Capital Allocation Decisions Research Articles

Do environmental and climate scores for financial institutions reflect lending and underwriting activity? A case study of global banks

AbstractAchieving international climate targets may require more than $8 trillion in annual investments to 2030. We investigate the extent to which third‐party environmental scores for banks reflect lending and underwriting in fossil‐fuel and low‐carbon industries, and how ratings are influenced by outward signals of commitment to climate action. We provide empirical evidence on the performance of leading Environmental, Social and Governance (ESG) ratings providers and offer actionable guidance as to how ESG ratings may be improved in this context. We find that banks' environmental scores are most strongly influenced by signals of future intention regarding climate action, rather than by prior and current lending and underwriting behaviour. Our analysis highlights the need for rating providers, when constructing environmental scores for banks, to place more weight on key capital allocation decisions, and less on future intentions. We recommend that banks disclose breakdowns of their financing activities in key carbon‐intensive and low‐carbon industries.

Uncertainty and international fund flows: A cross-country analysis

This paper investigates the impacts of uncertainty on international portfolio allocation decisions and returns across 27 countries. Using panel structural vector autoregressive analysis, a positive link between both country-level and global uncertainty with equity fund flows is uncovered, highlighting the role of investor sentiment in capital allocation decisions. Findings also support the portfolio rebalancing theory, revealing the negative influence of past returns on fund flows. Results show that the VIX demonstrates a positive association with fund flows, particularly during periods of elevated global uncertainty. Moreover, this research analyzes differences between developed and emerging markets in their sensitivity to uncertainty shocks.

Examining Investment Companies’ ESG Data to Determine Investment Efficiency

Environment, Social, and Governance (ESG) investing is a crucial topic in modern society. Every day, new government regulations and incentives fuel sustainable investing by requiring robust corporate ESG disclosures. As companies become more aware of their societal and environmental impacts, investment companies such as Blackrock and Vanguard also learn to reshape their capital allocation decisions to benefit their customers. In this paper, we examine the S&P 500 equity holdings of some of these significant asset managers with a specific focus on the ESG scores of the companies they invest in. Through the compiled data, we see that the ESG scores of asset managers are ultimately very similar. Additionally, we derive that asset managers tend to base their decisions on several other factors, including the expected returns, as most investors also demand profit. As the ESG investing landscape continues to evolve, we determine that investors approaching their investments in an ESG-conscious manner may prefer to make their investments based on their independent analysis until the birth of more ESG-conscious investing strategies.

Do industry-specific accounting standards matter for capital allocation decisions?

This study examines whether the implementation of industry-specific accounting standards helps capital market participants in making decisions about providing capital to firms. We predict and find an, on average, increase in firms’ capital growth in years following implementation of the relevant industry standard. The increase in capital growth arises primarily from equity issuances and is attributable to the implementation of the standards rather than industry-specific trends or economic shocks. We explore heterogeneity in industry standards and find more pronounced effects for (i) industry standards that reveal new information, provide explicit guidance, or increase accounting uniformity, and (ii) small firms, firms with greater information asymmetry, and firms with greater capital constraints before implementation of the standards. We also find evidence consistent with two channels explaining the documented increase in capital flows: reduction of information asymmetry and increase in financial statement comparability.

Foreign direct investment and local interpretable model-agnostic explanations: a rational framework for FDI decision making

PurposeThis study aims to examine foreign direct investment (FDI) factors and develops a rational framework for FDI inflow in Western European countries such as France, Germany, the Netherlands, Switzerland, Belgium and Austria.Design/methodology/approachData for this study were collected from the World development indicators (WDI) database from 1995 to 2018. Factors such as economic growth, pollution, trade, domestic capital investment, gross value-added and the financial stability of the country that influence FDI decisions were selected through empirical literature. A framework was developed using interpretable machine learning (IML), decision trees and three-stage least squares simultaneous equation methods for FDI inflow in Western Europe.FindingsThe findings of this study show that there is a difference between the most important and trusted factors for FDI inflow. Additionally, this study shows that machine learning (ML) models can perform better than conventional linear regression models.Research limitations/implicationsThis research has several limitations. Ideally, classification accuracies should be higher, and the current scope of this research is limited to examining the performance of FDI determinants within Western Europe.Practical implicationsThrough this framework, the national government can understand how investors make their capital allocation decisions in their country. The framework developed in this study can help policymakers better understand the rationality of FDI inflows.Originality/valueAn IML framework has not been developed in prior studies to analyze FDI inflows. Additionally, the author demonstrates the applicability of the IML framework for estimating FDI inflows in Western Europe.

