Investment Decisions

Question 1

Leland and Pyle 1977

Answer 1

LP 77 shows that in a world with relatively more low-type firms, high-type will be driven out of the market. Entrepreneurs can signal firm type by retaining equity in the firm. This improves investment efficiency, but inefficiences still remain due to informational transaction costs. FI may have a role by reducing transaction costs through economies of scale and with their ability to signal firm type by having skin in the game through holding a portfolio of risky loans. The testable implication of this model is that high-type firms will have low leverage, which contrasts with the contemporary Ross 77 in which leverage is a positive signal.

Question 2

Miller and Rock (1985)

Answer 2

• Key assumptions: active investors; firm max long-run intrinsic value (Fisher criteria)
• signaling model that investors draw inferences about implied changes in expected net operating cash flows from corporate dividend announcements:
• If the amount of investment and external financing is held fixed, the cash dividend paid by the firm reveals its operating cash flow.
• Thus, a larger-than-expected dividend reveals larger-than-expected cash flow, and stock price increases.
• A larger-than-expected external financing reveals lower-than-expected cash flow, which is bad news for investors.
• Thus Miller and Rock’s model predicts that announcements of new security issues will, on average, depress stock price.

Question 3

Fazzari, Hubbard and Petersen 1988

Answer 3

• Strand: investment cash-flow sensitivity
• Hyp: info asymm means exteranal investors can’t evaluate quality of firms investment opps. For small, young firms external funding not perfect substitute for internal.
• Key empiric meth: use manufacturering firms data. Financially constrained firms rely on internally generated cash to fund investments, thus if a firms investments relate to a fluctuation in cash flows —> they have no low-cost outside sources of finance.
• Maturity matters in firm’s ability to access cap markets
• Small firms more likely to get bank vs public debt, b/c of bank’s monitoring

Question 4

Stein 1996

Answer 4

• Do we drop WACC that uses CAPM for setting hurdle rates? Or swith to FF3F?
• Is beta still useful for cap budgeting, when mkts not efficient?
• Axioms: *benevolent* mngrs max wealth of *passive* inside investors; outside investors make expectational errors –> drives stock price
• Problem occurs when mngr *does* take into account mkt reactions
• Imp: (A) Use NEER approach (e.g. FF3F) when (i) mngrs interested in max ST stock prices (ii) firm faces financial contraints (B) Use FAR when mgrs interested in max LR value & firm not fin constrained

Question 5

Investment Decisions Lit

Answer 5

1. Leland and Pyle (1977): ent ownership signals quality. FI reduce tx costs; signal inv qual thru risky asset pf. Predicts good firms –> low leverage.
2. Miller and Rock (1985): div policy signals firm type. Incr div –> signals incr CF; incr ext fin –> decr CF.
3. Fazzari, Hubbard, Petersen (1988): fin constrained firms inv depend on internal CF; find young, small firms get bank vs public debt
4. Stein 1996: use NEER to max ST stock prices & when constrained. Use FAR to max LR intrinsic value & when not constrained