so doing, understates the true economic costs of “illiquid” bank investments. Illiquid investments require special treatment because they impose risks that, although “diversifiable” by shareholders, cannot be readily hedged by the bank and therefore require it to hold more equity capital. The authors accordingly propose a “two-factor” model for capital budgeting— one in which banks' investment decisions are linked to their capital structure and risk management decisions. One of the key implications of the two-factor model is that a bank should evaluate new investments according to both their correlation with the market portfolio and their correlation with the bank's existing portfolio of unhedgeable risks. The authors describe several potential applications of their model, including the evaluation of proprietary trading operations and the pricing of unhedgeable derivatives positions. They also compare their approach to the RAROC methodology that has been adopted by a number of banks.     

Investment appraisal practices: A comparative study of conventional and Islamic financial institutions

This paper compares the use of capital budgeting techniques of conventional and Islamic financial institutions, using data obtained from a survey of 105 conventional and Islamic financial institutions. Our main aim is to analyze the use of capital budgeting and risk techniques by the two types of financial institutions from a comparative perspective to see whether prohibition of riba makes a difference. Standard difference-of-means tests of the mean scores methods were used to test the hypotheses of the study. The results reveal a number of important conclusions. First, discounted cash flow techniques are found to be more widely used by financial institutions, and among those techniques internal rate of return is the most common. Second, Islamic financial institutions are found to adopt traditional methods that do not comply with the principles of Islamic Sharia'a. Third, a huge gap is found between the theory base of Islamic institutions and some of the practices of those institutions. Fourth, firms' characteristics, such as size, listing status, sources of revenue and government ownership, have some impact on their decisions to adopt capital budgeting criteria, methods of estimating costs of capital and risk. Finally, the decisions to select particular capital budgeting techniques, cost of capital estimation methods, and risk assessments are partly related to the characteristics of the chief financial officers.     

Mediating instruments and making markets: Capital budgeting, science and the economy

We examine in this paper how certain instruments link science and the economy through acting on capital budgeting decisions, and in doing so how they contribute to the process of making markets. We use the term “mediating instruments” to refer to those practices that frame the capital spending decisions of individual firms and agencies, and that help to align them with investments made by other firms and agencies in the same or related industries. Our substantive focus is on the microprocessor industry, and the roles of “Moore’s Law” and “technology roadmaps”. We examine the ways in which these instruments envision a future, and how they link a multitude of actors and domains in such a way that the making of future markets for microprocessors and related devices can continue. The paper begins with a discussion of existing literatures on capital budgeting, science studies, and recent economic sociology, together with the reasoning behind the notion of “mediating instruments”. We then address the substantive issues in three stages. Firstly, we consider the role of “Moore’s Law” in shaping the fundamental expectations of an entire set of industries about rates of increase in the power and complexity of semiconductor devices, and the timing of those increases. Secondly, we examine the roles of “technology roadmaps” in translating the simplified imperatives of Moore’s Law into a framework that can guide and encourage the myriad of highly uncertain and confidential investment decisions of firms and other agencies. Thirdly, we explore one particular and recent example of major capital investment, that of post-optical lithography. The paper seeks to help remedy the empirical deficit in studies of capital budgeting practices, and to demonstrate that investment is much more than a matter of valuation techniques. We argue, through the case of the microprocessor industry, for greater attention to investment as an inter-firm and inter-agency process, thus lessening the fixation in studies of capital budgeting on the traditional hierarchical and bounded organization. In addition, we seek to extend and illustrate empirically the richness of the notion of “mediating instruments” for researchers in accounting, science studies, and economic sociology.     

Takeovers,market monitoring,and international corporate governance

We theoretically and empirically examine the role of international takeover markets in curtailing dominant shareholder moral hazard for firms with higher value‐added from acquisitions. In equilibrium, such firms strategically list shares in the markets of their targets and voluntarily dilute dominant shareholder control through capital‐raising events to lower their expected acquisition costs. Empirical tests, using a sample of foreign firms cross‐listing on U.S. stock exchanges during 1990–2003, support the framework. We find a strong influence of post‐listing dilution of dominant shareholder control through capital‐raising events on the likelihood of acquisitions and their cost to the acquirers, in both U.S. and non‐U.S. markets.     