Foreign economic policy uncertainties and corporate investments: Insights from Hong Kong

Our study reveals that corporate investment decisions in Hong Kong, a small open economy with a significant presence of multinational corporations, are largely and negatively influenced by economic policy uncertainties from foreign countries (foreign EPU). Furthermore, the adverse impact of foreign EPU on corporate investments is more pronounced in firms with extensive international operations. Our findings highlight the relevance of global uncertainties, implying that economic policy shocks in other parts of the world can have far-reaching effects on capital allocation decisions in the home country, and therefore, are consequential from the perspectives of both corporate managers and policymakers.

Why the High Values for the CAPE Ratio in Recent Years Might Be Justified

In this paper, I propose a tracking error approach using the P/E ratio equation to approximate the CAPE Ratio. After accounting for the recent structural changes in the composition and valuation of the S&P 500 index, along with a persistently low interest rate environment over the last three decades, I show that the average CAPE Ratio had increases over time. Relying solely on historical CAPE averages to forecast equity returns may therefore prove unreliable. The findings in this paper indicate that investors should incorporate multiple factors, including required return and expected earnings growth, when forming capital allocation decisions across asset classes. Rotating out of the equity market simply because the CAPE Ratio shows that the equity market is too expensive might not produce the desire outcome investors hope for.

Are environmental, social and governance (ESG) ratings reliable indicators of emissions outcomes? A case study of the airline industry

AbstractWe analyse environmental ratings and emissions scores for commercial airlines from several major environmental, social and governance ratings providers. Specifically, we investigate whether emissions scores capture and predict absolute carbon emissions and emissions intensity levels, and whether scores are consistent across providers. This builds on existing literature by evaluating the predictive ability of ratings over significantly longer periods than past studies, examining within‐industry ratings disagreement for carbon emissions scores, and using an industry‐specific emissions intensity metric. Data covers 57 airlines from 2012 to 2021. Cross‐sectional and panel regressions are estimated to investigate whether ratings capture and predict carbon emissions data. We find no evidence that emissions scores capture or predict reported carbon emissions, and find that scores from different providers diverge substantially. Persistent shortcomings may undermine trust in the ratings industry, create trade‐offs between emissions abatement and ratings improvement, and hinder the incorporation of climate‐related information in capital allocation decisions.

Multinational corporations’ capital allocation decisions across asymmetric risk locations: intertemporal equilibrium and optimal transitional adjustment paths

Abstract Multinational corporations operate across locations with different risk profiles. We examine how multinational corporations address the optimal allocation of capital across multiple locations and analyse the transition path to the intertemporal equilibrium. Our model considers returns, risks and adjustment costs to reflect the dynamics of allocating capital assets across locations over time, as well as the mix of assets across locations in equilibrium. Variational calculus is employed to show that the model confirms standard expectations that where a location’s rates of return on assets increase, or adjustment costs decrease, equilibrium capital allocation and transitional capital flows to that location will increase. Symmetrically, rising (falling) risk increases (decreases) the proportion of the capital asset holdings of a location. The crucial insight is that for the transitional dynamics to intertemporal equilibrium, the optimal relative capital flow response to changes in risk can generate relative portfolio allocations that may initially move in the opposite direction to that implied by the stock equilibrium. Specifically, an increase in risk for the high-risk location may initially result in an increase in the relative capital asset flow to the high-risk location relative to the low-risk location. Empirical research must account for the possibility of non-monotonicity in asset allocation flows to avoid misspecification. Moreover, policy makers will have to anticipate possible pressure for reversal resulting from short-term worsening capital flows. These reflections are mirrored in recent research calls for separating structural and transition effects of institutional change on the investment decisions by multinational corporations.

China's Internet sector reforms and the rise of ESG in the state techno‐nationalist agenda

AbstractFrom 2020 onward, sweeping reforms were implemented in China's domestic Internet sector that stirred debate about its future. Analyzing all Chinese government policies and penalties issued on domestic Internet enterprises from 2020 to 2022, this article provides the first systematic account of the authoritative themes that guided the design of the policy reforms. Latent Dirichlet Association topic modeling and qualitative content analyses reveal that policy reforms are guided by a state techno‐nationalist agenda shifting closer to a framework of environmental, social, and governance concerns (ESG). The results show that the new policies restructured Internet firm operations, capital allocation decisions, and accountability mechanisms with local government collaborators to ultimately push firms toward improving ESG adherence: social wellbeing, corporate governance, and environmental sustainability. This article theorizes that these changes reposition the Internet sector in a new techno‐nationalist agenda, shifting it from a vehicle of unfettered economic growth to an incubator for social wellbeing and sustainable finance.

