Knowledge that Transforms

This article presents a theory of capital allocation that shows how the use of net present value (NPV) as an investment criterion leads to inefficient capital budgeting outcomes and how this criterion may be dominated by other capital budgeting criteria, like the internal rate of return and the profitability index. The essence of our theory is rooted in the mainstream paradigm of corporate finance: while firms use NPV to measure the addition to firm value from prospective projects, "classical" informational and agency considerations prevent it from implementing the optimal capital budgeting outcome. Our theory also identifies conditions when alternative criteria should be used. Finally, we characterize when direct monitoring through capital budgeting dominates compensation contracts in alleviating the agency problem. Copyright 2004, Oxford University Press.

We examine optimal capital allocation and managerial compensation in a firm with two investment projects (divisions) each run by a risk-neutral manager who can provide (i) (unverifiable) information about project quality and (ii) (unverifiable) access to value-enhancing, but privately costly resources. The optimal managerial compensation contract offers greater performance pay and a lower salary when managers report that their project is higher quality. The firm generally underinvests in capital and managers underutilize resources (relative to first-best). We also derive cross-sectional predictions about the sensitivity of investment in one division to the quality of investment opportunities in the other division, and the relative importance of division-level and firm-level performance-based pay in managerial compensation contracts.

We examine Japan's 1997 introduction of book building as an alternative to a previously required hybrid auction method. Despite higher cost for some issuers, all issuers in Japan now select book building. Book building enables more accurate valuation of firms, but gains from accurate valuation are partly redistributive. Thus book building can drive auction-method offerings from the market even if it yields no aggregate benefit. Compared to the auction regime, book building reduces issue costs for large issuers. Auctioning is less costly for small issuers, but appears to foreclose some small firms from issuing. The aggregate costs of book building and auctioning are similar. Copyright 2004, Oxford University Press.

Gallant, Hansen, and Tauchen (1990) show how to use conditioning information optimally to construct a sharper unconditional variance bound (the GHT bound) on pricing kernels. The literature predominantly resorts to a simple but suboptimal procedure that scales returns with predictive instruments and computes standard bounds using the original and scaled returns. This article provides a formal bridge between the two approaches. We propose an optimally scaled bound that coincides with the GHT bound when the first and second conditional moments are known. When these moments are misspecified, our optimally scaled bound yields a valid lower bound for the standard deviation of pricing kernels, whereas the GHT bound does not. We illustrate the behavior of the bounds using a number of linear and nonlinear models for consumption growth and bond and stock returns. We also illustrate how the optimally scaled bound can be used as a diagnostic for the specification of the first two conditional moments of asset returns. Copyright 2004, Oxford University Press.

An important feature of financial markets is that securities are traded repeatedly by asymmetrically informed investors. We study how current and future adverse selection affect the required return. We find that the bid-ask spread generated by adverse selection is not a cost, on average, for agents who trade, and hence the bid-ask spread does not directly influence the required return. Adverse selection contributes to trading-decision distortions, however, implying allocation costs, which affect the required return. We explicitly derive the effect of adverse selection on required returns, and show how our result differs from models that consider the bid-ask spread to be an exogenous cost.

This article develops an asset allocation framework that incorporates prior beliefs about the extent of stock return predictability explained by asset pricing models. We find that when prior beliefs allow even minor deviations from pricing model implications, the resulting asset allocations depart considerably from and substantially outperform allocations dictated by either the underlying models or the sample evidence on return predictability. Under a wide range of beliefs about model pricing abilities, asset allocations based on conditional models outperform their unconditional counterparts that exclude return predictability. Copyright 2004, Oxford University Press.

Little is known about the timing and execution of open market repurchases. U.S. firms are under no obligation to disclose when they are trading, and generally report only quarterly changes in shares outstanding. We use 64 firms' supplementally disclosed repurchase trading data to provide the first examination of repurchase timing and execution. Across the days reported in our sample, firms adopted a variety of execution styles ranging from immediate intense repurchasing to delayed and smoothed repurchasing. We find no clear evidence that repurchases are timed to coincide with, precede, or follow, days on which information is released. We benchmark the costs and value of a given repurchase program against naive accumulation strategies achieving the same terminal portfolio. While there is considerable variation across the firms, NYSE firms on average beat their benchmarks, whereas NASDAQ firms do not. Finally, we document the liquidity impact of open market repurchases. We find that repurchasing contributes to market liquidity by narrowing bid-ask spreads and attenuating the price impact of order imbalances on days when repurchase trades are completed.

Dai and Singleton (2002) and Duffee (2002) show that there is a tension in affine term structure models between matching the mean and the volatility of interest rates. This article examines whether this tension can be solved by an alternative parametrization of the price of risk. The empirical evidence suggests that, first, the examined parametrization is not sufficient to solve the mean-volatility tension. Second, the usual result in the estimation of affine models, indicating that some of the state variables are extremely persistent, may have been caused by the lack of flexibility in the parametrization of the price of risk. Copyright 2004, Oxford University Press.

We show that bidding firms consider target board characteristics when deciding takeover offer types and initial offer premiums. We study a sample of 436 proposed negotiated mergers and bypass offers. Firms with individuals holding the titles of both chief executive officer (CEO) and board chair are more likely to receive bypass offers. These offers are more likely to be successful and generate higher target shareholder gains over the takeover offer period. When the target's board is independent, the target is less likely to receive a high premium and the offer is less likely to succeed.

The apparent conflict between the level of resources dedicated to technical analysis by practitioners and academic theories of market efficiency is a long-standing puzzle. We explore a previously unexamined feature of technical analysis — namely its relation to liquidity provision. We demonstrate that support and resistance levels coincide with peaks in depth on the limit order book and moving average forecasts reveal information about the relative position of depth on the book. Furthermore, we show that these relationships stem from technical rules locating depth already in place on the limit order book.