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Corporate investments and finance.

This special issue of Financial Management is concerned with the manner in which projects are chosen, organized and financed by firms. The three other papers in this special issue deal with a variety of different aspects of this capital allocation process. The purpose of this paper is to provide an introduction to this special issue, sketch a framework for thinking about capital allocation decisions in an informationally constrained environment, and place a subset of the contemporary literature -- including the papers in this special issue -- in the context of this framework.(1)

The "textbook" approach to the corporate capital allocation decision is strikingly simple: invest in all projects with positive, risk-adjusted net present values (NPVs). It is irrelevant whether this decision is made in a centralized or decentralized capital budgeting environment. It does not matter whether the project is included as part of the firm's portfolio of assets or organized outside the firm, i.e., incorporated as a subsidiary with a legal delineation from the firm's existing assets. The details of how the project is financed -- debt, external equity, retained earnings, or whatever -- are of no consequence either. This approach is so alluringly simple and so blessed with apparently irrefutable logic that, over the last few decades, it has become the centerpiece of basic corporate finance pedagogy.

An intrusion into this idyllic setting, however, is the real world! Firms do not always invest in every positive NPV project available; sometimes they ration capital.(2) Firms pay a great deal of attention to how capital budgeting decisions are made and the extent to which these decisions are centralized. Occasionally, projects are organized outside the firm. And the manner in which a project is financed is of great consequence.

In recognition of these discrepancies between traditional theory and practice, there has emerged a literature that has sought to explain capital budgeting practice based on rational economic behavior. This literature has addressed a wide-ranging set of topics. In Exhibit 1, I have indicated what these topics are and how they are connected. I also indicate where the rest of the papers in this special issue of Financial Management fit in. Collectively, the research done on these topics teaches us that informational asymmetries of various sorts create three fundamental types of distortions. First, they drive a wedge between the interests of different financial claimants. Consequently, shareholders' incentives diverge from those of bondholders, and the mix of financing chosen for the project becomes a relevant decision variable for the firm. Moreover, the optimal financing mix will usually depend on project attributes, i.e., its riskiness, the timing of its future cash flows, etc. Second, informational asymmetries can also drive a wedge between the interests of current shareholders and future shareholders. If the firm's interest is in maximizing the wealth of current shareholders, it may make project choices that are quite different from those that maximize the firm's total value in a symmetric information setting. Third, informational asymmetries can create a divergence in the interests of shareholders and managers. This can profoundly affect the capital budgeting decision, both in terms of the initial project choice and the subsequent decisions of whether to continue with the project or to divest/terminate it.

The principal conclusions that emerge from this body of research can be divided into those that pertain to value-dissipating managerial behavior and those that pertain to behavior that seems value-dissipating or irrational but is in fact value-enhancing. Given below are value-dissipating managerial actions.

* Managers may display "herd behavior" in their project choices. That is, managers within, say, a given industry may all choose to make similar choices. This need not be optimal for shareholders.

* Managers may either be too "short-term" oriented (myopic) in their project choices or choose projects that are too "long-term" oriented, relative to what is optimal for shareholders. Myopia or "short-termism" here can refer to either advancing cash flows or advancing the resolution of uncertainty about project performance.

* The divergence of interests between shareholders and the manager can affect the conflict of interests between shareholders and bondholders, and hence influence both the firm's project choice and its debt policy. Managers will sometimes display excessive "conservatism" in their project choices, opting for safer projects than would be optimal for shareholders.

* Managers will sometimes delay divesting projects that are losing money for the shareholders. This may encourage hostile takeovers.

Actions by managers that may seem to be value-dissipating, but are value-enhancing, are listed below.

* Firms will sometimes ration positive NPV projects in the best interests of existing shareholders.

* Firms will sometimes find it optimal to (at least partially) centralize their capital budgeting. Such behavior may be in the best interests of existing shareholders.

* The firm's choice of capital structure, as well as its choice of how to incorporate/organize the project, will be driven by the desire to minimize the capital allocation distortions created by informational asymmetries. Innovative financing and organization modes can be expected to emerge in response to informational impediments.

* Incentive schemes for managers will also be designed to minimize capital allocation distortions.

