NBER Reporter: Winter 2000/2001

Corporate Finance

The NBER's Program on Corporate Finance met on November 10 in Cambridge. Rene M. Stulz, NBER and Ohio State University, organized the meeting and chose these papers for discussion:

Luigi Guiso, University of Sassari, Paola Sapienza, Northwestern University, and Luigi G. Zingales, NBER and University of Chicago, "The Role of Social Capital in Financial Development" (NBER Working Paper No. 7563)

Discussant: Tarun Khana, Harvard University

Charles P. Himmelberg and Inessa Love, Columbia University, and R. Glenn Hubbard, NBER and Columbia University, "Investor Protection, Ownership, and Investments: Some Cross-Country Empirical Evidence"

Discussant: David S. Scharfstein, NBER and MIT

Julie Wulf, University of Pennsylvania, "Internal Capital Markets and Firm-Level Compensation Incentives for Division Managers"

Discussant: Antoinette Schoar, MIT

Michael J. Barclay, NBER and University of Rochester; Clifford G. Holderness, Boston College; and Dennis P. Sheehan, Pennsylvania State University, "The Block Pricing Paradox"

Discussant: Karen H. Wruck, Ohio State University

Brett Trueman, M. H. Franco Wong, and Xiao-Jun Zhang, University of California, Berkeley, "The Eyeballs Have It: Searching for the Value in Internet Stocks"

Discussant: Jay R. Ritter, University of Florida

Eugene F. Fama, University of Chicago, and Kenneth R. French, NBER and MIT, "The Equity Premium"

Discussants: G. William Schwert, NBER and University of Rochester, and Andrei Shleifer, NBER and Harvard University

To identify the effect of social capital on financial development, Guiso, Sapienza, and Zingales exploit the well-known differences in social capital and trust across different areas of Italy. In regions with high levels of social trust, households invest less in cash and more in stock, use more checks, have higher access to institutional credit, and make less use of informal credit. The effect of social capital is stronger where legal enforcement is weaker and among less-educated people. These results are not driven by omitted environmental variables, because the authors also show that the behavior of people who move is still affected by the level of social capital in the province where they were born.

Himmelberg, Love, and Hubbard investigate the effect of investor protection on corporate investment, emphasizing the endogeneity of ownership structure as one means of identifying firms operating under weak legal protections. Building on the idea that a weak legal environment increases the cost of external financing, the authors derive a model of investment in which changes in the marginal cost of capital are identified by changes in leverage and by the interactions of leverage with the concentration of inside equity ownership. Using firm-level data for a broad sample of 39 countries, they confirm that weaker legal protection empirically predicts higher concentrations of inside equity ownership. They also find that the marginal cost of capital is more sensitive to changes in leverage when inside equity ownership is highly concentrated. These results provide evidence that weak investor protection inhibits the efficient allocation of capital.

Using Compustat financial data and compensation data from a proprietary survey, Wulf finds that compensation and investment incentives are substitutes: firms that more strongly link firm performance to incentive compensation for division managers also provide weaker investment incentives through the capital budgeting process. Specifically, as the proportion of incentive pay for division managers that is based on firm performance increases, division investment is less responsive to division profitability. These findings are consistent with a model of influence activities by division managers and the implied relative weights placed on imperfect, objective signals (that is, accounting measures) versus distortable, subjective signals (that is, manager recommendations) in interdivisional capital allocation decisions.

Barclay, Holderness, and Sheehan examine the disparity in prices of large traded blocks of stock. On average, block trades are priced at an 11 percent premium to the post-announcement exchange price, while private placements are priced at a 19 percent discount. This paradox cannot be resolved by obvious considerations such as block size or liquidity. According to the authors, resolution comes from what happens after the transactions. Most block-trade purchasers become involved in management, suggesting that their premiums reflect anticipated private benefits from control. Most private-placement purchasers remain passive: firm value declines, and there are few acquisitions and little management turnover. This suggests that discounts on private placements reflect implicit compensation for helping to entrench management, not for monitoring, or for providing certification.

Trueman, Wong, and Zhang show how the market uses limited accounting information and measures of Internet usage to value Internet firms. The authors do not find a significant association between bottom-line net income and their sample firms' market prices; this is consistent with some investors' claims that financial statement information is of very limited use in the valuation of Internet stocks. However, they do find that gross profits are positively and significantly associated with prices. In addition, they find that unique visitors and page views, as measures of Internet usage, provide incremental explanatory power for stock prices, over and above net income and its components. They also find significant differences in valuation between e-tailers and portal and content/community firms with respect to their financial data and measures of Internet usage.

Fama and French compare estimates of the equity premium for 1872-1999 from realized returns and the Gordon constant dividend growth model. The two approaches produce similar estimates of the real equity premium for 1872-1949, about 4 percent per year. But for 1950-99, the Gordon estimate of 3.4 percent per year is about 40 percent of the estimate from realized stock returns of 8.28 percent. The authors suggest that the difference between the two estimates for 1950-99 is largely attributable to unexpected capital gains, the result of a decline in discount rates to unusually low values at the end of the sample period. They conclude that the unconditional expected stock return of the last half-century is a lot lower than the realized average return.

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