Why Do Managers Diversify Their Firms - Annotated Bibliography Example

Annotated Bibliography Annotated Bibliography Aggarwal, R. K., & Samwick, A. A. (2003). Why do managers diversify their firms? Agency reconsidered. Journal of Finance, 58(1), 71-118. Aggarwal and Samwik discus the key reasons as to why managers spread and diversify their firms. It identifies the two types of agency relationship that managers derive utility from decreasing the unusual risks they face in business. Managers with higher equity ownership face higher idiosyncratic risk from incentives and thus diversify their firms more to lower that risk. Managers also diversify because they derive a private benefit from managing a more diversified firm. These benefits arise from areas such as prestige or better career prospects connected with managing a more diversified firm such as pay increases or opportunities for skimming. This article has found that the performance of the firm is increasing as incentives increase and decreasing in diversification. Evidence has showed that diversification is increasing in incentives. However, earlier studies had shown a negative relationship due to studies of unobserved, firm specific activities. The connection between performance and incentives is significantly weaker for firms that undergo changes in diversification when compared to firms that do not experience changes in diversification. It also suggests that relationship between diversification and incentives is caused by exogenous changes in the private benefits associated with diversification. The article does not however, support the notion that managers diversify their firms to reduce exposure to risk. 2. Cho, M. (1998). Ownership, structure, investment, and the corporate value: An empirical analysis. Journal of Financial Economics, 47(1), 103-121. Retrieved from the Science Direct Business database. This article commences by asserting that ownership structure affects investment, which, in turn affects corporate value. Previous research has shown that Investment positively affects corporate value due to the return on various forms of investment. The article tests whether ownership structure affects investment. The author suggests that, at low levels of managerial ownership, an increase in managerial ownership more closely aligns the interests of managers and shareholders, therefore increasing corporate value. However, at high levels of managerial ownership, an increase in managerial ownership makes management more entrenched and less subject to market discipline, thus reducing corporate value. There is evidence in support of the hypothesis that investment affects corporate value. Research evidence has found that, on average, the stock markets react positively to announcements of increases in planned capital expenditure and negatively in decreases in planned capital expenditure. Share-price responses to announcement of increased research and development spending are significantly positive. Simultaneous regressions reveal that investment affects corporate value, which, in turn, affects ownership structure, but not the reverse. This means that ownership may not be an effective incentive mechanism to induce managers to make value maximizing investment decisions, thus a doubt to whether compensation packages such as stock grants to executives provides incentives for managers to make decisions that maximize corporate value. These findings also bring into a question the results in the previous studies that treat ownership structure as exogenous. 3. Dorfman, R. (1981). The meaning of internal rates of return. Journal of Finance, 36(5), 1,011-1,021. The author is trying to develop a standpoint on whether it is the net present value or internal rate of return that has remained relevant in appraising projects to be undertaken by a firm. Internal rate of return has remained relevant mostly in the banking sector. Also, it is widely used by businessmen. The confusing aspect of the internal rate of return criterion is when the duration of an investment project is subject to choice, and if it is chosen to maximize internal rate of return, then the equation for the rate of return can have only one root. The net present value has limitations such as; it is computed from cash flows generated by an initial act of investment, without allowance for the possible reinvestment of those cash flows. In a series of papers, John S. Chipman developed the insights that when the net proceeds resulting from investments in an economy are wholly or partially reinvested, the economy growth can be described by a renewal equation whose roots is identical with the rate of return equation for the typical investment in that economy. Many important questions remain unanswered. The most pressing is concern for the implications regarding the choice of investment projects by a developing economy that is determined to grow as fast as possible. The nature of general equilibrium in an economy in which all firms select their investments in order to maximize their rate of growth is another intriguing question. Preliminary explorations indicate that all these questions are too complicated to be dealt with in this paper and thus more research is necessary. 