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Abstract:
This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity. A number of new predictions follow.

Dynamic Capital Structure, Credit Spreads, Macroeconomic Conditions

Abstract:
This paper embeds a dynamic industry equilibrium model in a real options framework to examine the interaction between product market competition and takeover activity. Industry equilibrium generates endogenous synergy gains. Heterogeneous firms have an incentive to merge because restructuring decisions are motivated by operating and strategic benefits. The unified framework predicts that (i) merger activities are more likely in more concentrated industries or in industries that are more exposed to industrywide shocks; (ii) returns to merger and rival firms arising from restructuring are higher in more concentrated industries; (iii) increased industry competition delays the timing of mergers; (iv) in sufficiently concentrated industries, bidder competition induces a bid premium that declines with product market competition; and (v) mergers are more likely and yield larger returns in industries with higher dispersion in firm size.

industry structure, anticompetitive effect, real options, takeovers

Abstract:
This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. This effect has a number of testable implications. For example, high growth industries have relatively lower leverage and turnover rates.

Abstract:
This paper provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and the associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the equilibrium output price has an important feedback effect. Due to this effect, the model generates a number of new testable predictions. In particular, it is shown that high-growth industries have relatively lower leverage and lower turnover rates.

Abstract:
Conflicts of interest between insiders (e.g, controlling shareholders) and outsiders (e.g., minority shareholders) are central to the analysis of modern corporation. In an integrated continuous-time contingent claims framework with imperfect corporate governance, we examine a controlling shareholder's optimal choice of capital structure, ownership concentration, private benefit diversion, consumption, and financial market investment. We derive solutions in explicit parametric forms up to numerical integrations. In addition to generating implications consistent with existing empirical evidence, we also show that managerial preference characteristics (such as risk aversion and impatience), corporate governance, and financial market are important determinants of equity value, credit spread, agency costs, capital structure, and ownership concentration. Our model produces many novel empirically testable predictions. For example, it implies that a more risk averse or a less impatient entrepreneur issues less debt and more equity, and that stronger corporate governance leads to higher equity value, lower leverage, less ownership concentration, and lower credit spread. In addition, it also suggests that as the Sharpe ratio in the financial market increases, firm leverage ratio, agency costs, and credit spread all increase.

Managerial/entrepreneurial characteristics, ownership and capital structure, private benefits of control, corporate governance

Abstract:
Under the real options approach to investment under uncertainty, agents formulate optimal policies under the assumption that firms' growth prospects do not vary over time. This paper proposes and solves a model of investment decisions in which the growth rate and volatility of the decision variable shift between different states at random times. A value-maximizing investment policy is derived such that in each regime the firm's investment policy is optimal and recognizes the possiblity of a regime shift. Under this policy, investment is intermittent and increases with marginal q. Moreover, the rate of investment typically is very small but exhibits some spurts of growth. Implications for marginal q and the user cost of capital are also examined.

Investment, Capacity Choice, Regime Shifts, Real Options

Abstract:
This paper presents a contracting model of governance based on the premise that CEOs are the main promoters of governance change. CEOs use their power to extract higher pay or private benefits, and different governance structures are preferred by different CEOs as they favor one or the other type of compensation. The model explains why good country-wide investor protection breeds good firm governance and predicts a race to the top in firm-governance quality after the Sarbanes-Oxley Act. However, such governance changes may be associated with higher rather than lower CEO pay as CEOs substitute away from private benefits. The model also provides an explanation for the observed correlation of CEO pay and firm governance as driven by CEO power.

CEO power, moral hazard, CEO compensation, corporate governance, investor protection

Abstract:
We propose a novel generalized recursive smooth ambiguity model which allows a three-way separation among risk aversion, ambiguity aversion, and intertemporal substitution. We apply this utility to a consumption-based asset pricing model in which consumption and dividends follow hidden Markov regime-switching processes. Our calibrated model can match the mean equity premium, the mean riskfree rate, and the volatility of the equity premium observed in the data. In addition, our model can generate a variety of dynamic asset pricing phenomena, including the procyclical variation of price-dividend ratios, the countercyclical variation of equity premia and equity volatility, and the mean reversion of excess returns. The key
intuition is that an ambiguity averse agent behaves pessimistically by attaching more weight to the pricing kernel in bad times when his continuation values are low.

ambiguity aversion, learning, pessimism, asset pricing puzzles

Abstract:
Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to firm investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.

