The Lifecycle of the Firm, Corporate Governance and Investment Performance

Abstract

According to firm lifecycle theory the agency costs of free cash flows are not transitory problems, but are a recurrent issue once firms reach a certain stage in their lifecycle. In particular, as firms mature their cash flows increase substantially while their investment opportunities decline and, to prevent retrenchment, managements need to invest in negative net present value projects. However, too much overinvestment leads to low firm valuation and potentially a hostile takeover. This paper extends firm lifecycle theory by arguing that to neutralize the threat of takeover, managements of maturing firms and their boards of directors progressively deploy antitakeover provisions which allow them to overinvest safely and prevent a decline in the size of their corporations. Firm lifecycle theory is also tested empirically. In this respect, a contribution of this paper is to develop a new empirical index that permits the identification of mature corporations with governance problems due to agency costs of free cash flows. The empirical results show that as firms mature agency costs of free cash flows increase, more antitakeover provisions are put into place and firms invest in projects with returns below their cost of capital.

The determinants of systematic risk: A firm lifecycle perspective

“…The upshot is that because of the abovementioned predictable changes in the structure companies over time, an empirical test designed to study the behavior of beta should find that beta falls over the lifecycle of the firm. So far several papers have provided some evidence supporting firm lifecycle theory's claims regarding the different characteristics of young firms compared to mature firms (Garcia, Saravia and Yepes, 2016;Mueller and Yun, 1998;Saravia, 2014;Saravia and Saravia-Matus, 2016). However, to the best of our knowledge no paper has yet tested empirically whether the market equity betas of young firms are larger than those of mature firms while holding other real determinants of systematic risk constant.…”

“…The upshot is that because of the above‐mentioned predictable changes in the structure companies over time, an empirical test designed to study the behaviour of beta should find that beta falls over the lifecycle of the firm. So far, several papers have provided some evidence supporting firm lifecycle theory's claims regarding the different characteristics of young firms compared to mature firms (Garcia, Saravia, & Yepes, 2016; Mueller & Yun, 1998; Saravia, 2014; Saravia & Saravia‐Matus, 2016). However, most important for this paper are the results of behavioural finance scholars such as Baker and Wurgler (2006), who have shown that investor sentiment can have a large impact on the returns of young firms “whose valuations are highly subjective and difficult to arbitrage.” If investor sentiment causes young firm returns to be too high during economic booms (and too low during recessions) compared to what can be justified by rational factors, then the covariance of returns between the market portfolio and young firms will also be higher than can be rationally justified.…”