The above list is more illustrative than exhaustive. The main point of this literature is that the probability distribution of cash flows associated with a given capital allocation decision is partly endogenous in that it is affected by a variety of factors -- the project choice, the decision of what resources to allocate in managing the project, the financing mix, the mode of organization/incorporation for the project, the managerial compensation scheme, etc. -- that are (at least partially) controllable. If one thinks in the context of an asset's value being defined as V = C/k, where C is the asset's cash flow and k is the appropriate discount rate, then we can view the literature relevant to this paper as being concerned with C. It should not come as a surprise to anyone that a much greater portion of the finance literature has been concerned with k.(3)

The rest of the paper is organized as follows. In Section I, I discuss the different types of informational asymmetries that impinge on the capital allocation process. In Section II, I discuss the distortions that arise from these informational asymmetries and their implications. I focus on distortions in the project choice and project continuation decisions. Section III takes up the issue of how firms attempt to reduce these distortions through their financing, capital budgeting organization, project organization, and managerial compensation design decisions. Section IV concludes.

I. Informational Asymmetries

We say that information is asymmetric when the transacting parties are not equally informed either at the outset or ex post (for recent expositions, see Thakor |18~ and Thakor |20~). For example, an individual seeking insurance typically knows more than the insurance company about his/her own health and habits that could affect that health. This is a situation of pre-contract private information, i.e., in which the two parties are asymmetrically informed at the outset. We say that the individual seeking insurance is privately informed and has ex ante superior information. Another example is that of an entrepreneur who observes the cash flow from his firm's operations but can divert part of it for personal use before the bank observes that cash flow. This is a situation of post-contract private information, and we say that the entrepreneur has ex post superior information.

In the capital budgeting context, we are concerned with three main types of informational asymmetries between three distinct pairs of stakeholder groups. The first pair is (current) shareholders and bondholders. As is now well known from the analysis of Jensen and Meckling |13~, when the firm has equity and risky debt outstanding, the equity can be viewed as a call option on the firm's total assets. Consequently, shareholders have an incentive to increase the firm's operating risk to the bondholders' detriment, and this often entails choosing risky projects that do not maximize the total value of the firm but maximize the value of equity. The key informational asymmetry here stems from the ex post private information of shareholders. That is, if shareholders can dictate project choices to the manager, then they can have him choose projects that are best for the shareholders, as long as bondholders cannot perfectly observe these project choices in a mutually verifiable way. If bondholders had the same information as the shareholders, and this information could be (at relatively low cost) verified by an objective third party, we could visualize bond covenants precluding project choices that could hurt the bondholders ex post. Thus, the key is that after they entrust their money to the firm (i.e., in the post-contracting stage), bondholders are at an informational disadvantage relative to the shareholders (or their agent, the manager). This post-contract private information "problem" has numerous interesting implications, as we will see shortly.

The second pair is existing shareholders and future shareholders. Existing shareholders are the current owners of the firm and therefore capable of influencing managerial decisions. Moreover, as current owners, they may have access to information that prospective owners do not. Hence, there is likely to be asymmetric information between these groups. Current shareholders are likely to be better informed -- both in a pre-contract and a post-contract sense -- than future/prospective shareholders. This simple fact can have many interesting effects on the firm's capital budgeting decision, as we shall see later.

Finally, managers have both a pre-contract and a post-contract private information advantage over shareholders. Being "close to the action," managers typically know more than shareholders about the ex ante payoff attributes of the projects they are considering, as well as the actual (ex post) performances of these projects. Since managers are merely agents of the shareholders, they can be expected to act in a manner consistent with the maximization of their own welfare, even if this is at the shareholders' expense. Shareholders will rationally anticipate this, and it leads to numerous interesting implications for project choices, project divestiture decisions and takeover activity.

In the subsequent sections, these three types of informational asymmetries play key roles in our discussions of the capital allocation process.

II. Investment Distortions

All three types of informational asymmetries discussed in the previous section lead to investment distortions. As indicated in Exhibit 1, these distortions refer to deviations from value maximization in the initial project choice as well as in the subsequent divestiture decisions. I will discuss each briefly in this section.

A. Project Choice Distortions

The nature of project choice distortions will differ based on the nature of the informational asymmetry. It is, therefore, convenient to organize this discussion around each of the three informational asymmetries.

