UC Berkeley

The current thesis presents three chapters in finance that investigate how a firm's characteristics affect its internal corporate financing decision as well as the external perception of the firm by the financial market. The paper advances empirical asset pricing by studying how the market's expectations about firms vary systematically with firms' profitabilities and the impact of these expectations on stock prices. Further, the paper adds to corporate finance by investigating new channels through which firms determine their capital structure and compensation contract for their executives.

Previous research indicated that sorting firms by their profitabilities generates sizeable cross-sectional variations in subsequent period stock returns. Firms that have high profitability this period tend to outperform low profitability firms in the next period. The first chapter of this paper investigates whether high profit firms have higher returns because they are fundamentally riskier in some way, or whether mispricing drives the return difference. The chapter presents evidence that the premium associated with profitability is difficult to reconcile with risk-based explanations but is consistent with expectation errors. Firms with a lower profitability prove more volatile, suffer greater drawdowns and are more sensitive to macroeconomic conditions. This means that the profitable firms are actually less risky by most measures and perform better during economic downturns. In addition, a monotonic relationship exists between profitability and forecast error. Stock analysts tend to be overoptimistic for low profitability firms relative to high profitability firms. Surprisingly, this mis-expectation can persist for as long as five years into the future. Furthermore, the profitability premium is mainly concentrated among firms about which the anlysts express the most optimism.

The second chapter, jointly authored with Francesco D'Acunto, Carolin Pflueger and Michael Weber, shows that the frequency with which firms adjust output prices is an important determinant of persistent capital structure. Using restricted BLS data, we constructed a measure of the individual firm's output price rigidity and matched it with financial information of the firm. Flexible-price firms choose higher financial leverage than inflexible-price firms, controlling for known determinants of capital structure. We rationalize this novel fact using a costly-state-verification model, where inflexible-price firms are more exposed to aggregate shocks, and hence face tighter financial constraints. The model predicts that bank lending, by providing monitoring, relaxes financial constraints and narrows the leverage gap between inflexible- and flexible-price firms. Consistent with model predictions, we show that inflexible-price firms increased leverage more than did flexible-price firms following the staggered implementation of the 1994 repeal of interstate bank branching regulations. Firms' frequency of price adjustment did not change around this deregulation, supporting a causal interpretation of price flexibility on corporate leverage.

In the third chapter of the dissertation, I investigate the role that innovation plays in executive compensation. Agency-based theory of optimal executive compensation literature has long puzzled over the empirical observation that executives are being compensated for industry performances that are outside the executive's control. Using patent-based metrics as the measure of innovativeness, I show that this “pay for luck” phenomenon is mainly concentrated among the most innovative firms and is stronger for firms in more innovative industries. I conjecture that motivating innovation might require a different contract design,and in some cases, “pay for luck” might actually be optimal in incentivizing experimentation.