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.     

Market Feedback,Investment Constraints,and Managerial Behavior

This paper examines the joint role of market feedback and investment constraints on managerial behavior. Using a sample of UK fixed price initial public offerings, we show that underperformance of share returns at the IPO significantly affects managerial investment decisions in the period after the offering. Firms with better investment opportunities and proportionately lower fixed (higher intangible) assets are more sensitive to negative market feedback. Over the longer term, the more responsive firms perform significantly better than their non‐responsive counterparts. The findings contribute to the debate on the informational advantage of managers over investors and present strong evidence that the market, on aggregate, can provide a superior assessment of a firm's opportunities. Managers who are able to respond to negative market feedback can significantly improve their firm's future prospects.     

Voluntary Disclosures,Corporate Control,and Investment

We examine the valuation and capital allocation roles of voluntary disclosure when managers have private information regarding the firm’s investment opportunities, but an efficient market for corporate control influences their investment decisions. For managers with long‐term stakes in the firm, the equilibrium disclosure region is two‐tailed: only extreme good news and extreme bad news is disclosed in equilibrium. Moreover, the market’s stock price and investment responses to bad news disclosures are stronger than the responses to good news disclosures, which is consistent with the empirical evidence. We also find that myopic managers are more likely to withhold bad news in good economic times when markets can independently assess expected investment returns.     

The Relationship Among Managerial Sentiment,Corporate Investment,and Firm Value: Evidence from Taiwan

This study has two objectives: to examine the relationship between managerial sentiment and corporate investment and to examine the relationship between investment and firm value. We use a sample of Taiwanese firms and find that an optimal level of investment that maximizes a firm's value does exist and that it depends upon the quality of the investment opportunities. In addition, the empirical results show that when firms have valuable (nonvaluable) investment opportunities, managerial optimism (pessimism) makes overinvestment (underinvestment) more likely. Interestingly, the overinvestment (underinvestment) phenomenon for optimistic (pessimistic) managers differs significantly between valuable project and nonvaluable project firms.     

Dynamic Agency and the q Theory of Investment

We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history‐dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with idiosyncratic risk, and is positively correlated with past profits, past investment, and managerial compensation even with time‐invariant investment opportunities. Optimal contracting involves deferred compensation, possible termination, and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.     

The influence of governance on investment: Evidence from a hazard model

Does corporate governance affect the timing of large investment projects? Hazard model estimates suggest strong shareholder governance may deter managers from pursuing large investments. Controlling for investment opportunities, firms with good governance experience longer spells between large investments. However, in the presence of financial constraints or strong CEO incentives (high delta (δ)), we find no such timing differences. Finally, these higher investment hazard firms exhibit significantly negative long-run operating and stock performance. Overall, our findings are consistent with the notion that poor governance associates with overinvestment.     

Strategy Selection,Surrogation, and Strategic Performance Measurement Systems

Strategic performance measurement systems operationalize firm strategy with a set of performance measures. A consequence of such alignment is the tendency for managers to lose sight of the strategic construct(s) the measures are intended to represent, and subsequently act as though the measures are the constructs of interest, a phenomenon referred to as surrogation. We investigate how involvement in strategy selection affects managers’ propensity to exhibit surrogation. We predict and find that strategy selection reduces surrogation. Surprisingly, we do not find that engaging in strategy deliberation, a key process underlying strategy selection, reduces surrogation. Thus, managers’ involvement in the actual choice of strategy appears to be both a necessary and sufficient condition to mitigate surrogation. Our paper broadens understanding of factors that influence surrogation, such as the effects of different aspects of managers’ strategic involvement and buy‐in. Further, by documenting how managers behave within (as opposed to simply with) strategic performance measurement systems, we highlight the potential for managers to endogenously influence the effectiveness of such systems.     

Corporate investment and earnings surprises

ABSTRACT

We find that firm-level investment is negatively related to the likelihood of meeting or beating analysts’ short-term EPS forecasts. In a 35-year panel dataset of US based companies, we find evidence that suggests firms with the best growth opportunities, opaque firms, and firms with higher than usual bonus compensation, are the ones to alter investment in order to beat benchmarks. Utilizing the passage of Sarbanes-Oxley as a natural experiment we find that firms trade off accruals-based earnings management in lieu of investment cuts. Results are robust to a number of covariates, and endogeneity or reverse causality does not seem to drive our inferences. This study suggests that, consistent with survey results from Graham, Harvey, and Rajgopal [2005. “The Economic Implications of Corporate Financial Reporting.” Journal of Accounting and Economics 40: 3–73], managers may reduce or delay corporate investment to meet or beat short-term earnings benchmarks.     

How Fundamental are Fundamental Values? Valuation Methods and their Impact on the Performance of German Venture Capitalists

This paper studies how the use of alternative valuation methodologies affects investment performance for a sample of 53 German venture capitalists. We measure investment performance by the amount of investments they need to write off and by the number of companies they take public. We find that a significant number of investment managers use discounted cash flow (DCF) techniques, but only a minority appears to use a discount rate related to the cost of capital. The majority applies DCF using subjective discount rates. We present evidence that the use of DCF is correlated with superior investment performance only if applied in conjunction with an objectifiable discount rate. Also, funds that invest with a longer horizon perform better. The use of multiples is not significantly correlated with investment performance. We conclude that a focus on fundamental values confers an advantage.     

Stock Market Efficiency and Economic Efficiency: Is There a Connection?

In a capitalist economy, prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most “informationally efficient” prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that stock price efficiency is not sufficient for economic efficiency by showing that the model may have another equilibrium in which prices are strong-form efficient, but investment decisions are suboptimal. We also suggest that stock market efficiency is not necessary for investment efficiency by considering a banking system that can serve as an alternative institution for the efficient allocation of investment resources.     

