PABLO FERNANDEZ, University of Navarra - IESE Business School
Email: fernandezpa@iese.edu
HEINRICH LIECHTENSTEIN, University of Navarra - IESE Business School
Email: hl@iese.edu

Mehra and Prescott (1985) argued that, according to sensible asset pricing models, stocks should provide at most a 0.35% premium over bills. However, companies use higher equity premia (average around 6%) for evaluating their investment projects, professors use in class and in their textbooks higher equity premia (average around 6%, range from 3 to 10%) and investors use higher equity premia for valuing companies. The overall result is that equity prices are, on average, undervalued (and have been undervalued in the last decades) and, consequently, the measured ex-post equity premium (HEP) is also high.

If the additional returns beyond the risk-free rate demanded by equity investors (ex-ante risk premia) and used in financial asset pricing models have been high, it is not a surprise that the ex-post risk premia (calculated with historical data) have been also high. If most investors use historical data to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.

JOHN ASKER, Leonard N. Stern School of Business - Department of Economics
Email: jasker@stern.nyu.edu
MARIAGIOVANNA BACCARA, Leonard N. Stern School of Business - Department of Economics
Email: mbaccara@stern.nyu.edu

We analyze the link between industry size and R&D spending distribution. We consider amonopolistically competitive market in which firms can invest in cost-cutting R&D by paying a fixed cost first. For an intermediate level of fixed cost, there is a unique equilibrium in which the market segments into investing and non-investing firms. Using this equilibrium, we study howthe distribution and level of R&D expenditure changes as industry size increases. In particular, we show that, as the market size increases, R&D spending can become more concentrated. Data motivating these results are drawn from the Taiwanese and Korean semiconductor industries.

WILLIAM H. GREENE, Leonard N. Stern School of Business - Department of Economics
Email: wgreene@stern.nyu.edu
ABIGAIL S. HORNSTEIN, Leonard N. Stern School of Business - Department of Economics
Email: ahornste@stern.nyu.edu
LAWRENCE J. WHITE, Stern School of Business, New York University
Email: lwhite@stern.nyu.edu
BERNARD YIN YEUNG, Leonard N. Stern School of Business - Department of Economics, National University of Singapore - Business School
Email: byeung@stern.nyu.edu

This paper examines the effectiveness of multinational enterprises capital budgeting decisions as compared to the decisions of purely domestic enterprises. This is an important question because of multinationals role in allocating capital globally. Answering this question may also shed light on whether multinationals are indeed better managed than are purely domestic firms. We examine this question empirically using the deviation of a firm s estimated marginal Tobin s q from an appropriate benchmark as an indicator of effective resource allocation. We find that multinationals make more efficient capital budgeting decisions than do purely domestic firms. The result stems from multinational enterprises exercising greater restraint on over-investment, but is not due to looser liquidity constraints. In obtaining the result, we account for the impact of institutional ownership, managerial ownership, and managerial entrenchment. We also test whether multinationals greater capital budgeting efficiency might be due to their investment locations, since they might thereby be monitored by more agents and also may be more successful in resisting pressures from special interest groups and governments to adopt practices that are not consistent with firm value maximization. We do not find support for the monitoring and bargaining hypotheses. Our observations therefore suggest that multinationals may be intrinsically better managed firms than are purely domestic firms.

GAYANÉ HOVAKIMIAN, Fordham University
Email: hovakimian@fordham.edu

This study examines whether conglomerates operate more efficient internal capital markets when they face financial constraints. I compare the patterns of internal capital allocation during recessions and non-recession periods for bank-dependent and bank-independent conglomerates. I find that during recessions when external capital markets are tighter conglomerates improve the efficiency of internal capital markets by allocating more funds to high growth divisions relative to low growth divisions. This evidence is significantly stronger for bank-dependent conglomerates, for which the liquidity constraints are more binding. These findings suggest that when faced with financial constraints, managers restrict overinvestment in low quality projects and use the flexibility of internal capital markets to provide funding for more valuable investment projects.

GUNTHER FRIEDL, Munich University of Technology - Faculty of Economics and Business Administration
Email: gunther.friedl@wi.tum.de
BERNHARD SCHWETZLER, Handelshochschule Leipzig (HHL) - Department of Finance
Email: schwetzler@finance.hhl.de

The terminal value generally reflects a substantial portion of a firm's market value. Stable growth models are usually used to estimate terminal values. We use a simple model of a firm to derive a valuation function for the terminal value in the presence of inflation. Our model reveals that there is a simple way to include the effect of inflation in the valuation model. Moreover, we show that recent recommendations on how to consider inflation in valuation models fail to provide correct estimates of firm value.

MADHAV V. RAJAN, Stanford Graduate School of Business
Email: MRAJAN@GSB.STANFORD.EDU
STEFAN J. REICHELSTEIN, Stanford Graduate School of Business, CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
Email: reichelstein_stefan@gsb.stanford.edu

The reported cost of a product frequently contains historical cost components that reflect past investments in productive capacity. We examine a setting wherein a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules with the property that, on a per unit basis, the historical cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate and characterize the direction and magnitude of the bias in reported historical cost that results from alternative depreciation rules, including in particular straight-line depreciation in conjunction with partial direct expensing. In addition, we demonstrate that for a reasonable range of parameter specifications the resulting bias is rather small. Finally, we apply our framework to two specific settings. First, in a regulatory context, we establish the extent to which the Accounting Profit Margin is indicative of a firm's pricing power in the product market. Second, we model an internal control scenario in which a manager's performance is evaluated using residual income, and identify the distortions in investment levels that result from the use of alternative depreciation rules.