Advanced Corporate Finance
Summary of the Lectures
University of Amsterdam
MSc Finance
2022
,Week 1
How do firms make investment decisions?
Common rule of thumb: Invest in any project with NPV > 0
● NPV is discounted value of all project cash flows:
○ –C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + ….
● Discount rate r is opportunity cost of capital, the next-best return that firm’s investors could
receive elsewhere
○ returns should be adjusted for differences in risk before comparing
● NPV > 0 ⇒ Project offers higher return than best alternative investment opportunity
○ Do firms follow this rule when making investment decisions?
Measuring investment opportunities
● Positive NPV means that value created from investment exceeds the firm’s initial cost of
purchasing capital
● Stock market participants should anticipate this, and bid up firm’s share price even before
investment undertaken
● We can measure investment opps by comparing firm’s market value to purchase price of its
assets
● Tobin’s Q = (Market value of firm)/(Replacement cost of capital)
○ replacement cost: price firm would have to pay on market for capital
○ Market-book ratio is similar, and sometimes used instead
○ Q numerator often measured as firm’s market cap + debt
■ should use debt’s market value, but often only book value observed
○ Denominator is book value of total assets, or PP&E
■ book values measure prices firm actually paid to buy assets on market
■ It may be worth something else now
How to interpret Q
● Firm with Q > 1 generates more value using capital than other investors or firms would
○ internal value of capital higher than what market willing to pay
○ Example: Shipping firm with Q of 1.5 can buy new truck for 100 and use it to
generate NPV of 50
● Firm with Q < 1 is wasting some capital, better off selling assets
○ Bad managers won’t
Brief overview of Q theory
● Firm owns capital K0 and can spend I0 on new assets
○ capital depreciates at annual rate δ
● Next year’s profits are V1 = αK1/(1+r), where K1 = I0 + (1–δ)K0
● Firm also pays capital adjustment cost of (I0 / K0)2
○ Example: Operating more machines requires increasing amount of attention from
management
1
,Firm’s maximization problem (not asked in exam)
A few technical details
● In the maximization problem, q = ఎV1ఎ/K1 is based on a derivative. So investment depends
on the marginal profits from one extra unit of capital
○ But Q measured as average value of capital (total market value divided by total
capital cost)
○ Hayashi Theorem shows that average and marginal Q are the same under plausible
conditions
● What happens when a firm has no adjustment costs?
○ In maximization problem, q = 1 always
○ Any change to q > 1 would cause firms to invest an infinite amount, since there
would be no net cost to investment. That's why there are adjustment costs.
Empirical evidence on Q theory
The prediction of Q theory states that Q completely explains investment. Studies have highlighted
several problems with Q theory.
● Q explains little of the variation in investment (regression R2 values are low)
● Regression estimates of Q’s effect are only consistent with theory if adjustment costs are huge
● Numerous other variables are significantly related to investment
In sum, findings imply that Q matters for corporate investment, but other factors matter more
Hypothesis 1: Measurement error in Q (Theory is right, Test is wrong)
Measurement error could explain lack of empirical evidence
● In OLS regressions, coefficient is biased toward 0 when variable contains measurement error,
and R2 falls as well
● Bias can also lead to significant coefficients on other variables
Q likely has some measurement error
● market value of equity may be influenced by factors other than investment opps
● Q should be based on market value of debt, but often book value used
● book value of assets based on historical prices, and may not reflect current replacement costs
● most intangible assets have value but are not recorded in financials.
2
,Erickson and Whited (2000) employ advanced statistical technique to remove measurement error from
Q
● Main findings:
○ R2 more than doubles after accounting for measurement error
○ Coefficient estimates on Q are substantially larger than simple OLS
○ Estimates of other variables (e.g., cashflows) small and insignificant
However, you see that measurement error partly explains it, but not enough (R2 from 0.106 to 0.237).
Peters and Taylor (2017): Intangible capital and the investment-q relation (Paper 1) find that Q
works much better when intangible assets (software and brand value for example) are included
Above you can see that Q coefficient increases from 0.029 to 0.049.