1. Informational Asymmetries Between Shareholders and Bondholders

This is perhaps the most familiar of the three informational asymmetries. Its most well-known consequence is asset substitution moral hazard, which refers to the shareholders' propensity to have the manager substitute riskier assets for safer assets, at the bondholders' expense. Flannery, Houston, and Venkataraman |5~ show that this kind of project choice distortion -- and it is a distortion in the sense that total firm value is not necessarily maximized -- is prominent if a debt-financed firm incorporates a new project within the firm as with conventional capital budgeting. Moreover, the nature of this distortion also depends on the debt covenants negotiated ex ante and the source of debt financing (see Berlin and Mester |2~).

There is, however, another project choice distortion as well. As shown by Myers |14~, the presence of risky debt creates underinvestment moral hazard, which refers to the incentive that shareholders have to avoid investing in projects that could enhance total firm value. This incentive arises in firms that have risky debt outstanding. The reason is that the presence of risky debt means that some portion of the cash flow from a new investment will be diverted to paying interest on the existing debt. This reduces the net payoff available to the shareholders who contribute equity to the new investment. Their net payoff may be so low that they may prefer not to invest, even though their equity input could result in total firm value being maximized. The key again is that, with risky debt, there is a difference between maximizing total firm value and maximizing shareholder wealth. Flannery, Houston, and Venkataraman |5~ show that the firm may be forced to trade off the cost of asset substitution moral hazard against that of underinvestment moral hazard. I will revisit this issue in Section III.

2. Informational Asymmetries Between Current Shareholders and Prospective Shareholders

This kind of informational asymmetry has received less attention but is distortive nonetheless. For example, suppose that the firm must make a resource commitment to a project, and that this commitment cannot be observed by prospective (new) shareholders, who will purchase new shares issued by the firm. Then new shareholders will share in the incremental payoffs generated by this resource commitment, but they will not fully share the cost of the commitment with current shareholders since its unobservability means that it will not be fully reflected in the firm's stock price. An example would be advertising and product development undertaken prior to financing a new product launch. This has the effect of increasing the firm's cost of capital for external financing relative to that for internally generated funds.

It turns out that this wedge between the costs of external and internal funds means that the firm will have a preference for projects that pay off faster since such projects help to build up internal funds. This intuition, developed in Thakor |19~, leads to numerous capital budgeting implications for firms that seek to maximize the wealth of existing shareholders. First, firms may prefer projects with shorter payback periods, even though these projects may be valued lower than others in a symmetric information setting. Such "investment myopia" will be encountered in all firms seeking external capital, regardless of sophistication or size. Second, a greater use of the payback criterion is likely to be accompanied by more capital rationing within the firm. Projects which pay off more slowly are more likely to be rationed. Third, the implementation of capital rationing will require a centralized capital budgeting system, so that payback use and capital rationing are likely to be more prevalent in firms with centralized capital budgeting. Fourth, a firm may accumulate liquidity despite having positive NPV projects it could invest in. Consequently, firms may hold liquid assets in excess of normal operating needs. Fifth, a given project need not be valued symmetrically by technologically similar firms. The firm with the higher retained earnings will use a lower discount rate for valuing the project. Hence, two firms, identical in all respects except for their initial endowments of retained earnings, may choose different projects from a set of mutually exclusive projects. Finally, payback reliance is likely to be greater in firms that have a higher frequency of new investments to be financed through time. The reason is that such firms have a greater need for financing and are hence more concerned about the differential between the costs of external and internal financing.

Another type of informational asymmetry between current and prospective shareholders is that the former will usually know more about the probability distribution of the firm's future cash flows. That is, suppose there are two types of firms that can be rank-ordered based on "fundamental/intrinsic value" (i.e., the value of each firm in a symmetric information setting), but appear indistinguishable to the market (prospective shareholders). Then the firm with the higher fundamental value will be undervalued by the market and the firm with the lower fundamental value will be overvalued by the market. Taking this approach, I (see Thakor |21~) show that, in an informational equilibrium, the intrinsically higher-valued firm will invest myopically, choosing a lower-valued project that pays off faster over a higher-valued project that pays off in the more distant future. No such project-choice distortion is encountered with the intrinsically lower-valued firm which invests in the (socially preferred) higher-valued project. Thus, in this setting, there is "selective" investment myopia. Moreover, security issuances by firms evoke price reactions because they convey information about internally available funds. And the nature of these reactions depends on investors' prior beliefs about the firm (see also Bayless and Chaplinsky |1~).

