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Equity And Corporate Investment Decisions.........

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UCLA experts discuss the relationship between equity and corporate investment that can affect your business and what to consider while making corporate decisions.

UCLA Anderson’s Andrea L. Eisfeldt, UCLA’s Huifeng Chang, a Ph.D. student, and Stockholm School of Economics’ Adrien d’Avernas offer views examining bond prices and their role in corporate decisions about investing or not investing in assets. They discuss the “investment channel,” and explore how investment decisions are made by companies alongside the state of equity prices and credit spreads.

Investment rates, defined as quarterly capital expenditures as a percentage of the firm’s existing net property, plant and equipment
Equity volatility, as measured by daily realized stock market returns
Credit spread 
Market leverage, or the ratio of the market value of a firm’s assets to the market value of its equity
Asset volatility, which measures changes in the fundamental value of a business’s total assets. For example, the value of Purell’s inventory went up when demand for hand sanitizer soared in the early days of the pandemic, demonstrating high (and some might say surprising) asset volatility. Another way of thinking about asset volatility is that it represents equity volatility, but without the leverage; in the paper, the authors arrive at the value of asset volatility by de-levering equity volatility. 
The researchers pull quarterly data for any firm that has been in the panel for at least three years, yielding 1,161 firms with 54,033 firm-quarter observations. They split their sample into thirds: A low-risk firm is one with a credit spread of 147 basis points or fewer; a medium risk firm with a spread between 147 and 326 basis points; and a high-risk firm has a credit spread of 326 basis points or higher. 

They find that firms with narrow credit spreads, such as Prudent Corp, have a positive investment response to high equity volatility. If a firm’s managers see high potential upside and a low risk of default, they are keen to invest in future projects for the firm. Since Prudent Corp. doesn’t have any major loan obligations or expensive debt payments, it has the financial freedom to invest in resources (such as property, plants or equipment). 

On the other hand, firms with wide credit spreads, such as Leveraged Corp., are disinclined to invest in the face of equity volatility. This makes intuitive sense. Leveraged Corp.’s managers and shareholders might think, “Hmm, given this observed uncertainty and the big pile of debt already outstanding, perhaps it’s not the best idea to build another factory.” 

In other words, high equity volatility can affect investment decisions in either direction, but it depends on how near or far a firm is from insolvency.

The long-standing idea that a firm’s share price holds less predictive power than a bond yield comes from the fact that, taken in aggregate, the different effects of equity volatility across firms cancel out. The low price of a range may indeed be predictive of some firms’ futures, while the high price of a range may predict that of others.

This gives the false impression that equity volatility has a neutral effect on investment decisions and doesn’t have a close relationship to the broader economy. By observing the “investment channel,” or how a firm’s risk of default (as measured by bond yields) interacts with asset volatility to encourage or discourage investment, the authors suggest why bonds are a better predictor of investment, which in turn ripples out into the economy.

“Our results indicate that the closer relation between bond markets and the macroeconomy is not due to differences