THE RELATION BETWEEN THE MAGNITUDE OF GROWTH OPPORTUNITIES AND THE DURATION OF EQUITY

I examine the relation between the magnitude of growth opportunities in a firm and the duration of the firm's equity. Conventional wisdom holds that because cash flows from growth opportunities occur late relative to cash flows from existing projects, firms that can be characterized as growth firms have a higher duration. I adopt the real option approach to the valuation of growth opportunities and show that under certain circumstances the opposite can be true; equity duration can be lower for growth firms. I further show that the relation between equity duration and the magnitude of growth opportunities depends on (a) the magnitude of the duration of assets in place, (b) dominance of the firm in its industry, (c) the magnitude of R&D expenditure, and (d) the volatility of expected cash flows generated by the investment project underlying the growth opportunity. I empirically test these predictions and find the predictions are not rejected, particularly for the utility and banking industries. JEL classification: G31, G12.     

Monetary policy and regional availability of debt financing

The relative availability of bond and bank financing should affect the firm's external financing and investment decisions. We define a measure that proxies for the regional borrowing inflexibility to substitute between bank and bond financing: “debt inflexibility”. Debt inflexibility tilts the firm's financial structure towards equity and reduces investment. The impact is stronger during the period of tight monetary policy, particularly for smaller firms and firms without banking relationships. Debt inflexibility increases the sensitivity of cash holdings to cash flows, reduces the likelihood of dividend payment and makes the firm more likely to pay equity in mergers and acquisitions.     

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Much of a firm's market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.” Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research‐intensive Biopharmaceutical industry. This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step‐by‐step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm‐specific measure of risk and the industry‐wide value of growth operating cash flows. This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm's growth opportunity. The DCF approach permits top‐down estimation of the size of the industry‐wide growth opportunity that competing firms must race to capture, while the contingency‐claims technique allows bottom‐up incorporation of the firm's successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.     

Duration-Driven Returns

We propose a duration-based explanation for the premia on major equity factors, including value, profitability, investment, low-risk, and payout factors. These factors invest in firms that earn most of their cash flows in the near future and could therefore be driven by a premium on near-future cash flows. We test this hypothesis using a novel data set of single-stock dividend futures, which are claims on dividends of individual firms. Consistent with our hypothesis, the expected Capital Asset Pricing Model alpha on individual cash flows decreases in maturity within a firm, and the alpha is not related to the above characteristics when controlling for maturity.     

What determines the composition of a firm's cash reserves?

We investigate what determines variation in the composition of the financial assets that constitute corporate cash reserves and how this variation relates to other key liquidity management practices. The degree to which a firm invests its cash reserves in less liquid, longer-maturity financial assets that earn a higher yield is explained by financial constraints, the ability to accurately forecast short-term liquidity needs, and the firm's likelihood of defaulting on its debt. During years when a firm's cash reserves are required to fund increases in investment or operating expenses the firm transfers funds from less liquid to more liquid financial assets. A firm's decisions relating to the composition of its cash reserves interacts with other key liquidity management practices, such as relying on credit lines for liquidity, extending trade credit or using it as a source of financing, and holding large amounts of inventories. Our findings provide insights on an important component of corporate liquidity management decisions.     

Cash holdings,risk, and expected returns

In this paper I develop and empirically test a model that highlights how the correlation between cash flows and a source of aggregate risk affects a firm's optimal cash holding policy. In the model, riskier firms (i.e., firms with a higher correlation between cash flows and the aggregate shock) are more likely to use costly external funding to finance their growth option exercises and have higher optimal savings. This precautionary savings motive implies a positive relation between expected equity returns and cash holdings. In addition, this positive relation is stronger for firms with less valuable growth options. Using a data set of US pubic companies, I find evidence consistent with the model's predictions.     

Investment, Uncertainty, and Liquidity

We analyze the dynamic investment decision of a firm subject to an endogenous financing constraint. The threat of future funding shortfalls lowers the value of the firm's timing options and encourages acceleration of investment beyond the first‐best optimal level. As well as highlighting another way by which capital market frictions can distort investment behavior, this result implies that (1) the sensitivity of investment to cash flow can be greatest for high‐liquidity firms and (2) greater uncertainty has an ambiguous effect on investment.     

Two Different Ways of Treating Corporate Cash in FCF Valuations—and the Importance of Getting the Cost of Capital Right

The methods for calculating free cash flow presented in texts on financial statement analysis and valuation appear to be very different from those in corporate finance texts, causing some confusion among academics as well as practitioners. Financial statement analysis and valuation texts generally begin by valuing just the enterprise operations—that is, the entity that engages in the firm's primary revenue‐generating activities—and then adding back the value of its cash holdings and other financial assets. The corporate finance approach is typically to value all the assets together, including financial assets that are not used in the production of the goods and services provided by the firm. Using a simple example, the authors show that the valuation of the equity ownership of the firm should be the same for both methods of calculating free cash flow, provided the analyst makes the appropriate adjustments to the method for calculating the cost of capital (WACC) used to discount forecasted free cash flows to a present value.     

