Agency Frictions Research Articles

The Marginal Value of Cash: Structural Estimates from a Model with Financing and Agency Frictions

How much value does an additional dollar of cash create for a firm? It is generally recognized that the marginal value of cash (MVC) can either exceed or fall below one dollar. Estimates of MVC can guide corporate cash and payout policy, indicate the quality of governance, and make a firm a target for takeover or activism. Yet the existing methods of estimation lack a rigorous theoretical foundation and often provide implausibly high or low estimates. In this paper, we provide a formulation of MVC and structurally estimate the MVC based on a model that encompasses the important determinants for the choice of cash savings, including financing and agency costs. We find that firms with large cash and capital stocks have lower marginal value of cash, whereas the relationship between leverage and marginal value of cash is hump shaped. Two quasi-natural experiments validate the MVC estimates. This paper was accepted by Lukas Schmid, finance. Funding: D. Li would like to thank the support by the Guangdong Natural Science Foundation [Grant 2024A1515011703]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01013 .

PCAOB International Inspections and the Market Value of Cash Holdings

ABSTRACT This study examines whether and how Public Company Accounting Oversight Board (PCAOB) international inspections mitigate the market value discount in cash holdings. We find that shareholders value internal cash holdings more highly for the non-U.S.-listed clients of inspected auditors after the public disclosure of the auditors’ inspection reports. We show that the decreased agency frictions and the increased financial reporting credibility are potential mechanisms. Further, we find that the effect of PCAOB international inspections on the market value of cash holdings is stronger in countries with weaker legal institutions and less sound information environment. Since investors’ valuation of cash mirrors how they expect the cash to be used, our results suggest a unique role of PCAOB oversight in mitigating unresolved agency problems and safeguarding corporate resources, thereby lessening investors’ markdowns of cash assets. Our findings help identify the real economic impacts of PCAOB oversight in enhancing global stock market confidence. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G34; M42; M48.

CSR Disclosures and Agency Frictions: Evidence from a Shift from Mandatory to Voluntary Corporate Philanthropy Disclosures

CSR Disclosures and Agency Frictions: Evidence from a Shift from Mandatory to Voluntary Corporate Philanthropy Disclosures

Learning in Financial Markets: Implications for Debt-Equity Conflicts

Abstract Financial markets reveal information that firm managers can utilize when making equity value-enhancing investment decisions. However, for firms with risky debt, such investments are not necessarily socially efficient. Despite this friction, we show that learning from prices improves investment efficiency. This effect is asymmetric, however, as investors learn less about projects that decrease the riskiness of cash flows: efficiency is lower for diversifying investments than for focusing (risk-increasing) investments. This also implies that investors’ endogenous learning further attenuates risk shifting but amplifies debt overhang. Our model provides a novel channel through which learning from financial markets affects agency frictions between stakeholders.

Agency Frictions and Procurement: New Evidence from U.S. Electricity Restructuring*

This article presents new quantitative evidence of the sources of efficiency benefits from deregulation. We estimate the heterogeneous effects of plant divestitures on fuel procurement costs during the restructuring of the U.S. electricity industry. Guided by economic theory, we focus on three mechanisms and find that restructuring reduced fuel procurement costs for firms that (i) were not subject to earlier incentive‐regulation programs, (ii) had relatively strong bargaining power as coal purchasers after restructuring, and (iii) were locked in with disadvantaged coal contracts prior to restructuring.

ES Risks and Shareholder Voice

Abstract We examine whether shareholder votes in environmental and social (ES) proposals are informative about firms’ ES risks. ES proposals are unique in that they nearly always fail. We examine whether mutual funds’ support for these failed proposals contains information about the ES risks that firms face. Higher support in failed ES proposals predicts subsequent ES incidents and the effects of these incidents on shareholder value. Examining the detailed records of fund votes, we find that agency frictions between a group of shareholders contribute to proposal failure. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online

Purpose, profit and social pressure

We develop a model in which there are firms and employees who care about profit-sacrificing higher purpose (HP) and those who do not. Firms and employees search for each other in the labor market. Each firm chooses its HP investment. When there is no social pressure on firms to adopt a purpose, HP dissipates agency frictions, lowers wage costs, yet elicits higher employee effort in firms that intrinsically value the purpose. However, social pressure to invest in HP can distort the HP investments of all firms and reduce welfare by making all agents worse off. Applications of these results to banking are discussed.

