Does CEO overconfidence help to explain merger decisions? Overconfident CEOs overestimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs' personal overinvestment in their company and their press portrayal. We find that the odds of making an acquisition are 65 % higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (–90 basis points) is significantly more negative than for non-overconfident CEOs (–12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.

We identify a specific channel (debt covenants) and the corresponding mechanism (transfer of control rights) through which financing frictions impact corporate invest-ment. Using a regression discontinuity design, we show that capital investment de-clines sharply following a financial covenant violation, when creditors use the threat of accelerating the loan to intervene in management. Further, the reduction in in-vestment is concentrated in situations in which agency and information problems are relatively more severe, highlighting how the state-contingent allocation of control rights can help mitigate investment distortions arising from financing frictions. WHILE PREVIOUS RESEARCH HAS CLEARLY ANSWERED THE QUESTION of whether financ-ing and investment are related, it has been much less clear on how financing and investment are related (Stein (2003)). In other words, the precise mech-anisms behind this relationship are largely unknown. Further, the extent to which these mechanisms mitigate or exacerbate investment distortions arising from underlying financing frictions is largely unknown as well. The goal of this

There is widespread evidence supporting the conjecture that borrowing constraints have important implications for firm growth and survival. In this paper we model a multi-period borrowing/lending relationship with asymmetric information. We show that borrowing constraints emerge as a feature of the optimal long-term lending contract, and that such constraints relax as the value of the borrower’s claim to future cash-flows increases. We also show that the optimal contract has interesting implications for firm dynamics. In agreement with the empirical evidence, as age and size increase, mean and variance of growth decrease, firm survival increases, and the sensitivity of

Many firms issue stock options to all employees. We consider three potential economic justifications for this practice: providing incentives to employees, inducing employees to sort, and helping firms retain employees. We gather data on firms’ stock option grants to middle managers from three distinct sources, and use two methods to assess which theories appear to explain observed granting behavior. First, we directly calibrate models of incentives, sorting and retention, and ask whether observed magnitudes of option grants are consistent with each potential explanation. Second, we conduct a cross-sectional regression analysis of firms option-granting choices. We reject an incentives-based explanation for broad-based stock option plans, and conclude that sorting and retention explanations appear consistent with the data.

We develop a general model of lending in the presence of endogenous borrowing constraints. Borrowing constraints arise because borrowers face limited liability and debt repayment cannot be perfectly enforced. In the model, the dynamics of debt are closely linked with the dynamics of borrowing constraints. In fact, borrowing constraints must satisfy a dynamic consistency requirement: the value of outstanding debt restricts current access to short-term capital, but is itself determined by future access to credit. This dynamic consistency is not guaranteed in models of exogenous borrowing constraints, where the ability to raise short-term capital is limited by some prespecified function of debt. We characterize the optimal default-free contract-which minimizes borrowing constraints at all histories-and derive implications for firm growth, survival, leverage and debt maturity. The model is qualitatively consistent with stylized facts on the growth and survival of firms. Comparative statics with respect to technology and default constraints are derived.

Abstract. This paper shows that financial constraints of local banks in emerging markets lead to underinvestment and credit constrained borrowers. I find that local bank lending is sensitive to an exogenous expansion in the availability of external financing. Using novel data to measure risk and return on marginal lending, I show that the profitability of loans does not decline during lending expansions. The resulting credit expansion leads to an increase in total borrower debt, holding investment opportunities constant. Overall, financial shocks to constrained banks are found to have a quick, persistent and amplified effect on the aggregate supply of credit. (JEL: G21, E50, D82) * Columbia University GSB. This paper was formerly circulated under the title: “Constrained Banks, Constrained

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

Abstract: We investigate the link between compensation and risk-taking among finance firms during the period of 1992-2008. First, there are substantial cross-firm differences in residual pay (defined as total executive compensation controlling for firm size). Second, residual pay is correlated with pricebased risk-taking measures including firm beta, return volatility, the sensitivity of firm stock price to the ABX subprime index, and tail cumulative return performance. Third, these risk-taking measures are correlated with pay even though executives are highly incentivized as measured by insider ownership. Finally, compensation and risk-taking are not related to governance variables but covary with ownership by institutional investors who tend to have short-termist preferences and the power to influence firm management policies. Our findings suggest that our residual pay measure is picking up other important high-powered incentives not captured by insider ownership. They also point to substantial heterogeneity in both firm culture and investor preferences for short-termism and risk-taking. _____________________ We thank

We propose a model of dynamic investment, financing, and risk management for financially constrained firms. The model highlights the central importance of the en-dogenous marginal value of liquidity (cash and credit line) for corporate decisions. Our three main results are: (1) investment depends on the ratio of marginal q to the marginal value of liquidity, and the relation between investment and marginal q changes with the marginal source of funding; (2) optimal external financing and payout are characterized by an endogenous double-barrier policy for the firm’s cash-capital ratio; and (3) liquidity management and derivatives hedging are complemen-tary risk management tools. WHEN FIRMS FACE EXTERNAL financing costs, they must deal with complex and closely intertwined investment, financing, and risk management decisions. How to formalize the interconnections among these margins in a dynamic setting and how to translate the theory into day-to-day risk management and real investment policies remains largely to be determined. Questions such as

We analyze the relationship between conglomerates ’ internal capital markets and the efficiency of economy-wide capital allocation, and identify a novel cost of conglomeration that arises from an equilibrium framework. Because of financial market imperfections engendered by imperfect investor protection, conglomerates that engage in “winner-picking ” (Stein, 1997) find it optimal to allocate scarce capital internally to mediocre projects, even when other firms in the economy have higher productivity projects that are in need of additional capital. This bias for internal capital allocation can decrease allocative efficiency even when conglomerates have efficient internal capital markets, because a substantial presence of conglomerates might make it harder for other firms in the economy to raise capital. We also argue that the negative externality associated with conglomeration is particularly costly for countries that are at intermediary levels of financial development. In such countries, a high degree of conglomeration, generated for example by the control of the corporate sector by family business groups, may decrease the efficiency of the capital market. Our theory generates novel empirical predictions that cannot be derived in models that ignore the equilibrium effects of conglomerates. These predictions are consistent with anecdotal