Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment

Abstract

This paper derives a real options model that accounts for the value premium. If real investment is largely irreversible, the book value of assets of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to fully benefit from positive aggregate shocks without undertaking costly investment. Thus, returns to equity holders of a high book-to-market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium. Copyright 2006 by The American Finance Association.

Size, book-to-market ratio and macroeconomic news

“…They argue that value firms earn higher average returns than growth firms since they have persistently lower earnings and higher financial leverage (signaling higher risk of financial distress) than growth firms. Several papers, including Berk, Green, and Naik (1999), Gomes, Kogan, and Zhang (2003), Carlson, Fisher, and Giammarino (2004), Zhang (2005) and Cooper (2006), develop theoretical frameworks to link firm characteristics and expected returns to economic fundamentals. For example, Zhang (2005) argues that assets-in-place of value firms are riskier than growth options especially during bad times when the price of risk is high.…”

The Effects of Financial Support Policies on Corporate Decisions by SMEs

“…This paper refers to many earlier works about such dynamic decision models. Zhang (2005); Cooper (2006); Li, Livdan, and Zhang (2009);Nikolov and Whited (2009);and Livdan, Sapriza and Zhang (2009) are the main references. These all posit various dynamic designs of corporate decision models and discuss how they are affected by uncertainty in the macro-economy or by idiosyncratic shocks.…”

Investment and The Cross-Section of Equity Returns

“…On the other, a series of papers that started with Carlson et al (2004), Zhang (2005), and Cooper (2006) have investigated the restrictions on the same choices coming from equity returns. The upshot of these distinct strands of literature is that the same theoretical framework, when appropriately specified, has empirically sensible implications for quantities (investment rate) and prices (equity returns).…”