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Do Short-Term Objectives Lead to Under-or Overinvestment in Long-Term Projects?

Presented by Philip Balele

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IntroductionMotivation:

◦ Managerial short-term objectives under imperfect information lead to DISTORTIONS in the level of investment in long-term projects.

Previous research: ◦show that managerial investment

decisions under imperfect information and short-term managerial objectives lead to underinvestment.

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Introd…This paper’s contribution:

◦Managerial investment decisions under imperfect information and short-term managerial objectives may also lead to overinvestment.

Paper adopts a game theoretic approach and mathematical proofs to show the two arguments.◦Players: manager (sender) and the

market/investor (receiver).

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Introd…Definition:

◦short term managerial objectives firm’s stock price/value

◦asymmetric information the market/investors has less information than the firm’s managers about the firm’s long term projects

Type of distortion depends on the type of available information

Two types of asymmetric information in investment decisions:

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Introd… Investors cannot observe the level of

investment in long term project (hidden action)◦soft investment, e.g. managerial

effort and time, entrepreneurial talent, internal personnel resources, new product designs etc.

Investors obverse the level of investment in a given long term project but not its productivity (hidden information) (contribution of this paper). ◦Case of hard investment, e.g.

plants/equipment etc., also disclosed soft investment

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Model (Framework of analysis)

Two time horizons: ◦SR project realize return after one

period and ◦LR project realize return in the second

period Managers are concerned not only

about but also about .Manager’s utility function depends

on both and .◦ )=ϒ+------------------------(1)

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Framework…◦Where ,

SR return: )+ϵ-------------------(2)◦ is the level of short-term investment◦)˃0, )˂0

LR return: )+η-----------------(3)◦=level of long-term investment,

=productivity of long-term investment

◦)˃0, )˂0

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Framework…

Except for and , everything is common knowledge between the market and the manager

The market forms rational expectations about firm's value given available information

The manager has a limited amount of capital (K) to allocate between the two investment projects

It is not optimal to invest all available capital in one project.

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Framework…Therefore, investment decision

reduces into a single variable, (level of investment in the LR), with K- invested in the SR project).

Optimal solves:◦Max ------------------------(4)

In SR, output is common knowledge In LR, level of output is the manager’s

private information In both SR and LR, manager knows and

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Case 1: Unobservable ’ (hidden action)Assumptions:

◦The market does not observe ◦The market learns from and forms

expectations about and , which determines in turn

◦)---------------------------------------------(5) Is the market conditional distribution over

long-term investment.

• (2)(5))=+ ϵ] -------(6)• Define: =

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Case 1…Rewrite manager’s utility

function(1)=ϒ+[]--(7)

After some manipulations, the FOC = -}—(8)

Full information contract requires the LHS of (8) equal to zero….. In this case, there is a distortion from the first best contract such that,

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Case 1…

Note:

(i) Manager’s strategies are deterministic, (ii) Support of ϵ is sufficiently large (…has incentives in )

Because of (i) and (ii) the market does not consider to be informative,

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Case 1…#(8) therefore reduces to:

= ˃0-------(9)#(9)˃ ˂ Intuition:

Because the manager knows that the market cannot observe , the level of investment has no effect on the stock market valuation of the firm SIGNAL JAMMING

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Case 1…PROPOSITION 1

◦Unique pure strategy NE (manager underinvests in long-term projects relative to first best).

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Case 2: Unobservable ‘θ’ (hidden information)Change in the type of asymmetric

information leads to change in equilibrium

If the market does not observe , underinvestment in long term projects may occur.

Assumptions:◦It is common knowledge that is a

continuous probability function on []

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Case 2…Manager’s utility function:

(, θ)=ϒ+[]--(10)

LEMMA: In any NE of a signaling game, (θ) will be a non-declining function of θ

PROPOSITION 2: Unique fully separating PBE exists which involves overinvestment with probability 1, and where the equilibrium choice of investment (θ), is such that and for all θϵ(

FOC: = ]

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Case 2…

........and consequent In a fully separating equilibrium,• The worst inference the market can place

on a manager is that in long-term = , which implies that the worst firm’s manager will earn

• The best inference the market can place on a manager is that in long-term =, which implies that the best firm’s manager will earn

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Case 2…Implication (Prop.2):

◦A manager with a highly productive project would prefer to demonstrate to the market TODAY that the firm's is high in order to increase current market valuation rather than wait for the market to react to the realization of ) in the future (…has incentive since ˃0)

◦While a manager with a less productive project will prefer to invest efficiently rather than mimic the highly productive firms (…has no incentive to deserve the market since =0)

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Case 2… This equilibrium is similar to the

results in Spencer (1973) where the fully separating equilibrium in his job market model has talented employees overinvesting in education so as to signal their product of labor to employers.

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ConclusionSummary:

◦Unobservable level of investment: Signal jamming equilibrium (manager cannot communicate investment choices to the market) leading to underinvestment because it is costly to overinvest

◦Unobservable investment productivity: The manager successfully communicates to the market via observable investment choices, leading to overinvestment because it is less costly to overinvest.

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Conclusion… Limitation of the model:

◦ It assumes observability of investment is exogenous

Reality: Obervability is endogenous◦Level of investment would be unobservable

(soft investment) unless managers, possibly at a cost take actions to disclose (release reports)

◦Level of investment would be observable (hard investment) unless managers, possibly at a cost take actions to make it unobservable