4. Fuller, R. J., & Kerr, H. S. (1981). Estimating the divisional cost of capital: An analysis of the pure-play technique. Journal of Finance, 36(5), 997-1, 009. Fuller’s and Kerr’s article proposes that the pure-play technique can be used in combination with the asset pricing model to determine the cost of equity capital for the various divisions in a firm with many divisions. In a recent study, researchers found that nearly one-half of a sample of industrial firms in the U.S. used a single cost of capital to evaluate capital investment projects. Using such a criterion is inappropriate for a project if its systematic risk differs significantly from that of the firm. The result of such single criterion for all projects is misallocation of capital since the acceptance rule is biased in favor of the acceptance of high-risk projects. The divisional cost of capital has been analyzed using models such Hamada, Gordon and Halpern. Two approaches for estimating a divisional cost of capital is analytic and analogies approach. The findings indicated that a weighted average of pure-play debt ratios consistently underestimate the debt ration of multidivision firm. Previous research did not find any significant difference between pure play proxy cost of debt and the cost of debt for the respective multidivision firm. In addition, the fact that debt ratios of multidivision firms were persistently larger than the debt rations of their associated pure-plays provides weak support for the argument that diversifying across business lines increases the borrowing power of the firm. 5. Hovakimian, A., Opler, T., & Titman, S. (2001). The debt-equity choice. Journal of Financial & Quantitative Analysis, 36(1), 1-24. This article tests the hypothesis that firms tend to move toward a target debt ration when they either raise new capital or retire or repurchase existing capital. There should be a trade- off between the costs of using debts and the benefits derived thereof. The article has noted that the negative correlation between profits and leverage is consistent with the pecking order description of how firms make their financing decisions. Managers prefer to fund new investment with retained earnings rather than debt, but prefer debt financing to equity financing. Firms passively accumulate retained earnings, becoming less levered when they are profitable, and accumulate debt, becoming more levered when they are unprofitable. Although past profits are an important predictor of observed debt rations, firms often make financing and repurchase decisions that offset these earnings-driven changes in their capital structure. In addition, stock prices play a vital role determining a firm is financing choice. The fact that optimal capital structure considerations and stock prices play an important role in issuance and repurchase choice has a wide range of implications. For example, a firm’s capital expenditure choice might be closely related to management’s concern about deviating from their target debt. 6. Klock, M., Mansi, S., & Maxwell, W. (2005). Does corporate governance matter to bondholders?Journal of Financial & Quantitative Analysis, 40(4), 693-719. The paper has given an analysis on how various antitakeover defence mechanisms affect the bondholders. It is an extension of the literature on the relationship between the Gropers et al. governance index and the firm’s value but from the bondholders view. According to the article, while the stockholders may often benefit from acquisitions, the bond holders do suffer. The bondholders with investments grade debt have limited potential benefit from takeovers but bear unlimited risk from the same. Leverage recapitalization transfers wealth from bondholders to stockholders. Spin-offs, and sale -offs reduce collateral. Financial distress results in an increase in the likelihood of loss of principal and interest by the Bondholders. Hence firms with antitakeover defence mechanisms have lower cost of debt. The study, can be said to be reliable due to the broad spectrum of data used and the control measures put in place, concluded that antitakeover mechanisms have an impact on the cost of debt financing by a firm. Since bondholders risk of loss increases with an increase in the chances of the takeover mechanisms, they are concerned with the corporate governance mechanisms put to deter takeovers. Hence, while the antitakeover mechanisms neutralize the powers of the stockholder, it increases the strength of the managers to the advantage of the bondholders. The study has also proved the usefulness of the Gropers et al. index in the analysis of the relationship of corporate governance and the value of the firms. Therefore, managers ought to look at the effect of corporate governance provisions on all types of securities held since the results differ with each type of class. 7. Malkiel, B. (2005). Reflections on the efficient markets hypothesis: 30 years later. The Financial Review, 40(1), 1-9. The author is affirming the theory that securities markets are indeed efficient. He notes that financial economists question the efficient market hypothesis. They doubt the theory since there were some instances when the markets failed to reflect the available information. As a result, the financial economists advocate for the use of past returns and valuation metrics to forecast stock prices. Michael disregards this view. He points out that if the markets were indeed inefficient, then portfolio managers of the mutual funds would be beating their index benchmarks. The author has gone ahead and provides statistics that show that often about 85% of the mutual fund managers do not outperform their index. Managers and investors who beat the market returns do not do it consistently. For example, he has shown that managers that outperformed the market in the 1970s lost terribly in the 1980s. He attributes the poor performance of the fund to the high operating expenses involved in the movement of funds. He points out that the ratings by the professional investment services are also not effective. For better returns, he advocates for buying low-cost broad-based index fund that holds all the stocks comprising of the market portfolio. The statistics have shown that index funds outperform actively managed funds in both international and domestic markets. Michael has concluded his work with quotes from two great investors: Benjamin Graham and Warren Buffett. Graham is against active management of the securities as a way of maximizing returns. On the other hand, Warren confirms his faith in the ability of index funds to generate returns at minimal fees. 8. Amin, G. S., & Kat, H. M. (2003). Hedge fund performance 1990-2000: Do the "money machines" really add value? Journal of Financial & Quantitative Analysis, 38(2), 251-274. Hedge funds have known to be diligently managed by competent personnel who use high-level skills to generate returns to their clients of course at a high fee. The paper has investigated claims that hedge funds