Calibration issues under the EU capital regime for investment firms

PurposeThe EU prudential regime for investment firms comprising the Directive (EU) 2019/2034 (IFD) and Regulation (EU) 2019/2033 (IFR) introduces a fit-for-purpose capital framework for investment firms. The capital impact on the practice of investment management can be material depending on firms’ specific business models and risk profiles, which may require them to take strategic decisions with respect to the services they provide. Despite the importance of this issue for the practice of investment management, there exists no study among the existing studies that focuses on this issue. This study aims to fill this gap in the literature.Design/methodology/approachThis paper reviews the calibration approaches the European Banking Authority (EBA) has used by exploring the deficiencies of the regime with respect to the calibration of categorization thresholds and coefficients that are used by the EBA to calculate regulatory capital requirements.FindingsThis paper sets out that the choice of the relevant percentile for setting the firm categorization thresholds was not based on any theoretical rule. It also discusses that the calibration of the K-factors was subjective and lacked consistency. In addition, it criticizes the sample that the EBA used for business model coverage on the grounds that it was unbalanced, resulting in certain K-factors driving the overall capital impact.Research limitations/implicationsFurther research is needed on the calibration of thresholds as this will remain a crucial factor for the effectiveness of the new regime. In particular, a more data-driven and transparent approach would be necessary to ensure the accuracy and consistency of the thresholds.Practical implicationsThis paper leads to the policy implication that, despite its merits that overweigh its shortcomings, potential market competition and financial stability issues that may stem from inconsistencies and a general lack of objectivity in certain aspects of the regime should not be underestimated by the EU policy makers.Originality/valueThe present paper contributes to the existing knowledge primarily by reviewing the EBA’s calibration approaches with respect to the K-factor coefficients and firm categorization thresholds, concluding that lack of objectivity and precision in the relevant methodologies could distort capital allocation decisions in the practice of investment management.

Analyst workload and information production: Evidence from IPO assignments

AbstractI examine how changes in analysts' workloads affect their information production. Examining determinants of analysts' information production is important because analyst research affects stock prices and capital allocation decisions. Using periods when analysts work on IPOs to proxy for shocks to their workloads, I predict and find that the accuracy, quantity, and timeliness of analysts' forecasts for non‐IPO firms decline when they are working on IPOs, and they herd closer to the consensus. The reductions in research quality are larger for less experienced analysts, larger IPOs, and less important portfolio firms. Last, I predict and find that information asymmetry increases for non‐IPO firms covered by analysts who are working on IPOs, consistent with analysts' reduction in research quality during IPO assignments negatively affecting the information environment of non‐IPO firms. In sum, I provide the first evidence that analysts' work on IPO deals imposes negative externalities on both the quality of research they produce for the non‐IPO firms they cover and the information environments of these firms, highlighting at least one reason why analyst workload is important to firms and investors.

The Effect of Financial Statement Incomparability on Investment Decisions

ABSTRACTI use standard setters’ description of comparability to conceptualize two forms of incomparability in financial reporting. Using a laboratory experiment, I construct states of both comparability and incomparability and investigate investors’ capital allocation decisions under each. Benchmarking against states of comparable reporting, I find that incomparable reporting making different economics look alike results in lower-quality investment decisions, relative to incomparable reporting making similar economics look different. My evidence suggests the difference in investment quality is due to the reduced ability of supplemental disclosures to compensate for one type of incomparability relative to the other type. The study uses a setting holding other reporting characteristics, such as faithful representation, constant, and results are robust to alternative configurations of incomparability. Collectively, my results suggest that the type of incomparability has differential effects on the quality of investment decisions. My findings should inform standard setters aiming to help users allocate capital.JEL Classifications: G11; M41.

Who should choose the money managers? Institutional sponsors' equity manager performance

Institutional sponsors increasingly seek outside help in investment management by delegating manager selection and capital allocation decisions to external lead managers. Whether this enhances performance, however, is yet to be examined. We fill the gap using a unique dataset of Korean institutional sponsors that enables a detailed comparison of domestic equity funds selected by the sponsors against those by lead managers. We find that lead managers allocate their capital more efficiently and are able to identify managers with greater skill. Their positive implications on performance appears to emanate from the lead managers’ ability to detach themselves from the sponsors’ internal organizational issues.

Capital allocation and pricing decisions under trade credit with time-sensitive stochastic demand

We investigate the delivery investment decision in the context of trade credit (TC), under which the retailer applies for deferred payments from its supplier. In addition to ordering procurement, the retailer must allocate limited capital to reduce delivery time, which promotes time-sensitive demand. We develop a Stackelberg game in which the supplier determines the wholesale price and then the retailer decides the delivery investment amount and order volume. The analytical results indicate that, unless the retailer is slightly capital-constrained, the retailer’s investment activity not only increases its profitability but also benefits the supplier and promotes the coordination of the supply chain. Supplier reduction in wholesale deepens the positive impact. With bank finance (BF) as a benchmark, the Pareto region that entices both parties to participate in TC exists when the investment cost is within certain limits and when the retailer is severely capital-constrained. We also provide insights on the sensitivity of participants’ profits to the capital level, delivery investment features, and other price parameters.