3. Informational Asymmetries Between Managers and Shareholders

This is an informational asymmetry that has received considerable attention. My remarks on this will be brief because the Hirshleifer |8~ paper focuses almost exclusively on this case.

Managers can be better informed than shareholders about a variety of factors. Perhaps the most important of these factors are: the effort expended by the effort-averse manager in running the firm, and the manager's innate ability to run the firm. These are the two factors that much of the research has been concerned with. Jensen and Meckling |13~ highlighted the importance of managerial perquisites consumption as a manifestation of the moral hazard engendered by informational asymmetries between managers and shareholders, referring to the "cost" of this moral hazard as the agency cost of equity. There is, however, a direct correspondence between models that capture "effort aversion" moral hazard and those that capture "perks consumption" moral hazard. Thus, when I refer to effort aversion, I mean perquisites consumption as well.

Because most people are familiar with all of the consequences of managerial effort aversion/avoidance, I will confine my attention to a brief overview of the consequences of unknown innate managerial ability. It is interesting that, in many models, distortions can arise even with symmetric information, i.e., one does not even need to assume that the manager knows more about this ability than shareholders. All that is needed is that this ability be imperfectly known to shareholders and that they attempt to learn more about it by observing the firm's performance. Note also that "ability" can represent a variety of innate attributes of the manager, such as: his skill in selecting the "best" projects ("winners") for the firm, his ability to elevate cash flows of projects in place by managing more efficiently, his skill in identifying appropriate takeover targets, etc.

Once the manager recognizes that investors are drawing inferences about his possibly multifaceted ability from the firm's cash flow performance, he will attempt to strategically influence perceptions of his ability. In other words, he will attempt to develop a reputation for possessing high ability. This incentive to build a reputation results in potentially severe distortions in corporate investment policy. For example, the manager may display "herd behavior," making decisions that most other managers are making rather than acting optimally for the firm based on his own information. One reason for doing this is that if he "follows the herd," then any state in which the manager fails would be a state in which a lot of other managers failed too. Hence, shareholders are likely to attribute the manager's failure to a systematic (macroeconomic) shock that was beyond the manager's control. On the other hand, a deviation from "the norm" could make the manager look like a fool if he fails. This argument is made more precise in Hirshleifer |8~.

Managerial incentives to build personal reputation could also lead to myopic behavior in investment policy. The reason is that, in a setting in which the firm's optimal wage policy involves downward rigidity in wages,(4) the manager has an incentive to move his wage up as high as he can in the next period. When shareholders base managerial wages on the firm's cash flow, the manager is induced to select projects that produce high cash flows relatively early. Of course, he may be doing this at the expense of more distant cash flows, but he knows that once his wage moves up, it will not fall below the level it has moved up to. That is, the manager essentially has an option on his human capital, and this leads to "myopia" (from the shareholders' standpoint) in project choices.

This phenomenon is discussed at greater length by Hirshleifer |8~ who states that managerial reputation-building could also lead to "long-termism" in project choices. Hirshleifer interprets long-termism as applying either to cash flows or to the timing of project uncertainty resolution. That is, managers may select projects that are inefficient for the firm but they yield cash flows or resolve project uncertainty in such a distant future that they delay resolution of uncertainty about the manager's ability in a way that personally benefits the manager. Whether reputational incentives lead to excessively "short-term" or excessively "long-term" behavior in project selection by managers depends on the details of the informational environment and project attributes. For more on this, see Hirshleifer |8~.

The riskiness of the project chosen may also depend on the manager's pursuit of reputation. For instance, managers may seek safe projects -- even if they sacrifice firm value relative to riskier projects -- because they have a lower probability of early conspicuous failure that could damage the manager's reputation. Hirshleifer and Thakor |10~ show that this may actually be beneficial for the shareholders because it (incidently) reduces the agency cost of debt by aligning the manager's interest more with creditors. Creditors will now be less concerned about wealth expropriation by shareholders due to undetected ex post asset substitution. This will lower the cost of debt and permit greater utilization of debt tax shields. Thus, not all consequences of managerial reputation building are bad for the shareholders. It is possible, however, that the manager could seek greater safety than is optimal for the shareholders from an agency-cost-of-debt standpoint. There are many other manifestations of managerial reputation building which are discussed in Hirshleifer |8~.

