Week 1 – Planning and Funding Corporate
Investment
A common rule of thumb in (corporate) finance is to invest in any project
where the NPV is positive. A positive NPV means that the value created
from the investment exceeds the firm’s initial cost of purchasing capital.
Stock market participants should anticipate this and bid up the firm’s
share price even before investment is undertaken. We can measure
investment opportunities by comparing a firm’s market value to the
purchase price of its assets. This is done by Tobin’s Q.
' Market value of firm
Tobi n s Q=
Replacement cost of capital
The market value of the firm is often measured as the firm’s market
cap plus debt. The market value of debt should be used, however
often only the book value is available.
The denominator is the book value of total assets, or Property, Plant,
and Equipment (PP&E).
So, basically, the replacement cost of capital is the price the firm
would have to pay on the market for the capital right now.
The market-book ratio is similar and sometimes used instead, as this
is more readily available.
How to interpret Tobin’s Q:
A firm with Q > 1 generates more value using capital than other
investors or firms would.
This means that the internal value of capital is higher than the
market’s willingness to pay.
A firm with Q < 1 is wasting some capital and is thus better off
selling assets.
Predictions of Q theory are as follows:
1. An increase in Tobin’s Q is associated with an increase in firm
investment (scaled by capital or size).
2. Tobin’s Q fully explains differences in investment across firms.
Both hypotheses can be tested by regressing investment/assets on Tobin’s
Q (along with some other controls).
Hypothesis #1 predicts that the β coefficient is positive.
Hypothesis #2 predicts that R2is close to 1 and that coefficients on
the included controls are insignificant.
Then there's the empirical evidence on Q theory; while regressions show
that Q is positively associated with investment, studies have highlighted
several problems with Q theory:
, Q explains little of the variation in investment > regression R2 values
are low.
Numerous other variables are significantly related to investment.
Regression estimates of Q’s effect are only consistent with theory if
adjustment costs are huge. Where adjustment costs are the costs
firms face when adjusting their capital structures.
So, the findings imply that Q matters for corporate investment, but other
factors may matter more. A possible explanation for this lack of empirical
evidence is measurement error in Q. This measurement error will bias the
coefficient down toward 0, and R2 will decrease as well. This bias can also
lead to significant coefficients on the other variables. This measurement
error may be caused by the following:
The market value of equity may be influenced by factors other than
investment opportunities.
Q should be based on the market value of debt, but often due to a
lack of available data on the market value of debt, book value is
used instead.
The book value of assets is based on historical prices and may not
reflect current replacement costs.
Most intangible assets have value but are not recorded in financials.
When Tobin’s Q is researched accounting for this measurement error, as
done by Erickson and Whited (2000), the statistical significance of the
coefficient increases significantly. Their main findings include:
R2 more than doubles after accounting for measurement error.
The coefficient estimates on Q are substantially larger.
And the estimates of other variables are small and insignificant.
Peters and Taylor (2017) analysed Tobin’s Q and found that Q works much
better when intangible assets are included. This shows that intangible
assets also have an important role in Tobin’s Q effect.
Another thing that is likely affecting investment is financial
constraints. Because if a firm has difficulty raising external financing, it
may pass up investment opportunities even when Q is high. Because
young firms start with almost no cash and most of the time are also not
profitable yet, their main way to fund investment is raising external
financing. While mature firms typically hold cash and are profitable, they
may face very large upfront investment costs and need external financing.
However, external financing is costly. Pecking order theory predicts that
investment is cheaper to finance using internal funds than external. The
key reason for this is asymmetric info: a firm’s managers know its
condition better than external investors.
If managers are trying to reduce ownership stake by selling shares,
then the firm could be in a bad condition.
Then, using internal cash signals, the firm believes its projects will
be profitable.
What are the implications from this information?
, This high information asymmetry can lead to a firm becoming
financially constrained.
This means that firms with volatile cash flows should build up
internal funds to ensure sufficient liquidity during bad years. This is
called precautionary savings.
We have been talking about (intangible) assets for a while now, but what is
the definition of a corporate asset actually? The defining characteristics of
an asset are:
It is something that the firm creates or acquires.
A firm uses the asset to create value (earn profits) for more than one
financial reporting period.
The firm invests money or other resources to create the asset.
Then the accounting treatment of investment. The firm must report the
investment into assets differently than ordinary business expenses in their
financial statements. Furthermore, all assets lose value over time, and
financial statements must reflect this to accurately capture a firm’s current
situation.
Tangible assets wear down physically.
While intangible assets become obsolete as technology improves.
In the year that an asset is created, its cost is recorded on the balance
sheet, usually as PP&E. Each subsequent year, the value of the asset is
reduced by a fixed amount.
The most common is straight-line depreciation over the asset’s
lifespan.
Accounting rules specify reasonable lifespans for different asset
types.
Amortization is similar, but for intangible assets.
Now, the definition of tangible assets. Some defining characteristics of a
tangible asset are:
Produces value for more than one year (as do all assets).
Has a physical form.
Can only be used in one place at any specific time.
Typically requires spending cash up front to purchase or create.
And the defining characteristics of an intangible asset:
Also produces value for more than one year.
Is not physically constrained to be used in only one place at a time.
Can be used by multiple people, across multiple firm
divisions, at the same time.
Part of its creation process does not require upfront cash spending.
However, there are some key issues for intangible assets. They differ from
tangibles in several ways, creating unique challenges for firms and
investors:
Limited information available in financial statements.