A Tale of Leadership in Value Creation

In this prologue to his new book, Curing Corporate Short‐Termism, the founder and CEO of Fortuna Advisors presents a fictional account of a corporate turnaround—a “composite” reflection of the author's many years of consulting experience that dramatizes the pressure to meet near‐term earnings targets and other kinds of “agency” problems facing a public company called Blue Dynamics Corp. The tale begins with the puzzlement of the incoming CEO, Betty Manning, at finding the company's highest‐return business unit starved for investment, even as the low‐return units continue to receive and spend capital with little success. At the core of the company's capital allocation and “underinvestment” problems, she finds a corporate‐wide performance measurement and reward system focused on setting and beating budgets and growth in EPS and ROE. Manning's solution is to divorce the performance and reward system entirely from the budgeting process and implement new annual incentives and target‐setting practices that result in both more reliable budgeting and forecasting and a longer‐term view of value creation. The new measure of economic profit, called BDVA (short for Blue Dynamics Value Added), is based on a customized measure of EBITDA less a capital charge. The adoption of the new measure has the effect of encouraging her team to take a number of decisive steps: make an objective, “fact‐based” case for a strategic acquisition whose price appears to be too high (at least using conventional measures like EPS accretion); pull the trigger on a divestment that appears to have been adding value, but is more valuable outside the firm; and, more generally and most important, guide operating managers toward an ideal balance of overall growth and return on capital.     

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.     

Corporate capital budgeting and CEO turnover

When a firm has minimal agency and informational asymmetry problems it should make efficient capital budgeting decisions. Many firms over-invest prior to CEO turnover, halt investments in the period surrounding the turnover, and then greatly increase their level of expenditures. Empirical analysis of the cross-sectional and inter-temporal variation in the quality of firms' corporate capital budgeting decision reveals that the impact of CEO turnover is asymmetric between under- and over-investing firms, and this complements the larger literature using average firm-wide performance measures. Firms are more likely to have forced turnovers when there is more over-investment prior to the turnover, and these firms make more efficient investment decisions subsequently. Board influence is largely insignificant prior to a CEO turnover but is consistently associated with higher levels of investment subsequently.     

A generalized coherent risk measure: The firm's perspective

This note extends the concept of a coherent risk measure to make it more consistent with a firm's capital budgeting perspective. A coherent risk measure defines the risk of a portfolio to be that amount of cash that must be added to the portfolio such that it becomes acceptable to a regulator. As such, a coherent risk measure implicitly assumes that the firm has already made its capital budgeting decision. Except for a cash infusion, the portfolio composition remains unchanged. We propose a generalized version of a coherent risk measure that also allows the portfolio composition to change as well. Once the investment decisions are fixed, our measure collapses to a coherent risk measure.     

Investment Decisions in Anticipation of Recessions and Outperformance of Pre-Acting Firms

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.     

股票流动性对公司资本结构的影响研究

本文分析了流动性对公司资本结构的影响。理论分析表明,一个公司股权交易流动性的提高,使得公司股权融资成本得以降低,公司更倾向于采用增发、配股等股权融资的方式融资,这会降低公司的财务杠杆率。同时,借鉴资本结构动态调整的思想分析,发现个股流动性越高,资本结构的调整速度越快。本文基于2002—2010沪深两市发行的非金融业A股数据,采用面板数据回归等方法研究了股票流动性等因素对公司资本结构的影响,本文的经验结果支持这一理论假设。     

The Elusive Underpinnings of U.S. Venturesomeness (If Not Prosperity)*

This article explores the question of how the U.S. economy has managed to maintain (or even increase) its lead over other nations in per capita income and the average productivity of its workforce. The answer provided in the author's recent book is that such productivity depends on the greater willingness and effectiveness of U.S. consumers and businesses in making use of innovations in products and business processes. But this begs the question: What accounts for the increase in the innovative capabilities or effectiveness of U.S. consumers and businesses, both over time and relative to that of their global counterparts? After starting with the conventional “supply‐side” focus on low taxes, limited regulatory barriers, and strong property rights, the author goes on to shift the main emphasis to the following six “institutional” contributors to U.S. prosperity:

• ? Breadth of participation: the modern U.S. economy draws, to a greater extent than either its global competitors or the U.S. of a century ago, on the contributions of far more individuals both as developers and as users of new products.
• ? Organizational diversity and specialization: the evolution of new forms of organization in the U.S., from small venture capital‐backed firms to huge public corporations with dispersed ownership, has enabled the system to use the contributions of many individuals more effectively.
• ? Changes in common beliefs and attitudes: greater receptiveness to technological change has accelerated the adoption of new products in all countries, but especially in the U.S.
• ? Increased pressure for growth: the “grow or die” imperative faced by U.S. businesses has encouraged them to look for help from new technologies.
• ? The professionalization of management and sales functions—a distinctively U.S. phenomenon whose beginnings can be traced to IBM in the 1920s—has improved the capacity of modern U.S. organizations to develop markets and use new products.
• ? The expansion of higher education, to a far greater extent in the U.S. than elsewhere, has increased the supply of individuals with habits and attitudes that improve their ability to develop and use innovations.

     

CAPITAL BUDGETING DECISIONS WHEN CASH FLOWS AND PROJECT LIVES ARE STOCHASTIC AND DEPENDENT

The purpose of this study is twofold: (1) to develop an operational economic state and simulation capital budgeting procedure for allowing cash flows and project lives to be dependent and (2) to provide empirical evidence of the impact of stochastic project lives on mean-variance and mean-semivariance capital budgeting decisions. The required number of input estimates for the proposed model is small. For individual projects, incorrectly assuming deterministic project lives when project lives are stochastic often results in large overestimates of expected net present values and large underestimates of the variance of the net present value. Similar results occur for the mean-variance and mean-semivariance portfolio models. The primary managerial implication of this study is that the inclusion of stochastic project lives in capital budgeting decisions is critical to obtain appropriate risk-return estimates.     

The practice of investment valuation in emerging markets: Evidence from Argentina

This paper discusses the challenges of applying traditional valuation techniques to emerging markets, and reports on how CFOs, financial advisors and private equity funds meet those challenges in Argentina, a major Latin American emerging economy. On many fronts, our findings show that there is substantial alignment with U.S. valuation practices. We find that: (a) discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model, yet it is frequently modified to account for country-specific risk; (c) capital budgeting analyses are performed in U.S. dollars by non-dollar companies; (d) financial advisors tend to apply U.S. betas to the emerging market, yet they rarely adjust betas for cross-border asymmetries; and (e) corporations tend to disregard the effects of small size and illiquidity. We provide tentative explanations for our findings.     

Strategic Financial Management: Lessons from Seasoned Equity Offerings

Each of today's three dominant academic theories of capital structure has trouble explaining the financing behavior of companies that have seasoned equity offerings (SEOs). In conflict with the tradeoff theory, the authors’ recent studies of some 7,000 SEOs by U.S. industrial companies over the period 1970‐2017 notes that the vast majority of them—on the order of 80%—had the effect of moving the companies away from, rather than toward, their target leverage ratios. Inconsistent with the pecking‐order theory, SEO issuers have tended to be financially healthy companies with low leverage and considerable unused debt capacity. And at odds with the market‐timing theory, SEOs appear to be driven more by the capital requirements associated with large investment projects than by favorable market conditions. The authors’ findings also show that, in the years following their stock offerings, the SEO companies tend to issue one or more debt offerings, which have the effect of raising their leverage back toward their targets. Whereas each of the three theories assumes some degree of shortsightedness among financial managers, the authors’ findings suggest that long‐run‐value‐maximizing CFOs manage their capital structures strategically as opposed to opportunistically. They consider the company's current leverage in relation to its longer‐run target, its investment opportunities and long‐term capital requirements, and the costs and benefits of alternative sequences of financing transactions. This framework, which the authors call strategic financial management, aims to provide if not a unifying, then a more integrated, explanation—one that draws on each of the three main theories to provide a more convincing account of the financing and leverage decisions of SEO issuers.     

ON THE WEALTH EFFECTS OF THE SUPERVISORY GOODWILL CONTROVERSY

We provide evidence on the potential wealth effects of the 1996 U.S. Supreme Court decision that the U.S. government had violated contractual obligations when, in 1989, it passed legislation prohibiting savings and loan associations from counting “supervisory goodwill” as capital. The Supreme Court decision produced large wealth gains for the savings and loan plaintiffs, as did prior court decisions in favor of these savings and loans. However, little evidence exists to suggest negative market responses to important events surrounding the 1989 legislation.