Knowledge that Transforms

This paper conducts powerful new tests of whether debt can mitigate the effects of agency and information problems. We focus on emerging market firms for which pyramid ownership structures create potentially extreme managerial agency costs. Our tests incorporate both traditional financial statement data and new data on global debt contracts. Our analysis is mindful of the potential endogeneity between debt, ownership structure, and value, and it takes into account differences in the debt capacity of a firm's assets in place and future growth opportunities. The results indicate that the incremental benefit of debt is concentrated in firms with high expected managerial agency costs that are also most likely to have overinvestment problems resulting from high levels of assets in place or limited future growth opportunities. Subsequent internationally syndicated term loans are particularly effective at creating value for these firms. Our results support the recontracting hypothesis that equity holders value compliance with monitored covenants, particularly when firms are likely to overinvest.

The term structure of interest rates is modeled as a random field with conditional volatility. Random field models allow consistency with the current shape of the term structure without the need for recalibration. However, most such models are Gaussian, with no conditional volatility. State-dependent volatility is introduced while a key property of Gaussian random field models is retained. Each forward rate is part of a low-dimensional diffusion process, simplifying estimation and derivatives pricing. The modeling approach also implies that, in general, the set of zero coupon bonds does not complete the market, and term structure derivatives cannot always be priced by arbitrage.

We analyze the resource allocation decision of a manager inside a multidivision firm whose compensation is based on the firm's stock price. We find that internal investments exhibit a positive correlation across the firms divisions. Namely, when two single-division firms merge the optimal investment level in one division becomes more positively related to the investment level in the other division. In addition, following a spinoff, divisional investments decline (increase) whenever the separated division has a project with a low (high) Sharpe ratio. Finally, multidivision firms trade at a discount which is larger the more diverse the investment sets of the divisions.

Governance problems have a direct and immediate impact on the effective discount rate guiding investment decisions. Information from a transformed net present value rule and variation in firm-level panel data “reveal” the effective discount rate influencing investment. For the firms most likely to be affected by Jensen agency problems, investment behavior appears to be guided by discount rates less than the market rate by 350–400 basis points. This wedge is reduced for firms with a concentrated ownership structure. Firms facing free cash flow problems have a stock of fixed capital approximately 7–22% higher than would prevail under value maximizing behavior.

We analyze changes in investment policy following 106 spinoffs between 1981 and 1996. Pre-spinoff, the sample firms are valued at a discount and invest less in their high q segments than do their single-segment peers. Post-spinoff, there is a significant increase in measures of investment efficiency and the diversification discount is eliminated. Furthermore, changes in excess value around the spinoff are positively related to changes in measures of investment efficiency. These findings support the view that (i) diversified firms allocate investment funds inefficiently, and (ii) by breaking up the conglomerate, spinoffs create value by improving investment efficiency.

This paper analyzes the timing of mergers motivated by economies of scale. We show that firms have an incentive to merge in periods of economic expansion. Relaxing the assumption that firms are price takers, we find that market power strengthens the firms’ incentive to merge and speeds up merger activity. Finally, comparing mergers with hostile takeovers we show that the way merger synergies are divided not only influences the acquirer's and the acquiree's returns from merging, but also the timing of the restructuring.

We use a bargaining framework to examine empirically the relations between director compensation and board-of-director independence. Our evidence suggests that independent directors have a bargaining advantage over the CEO that results in compensation more closely aligned with shareholders’ objectives. Firms with more outsiders on their boards award directors more equity-based compensation. When the CEO's power over the board increases, compensation provides weaker incentives to monitor. Firms with more inside directors and with entrenched CEOs use less equity-based pay. Furthermore, firms with entrenched CEOs and CEOs who also chair the board are less likely to replace cash pay with equity.

The consistency of positive past returns and tax-loss selling significantly affects the relation between past returns and the cross-section of expected returns. Analysis of these additional effects across stock characteristics, seasons, and tax regimes provides clues about the sources of temporal relations in stock returns, pointing to potential explanations for this relation. A parsimonious trading rule generates surprisingly large economic returns despite controls for confounding sources of return premia, microstructure effects, and data snooping biases.

We investigate the upstream and downstream product-market effects of a large sample of horizontal mergers and acquisitions from 1980 to 1997. We construct a data set that identifies the corporate customers, suppliers, and rivals of the firms initiating horizontal mergers and use this data set to examine announcement-related stock market revaluations and post-merger changes in operating performance. We find little evidence consistent with increased monopolistic collusion. However, we do find evidence consistent with improved productive efficiency and buying power as sources of gains to horizontal mergers. The nature of the buying power gains, i.e., rents from monopsonistic collusion or improved purchasing efficiency, is also investigated.

Which loss function should be used when estimating and evaluating option valuation models? Many different functions have been suggested, but no standard has emerged. We emphasize that consistency in the choice of loss functions is crucial. First, for any given model, the loss function used in parameter estimation and model evaluation should be the same, otherwise suboptimal parameter estimates may be obtained. Second, when comparing models, the estimation loss function should be identical across models, otherwise inappropriate comparisons will be made. We illustrate the importance of these issues in an application of the so-called Practitioner Black-Scholes model to S&P 500 index options.