We study optimal financial contracting for centralized and decentralized firms. Under centralized contracting, headquarters raises funds on behalf of multiple projects. Under decentralized contracting, each project raises funds separately on the external capital market. The benefit of centralization is that headquarters can use excess liquidity from high cash‐flow projects to buy continuation rights for low cash‐flow projects. The cost is that headquarters may pool cash flows from several projects and self‐finance follow‐up investments without having to return to the capital market. Absent any capital market discipline, it is more difficult to force headquarters to make repayments, which tightens financing constraints ex ante. Cross‐sectionally, our model implies that conglomerates should have a lower average productivity than stand‐alone firms.

Exchange-Rate Regimes and International Trade: Evidence from the Classical Gold Standard Era by J. Ernesto López-Córdova and Christopher M. Meissner. Published in volume 93, issue 1, pages 344-353 of American Economic Review, March 2003

A youth homicide reduction initiative in Boston in the mid- 1990s poses particular difficulties for program evaluation because it did not have a control group and the exact implementation date is unknown. A standard methodology in program evaluation is to use time series variation to compare pre- and postprogram outcomes. Such an approach is not valid, however, when the timing of program implementation or effect is unknown. To evaluate the Boston initiative, we adapt from the time series literature an unknown-breakpoint test to test for a change in regime. Tests for parameter instability provide a flexible framework for testing a range of hypotheses commonly posed in program evaluation. These tests both pinpoint the timing of maximal break and provide a valid test of statistical significance. We evaluate the results of the estimation using the asymptotic results in the literature and with our own Monte Carlo analyses. We conclude there was a statistically significant discontinuity in youth homicide incidents (on the order of 60%) shortly after the intervention was unveiled.

Prior research reveals that the accrual component of profitability is less persistent than the cash flow component, and that investors fail to fully appreciate their differing implications for future profitability (Sloan 1996). However, accruals are a component of growth in net operating assets as well as a component of profitability. Just as we can disaggregate profitability into accruals and cash flows from operations, we can disaggregate growth in net operating assets into accruals and growth in long-term net operating assets. We find that, after controlling for current profitability, both components of growth in net operating assets—accruals and growth in long-term net operating assets—have equivalent negative associations with one-year-ahead return on assets. This result is consistent with conservative accounting and diminishing marginal returns on investments. We also find that, after controlling for current profitability, the market appears to equivalently overvalue accruals and growth in long-term net operating assets relative to their association with one-year-ahead ROA. Our evidence suggests that the accrual anomaly documented in Sloan (1996) is a special case of what could be viewed as a more general growth anomaly.

The accuracy of sell-side analysts' forecast revisions is related to a number of factors, including characteristics of the analyst and the age of the forecast. In this study we examine whether there are differences in how sophisticated and unsophisticated investors use these factors to predict the relative accuracy of forecast revisions. We adapt the lens model methodological approach from the judgment and decision-making literature to investigate these differences in an archival setting. Our results suggest that sophisticated investors have greater knowledge overall about the relation of the factors to forecast accuracy. Further, our evidence is consistent with sophisticated investors relying more on the specific factors that provide the most benefits (relative to their costs) for predicting relative forecast accuracy.

This paper examines whether risk-management strategies (specifically, the use of specialist personnel and higher billing rates) moderate the effect of risk on client acceptance decisions, thereby assisting auditors in bringing prospective client relationships to acceptable risk/return levels. We propose a conceptual model of the client acceptance decision process, and use archival data on one firm's actual client acceptance decisions to test the model. Our results demonstrate the selective use of risk-management strategies in the client acceptance decision, based on the nature of the risks present for each particular client. Specifically, plans to charge a higher billing rate are associated with a reduction in the negative relationship between client acceptance likelihood and both going-concern risk and public trading status, and plans to assign specialist personnel are associated with a reduction in the negative relationship between client acceptance likelihood and both fraud risk and error risk. Therefore, we provide evidence that while risky clients are less likely to be accepted overall, the application of particular risk-management strategies to particular risks increases the likelihood of accepting such clients.

Empirical accounting research provides surprisingly little evidence on whether accounting earnings numbers capture cross-sectional differences in risk that are associated with cross-sectional differences in share prices. We address two questions regarding the risk-relevance of accounting numbers: (1) Are accounting-related risk measures (i.e., the systematic risk and total volatility in a firm's time-series of residual return on equity) associated with the market's assessment and pricing of equity risk? (2) If so, then are these accounting-related risk measures incrementally associated with the market's assessment and pricing of equity risk beyond other observable factors, such as those in the Fama and French (1992) three-factor model? We develop an accounting-fundamentals-based measure of the market's pricing of risk—the difference between actual share price and a residual income valuation model estimate of share value using risk-free rates of return. Our results show that both systematic risk and total volatility in residual return on equity partially explain this pricing differential, and that the explanatory power of total volatility is incremental to the Fama and French (1992) factors—market beta, firm size, and the market-to-book ratio.

We document several factors that help explain cross-sectional variations in the post-revision price drift associated with analyst forecast revisions. First, the market does not make a sufficient distinction between revisions that provide new information (“high-innovation” revisions) and revisions that merely move toward the consensus (“low-innovation” revisions). Second, the price adjustment process is faster and more complete for “celebrity” analysts (Institutional Investor All-Stars) than for more obscure yet highly accurate analysts (Wall Street Journal Earnings-Estimators). Third, controlling for other factors, the price adjustment process is faster and more complete for firms with greater analyst coverage. Finally, a substantial portion of the delayed price adjustment occurs around subsequent earnings-announcement and forecast-revision dates. Collectively, these findings show that more subtle aspects of an earnings revision signal can hinder the efficacy of market price discovery, particularly in firms with relatively low analyst coverage, and that subsequent earnings-related news events serve as catalysts in the price discovery process.

How Does Globalization Affect the Synchronization of Business Cycles? by M. Ayhan Kose, Eswar S. Prasad and Marco E. Terrones. Published in volume 93, issue 2, pages 57-62 of American Economic Review, May 2003

Prior empirical evidence regarding the impact of dividend taxes on firm valuation is mixed. This study avoids some of the complications encountered in previous empirical work by exploiting institutional characteristics of REITs, such as their limited discretion over dividend policy and the relative transparency of REIT assets. We regress the market value of equity on the market value of assets and tax basis, which creates tax deductions that lower future dividend taxes without affecting future pretax cash flow. We find that firm value is positively related to tax basis, suggesting that future dividend taxes are capitalized into share prices.