Berardino Palazzo

Entry, Exit, Firm Dynamics, and Aggregate Fluctuations

Do firm entry and exit play a major role in shaping aggregate dynamics? Our answer is yes. Entry and exit propagate the effects of aggregate shocks. In turn, this results in greater persistence and unconditional variation of aggregate time-series. These are features of the equilibrium allocation in Hopenhayn (1992)s model of equilibrium industry dynamics, amended to allow for investment in physical capital and aggregate fluctuations. In the aftermath of a positive productivity shock, the number of entrants increases. The new firms are smaller and less productive than the incumbents, as in the data. As the common productivity component reverts to its unconditional mean, the new entrants that survive become more productive over time, keeping aggregate efficiency higher than in a scenario without entry or exit.

Cash Holdings, Competition, and Innovation

In this paper we examine theoretically and empirically the determinants of cash holdings by innovating firms. Our model highlights an important strategic role that cash plays in affecting the development and implementation of innovation in the presence of competition in the market for R&D-intensive products. Firms’ equilibrium cash holdings are shown to depend on the degree of innovation efficiency in firms’ industries, on the intensity of competition in post-R&D output markets, on the structure of industries in which firms innovate, and on the interactions of these factors with the costs of obtaining external financing. In addition, the model provides a possible explanation for the temporal increase in cash holdings, particularly among R&D-intensive firms. Our empirical evidence demonstrates that financing costs, innovation efficiency, intensity of competition, and industry structure are indeed associated with firms’ observed cash-to-assets ratios in ways that are generally consistent with the model’s predictions.We demonstrate theoretically and empirically that strategic considerations are important in shaping cash policies of innovative firms. In our model, firms compete in product markets with uncertain structure using cash as a commitment device to invest in innovation. We show that firms equilibrium cash holdings are related to expected intensity of competition. The sign and magnitude of this relation depends on firms financial constraints. Consistent with the strategic motive for hoarding cash, we show that firms cash holdings are negatively affected by their rivals cash holding choices, more so when competition is expected to be intense.

Firm Selection and Corporate Cash Holdings

Among stock market entrants, more firms over time are R&D–intensive with initially lower profitability but higher growth potential. This sample-selection effect determines the secular trend in U.S. public firms’ cash holdings. A stylized firm industry model allows us to analyze two competing changes to the selection mechanism: a change in industry composition and a shift toward less profitable R&D–firms. The latter is key to generating higher cash ratios at IPO, necessary for the secular increase, whereas the former mechanism amplifies this effect. The data confirm the prominent role played by selection, and corroborate the model’s predictions.

Precautionary Finance: Evidence from the Timing and Size of Debt and Equity Issues

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

Debt Issue Motives and Earnings Optimism

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

The Motives and Limits of Long-Term Debt Issues

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

The Motives of Long-Term Debt Issues

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

Technology Adoption, External Financing Frictions, and the Cross Sectional Returns

We explore the asset pricing implications of an investment-based model that features a stochastic technology frontier and costly technology adoption. Firms adopt the latest technology embodied in new capital to reach a stochastic technology frontier, but this decision entails an adoption cost. The model predicts that old capital firms are more risky and hence offer a higher return than young capital firms. This is because old capital firms are more likely to upgrade their capital in the near future and hence are more exposed to shocks driving the technology frontier. Our empirical analysis supports the models predictions. We find an annual return spread of 7% between old and young capital firms. The CAPM fails in explaining this return spread.We explore the asset pricing implications of technological change in a model with costly technology adoption and external financing frictions. Firms adopt the latest technology embodied in new capital to reach the technology frontier, but entail adoption costs and external financing costs. The central finding is that optimal technology adoption is an important determinant of the cross section of stock returns. The model predicts that technology adopting firms are less risky than non-adopting firms. Intuitively, by restricting firms from freely upgrading the existing vintage capital to the technology frontier, costly technology adoption and external financing frictions reduce firms real and financial flexibilities, and hence generate the risk dispersion between technology adopting firms and non-adopting firms. The model is qualitatively and in many cases quantitatively consistent with the key empirical regularities in the cross sectional returns.