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I show that firms' ability to adjust variable capital in response to productivity shocks has important implications for the interpretation of the widely documented investment-cash flow sensitivities. The variable capital adjustment is sufficient for firms to capture small variations in profitability, but when the revision in profitability is relatively large,

I show that firms' ability to adjust variable capital in response to productivity shocks has important implications for the interpretation of the widely documented investment-cash flow sensitivities. The variable capital adjustment is sufficient for firms to capture small variations in profitability, but when the revision in profitability is relatively large, limited substitutability between the factors of production may call for fixed capital investment. Hence, firms with lower substitutability are more likely to invest in both factors together and have larger sensitivities of fixed capital investment to cash flow. By building a frictionless capital markets model that allows firms to optimize over fixed capital and inventories as substitutable factors, I establish the significance of the substitutability channel in explaining cross-sectional differences in cash flow sensitivities. Moreover, incorporating variable capital into firms' investment decisions helps explain the sharp decrease in cash flow sensitivities over the past decades. Empirical evidence confirms the model's predictions.
ContributorsKim, Kirak (Author) / Bates, Thomas (Thesis advisor) / Babenko, Ilona (Thesis advisor) / Hertzel, Michael (Committee member) / Tserlukevich, Yuri (Committee member) / Arizona State University (Publisher)
Created2013
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Description
Mutual monitoring in a well-structured authority system can mitigate the agency problem. I empirically examine whether the number 2 executive in a firm, if given authority, incentive, and channels for communication and influence, is able to monitor and constrain the potentially self-interested CEO. I find strong evidence that: (1) measures

Mutual monitoring in a well-structured authority system can mitigate the agency problem. I empirically examine whether the number 2 executive in a firm, if given authority, incentive, and channels for communication and influence, is able to monitor and constrain the potentially self-interested CEO. I find strong evidence that: (1) measures of the presence and extent of mutual monitoring from the No. 2 executive are positively related to future firm value (Tobin's Q); (2) the beneficial effect is more pronounced for firms with weaker corporate governance or CEO incentive alignment, with stronger incentives for the No. 2 executives to monitor, and with higher information asymmetry between the boards and the CEOs; (3) such mutual monitoring reduces the CEO's ability to pursue the "quiet life" but has no effect on "empire building;" and (4) mutual monitoring is a substitute for other governance mechanisms. The results suggest that mutual monitoring by a No. 2 executive provides checks and balances on CEO power.
ContributorsLi, Zhichuan (Author) / Coles, Jeffrey (Thesis advisor) / Hertzel, Michael (Committee member) / Bharath, Sreedhar (Committee member) / Babenko, Ilona (Committee member) / Arizona State University (Publisher)
Created2012