B. Project Divestiture Distortions

In addition to distorting initial project choices, managerial reputation-building also affects the decision of when to divest a project. Consider a manager whose ability to select "winners" (high-NPV projects) is a priori unknown. Shareholders may learn about this ability gradually by observing the firm's realized cash flows through time. But suppose these cash flows are observed with a great deal of noise, or their observed values can be manipulated by the manager. This is realistic, since shareholders observe reported earnings from which they must infer underlying cash flows. Accounting rules permit considerable discretion in what is reported. Thus, the manager's reported earnings may bear little resemblance to realized cash flows in some periods. In such instances, the decision to divest a project -- either by liquidating it or by selling it off to another firm -- can convey a lot of information to shareholders. In particular, a divestiture is like an admission by the manager that he was wrong in choosing the project in the first place. This hurts his reputation. A manager who is concerned about his reputation is therefore likely to delay divestiture. The delay can be viewed as analogous to "rolling the dice" in the hope that the manager will get lucky and the project will be turned around in the future. If the manager is wrong and the project eventually fails, his reputation will be tarnished, but delaying this unsavory event is beneficial to the manager. Of course, shareholders are hurt by such tactics because any divestiture delay creates a potentially deeper hole, and the manager's gamble is not in the shareholders' best interest.

This line of reasoning is formally developed by Boot |3~ who also refers to empirical evidence that managers tend to hang on to "losers" too long. He then analyzes the role of takeover pressures. If a firm is hanging on to negative NPV projects, an acquiror can step in and bid a premium for the firm, knowing that much value can be realized by taking over the firm and selling off the negative NPV projects to those who can put them to better use.(5) This creates an incentive for takeover bids. Moreover, the possibility of a takeover imposes a discipline on the incumbent manager to limit divestiture delays.

III. Ways to Minimize Distortions

If shareholders are rational, they will recognize that investment distortions are unavoidable and that the costs created by these distortions are ultimately borne by the shareholders. This creates powerful incentives for shareholders to come up with innovative approaches to lessen the burden of these distortions. As shown in Exhibit 1, these approaches can be classified in four groups: organization of the capital budgeting process, organization of the project itself, financing of the project, and the design of managerial incentive schemes. In this section, I will briefly discuss each of these approaches.

A. Organization of the Capital Budgeting Process

As indicated in Section II, the manner in which capital budgeting is organized may be important even if managers' interests are aligned with those of shareholders, as long as the interests of current and prospective shareholders diverge. In this section, however, I wish to focus on capital budgeting organization from the standpoint of coping with managerial self-interest.

In an interesting paper, Holmstrom and Ricart i Costa |11~ showed that capital rationing and centralized capital budgeting may be optimal for the firm when it is faced with a risk-adverse (divisional) manager whose initial ability is unknown and being inferred through time from observed cash flow realizations.(6) Holmstrom and Ricart i Costa |11~ prove that the optimal managerial wage contract in their model is an option on the value of the manager's human capital. This is because optimal risk-sharing entails giving the manager downside protection so that the wage contract is skewed in its reward/penalty structure -- the manager gains more from observed project success than he loses from observed project failure. This causes the manager to overinvest, i.e., invest not only in positive NPV projects but even in those with (slightly) negative NPVs. Since top management recognizes this propensity of the divisional manager, it counteracts the propensity by rationing capital. And this need to ration capital means that capital budgeting must be centralized, i.e., the decision to invest is not delegated to the divisional manager.

Managerial reputation-seeking is not the only reason to centralize capital budgeting, even if we confine our attention to the consequences of managerial self-interest. One example can be seen in the framework of private benefits to the manager from investing. That is, suppose the manager gains something from investing in a project that the firm does not. One interpretation of this private gain is that it is an enhancement in the manager's human capital, and the firm gains less from this than the manager does.(7) Another interpretation is that investing in the project puts a larger asset base at the manager's disposal, and this gives him higher utility either due to the sheer joy of presiding over a larger domain or due to the possibility of a higher unobserved consumption of perquisites. In such a setting, the (divisional) manager will wish to invest in projects that may not be optimal for the firm. Top management may find out later on that a project chosen by the divisional manager was a loser from an ex ante perspective (i.e., its NPV was negative). However, by the time top management realizes this, it may be too late in the sense that substantial investment may have already been sunk, and if these sunk costs are ignored, the project is worth continuing. In anticipation of such time-consistent behavior by top management, the divisional manager may be tempted to invest in losers in the first place. Of course, top management will recognize such strategic behavior by the divisional manager. It may respond by centralizing its capital budgeting procedures and investing in informational acquisition so that it is in a position to adequately screen divisional capital requests. For a model along these lines, see Wilson |22~.

