Week 9

Question 1

What 3 objectives does a rational manager need to balance in the presence of mispricing generated by irrational investors?

Answer 1

• Rational managers balance 3 objectives:
  1) Max. fundamental value f(K) - K –> i.e. NPV of future cash flows –> select project w highest NPV & reject all -ve NPV projects.
  2) Max. short-term share price –> goal pursued by taking various actions that cater to investor desires unrelated to value enhancement (catering channel) –> temporary mispricing is δ(K,e) –> e is fraction of firm potentially sold off in share issue.
  3) Exploit mispricing to benefit long-term shareholders.

Question 2

How might a rational manager exploit mispricing generated by irrational investors to benefit long-term shareholders?

Answer 2

• By timing market, i.e. issuing share when overvalued & buying it back when undervalued (timing channel) –> by selling fraction of firm, e, long-term shareholders gain by: eδ(K,e).
• When manager issues shares during a period when stock overvalued (i.e., δ(K,e)>0), they are able to sell these shares at higher mkt price than fundamental value —> long-term shareholders who own existing shares before the issuance, benefit by selling fraction (e) of their ownership in firm at this higher price –> may come at expense of new shareholders who purchase shares when stock overpriced.

Question 3

How can mispricing affect a company’s investment policy?

Answer 3

• E.g. increases investment via timing channel: if firm’s stock overvalued, external equity finance issuance by firm managers allows capital to be raised at higher price than stock’s fundamental value —> increased access to capital allows firm to undertake investment opportunities that might have been challenging to pursue in absence of mispricing.
• Polk & Sapienza: found +ve relation between abnormal investment & mispricing –> abnormal investment more sensitive to mispricing for firms w higher R&D intensity & w shorter shareholder horizons –> i.e. because these investors are more prone to react quickly to market inefficiencies e.g. if they perceive stock is mispriced, may seek to capitalize on opportunity promptly by adjusting their investment portfolios.
• Stein & Baker et al.: found that firms in need of external equity finance have investment especially sensitive to mispricing.

Question 4

How can mispricing affect a company’s financing policy?

Answer 4

• Managers often issue shares to exploit overpricing (Graham & Harvey).
• Pagano et al.: Likelihood of IPO increasing w industry’s mkt-to-book ratio (price) as higher amounts of capital can now be raised by firm for investment from investors who purchase shares –> likely that managers do this to ‘time the mkt’ as investment & profitability found to decrease after IPO as mkt corrects itself from overvaluation.
• Brockman & Chung: managers also repurchase shares to ‘time the mkt’ when stock believed to be undervalued to signal confidence in firm’s performance if they believe shares trading below their fundamental values & that they can profit when prices increase.

Question 5

How can mispricing affect a company’s dividend policy?

Answer 5

• Baker & Wurgler –> managers use divs as a catering tool for investors –> investigate div premium = diff between avg mkt-to-book ratio of dividend payers & non-payers.
• When div premium rises, div paying firms overvalued to reflect increased investor preference for divs –> firms cater to investors so div initiations increase.
• Conversely when div premium falls, non-div paying firms undervalued so reflects decreased investor preference for divs –> div initiations fall.