Dual transfer pricing with internal and external trade

This paper examines a transfer pricing problem between two divisions of a decentralized firm. The selling division is privately informed about its own costs and produces a good that is sold both externally in an intermediate market and internally within the firm. Unlike most previous work, we focus on dual transfer pricing systems that allow the selling division to be credited for an amount that differs from the amount charged to the buying division. We identify conditions under which efficient decentralized trade and external price setting incentives can be provided with a properly chosen set of dual transfer prices that do not rely on direct communication. Instead, the optimal dual transfer prices will depend only on public information about the market price charged by the upstream division in the external market, which indirectly communicates information about production costs to the downstream division. For a variety of well-known demand functions, the optimal transfer prices will be linear functions of the market price. Our main results hold when the upstream division faces multiple internal buyers or faces a binding capacity constraint.     

Do Asset Fire Sales Exist? An Empirical Investigation of Commercial Aircraft Transactions

This paper uses commercial aircraft transactions to determine whether capital constraints cause firms to liquidate assets at discounts to fundamental values. Results indicate that financially constrained airlines receive lower prices than their unconstrained rivals when selling used narrow-body aircraft. Capital constrained airlines are also more likely to sell used aircraft to industry outsiders, especially during market downturns. Further evidence that capital constraints affect liquidation prices is provided by airlines' asset acquisition activity. Unconstrained airlines significantly increase buying activity when aircraft prices are depressed; this pattern is not observed for financially constrained airlines.     

Divisional performance measurement and transfer pricing for intangible assets

This paper examines the effectiveness of three transfer pricing methodologies for an intangible asset that is developed through bilateral, sequential investment. In general, a royalty-based transfer price that can be renegotiated provides better investment incentives than either a non-negotiable royalty-based transfer price or a purely negotiated transfer price, and in some cases induces first-best investment. This result contrasts with previous research that finds that the inability to limit renegotiation of initial contracts reduces investment efficiency. Further, I examine how tax transfer pricing rules inform optimal internal transfer prices when the firm decouples internal and external transfer prices.     

The Valuation Impact on Distressed Residential Transactions: Anatomy of a Housing Price Bubble

Most previous empirical studies on foreclosure price discounts are based on data from housing-markets during periods of relative stability (Baton Rouge, Louisiana; Arlington, Texas; and Las Vegas, Nevada in 1980s and 1990s). The few studies with sample periods containing the Liquidity Crisis of 2008 were all focused on the Las Vegas market and even fewer studies have examined the pricing implications of short sale transactions. This study examines the discounts associated with foreclosure and short sale status in the Fresno, California from 2006 to 2010, a time period containing significant housing price volatility. Generally, we find approximately 20 % and 13 % discounts for foreclosure transactions and short sale transactions, respectively. These discounts remain consistent even after controlling for endogeneity of time-on-the-market and self-selection bias. We also document that both the foreclosure and short-sale discounts are time varying based on market conditions. Both foreclosure and short-sale discounts increase from 2008 to 2009 and decrease in 2010. Also, the foreclosure status decreases time on the market while the short-sale status increases time on the market.     

Unobservable transfer price exceeds marginal cost when the manager is evaluated using a balanced scorecard

This study investigates the optimal level of transfer prices chosen by managers in a divisionalized firm when they are evaluated based on a balanced scorecard. A unique assumption of our model is that transfer prices are unobservable to a competing firm's managers. In contrast to the findings in several studies that examine strategic transfer pricing, this research shows that a manager who is evaluated using a balanced scorecard chooses a transfer price that exceeds marginal cost given a market competitor in a specific economic environment. This result is caused mainly by our model's assumption that a manager considers the competitor's profit in his/her in decision-making when the objective is to maximize long-term profit. This study makes a significant contribution to the strategic transfer pricing literature by showing that even if the transfer price is unobservable to rivals, the optimal transfer price exceeds marginal cost when the final product market is characterized by price competition, something not shown in previous analytical accounting research.     

Timing of Sale,Pricing, and Cost Information: Evidence from the Airline Industry*

This study examines the association between when an airline sells its passenger seats and the pricing method (marginal cost or full cost) it employs. Prior literature suggests that when firms are able to change prices during the selling period, the optimality of full cost pricing or marginal cost pricing depends on when demand information is revealed during the period between capacity commitment decisions and time of sale. Full cost‐based pricing is appropriate in determining capacity commitment and prices simultaneously, while marginal cost provides more relevant information for pricing when capacity has been committed. Using the price and cost data from a sample of four U.S. domestic airlines, we find that full cost explains price variations of first‐day sales robustly. The adjusted R² of the marginal cost pricing model is larger in the sample of sales two days prior to departure than in the sample of first‐day sales. In the analysis of the sample of sales two days prior to departure, we find that, based on the adjusted R² of the full cost pricing and marginal cost pricing models, the explanatory power of marginal cost pricing is relatively weaker than full cost pricing. Our results document the use of different cost information along the dynamic change of price and provide implications in understanding the role of cost information in setting prices.     

