Do firm boundaries affect the allocation of resources? This question had spawned significant research in economics since it was raised in Coase (1937). A large body of work has focused on comparing the resource allocation in conglomerates relative to stand-alone firms to shed light on this issue. Theoretically, there are competing views on this aspect. On the one hand, Alchian (1969), Wiliamson (1985), and Stein (1997), among others, have put forth the view that conglomerates, by virtue of exerting centralized control over the capital allocation process, may do a better job in directing investments than the external capital markets. On the other hand, the “dark side” view of internal capital markets argues that problems of corporate socialism are more prevalent in conglomerates making them less efficient in resource allocation (Rajan, Servaes, and Zingales, 2000; Scharfstein and Stein, 2000).
Posts Tagged ‘R&D’
In our paper, Equity Vesting and Managerial Myopia, which was recently made publicly available on SSRN, we study the link between real investment decisions and the vesting horizon of a CEO’s equity incentives. We find that research and development (“R&D”) is negatively associated with the stock price sensitivity of stock and options that vest over the course of the same year. This association continues to hold when including advertising and capital expenditure in the investment measure. Moreover, CEOs with significant newly-vesting equity are more likely to meet or beat analyst consensus forecasts by a narrow margin. However, the market recognizes such CEOs’ incentives to inflate earnings—the lower announcement returns to meet or beating earnings forecasts are decreasing in the sensitivity of vesting equity. These results provide empirical support for managerial myopia theories.
Many academics and practitioners believe that managerial myopia is a first-order problem faced by the modern firm. While the 20th century firm emphasized cost efficiency, Porter (1992) argues that “the nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms,” such as innovation, employee training, and organizational development. However, the myopia theories of Stein (1988, 1989) show that managers may fail to invest due to concerns with the firm’s short-term stock price. Since the benefits of intangible investment are only visible in the long run, the immediate effect of such investment is to depress earnings and thus the current stock price. Therefore, a manager aligned with the short-term stock price may turn down valuable investment opportunities.
It has long been argued that synergies are key drivers of mergers and acquisitions (M&As), and that many M&As occur due to technology reasons. However, there is little direct evidence of whether and how synergies in the technology space drive individual firms’ decisions to participate in M&As, and of how they affect merger outcomes. In our paper, Corporate Innovations and Mergers and Acquisitions, forthcoming in the Journal of Finance, we first examine the relation between characteristics of corporate innovation activities and whether a firm becomes an acquirer or a target firm. We then study whether technological overlap between firm pairs affects transaction incidence. Finally, using a sample of bids withdrawn due to reasons exogenous to innovation as a control sample, we estimate the effect of a merger on future innovation output when there is pre-merger technological overlap between merging firms. Our large and unique patent-merger data set over the period 1984 to 2006 allows us to construct targeted measures of innovation output and technological overlap, extending the analysis of Hoberg and Phillips (2010) in product markets.
In our paper, Innovation, Reallocation, and Growth, which was recently made publicly available on SSRN, we build a micro-founded model of firm innovation and growth, enabling us an examination of the forces jointly driving innovation, productivity growth and reallocation. In the second part of our paper, we estimate the parameters of the model using simulated method of moments on detailed U.S. Census Bureau micro data on employment, output, R&D, and patenting during the 1987-1997 period.
Our model builds on the endogenous technological change literature. Incumbents and entrants invest in R&D in order to improve over (one of) a continuum of products. Successful innovation adds to the number of product lines in which the firm has the best-practice technology (and “creatively” destroys the lead of another firm in this product line). Incumbents also increase their productivity for non-R&D related reasons (i.e., without investing in R&D). Because operating a product line entails a fixed cost, firms may also decide to exit some of the product lines in which they have the best-practice technology if this technology has sufficiently low productivity relative to the equilibrium wage. Finally, firms have heterogeneous (high and low) types affecting their innovative capacity—their productivity in innovation. This heterogeneity introduces a selection effect as the composition of firms is endogenous, which will be both important in our estimation and central for understanding the implications of different policies. We assume that firm type changes over time and that low-type is an absorbing state (i.e., high-type firms can transition to low-type but not vice versa), which is important for accommodating the possibility of firms that have grown large over time but are no longer innovative.
