The Corporation
Investment, mergers, and growth
Chapter 7
Investment
1
Overview
• Investment in Macro- and Microeconomics
• What should be considered as Investment?
– Capital expenditures
– R&D
– Mergers
• Determinants
– Theories
– Tests
• MM Theorems
• CAPM
• Returns on Investment
– Methods using Accounting Data
– Methods using Stock Market Data
2
7.1 The Basic Investment Decision
3
4
7.2 The Accelerator Theory
• focuses only on the marginal returns side of the
investment scissors.
• Let f(K,L) be a linear homogeneous production function,
and i and w be constant.
• The firm’s output expansion path is then a straight line,
with its output being a constant proportion of its capital
stock,
Q = (1/b)K
(7.3)
• If demand conditions are such that its optimal output in
time t is Qt, then its desired capital stock in period t can be
written as
KDt = bQt
(7.4)
5
• The purchase and installation of capital
equipment takes time, and thus it is reasonable to
assume that a firm can adjust its capital stock
only a partial way towards its desired level.
• If a represents this adjustment factor, 0 < a < 1,
then the change in capital stock in any period
(investment) is proportional to the difference
between existing and desired capital stock.
It = Kt − Kt−1 = a(KDt − Kt−1)
(7.5)
• Using equation (7.4) to replace the desired
capital we obtain the basic accelerator equation.
6
It = abQt − aKt−1
Demand
(7.6)
Supply
for Capital Stock
7
7.3 Cash Flow Models
• The Basic Hypothesis
– managers have a desired flow of investment rather than
a desired capital stock.
It − It−1 = a(IDt − It−1)
(7.7)
where a is an adjustment factor (0<a<1)
– The desired flow of investment in period t is proportional
to some measure of cash flow, Ft.
IDt = bFt
(7.8)
– Substituting (7.8) into (7.7) yields the basic cash flow
investment equation
It = abFt + (1 − a)It−1
(7.9)
• Today’s investment is a function of cash flow and lagged
investment.
8
• When estimating equation (7.9) two measures of cash
flow have generally been used
– profits plus depreciation, or
– profits plus depreciation less dividends.
• Use of the second measure implicitly assumes that
dividends are a higher priority use of cash flow than
investment and are thus decided first. This assumption in
turn raises the question of what determines dividends.
We shall return to this issue later in the chapter.
• Difference to the accelerator model:
– the simple accelerator model stresses only the demand for
capital side of the investment decision,
– the simple cash flow model stresses only the cost of capital side.
• The difference between the two is depicted with the help
of Figure 7.2.
9
10
•
•
It is apparent that cash flow can be an important
determinant of investment, if the firm’s cost of capital
rises significantly when it has to resort to external
sources for funds.
We discuss three explanations that have been given
for why such a rise in the cost of capital might be
expected as the firm enters the external capital market.
1) Transaction Costs
2) Asymmetric Information
3) Managerial Discretion
11
(1) Transaction Costs (Duesenberry, 1958)
• External capital is more costly than internal capital
because of the transaction costs of raising capital
externally.
– Bonds or common shares must be printed,
– Investment bank fees must be paid,
– Advertisements must be placed in newspapers, etc.
• The next table shows that issuing securities may be prohibitively
costly for small firms.
– Issue costs for debt securities are lower than for equity--the costs for a
large debt issue are less than 1 percent--but show the same economies
of scale.
– Debt issues are cheaper because administrative costs are somewhat
less and because underwriters require compensation for the greater
risks they take in buying and reselling stock.
12
Issue costs as a percent of proceeds
for registered issues of common stock during 1971-1975
Size of the Issue
(Millions of Dollars)
Total Cost as a percentage of Issue
Underwritten Cash
Offers
Underwritten
Rights Issues
.50 - .99
13.7
8.2
1.00 - 1.99
15.3
10.5
….