Ambiguity, multiple-priors utility, real options, optimal stopping problem

Abstract:
Empirical evidence shows that entrepreneurs on average do not earn more than paid employees in terms of the net present value (NPV). One natural question is what makes the entrepreneurs to stay in business. To address this question, we propose a continuous time real options model in which an entrepreneur does not know his investment quality and learn about it over time. We show that due to the option value of learning, an entrepreneur may stay in business even though the NPV is negative. We also show that risk aversion erodes option value and lowers private firm value so that a highly risk averse entrepreneur may exit even when the NPV is positive. In addition, a more risk averse or a more pessimistic entrepreneur exits earlier. Finally, the model can generate the positive relation between wealth and survival duration without liquidity constraints.

real options, learning, private firm value, survival, precautionary savings, incomplete markets

Abstract:
Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of business investments, consumption-saving and portfolio selection. We show that precautionary saving motive affects the investment timing decision in an important way. When the investment payoffs are given in lump sum, risk aversion accelerates investment. For an agent with sufficiently strong precautionary motive, an increase in volatility may accelerate investment, opposite to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against the investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, for the flow payoff case, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing the reversal of the results in the lump sum payoff case.

real options, idiosyncratic risk, hedging, risk aversion, precautionary saving, incomplete markets

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations framework in which investors are heterogeneous in their information and investment opportunities. We assume that informed agents privately receive advance information about company earnings that materializes into the future. While this information is immediately incorporated into prices, stock prices underreact to it causing short-run momentum. Stock prices may appear to move in ways unrelated to current fundamentals. When the information materializes, the stock price reverts back to its long run mean mimicking an overreaction pattern.

advance information, momentum and reversal effects, overreaction, rational expectations equilibrium, underreaction

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations equilibrium framework in which investors have heterogeneous information and investment opportunities. We assume that informed investors privately receive advance information about company earnings that materializes into the future. This information is immediately partially incorporated into prices, and thus stock prices may move in ways unrelated to current fundamentals. Investors' speculative and rebalancing trades in response to advance information generate short-run momentum, mimicking an underreaction pattern. When this information materializes, the stock price reverts back to its long-run mean, mimicking an overreaction pattern.

advance information, momentum and reversal effects, underreaction, overreaction, rational expectations equilibrium

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations framework in which investors are heterogeneous in their information and investment opportunities. We assume that informed investors privately receive advance information about company earnings that materializes into the future. While this information is immediately incorporated into prices, stock prices underreact to it causing short-run momentum. Stock prices may appear to move in ways unrelated to current fundamentals. When the information materializes, the stock price reverts back to its long run mean mimicking an overreaction pattern.

advance information, momentum and reversal effects, underreaction, overreaction, rational expectations equilibrium

Abstract:
We study an investor's optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is large for extreme values of the predictive variable. Unlike in the Bayesian framework, model uncertainty induces a hedging demand, which may cause the investor to decrease his stock allocations sharply and then increase with his prior probability of IID returns. Adopting suboptimal investment strategies by ignoring model uncertainty can lead to sizable welfare costs.

generalized recursive ambiguity utility, ambiguity aversion, model uncertainty, learning, portfolio choice, robustness, return predictability

Abstract:
We develop a neoclassical partial equilibrium model to analyze the dynamic effects of permanent and temporary dividend tax policies on corporate investment and financing decisions. Facing a tax system with corporate and personal income taxes, dividend tax and capital gains tax, a firm decides how much to invest and how to finance investment by equity or debt subject to collateral constraints and capital adjustment costs. We characterize steady state and simulate transitional dynamics following tax policy changes. We find the following novel results: First, both temporary and permanent dividend tax changes do not have long-run effects on a firm's capital formation, but have short-run effects on its investment and financial policies. Second, an anticipated temporary dividend tax cut has a short-run effect of lowering investment, similar to an anticipated permanent dividend tax increase. Third, a firm responds asymmetrically to an anticipated permanent dividend tax increase versus an anticipated permanent dividend tax cut due to the collateral constraint. Finally, in anticipation of future tax changes, the firm engages in tax arbitrage by borrowing or saving in order to transfer corporate earnings across time so as to reduce shareholder's tax burden.

dividend tax policies, investment and financial policies, finance regimes, collateral constraint, intertemporal tax arbitrage

Abstract:
This paper analyzes a risk averse entrepreneur's real investment decision under incomplete markets. The entrepreneur smoothes his intertemporal consumption by investing in both a risk-free asset and a risky asset, which allows him to partially hedge against the project cash flow risk. We show that risk aversion lowers both the project value upon investment and the option value of waiting to invest through the precautionary saving effect. Furthermore, risk aversion delays investment since the project value is reduced more than the option value to invest. It is also shown that although hedging can reduce the cash flow risk, it may have a positive or negative return effect, depending on the correlation between the cash flow risk and the market. Consequently, investment timing is not monotonic with the extent of hedging opportunity. Finally, welfare implications of hedging are analyzed.