offer investors a superior risk-return trade off. The paper has also examined the performance of the hedge funds as a standalone and as part of a portfolio. Initial studies showed that hedge funds generate higher returns. However, those studies assumed that returns from the hedge funds were normally distributed and linear to the equity market returns. The studies also used Shape and Jansen ratios. There is a general assumption that hedge fund managers are skilled, and hence, investors pay a premium for the services of the managers. The authors have used the distribution pricing model of Dybvig to evaluate hedge funds’ performance. Their research has disputed much of the knowledge about the hedge funds. For example, they established that returns from the hedge funds were non-normal, skewed and nonlinear to equity returns. Hence, Sharpe and Jensen’s measures were ruled out as suitable measures for studying hedge funds. The dynamic trading based efficiency test is advocated for analysis of the hedge funds as it is unbiased. They discovered that hedge funds were inefficient as a standalone Investment. However, their efficiency improved when mixed with other assets in a portfolio. Only hedge funds provide returns that are not related to the markets. Hence, investors pay high fees for lack of another fund type returns and not because of the skills of the managers. 9. Ang, A., & Liu, J. (2004). How to discount cash flows with time-varying expected returns. Journal of Finance, 59(6), 2,754-2,783. The article by Ang and Liu has begun by pointing out the major weakness of the dividend growth model. Dividend growth model is the main technique that is used to value future cash flows. The model uses a discount rate calculated from the CAPM model. The main weaknesses of both of these models are that they assume that risk factors are constant. The assumption is misleading. Risk-free rate change over the time. The beta adjusts when companies merge. Risk premium is as well not stable. The existing dividend growth model cannot handle dynamic betas, risk premiums, and risk- free rates. To fill in the gap in forecasting of the value of cash flows, Ang and Liu have established with a model that can accommodate time-varying risk factors. The method involves developing a series of a term structure discount rates. The discount rates differ across various maturities and may be applied to value future cash flows. The model calculates the discount rates both the book to market and industrial portfolios. Time-varying betas, risk premiums, and risk-free rates are derived from the discount risk curve. Ang and Liu found out that in the short run, investors should be concerned about the time-varying interest rates and the risk premium. However, in the long term, the risk-free rate and betas are more important. In conclusion, Ang and Liu have pointed out parameter uncertainty in the prediction of risks and beta as the major weakness of the model. Use of wrong parameters would lead to worse results than those produced by the dividend growth model. 10. Markowitz, H (1952). Portfolio selection. Journal of Finance, 7(1), 77-91. The article by Markowitz has challenged the status quo in regard to the selection of a portfolio by investors. Investors are advised to select a portfolio that gives maximum returns per a particular risk. Markowitz advocates disregard of the rule because it does not accommodate diversification. The future is uncertain. Hence, investors don’t have certainty about the exact values that they are maximizing and the exact discount rates to maximize. Non-inclusion of diversification weakens the rule. The law that advocates the investors to diversify all the investment in securities that provide maximum returns is also rejected on the grounds that it assumes that there is a portfolio of assets that give maximum returns and minimum variance. According to the author, investors ought to use the E-V hypothesis. The theory states that for a particular probability investors have a choice of combination of E and V depending on the portfolio that they chose. An efficient portfolio should minimize V for a given E. E-V method is preferred because it leads to efficient portfolios that are almost fully diversified. The hypothesis takes into consideration that firms in the same industry are likely to suffer from the same risk. Spreading risks through diversification is highly recommended. He points out that reducing variance does not mean increasing the size of the portfolio. A balanced portfolio is one that is made up of securities that are negatively correlated and hence a small variance. Markowitz states that the hypothesis may be used in the theoretical analysis and the actual selection of the portfolios. References Aggarwal, R. K., & Samwick, A. A. (2003). Why do managers diversify their firms? Agency reconsidered. Journal of Finance, 58(1), 71-118. Amin, G. S., & Kat, H. M. (2003). Hedge fund performance 1990-2000: Do the "money machines" really add value? Journal of Financial & Quantitative Analysis, 38(2), 251-274. Ang, A., & Liu, J. (2004). How to discount cashflows with time-varying expected returns. Journal of Finance, 59(6), 2,754-2,783. Cho, M. (1998). Ownership structure, investment, and the corporate value: An empirical analysis. Journal of Financial Economics, 47(1), 103-121. Retrieved from the ScienceDirect Business database. Dorfman, R. (1981). The meaning of internal rates of return. Journal of Finance, 36(5), 1,011-1,021. Fuller, R. J., & Kerr, H. S. (1981). Estimating the divisional cost of capital: An analysis of the pure-play technique. Journal of Finance, 36(5), 997-1 ,009. Hovakimian, A., Opler, T., & Titman, S. (2001). The debt-equity choice. Journal of Financial & Quantitative Analysis, 36(1), 1-24. Klock, M., Mansi, S., & Maxwell, W. (2005). Does corporate governance matter to bondholders?Journal of Financial & Quantitative Analysis, 40(4), 693-719. Malkiel, B. (2005). Reflections on the efficient markets hypothesis: 30 years later. The Financial Review, 40(1), 1-9. Markowitz, H (1952). Portfolio selection. Journal of Finance, 7(1), 77-91. Read More