Corporate Finance

April 13, 2012
Yael Hochberg, Northwestern University's Kellogg School of Management, and Alexander Ljungqvist, NYU's Stern School of Business, Organizers

John Hund, Rice University; Donald R. Monk, Rutgers University; and Sheri T. Tice, Tulane University

Apples to Apples: The Economic Benefits to Diversification

Valuation differences between focused and diversified firms are misleading because they compare relatively small, young, and more volatile focused firms with larger, older, and less volatile diversified firms. The largest diversified firms are also the most valuable and as a consequence the value-weighted diversification "discount" is actually a premium. Hund, Monk, and Tice highlight this issue by showing that diversified firms have a value-weighted average economy-wide gain of $885 billion annually relative to imputed firm values based on focused firms. Diversified firms also comprise 75 percent on average of the market value of the S&P 500, so among large firms, they are considered more valuable. The authors also test whether the diversification "discount" is an artifact of comparing focused and diversified firms which differ substantially on dimensions related to the uncertainty of their growth rates. After accounting for firm differences using both propensity score methods and coarsened exact matching, they show that diversified firms trade at a premium compared to similar focused firms. Their findings reveal higher values for diversified firms relative to comparable focused firms---a result that is inconsistent with prior theoretical research concluding that diversification destroys value.

Geoffrey Tate and Liu Yang, University of California at Los Angeles

The Bright Side of Corporate Diversification: Evidence from Internal Labor Markets

Tate and Yang estimate the labor market consequences of corporate diversification using worker-firm matched data from the U.S. Census Bureau. They find that workers in diversified firms have greater cross-industry mobility. Displaced workers experience significantly smaller losses when they move to a firm in a new industry in which their former firm also operates. They also find more active internal labor markets in diversified firms. Diversified firms exploit the option to redeploy workers internally from declining to expanding industries. Although diversified firms pay higher wages to retain workers, their labor is also more productive than focused firms of the same size, age, and industry. Overall, internal labor markets provide a bright side to corporate diversification.

Zhiguo He, University of Chicago, and Gregor Matvos, University of Chicago and NBER

Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal? (NBER Working Paper No. 17920)

He and Matvos illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. The firms differ on two dimensions: exogenous productivity and the endogenously chosen amount of debt financing, which results in a two-dimensional war of attrition. Debt financing increases incentives to exit; while socially beneficial, this is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in this model and the costs of subsidizing corporate debt taken from the existing literature. The theory here also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax benefits.

Dirk Hackbarth, University of Illinois at Urbana-Champaign; Richmond D. Mathews, University of Maryland; and David T. Robinson, Duke University and NBER

Capital Structure, Product Market Dynamics, and the Boundaries of the Firm

Hackbarth, Mathews, and Robinson study how interactions between financing and investment decisions can shape firm boundaries in dynamic product markets. In particular, they model a new product market opportunity as a growth option and ask whether it is best exploited by a large incumbent firm (Integration) or by a separate, specialized firm (Non-Integration). Starting from a standard theoretical framework, in which value-maximizing corporate investment and financing decisions are jointly determined, they show that Integration best protects assets' in-place value, while Non-Integration best protects the value of the growth option and maximizes financial flexibility. These forces drive different organizational equilibriums depending on firm and product market characteristics. In particular, the authirs show that increases in standard measures of cash flow risk predict exploitation of new opportunities by specialized firms, while increases in product market risk (that is, the risk of preemption by competitors) predict exploitation by incumbents. They also show that alliances organized as licensing agreements or revenue sharing contracts sometimes better balance the different sources of value, and thus may dominate more traditional forms of organization. These key results arise from the dynamic interaction of the new opportunity's option-like features with realistic competitive forces.

Casey Dougal, University of North Carolina; Christopher A. Parsons, University of California at San Diego; and Sheridan Titman, University of Texas, Austin and NBER

Urban Vibrancy and Corporate Growth

Dougal, Parsons, and Titman demonstrate that positive local spillovers strongly influence corporate investment decisions. A firm's investment is highly sensitive to the investments of other firms headquartered nearby, even those in very different industries. Moreover, a firm's investment is related to the q and cash flows of nearby firms outside its industry, even when controlling for its own q and cash flows. Similar correlations exist for capital raising, both debt and equity. These time-varying regional effects are large, averaging over half the size of the typical time-varying industry effect, and indicate that local agglomeration economies are important determinants of firm investment and growth.

Moqi Xu, London School of Economics

The Costs and Benefits of Long-term CEO Contracts

Xu uses a new dataset of 3,717 U.S. CEO employment contracts to study the time horizon of executives. Longer contracts offer protection against dismissals: turnover probability increases by 20 percent each year that passes towards contract expiration. In theory, this should encourage CEOs to pursue long-term projects. Using an instrumental variable approach based on inter-state judicial differences, Xu shows that contract horizon indeed affects investment positively. However, because longer contracts make it harder to dismiss managers, they also impose less discipline. Consistent with this argument, CEOs under shorter contracts perform better in acquisitions, and CEOs with a longer contractual horizon receive more salary increases and perquisites. Overall, firm value does not differ across contract types.

Erik P. Gilje and Jerome P. Taillard, Boston College

Do Public Firms Invest Differently than Private Firms? Taking Cues from the Natural Gas Industry

Gilje and Taillard exploit a unique dataset of onshore North American natural gas producers to study how private and public firms differ in their investment behavior. The authors use two distinct empirical strategies. First, in firm-level regressions, they find that investments by private firms respond less to changes in natural gas prices, an exogenous measure that captures marginal q in this industry. Second, they use county-specific shale gas discoveries as a natural experiment and find that private firms react significantly less to a positive investment opportunity shock. These results are not driven by heterogeneity in firm size, product markets, pricing, location, or costs. Financing constraints are a plausible explanation for these results.

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