Real options, risk aversion, incomplete markets, hedging, precautionary saving

Abstract:
Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into two stochastic continuous-time monetary models of endogenous growth. Motivated by psychology, we model an agent's money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent's perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is second order, whereas its impact on long-run growth is first order relative to the degree of money illusion. A monetary policy can eliminate this cost by correcting the distortions on a money-illusioned agent's consumption/savings decisions.

money illusion, inflation, growth, welfare cost, behavioral macroeconomics

Abstract:
This paper adopts the Gul and Pensendorfer self-control utility model to analyze an agent's option exercise decision under uncertainty over an infinite horizon. The agent decides whether and when to do an irreversible activity. He is tempted by immediate gratification and suffers from self-control problems. The cost of self-control lowers the benefit from continuation or stopping and may erode the option value of waiting. When applied to the investment and exit problems, the model can generate the behavior of procrastination and preproperation. In addition, unlike the hyperbolic discounting model, the model here provides a unique prediction.

time (in)consistencey, self-control, temptation, procrastination, preproperation, option value

Abstract:
This paper analyzes an agent's option exercise decision under uncertainty. The agent decides whether and when to do an irreversible activity. He is tempted by immediate gratification and suffers from self-control problems. This paper adopts the Gul and Pensendorfer self-control utility model. Unlike the time inconsistent hyperbolic discounting model, it provides an explanation of procrastination and preproperation based on time consistency. When applied to the investment and exit problems, it is shown that (i) if the project value is immediate, an investor may invest in negative NPV projects; (ii) if the production cost is immediate, a firm may exit even if it makes positive net profits; and (iii) if both rewards and costs are immediate, an agent may simply follow the myopic rule which compares only the current period benefit and cost.

Abstract:
Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete markets model of entrepreneurial finance to demonstrate the important implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur's valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete-markets model of entrepreneurial finance to demonstrate the important implications of non-diversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur's valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.

Default, diversification benefits, entrepreneurial risk aversion, incomplete markets, private equity premium, hedging, capital structure, cash-out option, precautionary saving

Abstract:
What is the long-run effect of dividend taxation on aggregate capital accumulation? To address this question, we build a dynamic general equilibrium model in which there is a continuum of firms subject to idiosyncratic productivity shocks. We show that at any point in time, a firm may lie in one of three finance regimes: dividend distribution regime, liquidity constrained regime, and equity issuance regime. These finance regimes may change over time in response to idiosyncratic productivity shocks. Firms in different finance regimes respond to dividend taxation in different ways. We calibrate our model to the US data from COMPUSTAT and use this calibrated model to provide an initial quantitative evaluation of the Bush government dividend tax reform in 2003. Our baseline model simulations show that when both dividend and capital gains tax rates are cut from 25 and 20 percent, respectively, to the same 15 percent level permanently, the aggregate long-run capital stock increases by about 3 percent. This result is robust to small changes of parameter values and to several extensions of our baseline model.

firm heterogeneity, general equilibrium, finance regime, the new and tranditional veiws of dividend taxation

Abstract:
This paper studies competitive equilibria of a production economy with aggregate productivity shocks. There is a continuum of consumers who face borrowing constraints and individual labor endowment shocks. The dynamic economy is described in terms of sequences of aggregate distributions. The existence of sequential competitive equilibria is proven and a recursive characterization is established. In particular, it is shown that for any sequential competitive equilibrium, there exists a payoff equivalent sequential competitive equilibrium that is generated by a suitably defined recursive equilibrium with state variables including continuation value.

