Stein Chapter 2- Agency, Information and Corporate investment

1. Introduction

Fundamental question: to what extent does capital get allocated to the right investment
projects?

Distortionary forces that prevent equated marginal product of capital:

 Taxes
 Transactions costs
 Factors arising from informational asymmetries
 Factors arising from agency problems

Sub questions:
 Does the external capital market channel the right amount of money to each firm 
does the market get across-firm allocations right, so that the marginal return to
investment in firm I is the same as in firm j?
 Do internal capital markets channel the right amount of money to individual projects
within firms?  does the internal capital budgeting process get within-firm
allocations right, so that the marginal return to investment in firm i’s division A is the
same as in B?

Part A Investment at the firm level

2. Theoretical building blocks: investment at the firm level

2.1 Models of costly external finance

Models predicting underinvestment relative to a first-best benchmark.

Cost of equity finance

 Raising equity will generally be problematic due to adverse selection  managers
favor their current stockholders at the expense of future investors
 Equity issues are generally seen as bad news, which in turn can make managers of
good firms reluctant to sell equity in the first place
 Bottom line: even firms that are badly in need of new equity may be unable or
unwilling to raise it.
Cost of debt finance (More ex ante)
 Adverse selection, moral hazard and credit rationing in the debt market
o Due to adverse selection debt involved has some default risk, which means at
any given interest rate, managers will be more likely to borrow if their private
info suggests that they are relatively prone to default.
o Moral hazard  managers who borrow have an increased incentive to take
the sort of risks that lead to default
o Credit rationing  firms are simply unable to obtain all the debt financing
they would like at the prevailing market interest rate.
  Debt overhang (Ex post)
o In particular, large debt burden on a firm’s balance sheet discourages further
new investment, particularly if this new investment is financed by issuing
claims that are junior to the existing debt
o Part of any increase in value goes to the existing lenders, and therefore will
not be used to pay back the new investors.
o Debt overhang models have two empirical implications:
 Ex post  suggests that highly leveraged firms (=firms with high debt)
will be most prone to underinvestment
 Ex ante  offers the reason why even more modestly-leveraged firms
may be reluctant to raise much debt in the first place, even if this
means foregoing some current investment projects.
 Optimal contracting models of debt: underinvestment in entrepreneurial firms
o Optimal Contract
 This part describes how firms develop internal financial contracts to
tackle various agency problems. The optimal contract that emerges
resembles a standard debt contract without outside equity financing.
 These firms should be seen as entrepreneurial in the sense that their
only stockholders are their managers.
 One example posits that an outside investor can verify a firm’s
cashflow by paying for an audit. As long as the manager pays the debt
payments there won’t be any audit, but if a payment is missed the
investor will hire an auditor and claim the remaining debt. In this
situation, less managerial wealth means bigger loans and a greater
chance of audits.
o Allocation of control rights
 Debt is seen as an incentive scheme that rewards management with
continued control if it makes the required debt payments, but
punished it with loss of control otherwise.  this enables outside
investors to receive payments even if cashflows appear to be
unverifiable.
Synthesis: a reduced-form model of costly external finance

2.2 The agency conflict between managers and outside stockholders

In previous situations the assumption was made that managers act in the interest of the
stockholders. However, this part emphasizes the situation where managers of publicly-
traded firms pursue their own private objectives, which need not clash with those of outside
stockholders.
o Empire building
o Empire building and overinvestment;
 Empire building suggests that managers will spend the available funds
on investment projects to be able to keep running a large firm.
 Basic predictions state that investment increases in internal resources
and that leverage will decrease investment
 Further developed ideas incorporate empire building preferences by
using the modeling device of managerial private benefits of control
 and assuming these are proportionate to either the investment of the
firm or the gross output.
 Insight  no matter how strong the underlying agency
problem, it cannot automatically be concluded that empire
building leads to overinvestment.  internally determined
level of debt remains in balance by ex post over-and
underinvestment.
o Empire preservation, entrenchment and diversification
 This part argues that if managers derive private benefits from being in
charge of large empires, this not only results in overinvestment, but
also leads to specific preference for diversification, where their
specific human capital is used and the risk of going out of business is
minimized.
o Reputational and career concerns; Concerns that actions affect reputations and
ultimately perceived value in the labor market.
o Short terminism (myopic behaviour);
 managers have incentives to boost measures of short-term
performance, e.g. boost reported earnings by underinvesting in hard
to measure assets (maintenance, customer loyalty, employee
training).  underinvestment is rewarded with an increase in either
stock price or personal reputation.
 Concern with near-term stock prices or reputation can lead to
investment distortions.
 Will probably lead to overinvestment rather than
underinvestment, considering the desire to impress the stock
market or labor market. Information asymmetry exists due to
managers’ ability to recognize good investment opportunities.
 Implications
 Investment distortions greatest when pressure to impress the
market is most
 Underinvestment is most acute when firms either face
takeover pressure or preparing to issue new equity.
 Young venture capital firms (must still boost reputation) more
likely than old venture firms to take distortionary actions to
boost near-term performance.
o Herding;
 Herding depicts blindly copying the decision of previous managers’
decisions.
 Incentive exists for managers to mimic each other, to boost
reputation. This would be more among young managers than older.
o Other distortions induced by career concerns
 Career concerns can cause managers to choose not to invest or
choose for safe investments to prevent their information from being
revealed, risking reputational damage or variance to their market
value.
o The quiet life
 Managers prefer the quiet life and are prone to make very slow
decisions (excessive inertia)
 Can lead to overinvestment if the decision is whether to shut down an
existing, poorly performing plant
 Can lead to underinvestment if the decision concerns entering a new
line of business.
o Overconfidence
o Can cause overinvestment by overpayment by acquiring firms in takeovers
o When managers make overly optimistic assessments of their firms’
prospects, they will be reluctant to issue new equity, as the stock price will
often seem unfairly low to them.  little external equity financing, and
investment increases with internal resources
o Overconfidence is taken seriously because it cannot just be resolved e.g. by
giving managers higher-powered incentive contracts. In contrast, they think
they are operating on behalf of shareholders, not knowing their decisions
may destroy value.

2.3 Investment decisions when stock prices deviate from fundamentals