3
,Hypothesis 2: Financial constraints (Theory incomplete)
Recall, firms must invest C0 up front, and receive cash flows in future. But where does initial cash C0
come from? Young firms start with almost no cash, and are also not profitable.
● main way to fund investment is raising external financing
● mature firms typically hold cash and are profitable, but may face very large upfront
investment costs
If a firm has difficulty raising external financing, financial constraints, it may pass up investment opps
even when Q is high.
Why might raising financing be costly?
● Pecking order theory: investment is cheaper to finance using internal funds (i.e., cash) than
external
● Key reason is asymmetric info: Firm’s managers know its condition better than external
investors
○ if managers are trying to reduce ownership stake by selling shares, then firm could be
in bad condition
○ using internal cash signals firm believes its projects will be profitable
● Implication: Firms with volatile cashflows should build up internal funds, to ensure sufficient
liquidity during bad years
○ Otherwise firm might be forced to pass up profitable investment opps
A simple example of precautionary savings (IN EXAM)
A firm operates for two years. In each year it has access to two investment opportunities
● Each project i = {1,2} requires an investment of Ii and generates return Ri in the next year
(projects last only one year)
● Suppose I1 = I2 = I but R1 > R2 (diminishing returns to investment)
In each year firm receives cashflows C(Good) = 2I with probability ϑ, or cashflows C(Bad) < I with
probability 1 – ϑ. This year, the firm is in a good state and receives C(Good).
Firm’s problem: Should it invest all cashflows, or save some for next year?
● cash is saved at risk-free rate of 0, and there is no discounting
4
,Empirical evidence on financial constraints
Fazzari, Hubbard, and Petersen (1988) provide early evidence that financial constraints affect
investment
● Split firms into three groups based on dividend payouts
● Firms that pay dividends instead of saving cash are likely not financially constrained
● Test relationship between annual cashflows and investment across each subset of firms
● Data shows that effect of cashflows is strongest for most constrained firms, weakest for least
constrained
● This indicates that investment depends on the availability of internal funds.
Above you can see that there are 3 groups, 1 most constrained based on the idea that firms that pay
dividends are not constrained. R2 is highest for most constrained firms (class 1). So the prediction that
most constrained firms invest less is correct and investments depend on availability of internal funds.
CF/K is cashflow.
5
,Kaplan and Zingales (1997) critique
● Empirically refute FHP (1988)’s results, showing that financial constraints may not affect
investment-cashflow sensitivity
● Re-classify firms based on discussion of constraints in 10-K filings
○ many “constrained” firms mention no problems raising funds
● Find cash flows associated with investment across all firms, regardless of financial constraints
○ indeed, association strongest for least constrained firms
● Additional problem with FHP (1988): Cashflows can be correlated with investment opps, thus
biasing regression estimates.
Constraints and precautionary savings
Another issue with FHP (1988): If firms engage in precautionary savings, then the estimated effect of
cash flows could be negative!
● reason is that constrained firms invest less when cash flows high, to fund more investment
when cash flows low
● cashflows depend on both current and future investment opps
Almeida et al. (2004) develop new theory showing constrained firms should save more out of annual
cash flows
● Cash Flow sensitivity of cash: Test relationship between cash holdings and cash flows
● association likely unbiased by error in measuring investment opps
Above you can see that constrained firms hold more cash in good times.
More recent evidence
● Newer papers exploit exogenous shocks to corporate liquidity or internal funds. Results show
that financial constraints matter for investment
● Lamont (1997) examines investment following 1986 oil price crash
○ finds that oil companies cut investment in their non-oil subsidiaries
○ oil price crash exogenous to these subsidiaries’ investment opps
● Rauh (2006) shows that firms that must increase contributions to employee pension fund also
cut Capex
○ exploits law requiring firms with pension assets just below threshold to raise
contributions
○ RDD design compares firms just above and below threshold
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,Above you can see that when firms are below the threshold there is less money left for investment.
