Robert L. McDonald

Investment and the Valuation of Firms When There is an Option to Shut Down

An important lesson from elementary microeconomics is that a plant should be shut down if operating revenues are less than variable costs. This simple production rule has implications -which have received little attentionfor the initial decision to build the plant.2 This paper develops and studies a methodology for valuing risky investment projects, where there is an option to temporarily and costlessly shut down production (with no effect on future prices and costs) whenever variable costs exceed operating revenues. It is obvious that future revenues or costs must be uncertain if the shut-down option is to affect the investment decision otherwise, it is always known ex ante whether the plant is to be operated. Uncertainty is introduced in this paper by supposing that prices and costs follow a continuous time stochastic process.3 The firm in our model is a risk-neutral, price-taking value maximizer, which is owned by risk-averse investors. Risk aversion thus influences the investment decision by affecting the cost of capital faced by the firm. This is in contrast to the model in Sandmo [1971], in which the firm maximizes the utility of profits.4 Our treatment is descriptive of value-maximizing, publicly-owned firms and is widely used in the finance literature. The economics literature studying the effect of uncertainty on firm behavior has, however, tended to follow Sandhmo. The explicit modelling of the shut-down option and our treatment of risk aversion give us results that differ from those obtained by others who have studied the valuation of risky projects. Our principal results are: 1) Increases in the variance of the output price can either raise or lower the

Equity Issues with Time-Varying Asymmetric Information

This paper develops a formal model of the effect of time-varying asymmetric information on the timing and pricing of equity issues when managers are better informed than outside investors. We assume that as time passes, the adverse selection problem becomes more severe as more managers receive a private signal. Under this assumption, the model predicts temporal variation in the quantity of issues, with a bunching of issues after information releases. It also predicts that the price drop at issue announcement increases with the time since the last information release. These predictions are consistent with several recent empirical studies relating equity issues to earnings and dividend announcements.

Shareholder Heterogeneity, Adverse Selection, and Payout Policy

When shareholders have different plans to sell their shares, they will, in general, have different preferences concerning the firms decision to pay out cash using dividends or share repurchase. We illustrate these different preferences and explore a model of payout policy that highlights the adverse selection costs of repurchases when managers have superior information about the value of the firm. We show that, in the absence of fixed costs to repurchasing shares, there is a separating equilibrium in which managers use taxable dividends to signal the quality of the firm, with better firms paying lower dividends, using repurchases for the remainder of the payout. With fixed costs to repurchasing, small payouts are made via dividend and large payouts are divided between repurchases and dividends, as in the no-fixed cost case. In both cases, the percentage of shares repurchased increases with the size of the payout and larger repurchases are better news.

Bank Financing and Investment Decisions with Asymmetric Information about Loan Quality

Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders. We model the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for riskless securities against future liquidity needs depends on both the regulatory environment and the informational structure. If banks are ex ante identical, they prefer issuing risky debt to fund a withdrawal to holding riskless securities ex ante. If banks have partial knowledge of loan quality, however, high quality banks may hold riskless securities to signal their quality, enabling them to issue risky debt at a lower interest rate. We present new empirical evidence that banks with higher asset quality do in fact hold more cash and securities.

Government Debt and Private Leverage: An Extension of the Miller Theorem

This paper shows how government financing decisions can influence the corporate decision to use debt or equity finance. In particular, it is shown that an increase in the stock of taxable government debt reduces the equilibrium quantity of corporate debt, and that an increase in the stock of tax-free government debt reduces the equilibrium quantity of corporate equity. The effects of inflation rate and tax rate changes are also considered.

Ratings and Asset Allocation: An Experimental Analysis

Investment ratings (e.g., by Morningstar) provide a simple ordinal scale (e.g., 1 to 5) for comparing investments. Typically, ratings are assigned within categories — groups of assets sharing common characteristics — but using the same ordinal scale for all groups. Comparing such categorized ratings across categories is potentially misleading. We study the effect of categorized ratings in an asset allocation experiment in which subjects make repeated allocation decisions under complete information. Subjects initially see no ratings, and they then see either categorized or uncategorized ratings. Although ratings convey no information, categorized ratings affect subject investment choices and harm performance in the experiment. Subjects do not simply invest more in highly rated assets. Rather, rating effects seem to occur when ratings conflict with subjects’ own evaluation of assets: subjects reduce their investment in a high quality asset which receives an intermediate rating, but they do not increase their investment in a high-quality asset that receives a high rating. Knowledge and experience help with the base allocation task but do not mitigate the harmful effect of categorized ratings.

Deconstructing the Taxation of Packaged Financial Strategies

Financial claims are often taxed according to the way in which they are nominally “packaged” rather than according to their economic characteristics. We deconstruct financial taxation by viewing any financial strategy as a dynamic portfolio of pure debt and pure equity. Given the taxation of these building blocks, there is a unique consistent equivalent tax treatment for any strategy, and this transparent tax is a benchmark against which burdens or subsidies due to packaging can be measured. We quantify tax effects in present value terms in the context of a partial equilibrium model. We apply our methodology to common hybrid securities, such as convertible bonds and reverse convertible bonds. We find tax-induced discrepancies of up to about up to about 6% of value (i.e., 20 basis points per year) for typical 30-year convertible bonds. With unfunded securities, such as puts and calls, the discrepancy becomes much larger in percentage terms. Because these unfunded positions are levered, however, investors do not buy as many of them, and the discrepancy in aggregate absolute terms is therefore likely not so much greater. In our framework, the discrepancy can be eliminated either by taxation based on an ongoing determination of building block equivalents or else by eliminating distinctions in taxation among the building blocks. In particular, this would require eliminating the tax distinction between debt and equity.