Does the Stock Market Harm Investment Incentives?

Original source: SimoleonSense.com .

Introduction (via Harvard Law )

In the paper, Does the Stock Market Harm Investment Incentives? which was recently made publicly available on SSRN, my co-authors, John Asker and Joan Farre-Mensa, and I examine whether the stock market harms investment incentives. The theory literature in economics and finance has long argued that the separation of ownership and control following a stock market listing can lead to agency problems between managers and dispersed stock market investors and hence to suboptimal investment decisions. The literature is divided on whether overinvestment (i.e., empire building) or underinvestment (due to rational short-termism) will result, or indeed whether effective corporate governance mechanisms can be devised to ensure investment does not suffer (Tirole (2001), Shleifer and Vishny (1997)).

Additional Excerpts (via Harvard Law)

We also show that public companies tend to smooth their earnings growth and dividends and are reluctant to report negative earnings. One interpretation for these patterns is that public firms treat investment spending as the residual after having paid dividends out of their cash flows, whereas private firms treat dividends as the residual after paying for their investment out of cash flows.

Overall, at least for our fast-growing sample firms, the benefit of cheaper funding via the stock market appears to be somewhat diminished by distortions in investment behavior, which are consistent with short-termism on the part of managers driven by the agency costs associated with the separation of ownership and control.

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