Takeaway: Cash Flows matter for financial decisions. So Tobins Q and financial constraints both
matter for investments.
Cash holdings: A challenge to theory
● Public firms’ cash holdings have risen dramatically since 1980s.
○ In U.S. level is higher than any point in past century except WW2
● Policymakers highly frustrated that firms are hoarding cash instead of investing to create jobs,
growth
○ Central banks have driven savings rates on cash to record lows
● Explanations that could reconcile this trend with traditional investment theories:
○ Positive NPV investment opps less frequent than before 1980
○ Financial constraints pose greater threat since 1980
○ Something else changed around 1980?
According to Q Theory they should invest but
they are not…
Both Cash Holdings figures are from Graham
and Leary (2018): The Evolution of Corporate
Cash (Paper 2)
7
,Common explanations for cash holdings
Prior academic literature put forth numerous explanations:
1. Precautionary savings to avoid future constraints
2. Reduce transaction costs from issuing bonds/stock
3. Agency problems: CEOs don‘t want to give back cash. They want a tech project to look cool.
4. Avoid taxes by hoarding cash abroad. If you want to bring back cash you need to pay taxes.
General view is that precautionary savings and taxes are strongest drivers of cash holding growth.
Innovative firms
Above you can see that innovative (doing more R&D) firms hold more cash. Also, firms hold more
cash at IPO.
Above you can see that US-EU gap is only there in cash holdings for high R&D firms.
Summary of recent trends
● Cash holdings/Assets are at record highs, while CapEx spending is consistently lower than
predicted by Q
● Trends started in 1980s, concentrated among innovative firms
○ Cash holdings have risen mostly at high-R&D firms
○ High-R&D firms hold much more cash at IPO
○ Most US and EU firms hold similar cash levels, except for highest R&D firms
● Common explanation: Innovative firms are more constrained
○ R&D creates intangible assets, which are poor collateral for raising external financing
8
, Can intangibles and human capital explain recent trends?
Doettling, Ladika, and Perotti (2019) offer an alternative explanation based on how intangible assets
are created:
● Intangibles are produced using employees’ knowledge and creativity
○ such “human capital” investment doesn’t require spending much cash up front
○ high R&D firms are not constrained, because they do not require much external
financing
● But employees can take intangibles when moving to another firm
○ firms grant deferred pay to retain employees (e.g., stock options)
○ need to hold onto project cashflows until pay vests
Week 2
Study Shliefer and Vishny (1997) A Survey of Corporate Governance (Paper 3), not in lecture
Governance in the Modern Corporation
● Corporations raise money from investors to fund projects, creating assets that they legally
own
○ In exchange, promise shareholders a portion of future profits, and creditors a series of
debt re-payments
● But investors do not actively participate in management of firm
○ How can they ensure that firm does not waste funding, and that money is returned as
promised?
● Corporate governance is a set of mechanisms allowing investors to control how firms use
money, and to encourage repayment
Governance Problems in Corporations
An agency problem is any conflict of interest between investors and managers of firm. Most common
model is principal-agent problem:
● The principal is the firm’s owner (shareholders), and agent is hired to manage firm on
day-to-day basis (CEO)
○ Model can apply to other relationships, e.g., renovation project or subcontracting part
of business
● Such relationships often lead to moral hazard: Agent engages in wasteful action because
principal bears much of cost
● These problems are inherent to modern corporate structure that separates ownership and
control (Berle and Means 1932)
Principal-Agent Problem: Basic Setup
● Firm obtains funding from large number of dispersed investors
○ E.g., most U.S./U.K. firms have thousands of small shareholders
● CEO owns small (or no) part of firm, but decides how to use investors’ funds
● Firm has access to both positive and negative NPV projects
Note: This setting does not apply to some other types of businesses
● E.g., small private firms, partnerships, family firms, state-owned firms
● Such businesses may suffer fewer agency problems, but have other drawbacks (illiquidity,
limited funding)
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