Essays in corporate finance and investments
This dissertation studies the interplay of asset and liability sides of balance sheets, and considers both the level and the risk attributions of investments and financing sources. The first chapter links financing frictions on the liability side to investment risk on the asset side. It studies the effect of financial constraints on equity holders' risk-shifting incentives within a real options framework. Within this framework, shareholders trade off the benefit of risk-shifting with the cost of financial constraints. Therefore risk-shifting is avoided ex post for highly constrained firms because the cost outweighs the benefit. In fact, both the risk-shifting incentive and the agency cost of risk-shifting are monotonically decreasing in financial constraints costs. In addition, the effect of debt maturity is also examined in this framework, and without financial constraints, there is no short-term debt effect. These model implications are supported in a large sample of firms over the 1965 to 2009 period: (1) financial constraints help to reduce risk-shifting incentives; (2) complementing the current view, financially unconstrained firms tend to shift risk even when they are still healthy; (3) short-term debt helps to strengthen the effect of financial constraints on reducing risk-shifting incentives; (4) the agency cost of risk-shifting is smaller for more constrained firms. The results are robust to the availability of internal financings. The second chapter studies the opposite direction: the effect goes from the asset side to the liability side. It studies corporate investment and financing in a dynamic trade-off model with a sequence of irreversible investments. Conditional on future investment and financing opportunities, juvenile firms underutilize debt when financing investment the first time to retain financial flexibility. Underutilization of debt persists when adolescent firms mature (i.e. exercise their last investment options), and it is more (less) severe for more back-loaded (front-loaded) investment opportunities. Thus, leverage dynamics crucially hinge upon the structure of the investment process and otherwise identical firms appear to have significantly different target leverage ratios. Structural estimation of key parameters reveals that simulated model moments can match data moments. Furthermore, capital structure regressions using model simulated data based on these parameter estimates produce results in line with the empirical evidence, and explain the empirical puzzle that average leverage ratios are path dependent and persistent for very long periods of time. The third chapter narrows down to the liability side and studies the puzzle of whether idiosyncratic risk predicts the cross-section of stock returns and the direction of the prediction. This chapter examines this relationship by extracting implied idiosyncratic variances from option prices and decomposing past realized idiosyncratic variances into expected and unexpected components. The Fama-MacBeth (1973) regressions using different samples show mixed results. The significant positive (negative) relationship between cross-sectional stock returns and implied idiosyncratic variance (past realized idiosyncratic variance) is mainly driven by the sample with low (high) idiosyncratic variances. It is plausible that the mixed results in the literature are caused by the conflicting effects of implied idiosyncratic variance for low idiosyncratic variance stocks and persistent idiosyncratic variance shock for high idiosyncratic variance stocks.
Financial Constraints, Risk Shifting, Asset Substitution, Real Options, Capital Structure, Financial Flexibility, Idiosyncratic Risk, Implied Volatility, Stock Returns.
University of Illinois - Urbana-Champaign
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University of Illinois at Urbana-Champaign