Underinvestment vs. Overinvestment: Evidence from Price Reactions to Pension Contributions

Abstract

Mandatory contributions to defined benefit pension plans provide a unique identification strategy to estimate the market's assessment of the value of internal resources controlling for investment opportunities. The price decrease following a pension-induced drop in cash is magnified for firms that appear a priori more financially constrained, suggesting a negative effect of financing frictions on investment. In contrast, low control on managerial discretion attenuates the negative price reaction to contributions consistent with empire-building theories. While overinvestment seems to be the prevalent distortion in a panel of large firms, underinvestment appears to dominate in a sample that is more representative of the cross-section of listed companies. * Francesco Franzoni: Swiss Finance Institute -University of Lugano, 13 Via Buffi, Lugano, 6904, Switzerland. Email: francesco.franzoni@unisi.ch. The author thanks seminar participants at HEC, Paris, University of Lausanne, University of Lugano, and Tilburg University. I am grateful to Giovanni Barone Adesi, Laurent Calvet, Jonathan Lewellen, Sebastien Michenaud, Joshua Rauh, Jeremy Stein, David Thesmar, Toni Whited, and David Zion for helpful comments. A special acknowledgment to François Degeorge for constant help.In interpreting the empirical literature on corporate investment, Stein (2003) argues that while it is hardly questionable that financial slack matters for investment, it is less clear to what extent this relationship is due to financing constraints or to empire building. On the one hand, by raising the costs of external funds, financial frictions may cause a sub-optimal level of investment. 1 This makes investment sensitive to the availability of cheap internal funds. On the other hand, if managers have empire-building preferences, they will use free cash flows to fund investment projects beyond the level that maximizes shareholders ' value (Jensen (1986)). Like costly external finance, this argument also leads to the prediction that investment is increasing in internal resources. Although the two theories are observationally equivalent with respect to the sensitivity of investment to cash flows, their policy implications are obviously different. Furthermore, the two hypothesis may very well coexist in a unified model that admits both under-and overinvestment. Then, the more interesting question is which distortion prevails empirically.The goal of this paper is to shed some light on this issue. More specifically, the paper develops an identification strategy for the impact of costly external finance and empire building on firm value. First, the objective is to test whether there is a significant effect on market value of the implications of these theories. Then, the analysis attempts a comparison of the importance of the two distortions.A simple consideration inspires the methodology of this paper. One obvious dimension along which the empirical predictions of the costly-external-finance and empire-building theories differ is the value that t...

Excess cash holdings and investment: the moderating roles of financial constraints and managerial entrenchment

“…Managers may be forced to give up positive NPV projects, because they are not willing to raise external capital by issuing underpriced securities. Therefore, cash flow and cash can benefit those firms facing external financing constraints by funding necessary expenditures, which makes their investment sensitive to the availability of internal funds (Stein, 2003; Franzoni, 2009). 4…”

“…With regard to the sensitivity of investment to cash flows, although the costly external financing and agency conflict theories are essentially equivalent, their policy implications differ markedly. Therefore, the two dimensions may well coexist in a unified model that considers both underinvestment and overinvestment (Stein, 2003; Franzoni, 2009).…”

How does the Funding Status of Defined Benefit Pension Plans Affect Investment Decisions of Firms in the United States?

“…That is, whether the requirement to make MPC and higher cost of capital causes managers to invest less. Franzoni () examines market reactions in response to mandatory pension contributions made by firms. However, he does not directly examine the relationship between investment and the funding of DB pension plans.…”

“…However, he does not directly examine the relationship between investment and the funding of DB pension plans. If the market reaction is positive, Franzoni () infers that managers are entrenched so making MPC helps a firm in reducing its liabilities and managers have less cash to waste in negative NPV projects (overinvestment). If the market reaction is negative, his interpretation is that financially constrained firms will have fewer funds available for investments (underinvestment).…”

Do investors misprice components of net periodic pension cost?

“…Franzoni () documents a negative association between future abnormal returns and mandatory pension contributions, suggesting that investors underreact to mandatory pension contributions. Rauh () finds that voluntary pension contributions account for two‐thirds of total pension contributions on average and argues that mandatory and voluntary pension contributions are likely to have different implications for future earnings and cash flows.…”