Toni Whited (University of Rochester), “Equity Market Misvaluation and Firm Financial Policies”, Paul Woolley Research Initiative Seminar, IDEI, March 19, 2012, 12:30–14:00, room MF323.
We quantify the extent to which nonfundamental movements in the price of a firm’s stock affect its policies. We estimate a version of a constant returns neoclassical investment model in which equity financing is costly, the firm can accumulate cash, and, most importantly, equity values can be subject to misvaluation shocks. In the model, firms naturally issue equity when it is overvalued and repurchase equity when it is undervalued. Depending on the model parameters, the funds flowing to and from these activities can come from either changes in cash balances or changes in investment. We find that a model in which we allow no mispricing fits the data worse than a model in which we do allow mispricing. In particular, the mispricing model does a much better job of matching moments related to cash balances and equity issuance. Our counterfactual exercises show that firms do issue equity in response to misvaluation shocks, but the proceeds from these issuances are not used to fund investment. Instead, they augment cash balances. Finally, managers’ rational responses to possible misvaluation increase intrinsic shareholder value from 0.2% to 1.1%.