Free Cash Flow,Issuance Costs,and Stock Prices

We develop a dynamic model of a firm facing agency costs of free cash flow and external financing costs, and derive an explicit solution for the firm's optimal balance sheet dynamics. Financial frictions affect issuance and dividend policies, the value of cash holdings, and the dynamics of stock prices. The model predicts that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price. This yields novel insights on the asymmetric volatility phenomenon, on risk management policies, and on how business cycles and agency costs affect the volatility of stock returns.     

Simulation of the Impact of the Recognition of Stock Options on the Earnings: The case of Canadian Companies*

One of the most controversial accounting issues pertains to stock compensation. In Canada, the Canadian Institute of Chartered Accountants (CICA) approved section 3870, Stock‐based Compensation and Other Stock‐Based Payments, on November 13, 2001, to take effect in January 2002. Section 3870 forces companies to “take a look at the real economic cost of most of the stock‐based compensation mechanisms” (AcSB Bulletin, October 2001, 1). The adoption of section 3870 was aimed at harmonizing Canadian accounting practice with U.S. standards. The new standard, which was initially based on two American accounting standards ‐ APB Opinion No. 25 and SFAS No. 123 ‐ gave companies the choice of using either the fair value method or the pro forma disclosure of net income and adjusted earnings per share to account for stock‐based compensation. The Accounting Standards Board (AcSB) nevertheless recommended that Canadian companies use the fair value method, which consists in estimating and recognizing the value of the stock options at the grant date.     

Why Do Firms Become Widely Held? An Analysis of the Dynamics of Corporate Ownership

We examine the evolution of insider ownership of IPO firms from 1970 to 2001 to understand how U.S. firms become widely held. A majority of these firms has insider ownership below 20% after 10 years. Stock market performance and liquidity play an extremely important role in ownership dynamics. Firms with stocks that are highly valued, are liquid, and have performed well experience large decreases in insider ownership and become widely held. Ownership also falls for low cash flow and high capital expenditures firms. Surprisingly, variables proxying for agency costs have limited success in explaining the evolution of insider ownership.     

ENTRY AND COMPETITION IN LOCAL HOSPITAL MARKETS*

We extend the entry model developed by Bresnahan and Reiss to make use of quantity information, and apply it to data on the U.S. hospital industry. The Bresnahan and Reiss model infers changes in the toughness of competition from entry threshold ratios. Entry threshold ratios, however, identify the product of changes in the toughness of competition and changes in fixed costs. By using quantity data, we are able to identify separately changes in the toughness of competition from changes in fixed costs. This model is generally applicable to industries where there are good data on market structure and quantity, but not on prices, as for example in the quinquennial U.S. Economic Census. In the hospital markets we examine, entry leads to a quick convergence to competitive conduct. Entry reduces variable profits and increases quantity. Most of the effects of entry come from having a second and a third firm enter the market.     

The Political Determinants of the Cost of Equity: Evidence from Newly Privatized Firms

In this paper, we investigate the political determinants of the cost of equity using a unique data set of 236 firms privatized between 1987 and 2006 in 38 countries. We find robust evidence that the cost of equity is increasing in government ownership. We also show that the cost of equity is significantly related to political orientation and the extent of government expropriation. Furthermore, we report a less pronounced effect of state ownership on the cost of equity in more populist governments and in more financially developed countries, in addition to a more pronounced effect of state ownership on the cost of equity when the risk of government expropriation is higher. Results from an event study examining the replacement of left‐wing governments by right‐wing governments suggest a lower cost of equity in more financially developed countries and a higher cost of equity in more autocratic countries and in countries with a high risk of government expropriation. Finally, we find that chief executive turnover is associated with a higher cost of equity in more autocratic countries.     

Markups and the Welfare Cost of Business Cycles: A Reappraisal

Gali, Gertler, and Lopez‐Salido (2007) recently show quantitatively that fluctuations in the efficiency of resource allocation do not generate sizable welfare costs. In their economy, which is distorted by monopolistic competition in the steady state, we show that they underestimate the welfare cost of these fluctuations by ignoring the negative effect of aggregate volatility on average consumption and leisure. As monopolistic suppliers, both firms and workers aim to preserve their expected markups; the interaction between aggregate fluctuations and price‐setting behavior results in average consumption and employment levels that are lower than their counterparts in the flexible‐price economy. This level effect increases the efficiency cost of business cycles. It is all the more sizable with the degree of inefficiency in the steady state, lower labor–supply elasticities, and when prices instead of wages are rigid.     

Aggregate Investment Externalities and Macroprudential Regulation

Evidence suggests that banks tend to lend a lot during booms and very little during recessions. We propose a simple explanation for this phenomenon. We show that instead of dampening productivity shocks, the banking sector tends to exacerbate them, leading to excessive fluctuations of bank credit, output, and asset prices. Our explanation relies on three ingredients that are characteristic of modern banks’ activities: moral hazard, high exposure to aggregate shocks, and the ease with which capital can be reallocated to its most productive use. At the competitive equilibrium, banks offer privately optimal contracts to their investors, but these contracts are not socially optimal: banks reallocate capital excessively upon aggregate shocks. This is because banks do not internalize the impact of their decisions on asset prices. We examine the efficacy of possible policy responses to these properties of credit markets, and derive a rationale for macroprudential regulation in the spirit of a Net Stable Funding Ratio.     

Ecological Intuition versus Economic “Reason”

This paper discusses the discount rate to be used in projects aimed at preserving the environment. The model has two different goods: one is the usual consumption good whose production may increase exponentially, and the other is an environmental good whose quality remains limited. The stylized world we describe is fully determined by four parameters, reflecting basic preferences, “ecological” and intergenerational concerns, and feasibility constraints. We define an ecological discount rate and examine its connections with the usual interest rate and the optimized growth rate. We discuss, in this simple world, different forms of the precautionary principle.