B. Organization of the Project

When a firm is faced with the option to invest in a new project, it must not only decide whether to invest in the project, but must also decide how to incorporate or organize the project. The conventional capital budgeting approach is to include the project as part of the firm. This, however, is not always efficient. There are many reasons for this. One is that creditors who provide funds for the project recognize that the credit risk they bear is related to the firm's total cash flows, rather than just the project's cash flows. That is, creditors have claims against the entire firm. This means that they need to evaluate the payoff attributes of the entire portfolio of the firm's assets. Doing this is likely to be more costly than evaluating only the payoff attributes of the project in question (see Shah and Thakor |16~). Another reason is that incorporating the project within the firm creates the possibility of cash flow commingling, i.e., the firm can divert cash flows from the project for investments in risky projects that can increase the creditors' risk exposure. Such asset substitution moral hazard will be anticipated by creditors and reflected in the initial price of credit. Thus, the firm bears a real cost in including the project as part of the firm (see Flannery, Houston, and Venkataraman |5~ and Shah and Thakor |16~).

One way to reduce these costs is for the firm to organize the project as a distinct entity, legally separated from the rest of the firm. Ownership of the project may be entirely with the sponsoring firm but the cash flows from the project are delineated so that those who provide credit for the project must be paid from these cash flows before they can be claimed by the firm. Shah and Thakor |16~ show that "project financing" -- the practice of setting up a project as a distinct entity which is wholly or partially owned by the firm -- can be rationalized on these grounds.

Flannery, Houston, and Venkataraman |5~ consider a slightly different version of this problem. They analyze the optimal corporate form for an entrepreneur who can invest in two risky projects -- one less risky than the other -- which must be financed with traded securities.(8) Debt and equity financing are the available choices, and debt offers the advantage of tax-deductible interest payments. The entrepreneur can incorporate each project separately, or can merge the two projects into a single corporate entity. In this setting, Flannery, Houston, and Venkataraman show that joint incorporation leads to a problem of asset substitution moral hazard, since the entrepreneur can shift more of the investment to the riskier project ex post than bargained for by the creditors.

Unfortunately, separate incorporation is not always desirable. Flannery, Houston, and Venkataraman show that it leads to a worse underinvestment problem. The intuition is as follows. Holding the investment in each project fixed, separate incorporation makes the debt for each project more risky because of the lost opportunity to diversify by combining two imperfectly correlated cash flows. The riskier debt directly increases the debt repayment burden of the firm since creditors recognize ex ante that they face more risk and hence adjust the price of credit accordingly. From our earlier discussion of the underinvestment problem in Section II, it is now transparent that greater project risk exacerbates underinvestment moral hazard.

In addition to this drawback, separate incorporation also suffers a tax disadvantage when compared to joint incorporation. Green and Talmor |6~ have shown that a firm's tax liability is analogous to a call option on the firm's profit. Now, a portfolio of options is more valuable to the government than an option on a portfolio. Moreover, the "tax game" is a "zero-sum game" -- in the sense that the government's gain is the taxpayer's loss and vice versa -- between the government and the taxpayer. Hence, reducing the value of the government's tax revenue option is profitable to the taxpayer. This implies that the firm can reduce its tax liability by joint incorporation. This effect also plays a role in the Flannery, Houston, and Venkataraman |5~ analysis.

Flannery, Houston, and Venkataraman consider the simultaneous determination of the firm's capital structure and its incorporation mode for the two projects by trading off the costs and benefits of separate and joint incorporation. This tradeoff includes tax considerations as well as moral hazard considerations related to asset substitution and underinvestment.