Introduction to the Virtual Special Issue: Strategy Science’s Contributions to Doctoral Reading Lists

Introduction to the Virtual Special Issue: <i>Strategy Science</i>’s Contributions to Doctoral Reading Lists

Corporate capital allocation: a behavioral perspective and guidance for future research

PurposeThe purpose of this integrative review is to develop a holistic behavioral framework on capital allocation decisions.Design/methodology/approachThe article first structures, maps and synthesizes the prevalent cognitive biases that are present during capital allocation decisions. It then seeks to offer a robust understanding on how firms can mitigate the effects of cognitive biases.FindingsNot only do several cognitive biases interfere with a decision-makers ability to make adequate capital allocation decisions but firms already have a number of tools at their disposal to mitigate them.Research limitations/implicationsBesides identifying cognition- and repair-based implications to extend the literature, this article outlines key methodological challenges for future research conducted along the lines of capital allocation.Practical implicationsSince the paper structures cognitive limitations in one of the most important managerial decision-making processes and discusses what firms can do to counteract them, it is of high relevance for practitioners. Managers need to know what drives successful capital allocation and what not.Originality/valueThe article provides a rare integrative review on the impact of cognitive biases on capital allocation and addresses the need to build linkages to the ongoing conversation on how to design strategic decision processes.

Tax avoidance and cost of debt: does integrated report assurance matter?

PurposeThis study examines the association between corporate tax avoidance and the cost of debt (COD). It also investigates the moderating effect of integrated report (IR) assurance on tax avoidance/COD relationship.Design/methodology/approachBased on a sample of 76 South African companies listed on the Johannesburg Stock Exchange (JSE) from 2010 to 2020, the authors built and estimated regression models using the feasible generalized least squares (FGLS) method. The authors significantly mitigated the endogeneity concerns using propensity score matching (PSM), difference-in-differences (DID) analysis and fixed effects regression.FindingsThe authors found that tax-avoiding firms pay higher costs of debt due to information asymmetries and agency problems. Bankers systematically reflect the increase in tax avoidance by adjusting the COD upward. However, results show that the assured IR disclosure mitigates these problems, which decreases the COD for tax avoidance strategies adopters. Using a quasi-natural experiment, well-grounded evidence was provided showing that the decrease in the COD for debtors who engage in tax avoidance practices is attributed to the availability of an assured IR.Practical implicationsThis study provides plausible evidence in favor of the role that an assured IR can play in capital allocation decisions. Consequently, it is likely to push policymakers in South Africa and other countries to set standards for IR assurance.Originality/valueThis is the first study that investigates and validates the role of IR assurance in solving the controversy about the “tax saving effect” vs. “risk exposure effect” that bankers face while identifying debtors with successful (non-risky/cash-saving) tax avoidance practices and those with non-successful (risky) ones.

DO STOCK BUYBACKS SUPPRESS CORPORATE INNOVATION?

In 2021, the United States (U.S.) publicly traded firms repurchased nearly $850 billion of their own shares, setting an all-time record. Given the enormous scale of this resource allocation away from investment in innovation and growth and toward shareholders, it is reasonable to consider if these buybacks create opportunity costs. Stock buybacks increase earnings per share, even in the wake of no earnings growth, driving up share price and benefitting the top executives who make these capital allocation decisions by increasing the value of their stock options. Pundits disagree on the impact that high levels of buybacks have on the economy, some arguing that stock buybacks come at the expense of strategic investment in innovation while others point to diminishing returns to research and development (RnD) investment as the reason for decreases in innovative activity. This paper empirically tests whether share buybacks are suppressing corporate innovation in ways that control for widely observed declines in returns to R&amp;D investment, and the endogenous relationship between stock buybacks and innovation. Statistical analysis provides strong evidence that share buybacks are suppressing corporate innovation. This has enormous ramifications to the long-term viability of U.S. industries and to social justice.

Accounting standards: the ‘too difficult’ box – the next big accounting issue?

Embracing the perspective of accounting as providing information to support capital allocation decisions could help avoid accounting issues ending up in the ‘Too Difficult' Box. Investors need and use information not contained in traditional financial statements. Thus, focusing on financial statements as the sole accounting output limits the ability of accounting reports to meet investors' information needs. Two issues on the horizon—accounting for digital assets and the effects of climate change—reveal how embracing this perspective could help avoid the ‘Too Difficult' Box. These issues reveal pitfalls arising from trying to fit newly created assets into categories—and consequent accounting—designed for previously identified assets. The issues also reveal potential benefits of substituting non-financial information for unavailable financial information rather than omitting the items from accounting reports. Both issues reinforce investors' need for information about risk. Digital assets, climate change, risk, and—more broadly—whether and how accounting reports should be broadened beyond financial statements motivate many interesting research questions. Insights from this research are vital as accounting faces potentially revolutionary changes in investors’ information needs.