A theory of equity carve-outs and negative stub values under heterogeneous beliefs

We develop a theory of new-project financing and equity carve-outs under heterogeneous beliefs. In our model, an employee of a firm generates an idea for a new project that can be financed either by issuing equity against the cash flows of the entire firm (“integration”), or by undertaking an equity carve-out of the new project alone (“non-integration”). While the patent underlying the new project is owned by the firm, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The firm's choice between integration and non-integration is driven primarily by heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders: if the marginal outsider financing the new project is more optimistic about the prospects of the project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding new-project cash flows than that about assets-in-place cash flows, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the firm's financing choice are the cost of motivating the employee to exert optimal effort, and the potential synergies between the new project and assets in place. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the “negative stub values” documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values.     

Organizational Capital and Investment‐Cash Flow Sensitivity: The Effect of Management Quality Practices

This paper examines the influence of organizational capital, as evident in management quality practices, on the response of firm investment to internal cash flows. We provide novel and strong evidence that investment sensitivity to internal cash flows decreases in the presence of superior management practices. We also find that superior management practices reduce the firm's financing frictions, evident in lower capital constraints. Our results are robust to numerous tests. Overall, our findings suggest that intangible organizational capital is important for investment decisions and that superior management practices contribute to value‐maximizing behavior.     

Determinants of Managerial Stock Ownership: The Case of CEOs

Research on the determinants of managerial equity ownership in firms is scant. To a limited extent, prior researchers have examined the variations in insider ownership proportions by combining the officers and directors into one group. This paper differs from earlier studies by focusing on the CEO. The evidence suggests that agency costs, free cash flow, and potential non-diversification losses and CEO attributes are important in explaining variations in CEOs' equity proportions in firms. Specifically, the paper finds that the proportion of CEO's ownership is related positively to the firm's debt level, diversification potential of the firm's common stock, free cash flows, and earnings volatility, and related negatively to the firm size.     

Accounting Information, Disclosure, and the Cost of Capital

In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the Capital Asset Pricing Model and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures affect the firm's assessed covariances with other firms' cash flows, which is nondiversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline in the cost of capital.     

Convertible debt and investment timing

In this paper we provide an investment-based explanation for the popularity of convertible debt. Specifically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This effect arises from the incentive of equity holders to accelerate the issuance of new equity, used to finance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the firm's cash flows. Since the underinvestment effect and the accelerated investment effect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight debt and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.     

Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment

This paper derives a real options model that accounts for the value premium. If real investment is largely irreversible, the book value of assets of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to fully benefit from positive aggregate shocks without undertaking costly investment. Thus, returns to equity holders of a high book‐to‐market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium.     

Interactions of corporate financing and investment decisions: The effects of agency conflicts

We examine interactions between flexible financing and investment decisions in a model with stockholder–bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set. The model has a number of testable predictions for the joint choice of leverage and maturity, and how these choices interact with a firm's growth opportunities.     

DIVIDENDS,UNCERTAINTY, AND UNDERWRITING COSTS UNDER ASYMMETRIC INFORMATION

This paper presents a two-period model in which dividends act as a signal of the stability of the firm's future cash flows. It is demonstrated that firms with more stable future cash flows pay a higher dividend. Dividends are a credible signal because the promise of a higher dividend, ceteris paribus, increases the probability that the firm will have to issue equity and pay underwriting costs. Empirically testable implications of the model relating to the cross-sectional determinants of the level of dividends are also discussed.     

Urban Vibrancy and Corporate Growth

We find that a firm's investment is highly sensitive to the investments of other firms headquartered nearby, even those in very different industries. A firm's investment also responds to fluctuations in the cash flows and stock prices (q) of local firms outside its sector. These patterns do not appear to reflect exogenous area shocks such as local shocks to labor or real estate values, but rather suggest that local agglomeration economies are important determinants of firm investment and growth.     

Signalling and the Pricing of New Issues

This paper develops a signalling model with two signals, two attributes, and a continuum of signal levels and attribute types to explain new issue underpricing. Both the fraction of the new issue retained by the issuer and its offering price convey to investors the unobservable “intrinsic” value of the firm and the variance of its cash flows. Many of the model's comparative statics results are novel, empirically testable, and consistent with the existing empirical evidence on new issues. In particular, the degree of underpricing, which can be inferred from observable variables, is positively related to the firm's post-issue share price.     

The Meaning of Internal Rates of Return

Nearly one hundred years after Irving Fisher' persuasive argument that net present value is the fundamental criterion for appraising investment projects, businessmen and bankers continue to consider the internal rate of return. Business practice is justified in some circumstances. It has long been recognized that a firm will grow asymptotically at a rate equal to the largest real positive root of an individual project' rate of return equation if the net cash flows are continually reinvested in projects of the same type. That same root also controls the firm' asymptotic growth rate if any fixed proportion of the cash flows is reinvested. The other roots of the equation are important also, since the stability of the firm' growth path depends on them.     

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firm's investment opportunity set. The results show that, on a relative scale, the market‐to‐book assets ratio has the highest information content with respect to investment opportunities. Although both the market‐to‐book equity and the earnings–price ratios are related to investment opportunities, they do not contain information that is not already contained in the market‐to‐book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market‐to‐book assets ratio.