Abstract:
This paper studies competitive equilibria of a production economy with aggregate productivity shocks and with a continuum of consumers subject to borrowing constraints and individual labor endowment shocks. The dynamic economy is described in terms of sequences of aggregate distributions. The existence of competitive equilibrium is proven and a recursive characterization is established. In particular, it is shown that for any competitive equilibrium, there is a first period payoff equivalent competitive equilibrium that is generated by a recursive equilibrium with the state space including expected discounted utilities.

competitive equilibrium, recursive equilibrium, aggregate distribution, heterogeneity, incomplete markets, aggregate shocks

Abstract:
This paper presents a search model of centralized and decentralized trade. In a centralized market, trades are intermediated by market makers at publicly posted bid-ask prices. In a decentralized market, traders search counterparties. Prices are negotiated and transactions are conducted in private meetings among traders. Traders can choose which market to enter. The determinant of bid-ask spreads and liquidity is analyzed. The welfare consequence of the market fragmentation is also analyzed. Some limiting results and convergence to the Walrasian equilibrium as search fricitions or transaction costs vary are established.

Search, matching and bargaining, bid-ask spread, liquidity, welfare, Walrasian equilibrium

Abstract:
This paper presents a contracting model of governance based on the premise that CEOs are the main promoters of governance change. CEOs use their power to extract higher pay or private benefits, and different governance structures are preferred by different CEOs as they favour one or the other type of compensation. The model explains why good countrywide investor protection breeds good firm governance and predicts a 'race to the top' in firm-governance quality after the Sarbanes-Oxley Act. However, such governance changes may be associated with higher rather than lower CEO pay as CEOs substitute away from private benefits. The model also provides an explanation for the observed correlation of CEO pay and firm governance based on CEO power. Finally, we discuss the optimality of introducing randomness in CEO hiring, for example, by evaluating CEOs based on qualitative characteristics, or soft skills, that are prone to diverse judgements.

CEO power, moral hazard, CEO compensation, investor protection

Abstract:
In this paper we present a recursive method for the computation of dynamic competitive equilibria in models with heterogeneous agents and market frictions. This method is based on a convergent operator over an expanded set of state variables. The fixed point of this operator defines the set of all Markovian equilibria. We study approximation properties of the operator as well as the convergence of the moments of simulated sample paths. We apply our numerical algorithm to two growth models, an overlapping generations economy with money, and an asset pricing model with financial frictions.

Heterogeneous agents, taxes, externalities, financial frictions, competitive equilibrium, computation, simulation

Abstract:
Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

Abstract:
We present an analytically tractable general equilibrium business cycle model that features micro-level investment lumpiness. We prove an exact irrelevance proposition which provides sufficient conditions on preferences, technology, and the fixed cost distribution such that any positive upper support of the fixed cost distribution yields identical equilibrium dynamics of the aggregate quantities normalized by their deterministic steady state values. We also give two conditions for the fixed cost distribution, under which lumpy investment can be important: (i) The steady-state elasticity of the adjustment rate is large so that the extensive margin effect is large. (ii) More mass is on low fixed costs so that the general equilibrium price feedback effect is small. Our theoretical results may reconcile some debate and some numerical findings in the literature.

generalized (S,s) rule, lumpy investment, general equilibrium, business cycles, marginal Q, exact irrelevance proposition

Abstract:
To study the long-run effect of dividend taxation on aggregate capital accumulation, we build a dynamic general equilibrium model in which there is a continuum of firms subject to idiosyncratic productivity shocks. We find that a dividend tax cut raises aggregate productivity by reducing the frictions in the reallocation of capital across firms. Our baseline model simulations show that when both dividend and capital gains tax rates are cut from 25 and 20 percent, respectively, to the same 15 percent level permanently, the aggregate long-run capital stock increases by about 4 percent.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
This paper characterizes informed trade when speculators can acquire distinct signals of varying quality about an asset's value at different dates. The most reasonable characterization of private information about stocks is that while information is long-lived, new information will arrive over time, information that may be acquired by other agents. Hence, while a speculator may know more than others at a moment, in the future, his information will become stale, but not valueless. In an environment that allows for arbitrary correlations among signals, we characterize equilibrium outcomes including trading, prices, and profits. We provide explicit numerical characterizations for different informational environments.

Abstract:
This paper describes a pure-exchange, continuous-time economy with two heterogeneous agents and complete markets. A novel feature of the economy is that agents perceive some security returns as ambiguous in the sense often attributed to Frank Knight. The equilibrium is described completely in closed-form. In particular, closed-form solutions are obtained for the equilibrium processes describing individual consumption, the interest rate, the market price of uncertainty, security prices and trading strategies. After identifying agents as countries, the model is applied to address the consumption home-bias and equity home-bias puzzles.