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CFE-3: Dynamic Models in Corporate Finance
Firm Selection and Corporate Cash Holdings
1Boston University; 2Harvard University
The gradual replacement of traditional U.S. public companies by more R&D-intensive firms is key to understanding the secular trend in average cash-holdings. Over the last 35 years, an increasing share of R&D - intensive firms has entered the stock market with progressively higher cash-balances. This positive entry-effect dominates the negative within-firm effect post IPO. We build a firm industry model with endogenous entry to quantify the importance of two competing selection mechanisms: an increasing share of R&D-intensive firms in the overall economy and more favorable IPO conditions. Only the combination of both mechanisms successfully generates a sizable secular increase.
Dynamic Financial Constraints: Which Frictions Matter for Corporate Policies?
1University of Lausanne, Swiss Finance Institute; 2University of Lausanne; 3Duke University
We build, solve, and estimate a range of dynamic models of corporate investment and financing. We focus on limited enforcement, moral hazard, and tradeoff models. All models share a common technology structure, but differ in the friction generating financial constraints. Using panel data on Compustat firms for the period 1980-2015 and a more recent dataset on private firms from Orbis, we determine which features of the observed data allow to distinguish among the models, and we assess which model performs best at rationalizing observed corporate investment and financing policies across various samples. Our tests, based on empirical policy function benchmarks, favor limited commitment models for larger compustat firms, and moral hazard models for private firms.
Misvaluation of Investment Options
1Boston University; 2University of Alberta; 3Penn State University
We study whether investment options are correctly priced. We build and estimate a real options model of optimal investment in the presence of demand uncertainty. We then classify stocks into undervalued and overvalued based on the difference between observed and model-implied firm values. A long-short strategy that buys undervalued and shorts overvalued stocks generates annualized alphas between 10% and 17%. This relation is only present in subsamples of firms with high fractions of investment options. We interpret these findings as evidence of mispricing of investment options. We propose that the investment community should reevaluate the methods used to value growth firms.
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Conference: EFA 2017
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