Socially responsible investment fund performance: the impact of screening intensity

Perhaps the most common criticism of socially responsible investment funds is that imposing non‐financial screens restricts investment opportunities, reduces diversification efficiencies and thereby adversely impacts performance. In this study we investigate this proposition and test whether the number of screens employed has a linear or curvilinear relation with return. Moreover, we analyse the link between screening intensity and risk. Screening intensity has no effect on unadjusted (raw) returns or idiosyncratic risk. However, we find a significant reduction in α of 70 basis points per screen using the Carhart performance model. Increased screening results in lower systematic risk – in line with managers choosing lower β stocks to minimize overall risk.     

Empire-builders and shirkers: Investment,firm performance,and managerial incentives

We consider the equilibrium relationships between incentives from compensation, investment, and firm performance. In an optimal contracting model, we show that the relationship between firm performance and managerial incentives, in isolation, is insufficient to identify whether managers have private benefits of investment, as in theories of managerial entrenchment. We estimate the joint relationships between incentives and firm performance and between incentives and investment. We provide new results showing that investment is increasing in incentives. Further, in contrast to previous studies, we find that firm performance is increasing in incentives at all levels of incentives. Taken together, these results are inconsistent with theories of overinvestment based on managers having private benefits of investment. These results are consistent with managers having private costs of investment and, more generally, models of underinvestment.     

Managerial Preference,Asymmetric Information,and Financial Structure

If firm performance affects managers' wealth or reputation, preferences of managers dominate firms' financing decisions. When information about real asset investment is symmetric, managers finance exclusively with equity. If managers know more about asset quality than do investors and if managers are sufficiently risk averse, they signal high-quality projects with debt. Increases in collateral value decrease risky debt use. Increases in interest rates that do not change productive opportunities increase debt use. The explanation for these and further results is based on underpricing of equity and overpricing of debt at the margin.     

Is it the Law or the Lawyers? Investment Covenants around the World*

This paper introduces a new dataset from 50 private investment funds from 17 countries around the world. We analyse the frequency of use of investment covenants imposed by institutional investors governing the activities of private investment fund managers in areas pertaining to investment decisions, investment powers, types of investments, fund operations and limitations on liability. While the data indicate a role for country legality in affecting the frequency of use of fund covenants, the data further indicate that the presence of legally trained managers has a more pronounced role in affecting the use of covenants. As private equity and venture capital investment increases across Europe and elsewhere, our results indicate that legal practice factors will matter more than the legal setting for the establishment of covenants governing new funds.     

Government intervention and investment efficiency: Evidence from China

The extant corporate investment literature has documented that information asymmetry and agency conflicts between managers and outside investors prevent firms from making optimal investment decisions. In this study, we investigate whether government intervention, as another form of friction, distorts firms' investment behavior and leads to investment inefficiency. Using Chinese data, we test this by measuring government intervention at two different levels. First, we compare investment efficiency between SOEs and non-SOEs. We find that the sensitivity of investment expenditure to investment opportunities is significantly weaker for SOEs. Second, we measure government intervention by whether a firm is politically connected through the employment of top executives with a government background. We find that political connections significantly reduce investment efficiency in SOEs. However, we do not find such evidence in non-SOEs. Taken together, our findings suggest that government intervention in SOEs through majority state ownership or the appointment of connected managers distorts investment behavior and harms investment efficiency.     

Voluntary Disclosure with Informed Trading in the IPO Market

We examine voluntary disclosure and capital investment by an informed manager in an initial public offering (IPO) in the presence of informed and uninformed investors. We find that in equilibrium, disclosure is more forthcoming—and investment efficiency is lower—when a greater fraction of the investment community is already informed. Moreover, managers disclose more information when the likelihood of an information event is higher, more equity is issued, or the cost of information acquisition is lower. Investment efficiency and the expected level of underpricing are non‐monotonic in the likelihood that the manager is privately informed.     

Debt and managerial rents in a real-options model of the firm

We present a theory of capital investment and debt and equity financing in a real-options model of a public corporation. The theory assumes that managers maximize the present value of their future compensation (managerial rents), subject to constraints imposed by outside shareholders’ property rights to the firm's assets. Absent bankruptcy costs, managers follow an optimal debt policy that generates efficient investment and disinvestment. We show how bankruptcy costs can distort both investment and disinvestment. We also show how managers’ personal wealth constraints can lead to delayed investment and increased reliance on debt financing. Changes in cash flow can cause changes in investment by tightening or loosening the wealth constraints. Firms with weaker investor protection adopt higher debt levels.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

Managerial conservatism, project choice, and debt

We show that the incentive for managers to build their reputationsdistorts firms' investment policies in favor of relatively safeprojects, thereby aligning managers' interests with those ofbondholders, even though managers are hired and fired by shareholders.Tbis effect opposes the familiar agency problem of risky debtthat is imperfectly covenant-protected, wherein shareholdersare tempted to favor excessively risk projects in order to expropriatebondholders. Consequently, when managerial concern for reputationresults in conservatism, it can actually make shareholders betteroff ex ante by allowing the firm to issue more debt. We examinehow the optimal choice of leverage from the shareholders' standpointis influenced by takeover activity, and how the adoption ofantitakeover measures affects a firm's investment policy andleverage choice.     

Is Investment‐Cash Flow Sensitivity Caused by Agency Costs or Asymmetric Information? Evidence from the UK

We investigate the investment‐cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow‐sensitive. Is this sensitivity a result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium? We find that investment‐cash flow sensitivity results mainly from the agency costs of free cash flow. The magnitude of the relationship depends on insider ownership in a non‐monotonic way. Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring. Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets. We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.