Ownership cannot always be enforced contractually.
Investment
A common rule of thumb in (corporate) finance is to invest in any project
where the NPV is positive. A positive NPV means that the value created
from the investment exceeds the firm’s initial cost of purchasing capital.
Stock market participants should anticipate this and bid up the firm’s
share price even before investment is undertaken. We can measure
investment opportunities by comparing a firm’s market value to the
purchase price of its assets. This is done by Tobin’s Q.
' Market value of firm
Tobi n s Q=
Replacement cost of capital
The market value of the firm is often measured as the firm’s market
cap plus debt. The market value of debt should be used, however
often only the book value is available.
The denominator is the book value of total assets, or Property, Plant,
and Equipment (PP&E).
So, basically, the replacement cost of capital is the price the firm
would have to pay on the market for the capital right now.
The market-book ratio is similar and sometimes used instead, as this
is more readily available.
How to interpret Tobin’s Q:
A firm with Q > 1 generates more value using capital than other
investors or firms would.
This means that the internal value of capital is higher than the
market’s willingness to pay.
A firm with Q < 1 is wasting some capital and is thus better off
selling assets.
Predictions of Q theory are as follows:
1. An increase in Tobin’s Q is associated with an increase in firm
investment (scaled by capital or size).
2. Tobin’s Q fully explains differences in investment across firms.
Both hypotheses can be tested by regressing investment/assets on Tobin’s
Q (along with some other controls).
Hypothesis #1 predicts that the β coefficient is positive.
Hypothesis #2 predicts that R2is close to 1 and that coefficients on
the included controls are insignificant.
Then there's the empirical evidence on Q theory; while regressions show
that Q is positively associated with investment, studies have highlighted
several problems with Q theory:
, Q explains little of the variation in investment > regression R2 values
are low.
Numerous other variables are significantly related to investment.
Regression estimates of Q’s effect are only consistent with theory if
adjustment costs are huge. Where adjustment costs are the costs
firms face when adjusting their capital structures.
So, the findings imply that Q matters for corporate investment, but other
factors may matter more. A possible explanation for this lack of empirical
evidence is measurement error in Q. This measurement error will bias the
coefficient down toward 0, and R2 will decrease as well. This bias can also
lead to significant coefficients on the other variables. This measurement
error may be caused by the following:
The market value of equity may be influenced by factors other than
investment opportunities.
Q should be based on the market value of debt, but often due to a
lack of available data on the market value of debt, book value is
used instead.
The book value of assets is based on historical prices and may not
reflect current replacement costs.
Most intangible assets have value but are not recorded in financials.
When Tobin’s Q is researched accounting for this measurement error, as
done by Erickson and Whited (2000), the statistical significance of the
coefficient increases significantly. Their main findings include:
R2 more than doubles after accounting for measurement error.
The coefficient estimates on Q are substantially larger.
And the estimates of other variables are small and insignificant.
Peters and Taylor (2017) analysed Tobin’s Q and found that Q works much
better when intangible assets are included. This shows that intangible
assets also have an important role in Tobin’s Q effect.
Another thing that is likely affecting investment is financial
constraints. Because if a firm has difficulty raising external financing, it
may pass up investment opportunities even when Q is high. Because
young firms start with almost no cash and most of the time are also not
profitable yet, their main way to fund investment is raising external
financing. While mature firms typically hold cash and are profitable, they
may face very large upfront investment costs and need external financing.
However, external financing is costly. Pecking order theory predicts that
investment is cheaper to finance using internal funds than external. The
key reason for this is asymmetric info: a firm’s managers know its
condition better than external investors.
If managers are trying to reduce ownership stake by selling shares,
then the firm could be in a bad condition.
Then, using internal cash signals, the firm believes its projects will
be profitable.
What are the implications from this information?
, This high information asymmetry can lead to a firm becoming
financially constrained.
This means that firms with volatile cash flows should build up
internal funds to ensure sufficient liquidity during bad years. This is
called precautionary savings.
We have been talking about (intangible) assets for a while now, but what is
the definition of a corporate asset actually? The defining characteristics of
an asset are:
It is something that the firm creates or acquires.
A firm uses the asset to create value (earn profits) for more than one
financial reporting period.
The firm invests money or other resources to create the asset.
Then the accounting treatment of investment. The firm must report the
investment into assets differently than ordinary business expenses in their
financial statements. Furthermore, all assets lose value over time, and
financial statements must reflect this to accurately capture a firm’s current
situation.
Tangible assets wear down physically.
While intangible assets become obsolete as technology improves.
In the year that an asset is created, its cost is recorded on the balance
sheet, usually as PP&E. Each subsequent year, the value of the asset is
reduced by a fixed amount.
The most common is straight-line depreciation over the asset’s
lifespan.
Accounting rules specify reasonable lifespans for different asset
types.
Amortization is similar, but for intangible assets.
Now, the definition of tangible assets. Some defining characteristics of a
tangible asset are:
Produces value for more than one year (as do all assets).
Has a physical form.
Can only be used in one place at any specific time.
Typically requires spending cash up front to purchase or create.
And the defining characteristics of an intangible asset:
Also produces value for more than one year.
Is not physically constrained to be used in only one place at a time.
Can be used by multiple people, across multiple firm
divisions, at the same time.
Part of its creation process does not require upfront cash spending.
However, there are some key issues for intangible assets. They differ from
tangibles in several ways, creating unique challenges for firms and
investors:
Limited information available in financial statements.
Ownership cannot always be enforced contractually.
