Three essays in corporate finance: the evolution of capital structure and the role of institutional investors on cash holdings and on firm value

© 2010 Dr. Yangyang ChenCHAPTER 1. CAPITAL STRUCTURE CONVERGENCE: REAL OR MECHANICAL Lemmon, Roberts, and Zender (2008) show two features of the data on capital structure: convergence and persistence. I replicate their results and then explore the source of the features. I show that capital structure convergence is likely to be mechanical rather than real. It sources from a statistical fallacy called the “regression fallacy”. The stationarity of the leverage ratio series and the misclassification problem in portfolio construction give rise to the apparent convergence. Finally, I test two implications of the misclassification argument and propose a method that is able to mitigate the mechanical convergence. CHAPTER 2. INSTITUTIONAL OWNERSHIP AND FIRM CASH HOLDINGS The precautionary theory of firm cash holdings argues that firms hold cash to protect themselves against adverse cash flow shocks or external financial constraints that might force them to default on payments or forgo valuable investment opportunities. The aggressive trading of a group of institutional investors magnifies the firm’s stock price volatility and makes its external financing costly. This may induce the firm’s precautionary demand for cash. Consistent with the hypothesis, I find that firms with greater institutional ownership have more cash holdings. The relationship is purely driven by the ownership of short-term institutions (i.e., institutions that trade frequently for short-term trading profits). The ownership of long-term institutions (i.e., institutions that trade infrequently for long-term holding profits) is negatively associated with firm cash holdings. Further tests show that the effect of both types of institutional ownership on firm cash holdings is more significant for growth firms that rely more on external financing and suffer more from cash shortages. CHAPTER 3. ON THE RELATIONSHIP BETWEEN INSTITUTIONAL OWNERSHIP AND FIRM VALUE: THE ROLE OF INFORMATION Prior studies that explore the relationship between institutional ownership and firm value focus exclusively on institutional monitoring. However, the information role of institutional investors may also drive the relationship. Institutional investors improve the firm's information environment through their trading and holding activities. This increases firm value via reducing the estimation risk of the stock and thus the cost of capital. Consistent with the information hypothesis, I find that institutional ownership is associated with a reduction in the cost of capital. Even for the group of institutions that are less likely to monitor the management, their ownership still enhances firm value and the enhancement is exclusively through reducing the cost of capital. Finally, I show that the effect of institutional ownership is more prominent for firms potentially subject to more information asymmetry