…
…
50.00 - 99.99
4.2
4.7
100.00 - 500.00
4.0
4.0
Average
6.2
6.1
Source: C. W. Smith, "Alternative Methods for Raising Capital: Rights versus Underwritten Offerings,“
Journal of Financial Economics, 5:273-307 (December 1977).
13
Hierarchy of Finance
Cost of internal capital < Cost of debt < Cost of equity
14
(2) Asymmetric Information
(Myers and Majluf, 1984)
• Basic Assumptions of the Model
– There is a profitable investment opportunity, however the firm
has not enough internal cash flows to finance it.
– The firm’s debt capacity has been reached.
– Managers know the true value of a company’s existing assets
and investment opportunities and the capital market does not.
• Basic Results
– The capital market can undervalue the company’s shares.
– If managers maximize the wealth of their existing (old)
shareholders, then they might forgo a profitable investment
opportunity.
15
How the Model Works
• There are two possible states of the world with an equal
probability of occurring. The firm’s managers are
contemplating an investment of 100 with the net returns
in both states given below:
State 1 State 2
P=1/2
P=1/2
Net Returns on Investment
20
10
Value of Assets in place
(Value of Firm with I = 0)
150
50
Value of Assets in place
(Value of Firm with I = 100)
270
160
16
• At this time, the market is uncertain as to whether state 1 or
state 2 will occur.
• The value of the shares of the existing shareholders at this
time should the managers undertake the investment is
P’ = 0.5 ( 150 + 20 ) + 0.5 ( 50 + 10 ) = 115
• The value of the shares of the new shareholders, E = 100.
• Thus, the old shareholder’s shares will be worth P’ / (P’ + E)
fraction of the value the firm is eventually worth once the
market learns the true state of the world is.
• The new shareholder’s shares will be worth E / (P’ + E)
fraction of the value the firm is eventually worth once the
market learns the true state of the world is.
• In state 1:
VOLD1 = (115 / (115 + 100) ) * 270 = 144.41
VNEW1 = (100 / (115 + 100) ) * 270 = 125.58
• In state 2:
VOLD2 = (115 / (115 + 100) ) * 160 = 85.58
VNEW2 = (100 / (115 + 100) ) * 160 = 74.41
17
• If managers know that State 1 will occur, they
will not issue any shares and they will not be
able to undertake the investment. To see this
compare the value of the shares of the existing
shareholders with and without investment
(144.41 < 150 ).
• If the firm had a 100 in cash flow, it could finance
the investment without harming the existing
shareholders.
• This result has been used as a justification to
include CF as an explanatory variable in
investment equations.
18
(3) Managerial Discretion
• Marris’ growth model:
– managers wish to expand the growth rate of their
company beyond the level which maximizes shareholder
wealth,
– while maintaining the company’s share price at a
sufficiently high level to avoid a takeover by outsiders who
will dismiss the managers.
• The managers’ utility function can thus be written as
a function of the growth rate of the firm, g, and the
probability of its being taken over, p
U = U(g, p), with ∂U/∂g > 0, and ∂U/∂p < 0
– The probability of takeover increases as the share price
falls.
19
• The market value of the firm’s equity is the present
discounted value of its dividend payments
– Et: the market value of outstanding equity,
– PSt: the price of a common share
– NSt: the number of shares outstanding,
– Divt+j: the dividends payment in year t+j,
– i : the firm’s cost of capital.
• Thus, share price rises ceteris paribus with dividends.
• If we assume that all cash flows go either to dividends or
investment, Ft ≡ It+Divt, then the firm’s share price falls as
investment increases, and the probability of takeover rises as
investment increases, p = p(I), p‘(I) > 0.
20
• A growth-seeking management invests more than the amount that
maximizes shareholder wealth, and thus for it the marginal impact of
investment on share price is negative.