Transfer Pricing and the Control of Internal Corporate Transactions

One potential weakness of all divisional profitability schemes is their inability to capture synergies among business units. One way of managing this problem is to design a transfer pricing scheme that attempts to assign common costs and benefits to different business units. What makes transfer pricing both so interesting, and such a challenge, is that the solution involves finding a way to encourage divisional managers whose pay is likely to depend on such transfer prices to reveal their private or unbiased information about the firm's costs in a way that serves the interest of the rest of the firm. With that end in view, the authors provide a general analytical framework for setting transfer prices and go on to discuss the costs and benefits of each of the most common transfer‐pricing methods: (1) market pricing; (2) marginal cost pricing; (3) full‐cost pricing; and (4) negotiated prices.     

Individual Agents,Firms, and the Real Estate Brokerage Process

This study examines how individual agents affect house selling prices and time on the market while controlling for brokerage firm-specific effects as well as supply and demand conditions that vary by neighborhood. Firm size effects disappear once firm specialization and agent characteristics are taken into account but geographic concentration by firms leads to higher selling prices. For individual agents, neither sex nor selling own listings affects price or selling time, but there are gains from partnering transactions across firms. Agents who specialize in listing properties obtain higher prices for their sellers while those who specialize in selling obtain lower prices for their buyers. Houses nearer to other transactions of an agent sell for higher prices. Finally, greater scale of listing and selling activity by an agent tends to lower selling price or lengthen the time on the market.

Short-Selling Prior to Earnings Announcements

This paper examines short‐sales transactions in the five days prior to earnings announcements of 913 Nasdaq‐listed firms. The tests provide evidence of informed trading in pre‐announcement short‐selling because they reveal that abnormal short‐selling is significantly linked to post‐announcement stock returns. Also, the tests indicate that short‐sellers typically are more active in stocks with low book‐to‐market valuations or low SUEs. The levels of pre‐announcement short‐selling, however, mostly appear to reflect firm‐specific information rather than these fundamental financial characteristics. We believe that these results should encourage financial market regulators to consider providing more extensive and timely disclosures of short‐selling to investors.     

BUYING AND SELLING COMPANIES IN THE NEW MILLENNIUM

The growth in corporate mergers and acquisitions in the 1990s has been nothing short of spectacular. Among the most important contributors to the growth of M&A are globalization and technological change, which are working together to create excess capacity in virtually all global industries. When industries are experiencing overcapacity, some degree of consolidation becomes inevitable, and M&A is a primary means for accomplishing consolidation. Although much of the dollar volume of M&A comes from the highly publicized mergers of large companies, by far the greatest number of transactions is taking place in the middle market—that is, companies with revenues less than $500 million or a market cap under $1 billion. Along with the sharp increase in middle‐market M&A, the author notes a relatively new financing practice in which private equity groups take large minority stakes in middle market companies. One factor contributing to this development, which the author calls “the small‐cap trap,” is that the stocks of small and mid‐sized public companies now appear to be trading “at large discounts to the values of their large‐cap peer group, even in cases where the operating performance of the smaller firms is better.” According to the author, the most plausible explanation for such discounts is the limited “float” of such companies; most receive little research coverage by Wall Street analysts and have limited institutional followings. After reviewing broad trends in M&A, the author offers some tips on designing a broad M&A strategy and conducting a selling process. One of the keys to the selling process is to create a sense of “exclusivity” among interested buyers without removing the pressure of competition. Consistent with the message of other articles in this issue, the author argues that one of the most reliable ways to create a sense of exclusivity is by providing good information, relatively full disclosure. Indeed, the disclosure should be sufficiently revealing that the initial bids are based on all relevant information.     

Information Asymmetry and Asset Prices: Evidence from the China Foreign Share Discount

We examine the effect of information asymmetry on equity prices in the local A‐ and foreign B‐share market in China. We construct measures of information asymmetry based on market microstructure models, and find that they explain a significant portion of cross‐sectional variation in B‐share discounts, even after controlling for other factors. On a univariate basis, the price impact measure and the adverse selection component of the bid‐ask spread in the A‐ and B‐share markets explains 44% and 46% of the variation in B‐share discounts. On a multivariate basis, both measures are far more statistically significant than any of the control variables.     

Negotiated versus Cost-Based Transfer Pricing

This paper studies an incomplete contracting model to compare the effectiveness of alternative transfer pricing mechanisms. Transfer pricing serves the dual purpose of guiding intracompany transfers and providing incentives for upfront investments at the divisional level. When transfer prices are determined through negotiation, divisional managers will have insufficient investment incentives due to hold-up problems. While cost-based transfer pricing can avoid such hold-ups, it does suffer from distortions in intracompany transfers. Our analysis shows that negotiation frequently performs better than a cost-based pricing system, though we identify circumstances under which cost-based transfer pricing emerges as the superior alternative.     