C. Financing of Project

The analyses of Shah and Thakor |16~ and Flannery, Houston, and Venkataraman |5~ have strong implications about the impact of the chosen financing mix on the distortions we have discussed. The firm's capital structure -- the mix of debt and equity -- is not only influenced by project choice distortions (as, for example, in Hirshleifer and Thakor |10~), but it also impinges on the nature of the distortions (as in Flannery, Houston, and Venkataraman |5~, Jensen and Meckling |13~, and Myers |14~).

There is, however, much to be learned by going beyond simple debt and equity considerations. Solt |17~ examines a new financing vehicle, SWORD, pioneered by some firms in the biotech industry. SWORD stands for "stock warrant off-balance-sheet research and development." It is a form of project financing designed to provide the biotech firm with the ability to float a research-and-development (R&D) outlay as a distinct project and then have the option to gain ultimate control over successfully developed products and technologies. Solt |17~ argues that a SWORD can promote innovation better than conventional capital budgeting. The reason is that conventional capital budgeting requires the firm to make an ex ante commitment to the project since the firm completely owns the project at the outset. By contrast, the "real" option embedded in a SWORD can be exercised by the firm at the end of the product development. Thus, a SWORD can be viewed as mitigating underinvestment moral hazard since it facilitates investments in R&D that would otherwise have been forgone. Moreover, Solt |17~ also shows that the structure of a SWORD is such that it helps to align the interests of existing shareholders, new (prospective) shareholders, and managers. Consequently, it provides (at least) partial attenuation of various forms of moral hazard. The empirical evidence presented in Solt |17~ suggests that SWORDs are favorably greeted by the stock market. The conclusion is that SWORD financing is likely to be an attractive option whenever product development is technical and risky, and (ultimate) control over manufacturing and marketing rights is important to the firm.

D. Managerial Incentive Schemes

Dybvig and Zender |4~ have pointed out that many of the project-choice and related distortions can be eliminated through appropriately designed managerial incentive contracts (see also Hirshleifer and Suh |9~ and Noe and Rebello |15~). This is true. For example, if shareholders find it desirable to eliminate the manager's preference for short-term projects, they can design the managerial incentive contract to have optionlike features so that the manager's compensation is driven more by the firm's long-term performance than by its short-term cash flows. Hagerty, Ofer, and Siegel |7~ show that the optimal contract to induce far-sighted behavior indeed has such features. Their empirical evidence indicates that firms with more growth opportunities tend to use more option-based compensation schemes for their managers.

However, one should not get too carried away with the idea that incentive contracts can eliminate project-choice distortions. Hirshleifer |8~ discusses a variety of reasons why incentive contracts may have limited usefulness in this regard. In addition to those reasons, there are other contributing factors as well. A long-term contract is effective only to the extent that the manager believes it will bind the firm to compensate the manager according to the terms specified in the contract. However, bankruptcy or liquidation can invalidate even explicit long-term contracts (see Jaggia and Thakor |12~), and takeovers can invalidate implicit contracts. Furthermore, a long-term contract can be quite costly to the firm because of an adverse selection problem -- managers who turn out to be stars will either renegotiate their contracts with the firm or quit for better opportunities elsewhere. Thus, the only managers who stay with their long-term contracts may be the under-performers.(9)

V. Conclusion

I have provided a brief overview of the salient issues in capital budgeting under informational constraints. In a world in which information is not costlessly and symmetrically available to all economic agents, corporate project choices do not abide by the golden rule that all positive NPV projects should be accepted. In a sense, this is somewhat unsettling because it is difficult to prescribe simple rules for managers, and there has been little normative research into optimal capital allocation policies in different types of informationally constrained environments. However, the contemporary research highlights the pitfalls of policy-oriented discussions about corporate investment behavior and managerial compensation packages that rely on the prescriptions of the traditional, symmetric-information paradigm of capital budgeting and financing. The research done to date indicates that many interesting things can happen under asymmetric information, none of which may be irrational, but some of which could be deleterious to the shareholders' welfare. To cope with these distortions, shareholders employ a variety of approaches, including innovative financing schemes, project organization experiments, different modes of organizing the capital budgeting process, and so on. For details of these and other noteworthy capital allocation consequences of informational impediments, I invite you to read the remaining papers in this special issue.

1 Without implicating them for any infelicities, I wish to thank David Hirshleifer, Patty Wilson and Jimmy Wales for comments.

