Capital budgeting and delegation

As part of our ongoing research into capital budgeting processes as responses to decentralized information and incentive problems, we focus in this paper on when a level of a managerial hierarchy will delegate the allocation of capital across projects and time to the level below it. In our model, delegation is a way to save on costly investigation of proposed projects. Therefore, it is more extensive the larger are the costs of such investigations. This delegation takes advantage of the fact that the lower-level manager's preferences are assumed to be similar (though not identical) to those of the higher level.     

Optimal bond trading with personal taxes

Tax considerations governing bondholders' optimal trading include: capital loss realization; capital gain deferment; change of the long-term holding period status to short-term by sale of the bond and repurchase, to realize future losses short-term; raising the basis above par by sale of the bond and repurchase, to deduct the amortized premium from ordinary income. The optimal policy which incorporates transactions costs and conforms to the IRS code substantially differs from the buy-and-hold and continuous-realization policies. Failure to account for optimal trading may seriously bias econometric estimation of the yield curve and the tax bracket of the marginal bondholders.     

Capital budgeting using residual income maximization

This analysis provides theoretical support for the use of residual income. Economic theory states that capital investment should maximize the present value of incremental cash flow. When a firm is decentralized, coordinating the necessary information to determine optimal investment in the short run may be impossible. But the residual income maximizing choice can be coordinated using a simple transfer-pricing system. Under appropriate capitalization and depreciation policies, the residual-income maximization policy leads the firm to make suboptimal short-run investment decisions, yet these decisions still lead the firm to its long-run, presentvalue-maximizing capacity level.Funding for this study was provided by grants from the Arthur Andersen & Co. Foundation and the National Science Foundation.     

Capital budgeting, information timing, and the value of abandonment options

This paper investigates how an abandonment option influences the optimal timing of information in a sequential adverse selection capital budgeting model. While the divisional manager has imperfect private pre-contract information, headquarters can time whether the manager obtains perfect project information before (timely information) or after (delayed information) the contract is signed. In the absence of the abandonment option, headquarters favors timely (delayed) information if the investment costs are high (low). The presence of the abandonment option favors delayed information because under the timely information regime the value of the abandonment option is zero, whereas under the delayed information regime the value of the option is positive.     

Corporate taxes,capital structure,and valuation: Combining Modigliani/Miller and Miles/Ezzell

The valuation of a firm with discounted cash flow (DCF) approaches requires assumptions about the firm’s financing strategy. The approaches of Modigliani and Miller and Miles and Ezzell assume that either a passive debt management with predetermined debt levels or active debt management with capital structure targets is applied. Over the last decades, various extensions of these approaches have been developed to allow for a more realistic depiction of financial decision making. However, recent empirical analyses indicate that current theories still have limited power to explain large variances in capital structure across time. We provide an alternative explanation for the empirical observation by assuming that firms combine both capital structure targets and predetermined debt within future periods, and we show how to value a firm given such a partially active debt management. The approaches of Modigliani and Miller and Miles and Ezzell are embedded into a common valuation framework, with the familiar valuation formulas shown as special cases. In a simulation analysis, we illustrate that the textbook valuation formulas may produce considerable valuation errors if a firm applies a partially active debt management.     

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.     

Capital budgeting with multiple criteria and multiple decision makers

In this article, we propose a model that incorporates the preferences of multiple decision makers into a decison-making process using (1) The analytical hierarchy process (AHP); and (2) multiple criteria and multiple constraint levels (MC²) linear programming in a capital budgeting context. Our model can foster strategic and nonfinancial factors that are important in the capital budgeting problems of the current business environment. The two-phased solution framework proposed in this article is sufficiently flexible to reach a compromise among decision makers. Our method also facilitates collection of decision makers' preferences to minimize suboptimization of overall company's goals. In addition, application of AHP to derive weights to decision makers' preferences for resource availability decreases the solution complexity. All these characteristics represent a significant improvement compared with previous linear or goal programming approaches to capital budgeting problems.     

Computing present values: Capital budgeting done correctly

This paper shows that the standard textbook formula for computing the present value of a future random cash flow – the discounted expected value – is formally incorrect and can generate significant errors when used to compute present values. The correct present value method is provided as well as a simple adjustment to the textbook formula which can be used to obtain an approximation to the correct value.     