Discussion of “decentralized capacity management and internal pricing”

Dutta and Reichelstein (2010) study the role of transfer pricing and organizational choice in providing incentives for efficient decisions on the acquisition and subsequent reallocation of capacity within decentralized firms. Their analysis suggests that transfer prices based on the historical cost of capacity facilitate the efficient allocation of resources. They also find that symmetric responsibility center structures are generally better suited for providing efficient investment incentives than hybrid organizations. An important condition for the derivation of the two results is the linearity of the shadow prices of capacity. If shadow prices are nonlinear, transfer prices should be below (above) the historical cost of capacity in order to counteract the managers’ incentives to underinvest (overinvest). Because profit center organizations can use transfer prices for mitigating the inefficiency caused by nonlinear shadow prices, they offer a natural advantage over pure investment center organizations in implementing efficient capacity decisions. Overall, these observations suggest that the curvature of profit functions is an important factor in determining the suitable instruments for decentralized capacity management.     

All‐units discounts as a partial foreclosure device

We investigate the strategic effects of all‐units discounts (AUDs) used by a dominant firm in the presence of a capacity‐constrained rival. Due to the limited capacity of the rival, the dominant firm has a captive portion of the buyer's demand for the single product. As compared to linear pricing, the dominant firm can use AUDs to go beyond its captive portion by tying its captive demand with part of the competitive demand and partially foreclose its small rival. When the rival's capacity level is well below relevant demand, AUDs reduce the buyer's surplus.     

WARRANT PRICING USING OBSERVABLE VARIABLES

The classical warrant pricing formula requires knowledge of the firm value and of the firm‐value process variance. When warrants are outstanding, the firm value itself is a function of the warrant price. Firm value and firm‐value variance are then unobservable variables. I develop an algorithm for pricing warrants using stock prices, an observable variable, and stock return variance. The method also enables estimation of firm‐value variance. A proof of existence of the solution is provided.     

A call on art investments

The art market has seen several booms and busts during the last 20 years and, despite its recent downturn, has received more attention from investors given the low interest environment following the financial crisis. However, participation has been reserved for a few investors and the hedging of exposures remains difficult. This paper proposes to overcome these problems by introducing a call option on an art index, derived from one of the most comprehensive data sets of art market transactions. The option allows investors to optimize their exposure to art. For pricing purposes, non-tradability of the art index is acknowledged and option prices are derived in an equilibrium setting as well as by replication arguments. In the former, option prices depend on the attractiveness of gaining exposure to a previously non-traded risk. This setting further overcomes the problem of art market exposures being difficult to hedge. Results in the replication case are primarily driven by the ability to reduce residual hedging risk. Even if this is not entirely possible, the replication approach serves as a pricing benchmark for investors who are significantly exposed to art and try to hedge their art exposure by selling a derivative.     

Intrafirm Trade,Bargaining Power,and Specific Investments

This paper compares the performance of standard-cost with negotiated transfer pricing under asymmetric information. Negotiated transfer pricing generally achieves higher expected contribution margins, as this method tends to be more efficient in aggregating private information into a single transfer price. Standard-cost transfer pricing confers more bargaining power to the supplier and therefore generates better incentives for this division to undertake specific investments. The opposite holds for buyer investments. If a corporate controller has disaggregated information about divisional costs and revenues, then the firm can improve upon the performance of standard-cost transfer pricing by setting a centralized transfer price equal to expected cost plus a suitably chosen mark-up.     

DISPOSITION EFFECT AND PUBLIC SECONDARY EQUITY OFFERINGS

Shareholders selling shares in public pure‐secondary equity offerings are affected by the disposition effect and tend to sell past winners. Selling shares in these offerings is associated with significant indirect offer costs. On average, shares are offered at a 5.5% discount from the market price. Moreover, shares of offering firms are about 8% underpriced. Offer discounts and underpricing are positively related to the proxy for the disposition effect. Our findings are consistent with the proposition that the disposition effect increases the supply of winning stocks and depresses their prices.     

Presidential Address: Liquidity and Price Discovery

This paper examines the implications of market microstructure for asset pricing. I argue that asset pricing ignores the central fact that asset prices evolve in markets. Markets provide liquidity and price discovery, and I argue that asset pricing models need to be recast in broader terms to incorporate the transactions costs of liquidity and the risks of price discovery. I argue that symmetric information‐based asset pricing models do not work because they assume that the underlying problems of liquidity and price discovery have been solved. I develop an asymmetric information asset pricing model that incorporates these effects.     

The Illiquidity of Corporate Bonds

This paper examines the illiquidity of corporate bonds and its asset‐pricing implications. Using transactions data from 2003 to 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bid–ask spreads. We establish a strong link between bond illiquidity and bond prices. In aggregate, changes in market‐level illiquidity explain a substantial part of the time variation in yield spreads of high‐rated (AAA through A) bonds, overshadowing the credit risk component. In the cross‐section, the bond‐level illiquidity measure explains individual bond yield spreads with large economic significance.