In the paper, R&D and the Incentives from Merger and Acquisition Activity, forthcoming in the Review of Financial Services, my co-author (Alexei Zhdanov of the University of Lausanne and the Swiss Finance Institute) and I examine how the incentives to innovate differ between large and small firms and whether the M&A market hinders or promotes innovative activity. Previous literature has documented that R&D and innovation decreases post-acquisition and has attributed this effect to large firms stifling innovative activity. Using recent data on pre-merger R&D activity, we show that this view is flawed. Rather than large firms stifling R&D by small firms, we show theoretically and empirically how mergers can stimulate R&D activity of small firms. Thus, ex ante R&D rises and then falls naturally after acquisition as the pre-merger stimulus effect wears off.
In the paper, Multinationals and the High Cash Holdings Puzzle, which was recently made publicly available on SSRN, we investigate whether the cash holdings of American companies are abnormally high after the financial crisis and whether these cash holdings can be explained by the theories summarized in the previous paragraph. We show that the extent to which cash holdings are unusually high after the crisis depends critically on the measure used. We would expect larger firms to hold more cash. Since corporate assets tend to grow over time, the dollar amount of cash holdings would grow even if the ratio of cash to assets stays constant. Consequently, at the very least, cash holdings should be measured relative to a firm’s assets. Using all non-financial and non-regulated public firms with assets and market capitalization greater than $5 million per year, the average cash/assets ratio is 20.18% in 2009-2010 compared to 20.50% in the 2004-2006 pre-crisis period. However, when we consider the median ratio, it is higher by 0.87% in 2009-2010 than in 2004-2006. Similarly, the asset-weighted ratio is higher by 0.74% in the recent period. The larger increase in the asset-weighted ratio than in the equally-weighted ratio suggests that large firms increased their holdings more and we show that this is the case. However, the changes in cash holdings from 2004-2006 to 2009-2010 are dwarfed by the changes in cash holdings from 1998-2000 to 2004-2006. Over that latter period, the average cash/assets ratio increases by 3.77%, the median by 6.39%, and the asset-weighted average by 3.62%. When we distinguish between private and public firms, we show that there is no evidence of an increase in the cash/assets ratio for private firms.
In our forthcoming Journal of Finance paper, Are Overconfident CEOs Better Innovators?, we find that over the 1993 to 2003 period, CEO overconfidence is associated with riskier projects, greater investment in innovation, and greater innovation as measured by the number of patent applications and patent citations even after controlling for the amount of R&D expenditures. In other words, the R&D investments of overconfident CEOs are more productive in generating innovation. However, greater innovative output of overconfident managers is achieved only in innovative industries. We also find evidence that overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value, especially within innovative industries. We find that overconfidence remains a strong and significant predictor of innovation even when we remove managers with short tenures at their firms, which suggests that the endogenous hiring of overconfident managers by innovative firms is not the main driver of our findings.
The results of this study have a bearing on the usual presumption that overconfidence is undesirable. Business commentators often point to examples of headstrong, overconfident CEOs who made disastrous decisions. However, the chance of a big defeat may be a corollary to the chance of great victory, so the lesson to draw from examples is unclear. A more serious charge is provided by the evidence of Malmendier and Tate (2008) that the market reacts more negatively to acquisitions made by overconfident CEOs. This dark side to CEO overconfidence might seem to suggest that the CEO selection process should be designed to filter out oversized egos, or that compensation and governance should be designed to severely constrain such CEOs.
In the paper, Narrative Disclosure and Earnings Performance: Evidence from R&D Disclosures, which was recently made publicly available on SSRN, I examine whether earnings performance relates to the quantity of narrative R&D disclosure that firms provide concurrently in their financial reports. A large body of research examines how managers’ incentives to voluntarily disclose information depend on whether that specific disclosure would reveal good or bad news. This study differs from prior work on the relation between performance and disclosure in that I examine whether earnings performance, a mandatory disclosure, relates to firms’ decisions to provide narrative disclosures – one of the main channels used to convey contextual information about a firm’s operations to investors. While more quantitative disclosures such as earnings guidance have received considerably more attention, narrative information makes up a comparatively large amount of disclosure information and helps to bridge the gap between a firm’s economic reality and its financial statements.
In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich ). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.
In our paper, Executive Compensation and Research & Development Intensity, which was recently made publicly available on SSRN, we examine the mediating effect of R&D intensity on the weights on signals of ability and financial performance measures in executive compensation contracts. There are many prior studies that investigate the impact of R&D intensity on total executive compensation (e.g., Dechow and Sloan 1991; Kwon and Yin 2006; Cheng 2004). However, prior studies did not incorporate adverse selection in their analysis. In other words, they did not investigate how R&D intensity affects the role of managerial ability in executive compensation. In contrast, we investigate how R&D intensity impacts the weights placed on human capital measures such as technical work experience, science and engineering degrees, and past experience in R&D intensive firms.