• The marginal impact of investment on growth is positive, g‘(I) > 0. A
growth-oriented management’s utility-maximizing level of investment
thus satisfies the following condition
21
22
7.4 The Neoclassical Theory of Investment
23
24
7.5 Expectations Theories of Investment
• The accelerator and neoclassical theories both make
today’s investment a function of today’s output. A firm
invests not to produce today’s output, however, but
tomorrow’s.
• Yehuda Grunfeld (1960) proposed that investment should
depend on a variable that captures expected future growth
in the demand for capital.
• He proposed the firm’s current market value, a variable
that varies across firms both because of scale differences,
and because of differences in market expectations
regarding future growth rates.
• Thus the Grunfeld model might be written as one in which
KD = bM
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26
27
• The q-theory of investment incorporates the basic
assumptions and conditions of the neoclassical model.
– Under these assumptions, differences in q across firms reflect
differences in desired capital stocks relative to actual capital
stocks and thus should explain differences in investment, without
actually having to measure the costs of capital of individual firms.
• Both the q-theory of investment and the neoclassical
theory make rather strong assumptions about the
functioning of the capital market, and its effects on
investment decisions.
• These assumptions can be justified by appeal to modern
finance theory.
• Given the importance of this theory to the investment
decision, we shall take a brief detour in the following two
sections to examine some of the basic propositions of
this theory.
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7.6 The Neoclassical Cost of Capital and the
Modigliani and Miller Theorems
1) The Irrelevance of Debt and Dividends
• If managers maximize the wealth of their shareholders,
then they should invest only in positive NPV projects,
i.e., those that offer a return (r) greater than the cost of
capital (i), or r/i>1.
• Franco Modigliani and Merton Miller (1958, 1961)
showed that this opportunity cost (i) is the appropriate
measure of the firm’s cost of capital, regardless of
whether the firm uses internal funds, or new debt, or new
equity to finance investment.
• We assume that companies with similar risks can be
grouped into risk classes.
29
• Definitions:
–
–
–
–
j = risk class
Π = earnings per share
P = price of common share
The cost of capital, ij, of a firm in the jth risk class is
ij 
j
Pj
• Theorem 1.
The cost of capital, ij, is independent of the firm’s capital
structure.
• Proof:
–
–
–
–
–
–
Ej: the value of the common stock of company j
Pj: share price
Nj: number of shares outstanding
Dj: total debt
r: the risk-free rate of return
V=E+D
30
•
We wish to show that
1. V = Total Profits / cost of capital, and
2. V is independent of the proportions of E and D.
•
Let U and L be two firms in the same risk
class with the same level of total profits :
U   L  
Note that
V U  EU ,
and
V L  E L  DL
31
• Consider an investor wishes to earn a
gross return of   
• There are two possible routes s/he can
take to achieve it.
32
Action
Investment
Earnings
1. Buy α % of U
α EU = α VU
αΠ
2. Buy α % of L
α EL = α VL =
α (VL - DL)
α Π – α r DL
Buy α DL
α DL
α r DL
Combined effect of
action 2
α VL
αΠ
33
• If VL <VU, action 2 is cheaper, all investors
will choose it, PL will increase, PU will
decrease until VL = VU .
• If VL > VU, action 1 is cheaper, all
investors will choose it, PL will decrease,
PU will increase until VL = VU .
34
Theorem 2
35
•
•
•
•
7.8 Empirical Investigations of the Determinants of
Investment
Most empirical studies of investment estimate a single
model or hypothesis about the determinants of investment,
and usually conclude that the data are consistent with the
hypothesized relationship.
All of the models of investment discussed in this chapter
have found empirical support in the literature.
Much more rare are empirical studies that compare two or
more hypotheses about the determinants of investment.
One of the first, and most ambitious of these, was by
Jorgenson and Siebert (1968).
They sought to compare the performance of the
accelerator, cash flow, expectations and neoclassical
models of investment. They did so by estimating equations
that differed only in the definition of the desired capital
stock, and the lag structure allowed. The assumptions
made with respect to the desired capital stock were as
follows:
36
Results:
Neoclassical > Accelerator ≈ Expectations > CashFlow
37
• Jorgenson and Siebert drew their conclusions from time-series
estimates of investment equations for 15 large U.S. companies.