The agency costs of tranching: Evidence from RMBS

This paper documents the agency costs resulting from the deeper tranching of subprime residential mortgage pools. Mortgage servicers are less likely to renegotiate delinquent loans collateralizing a greater number and variety of tranches. We find that an interquartile increase in tranching reduces mortgage servicers’ probability of loan renegotiation by 14% relative to the mean. This effect is concentrated in mortgages with greater ambiguity surrounding the loan value maximizing action. Overall, our results support the notion that tranching worsens agency frictions by increasing coordination costs among investors and impeding their monitoring of the agent.

Asset Management as Creator of Market Inefficiency

In this paper, we describe how agency frictions in asset management can generate prime violations of the Efficient Markets Hypothesis, such as momentum, value and an inverted risk-return relationship. Momentum in our theory is associated with procyclical fund flows and price over-reaction, and is more pronounced for overvalued assets. The investors who generate the momentum and who are losing from it are those requiring their asset managers to keep their portfolios close to benchmark indices. Our theory suggests a rethinking of asset management contracts. Contracts should employ measures of long-run risk and return, and benchmark indices that emphasize asset fundamentals. There should also be greater transparency on managers’ choice of strategies.

Optimal contracts and asset prices in a continuous-time delegated portfolio management problem

<p style='text-indent:20px;'>We study optimal contracts and asset prices in a financial market in which an investor delegates a portfolio manager to manage her wealth. The agency frictions are caused by the manager's "shirking" action and hidden effort. The shirking action converts part of the return of the managed portfolio into the manager's income without reducing his utility. The manager's effort improves the return of the portfolio but reduces the manager's utility. We illustrate this dynamic principal-agent problem under hidden effort and observable effort, respectively. When the effort is hidden, to alleviate the impact of moral hazard, the investor pays more for the manager's performance and always keeps the optimal contract related to the returns of the manager's portfolio and market portfolio, and their quadratic (co)variations. When the manager's effort is observable, the optimal contract is related to the return of the market portfolio if the agency friction caused by the shirking action is serious, but is only related to the return of the manager's portfolio if shirking is not serious. Analysing the expected utility of the manager, we find that he has a disposition to hide information about effort to pursue a higher expected utility.</p>

When does overlapping ownership soften competition? The role of agency frictions and repeated interaction

When does overlapping ownership soften competition? The role of agency frictions and repeated interaction

Do Corporations Retain Too Much Cash? Evidence from a Natural Experiment

Abstract Corporations have accumulated record amounts of cash. We study whether firms’ cash retention has been excessive by examining a Korean reform that introduced a new tax on earnings retained as cash. Difference-in-differences tests show that treated firms reduce cash retention and instead increase payouts and investments. Market participants react favorably to the reform, consistent with excessive cash retention. The valuation effects and the alternative uses of the cash are associated with behavioral and agency frictions. Firms that are more subject to behavioral biases increase payouts and experience higher valuations, while poorly governed firms allocate more to investment and experience relatively lower valuations. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Social capital and management commitment

ABSTRACT This study examines the role of social capital in fostering beneficial managerial behaviour that serves the interests of shareholders. Specifically, this research focuses on the effects of social capital on managerial ownership and dividend payout policy. We document evidence demonstrating that firms with headquarters in high social capital regions are associated with higher managerial ownership and greater dividend payouts to shareholders. Our findings are consistent with the notion that social capital induces cooperative norms and alleviates agency frictions between managers and shareholders. Additional analysis indicates that managerial ownership increases after a firm moves its headquarters to a county with higher social capital, while dividend payouts do not exhibit a significant change after relocation. In further tests, we find that the association between social capital and managerial ownership weakens after SOX, but that the association between social capital and dividend payouts does not. Finally, we show that both civic norms and associational networks influence the level of managerial ownership and dividend payouts. Overall, our study adds to the literature by deepening the understanding of the impact of social capital in shaping good managerial behaviour at the individual and corporate levels.

