Year: 2006
Type: article
Abstract: In the past 20 years, finance literature has focused on the imperfections of the market.As assumed in M&M (1958), the financial market is not perfect, but instead contains frictions.Stein (2001) argues that in a perfect capital market, funds flow in such a way that the marginal product of capital is equal across all projects.But in the real world with imperfections, a variety of distortions exist making the investment decision a complicated process.This chapter discusses the major aspects of market imperfection that affect corporate investment, and then specifically addresses the three topics to be covered in the essays. Market Imperfections that Affect Corporate InvestmentMarket imperfections can be generally classified into two groups, namely, fundamental factors and institutional factors.Fundamental factors include asymmetric information, moral hazard and adverse selection, agency problems, and behavioral factors.Institutional factors include diversification, industrial organizations, taxes, government regulations and subsidies.This section briefly discusses each of these factors. Asymmetric Information, Moral Hazard and Adverse SelectionAsymmetric information is one of the major market imperfections affecting firm investment.Myers and Majluf (1984) emphasize information asymmetries between managers and investors.They claim that the information on the performance of the firm held by managers is superior to that known by outside investors.Outside investors understand this and thus require a higher rate of return to compensate for this information asymmetry.Therefore, raising external funds is more costly to a firm than employing internally generated funds.When firms suffer from liquidity constraints, managers may not be willing to issue new stocks but rather forego profitableThe agency problem is another major market imperfection component that affects investment greatly.The influential work of Jensen and Meckling (1976) documents that managers of publicly-traded firms would pursue their own private objectives which need not coincide with those of outside stockholders.The agency problem between managers and shareholders is claimed to be the cause of empire-building and overinvestment.Managers may have an excessive taste for running large firms, as opposed to simply profitable ones.This "empire-building" tendency is emphasized by Jensen (1986), among many others.Another source of conflict between managers and shareholders is that managers may be concerned with how their actions affect their reputations, and ultimately their perceived value in the labor market.Narayanan (1985) observes that managers concerned with their labor-market reputations may have incentives to take actions that boost measures of short-term performance at the expense of long-run shareholder value.Stein (1989) makes a similar point about managers concerned not with their own reputations per se, but rather with their firms' stock prices over a near-term horizon.In both cases, the key to the argument is that managers can do things that are unobservable to outside shareholders.Consequently, underinvestment is rewarded with an increase in either the stock price, or in managers' personal reputations.In particular, a desire to impress the stock market or the labor market in the short run can in some circumstances lead to overinvestment, rather than underinvestment.Jensen (1986, 1993) argues that empire-building preferences will cause managers to spend essentially all available funds on investment projects.This leads to the prediction that investment in internal resources will increase.It also implies that investment will decrease with leverage, because high current debt payments force cash out of the firm, thereby reducing managers' discretionary budgets.Jensen's ideas have been further developed and refined into 80 Italy
Author: Sijing Zong
Institution: Kent State University
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W168245153