2 See Thakor |18~ for references to the relevant empirical evidence.

3 This is the extensive literature on asset pricing.

4 By downward rigidity in wages, I mean that the current wage forms a lower bound for next period's wage.

5 Boot's |3~ theory therefore explains why so much of corporate restructuring involves breakups of firms.

6 Let us abstract for now from the ex post observability problems considered by Boot |3~.

7 This could be because of the possibility that the manager will switch firms in the future.

8 Other than the two projects, the entrepreneur has no other assets.

9 Or perhaps the meek.


1. M. Bayless and S. Chaplinsky, "Expectations of Security Type and the Informational Content of Debt and Equity Offers," Journal of Financial Intermediation (June 1991), pp. 195-214.

2. M. Berlin and L.J. Mester, "Debt Covenants and Renegotiation," Journal of Financial Intermediation (June 1992), pp. 95-133.

3. A.W.A. Boot, "Why Hang on to Losers: Divestitures and Takeovers," Journal of Finance (September 1992), pp. 1401-1423.

4. P.H. Dybvig and J.F. Zender, "Capital Structure and Dividend Irrelevance with Asymmetric Information," Review of Financial Studies (Vol. 4, No. 1, 1991), pp. 201-220.

5. M.J. Flannery, J.F. Houston, and S. Venkataraman, "Financing Multiple Investment Projects," Financial Management (Summer 1993), pp. 161-172.

6. R.C. Green and E. Talmor, "The Structure and Incentive Effects of Corporate Tax Liabilities," Journal of Finance (September 1985), pp. 1095-1114.

7. K. Hagerty, A. Ofer, and D. Siegel, "Managerial Compensation and Incentives to Engage in Far-Sighted Behavior," Working Paper, Northwestern University, March 1993.

8. D. Hirshleifer, "Managerial Reputation and Corporate Investment Decisions," Financial Management (Summer 1993), pp. 145-160.

9. D. Hirshleifer and Y. Suh, "Risk, Managerial Effort, and Project Choice," Journal of Financial Intermediation (September 1992), pp. 308-345.

10. D. Hirshleifer and A.V. Thakor, "Managerial Conservatism, Project Choice and Debt," Review of Financial Studies (Vol. 5, No. 3, 1993), pp. 437-470.

11. B. Holmstrom and J. Ricart i Costa, "Managerial Incentives and Capital Management," Quarterly Journal of Economics (November 1986), pp. 835-860.

12. P. Jaggia and A.V. Thakor, "Firm Specific Human Capital and Optimal Capital Structure," International Economic Review, forthcoming.

13. M.C. Jensen and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," Journal of Financial Economics (October 1976), pp. 305-360.

14. S.C. Myers, "Determinants of Corporate Borrowing," Journal of Financial Economics (November 1977), pp. 147-175.

15. T.H. Noe and M.J. Rebello, "Adverse Selection, Contract Design and Investment Distortions," Journal of Financial Intermediation, forthcoming.

16. S. Shah and A.V. Thakor, "Optimal Capital Structure and Project Financing," Journal of Economic Theory (August 1987), pp. 209-243.

17. M.E. Solt, "SWORD Financing of Innovation in the Biotechnology Industry," Financial Management (Summer 1993), pp. 173-187.

18. A.V. Thakor, "Strategic Issues in Financial Contracting: An Overview," Financial Management (Summer 1989), pp. 34-58.

19. A.V. Thakor, "Investment 'Myopia' and the Internal Organization of Capital Allocation Decisions," Journal of Law, Economics and Organization (Spring 1990), pp. 129-154.

20. A.V. Thakor, "Game Theory in Finance," Financial Management (Spring 1991), pp. 71-94.

21. A.V. Thakor, "Information, Investment Horizon and Price Reactions," Journal of Financial and Quantitative Analysis, forthcoming.

22. P. Wilson, "Public Ownership, Delegated Project Selection and Corporate Financial Policy," Working Paper, Indiana University, March 1992.

Anjan V. Thakor is INB National Bank Professor of Finance at the School of Business, Indiana University, Bloomington, Indiana.
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Title Annotation:Corporate Investments Special Issue
Author:Thakor, Anjan V.
Publication:Financial Management
Date:Jun 22, 1993
Previous Article:Behavioral aspects of the design and marketing of financial products.
Next Article:Managerial reputation and corporate investment decisions.

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