Optimal Investment Rule in an Inefficient Financial Market

46 Pages Posted: 16 Feb 2005

See all articles by Yaping Wang

Yaping Wang

Peking University - Guanghua School of Management

Yunhong Yang

Peking University - Guanghua School of Management

Chunsheng Zhou

Peking University - Guanghua School of Management - Finance

Date Written: July 14, 2005

Abstract

This article studies the corporate investment decision problem faced by a manager whose compensation is pegged to the stock price at some future time (rewarding time)in a market that the stock price may deviate from its fundamental value. It provides an analytical solution on the optimal investment rule and finds that in certain cases the manager may not invest in a project even though its net present value is positive, or, the manager may invest in a project with a negative net present value. Hence both over-investment and under-investment problems can be explained in this unified model. This model also explains the empirical finding of Blanchard, Rhee and Summers (1993) that, given fundamentals, market valuations appear to play a limited role in affecting corporate investment decisions. In addition, the article finds that incentive mechanisms for managers which are related to the long-term stock prices can also lead to investment distortions. The results of this paper can reasonably explain the pattern of corporate investments, especially of venture capital investments.

Keywords: Capital budgeting, optimal rule, inefficient market

JEL Classification: G14, G31

Suggested Citation

Wang, Yaping and Yang, Yunhong and Zhou, Chunsheng, Optimal Investment Rule in an Inefficient Financial Market (July 14, 2005). Available at SSRN: https://ssrn.com/abstract=646362 or http://dx.doi.org/10.2139/ssrn.646362

Yaping Wang

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China
8610-62768188 (Phone)

Yunhong Yang

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China
8610-62768188 (Phone)

Chunsheng Zhou (Contact Author)

Peking University - Guanghua School of Management - Finance ( email )

Beijing, 100871
China
8610-62768188 (Phone)
8610-62768266 (Fax)

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