Agency frictions, managerial compensation, and disruptive innovations

Whether a manager leads the innovation efforts of a firm in line with shareholder preferences is key for firm value and growth. This, in turn, influences aggregate productivity growth and welfare. Data on US public firms reveals that (i) firms with better corporate governance tend to adopt highly incentivized contracts rich in stock options and (ii) such contracts are more likely to lead to disruptive innovations – patented inventions that are in the upper tail of the distribution in terms of quality and originality. Motivated by these empirical results, we develop and estimate a new dynamic general equilibrium model of firm-level innovation with agency frictions and endogenous determination of executive contracts. The model is used to study the joint dynamics of corporate governance, managerial compensation, and disruptive innovations, as well as the consequent aggregate implications on growth and welfare. Better corporate governance can reduce the influence of the manager in determining the compensation structure. This leads to more incentivized contracts and boosts innovation, with substantial benefits for the shareholders as well as the broader economy through knowledge spillovers. Removing agency frictions leads to contracts richer in stock options, boosting growth by 0.51pp, and welfare by 7.3% in consumption-equivalent terms. These findings are robust to incorporating short-termism. Short-termism itself is also detrimental, the removal of which increases welfare by 1.5%. Alleviating both frictions at the same time leads to amplified gains in growth and welfare.

Asset Management Contracts and Equilibrium Prices

We model asset management as a continuum between active and passive: managers can deviate from benchmark indices to exploit noise trader–induced distortions, but agency frictions constrain these deviations. Because constraints force managers to buy assets that they underweight when these assets appreciate, overvalued assets have high volatility, and the risk-return relationship becomes inverted. Distortions are more severe for overvalued assets than for undervalued ones because trading against the former entails more risk and tighter constraints. We provide empirical evidence supporting our model’s main mechanisms. Using the data, we infer the constraints’ tightness and compute a measure of effective arbitrage capital.

The Marginal Value of Cash: Structural Estimates from a Model with Financing and Agency Frictions

The Marginal Value of Cash: Structural Estimates from a Model with Financing and Agency Frictions

Financially constrained mortgage servicers

Financially constrained mortgage servicers destroyed substantial MBS investor value during the financial crisis through their management of delinquent mortgages. Servicers advance to investors monthly payments missed by borrowers. In order to minimize this obligation to extend financing to distressed borrowers, constrained servicers aggressively pursued foreclosures and modifications at the expense of investors, borrowers, and future mortgage performance. When agency frictions between the servicer and the investor are higher, the servicer’s financial constraints matter more. IV regressions suggest that, on average per defaulted loan, servicers’ financial constraints are responsible for 20% of the total investor value reduction during the financial crisis.

Bank Risk-Taking and Impaired Monetary Policy Transmission

We consider a standard banking model with agency frictions to simultaneously study the weakening and reversal of monetary transmission and banks’ risk-taking in a low-interest environment. Both, weaker monetary transmission and higher risk-taking arise because lower policy rates impair banks’ net worth.The pass-through to deposit rates, the level of excess reserves and the extent of the agency problem between banks and depositors are crucial determinants of monetary transmission. If the deposit pass-through is sufficiently impaired, a reversal rate exists. For policy rates below the reversal rate further interest rate reductions lead to a disproportionate increase in risk-taking and a contraction in loan supply.

The Effects of Financial Reporting and Disclosure on Corporate Investment: Analysis and Critique

The purpose of this paper is to present an analysis and critique of Roychowdhury, Shroff, and Verdi’s The effects of financial reporting and disclosure on corporate investment: A review (Journal of Accounting & Economics, 68 (2019)). Roychowdhury, Shroff, and Verdi survey the empirical literature over the previous two decades on “whether and to what extent financial reporting facilitates the allocation of capital to the right investment projects,” “provide a framework to organize this literature,” and “highlight opportunities for future research.” The framework they provide for organizing the literature “articulate[s] two broad scenarios in which financial reporting ‘matters’ for investment choices: (i) the presence of information asymmetry that gives rise to agency frictions such as adverse selection and moral hazard costs, and (ii) the presence of uncertainty about growth opportunities.” The analysis and critique presented herein addresses the framework and the first scenario. In particular, it focuses on what they refer to as agency frictions and the opportunities they suggest for future research. While the question of whether and to what extent financial reporting facilitates the allocation of capital to the right investment projects is important and worthy of future research, the framework and first scenario present several problems that cannot easily be ignored if the opportunities for future research are to be pursued.

The Sources of Financing Constraints

Which financial frictions drive firms’ financing constraints? We structurally estimate dynamic firm financing models embedding many financial frictions, on panels of public firms and private firms. We focus on limited enforcement, moral hazard, and trade-off models and assess which models rationalize best observed corporate policies across various samples. Our tests, based on empirical policy function benchmarks, favor trade-off models for larger public firms, limited commitment models for smaller public firms, and moral hazard models for Private firms. Our estimates suggest significant financing constraints due to agency frictions and highlight the importance of identifying their sources for firm valuation.