Structural models of corporate bond pricing with personal taxes

The structural approach offers an integrated framework to deal with yield spreads and default probability simultaneously. However, structural models perform poorly in predicting corporate bond spreads. It is unclear whether this poor performance is caused by characteristics of individual models, missing factors, or different calibration procedures. This study evaluates the performance of four structural models by incorporating two important factors, personal taxes and the liquidity factor, and calibrating these models to data. To ensure our results are not contingent on the calibration method, we further apply the maximum likelihood estimation method to a large sample of individual bonds. Results consistently show that the ability of structural models to predict spreads improves considerably when personal taxes and liquidity are taken into account. Our findings suggest that the poor performance of standard structural models is more likely due to missing factors than the characteristics of individual models or the calibration procedure.     

Redistributive effects of the shift from personal income taxes to indirect taxes: Belgium 1988–93

Between 1988 and 1993, the Belgian personal income tax system and the indirect tax system were reformed to a considerable extent. We use microsimulation models to investigate the impact of the reform on the liability progression and the redistributive effect of the combined tax system. The redistributive effect of personal income taxes decreased, notwithstanding an increase in liability progression. For indirect taxes, both the liability regressivity and the reverse redistributive effect have been enhanced. We use recently developed statistical tests to gauge the significance of the observed changes.     

Effect of personal taxes on managers’ decisions to sell their stock

We examine the effect of personal taxes on CEOs’ decisions to sell their equity, controlling for diversification, managerial overconfidence, and other determinants. While CEOs frequently sell large amounts of their unrestricted firm equity, the tax burden associated with the sale significantly deters them from selling equity even after controlling for other determinants like diversification. We also find that both taxable institutional investors and CEOs respond to taxes in their selling of equity, although CEOs appear to be less tax-sensitive. Our findings underscore the importance of taxes in corporate and managerial decisions and they have implications for executive compensation policies.     

Government, taxes and banking crises

This paper analyzes the effectiveness of different government policies to prevent the emergence of banking crises. In particular, we study the impact on welfare of using taxpayers money to recapitalize banks, government injection of money into the banking system through credit lines, the creation of a buffer and taxes on financial transactions (the Tobin tax). We illustrate the trade-off between these policies and derive policy implications.     

How much of the corporate bond spread is due to personal taxes?

Existing term structure models of defaultable bonds have often underestimated corporate bond spreads. A potential problem is that investors’ taxes are ignored in these models. We propose a pricing model that accounts for stochastic default probability and differential tax treatments for discount and premium bonds. By estimating parameters directly from bond data, we obtain significantly positive estimates for the income tax rate of a marginal corporate bond investor after 1986. This contrasts sharply with the previous finding that the implied tax rates for Treasury bonds are close to zero. Results show that taxes explain a substantial portion of corporate bond spreads.     

Optimal stock trading with personal taxes: Implications for prices and the abnormal January returns

The tax law confers upon the investor a timing option - to realize capital losses and defer capital gains. With the tax rate on long term gains and losses being about half the short term rate, the law provides a second timing option - to realize losses short term and gains long term, if at all. Our theory and simulation over the 1962–1977 period establish that taxable investors should realize long term gains in high variance stocks and repurchase stock in order to realize potential future losses short term. Tax trading does not explain the small-firm anomaly but predicts a seasonal pattern in trading volume which maps into a seasonal pattern in stock prices, the January anomaly, only if investors are irrational or ignorant of the price seasonality.     

Migration,wages and income taxes

We analyze labor migration flows between two countries (regions) with different-sized populations and different levels of productive efficiencies to determine the effects of such flows on income taxation. The residents are heterogeneous because they incur different migration costs, although they are otherwise identical. Each resident compares her post-tax revenue at home with that obtained abroad, including migration costs, and each country’s government maximizes tax receipts. We study the existence of an equilibrium for any configuration of wages and for any difference in the relative sizes of the countries (regions). Then, we compute and characterize the equilibrium, whenever it exists, for any set of parameters, sizes and wage differentials. Finally, we show that equilibrium migration flows affect the level of income taxation in both the origin and destination countries.     

The effect of personal taxes and dividends on capital asset prices: Theory and empirical evidence

This paper derives an after tax version of the Capital Asset Pricing Model. The model accounts for a progressive tax scheme and for wealth and income related constraints on borrowing. The equilibrium relationship indicates that before-tax expected rates of return are linearly related to systematic risk and to dividend yield. The sample estimates of the variances of observed betas are used to arrive at maximum likelihood estimators of the coefficients. The results indicate that, unlike prior studies, there is a strong positive relationship between dividend yield and expected return for NYSE stocks. Evidence is also presented for a clientele effect.