• J. Walter Elliott (1973) reestimated the four Jorgenson/Siebert
models both cross-sectionally and with time series, and expanded
the sample to 184 companies.
• Elliott’s rankings of the models were
38
• Grabowski and Mueller (1972) compared the performance
of a neoclassical model against that of a cash flow model
motivated by the managerial discretion growth hypothesis
(hereafter MDH).
• They specified equations for capital investment, R&D and
dividends, and were the first to emphasize the importance
of the dividends equation in testing the MDH against the
neoclassical model.
• G&M concluded that the MDH outperformed the
neoclassical model based on
– its overall fit to the data,
– the particularly good fit of the dividends equation in the MDH, and
– the strong performance of cash flow in both the investment and
R&D equations of the MDH in comparison with the weak
performance of both measures of the neoclassical cost of capital
employed.
39
• Owen Lamont (1997)
– petroleum companies
– a significant decrease in investment in nonpetroleum activities following a sudden drop in
their cash flows in 1986.
– It appeares that the petroleum firms regard
investment in non-petroleum operations as a
discretionary investment which they only
undertook when their cash flows were high.
40
• Fazzari, Hubbard, and Peterson (1988)
– first paper that tests the AIH
– a sample of 422 US corporations was divided
into low, medium and high retention ratio
subsamples,
– cash- flow / investment equations that also
include Tobin’s q to capture differences in
investment opportunities.
– They estimate positive coefficients on cash
flow for all three subsamples that increased in
size as the level of retentions rose, and
interprete this finding as supportive of the AIH.
41
• Devereux and Schiantarelli (1990)
– tried to identify both financial constraints and
information asymmetries in their study of 720
UK corporations by dividing their sample by
size, growth, and age.
– Some support for the AIH was found. For
example, cash flow had a (slightly) higher
coefficient in the small, young firm subsample
than in the small, old firm subsample, as one
expects if the market learns to evaluate firm
investment opportunities with time
42
• Hoshi, Kashyap and Scharfstein (1991)
– They divided their sample of 146 Japanese corporations
into independent and group firms, with the former having
dispersed outside ownership, and the latter being parts of
groups of companies with much cross-holding of one
another’s shares.
– Hoshi et al. hypothesize that group firms are not subject
to asymmetric information problems when financing their
investments, because of the access to information other
members have.
– Consistent with this hypothesis, they find that cash flow
has a positive and significant coefficient only in the
investment equation for the independent companies.
• Similar evidence has been provided for small firms
in the United States (Petersen and Rajan, 1994),
and for Italy (Schiantarelli and Sembenelli, 2000).
43
Rates of Return to Corporate Investment
44
45
46
47
Because it takes some time before invested funds begin to produce
profits, the regression equation must be properly lagged.
To adjust for this, BHMQ experiment with a number of different lag
structures consisting of 2, 3, 4, 5 and 7 years.
BHMQ then break investment down into the three sources of finance:
cash flow (P), new debt (D), and new equity (N) and consider these
components as separate independent variables.
Their coefficients are interpreted as the returns on the three sources of
capital.
Results:
Return (%)
Cash Flow
New Debt
New Equity
3.0 % - 4.6 %
4.2 % - 14%
14.5 - 20.8
48
• Two important implications:
(1) reconfirmation of the widely accepted pecking
order hypothesis.
(2) Since corporate investment has historically
been financed largely through retained earnings,
the extremely low return to this source of finance
raises the possibility that marginal returns to
investment may have been below the cost of
capital during this period.
49
• Fisher and Lorrie's (1964) estimates of
returns on the market portfolio of common
shares in 1950's range from 13 to 18 %
50
51
52
53
• SDFA come up with fairly low estimates of
returns and also show a downward trend
over the 1975-1984 period.
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