Date of Award

2014

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Graduate Group

Finance

First Advisor

Itay Goldstein

Abstract

This dissertation examines the relationship between financial markets and firms' investment decisions. In particular, it focuses on three distinct settings in which firms' real and financial decisions are interconnected.

The first chapter looks at how firms' investment and savings decisions are affected by strategic interactions in their product markets. In particular, current dynamic models in corporate finance ignore the potential for strategic interactions between firms. Empirical evidence nevertheless suggests that these strategic interactions are present and influence corporate saving behavior in a non-trivial way. The first chapter proposes a dynamic model of imperfect competition which captures the empirical evidence and provides insight into how product market interactions influence and are influenced by corporate saving behavior.

The second chapter turns to socially responsible investment (SRI) and develops a micro-structure trading model which sheds new light on the relationship between SRI screening and a firms' equity cost of capital. Previous research argued that SRI screening will lead firms shunned by socially responsible investors to trade at a discount, i.e. have a higher cost or capital, relative to non-shunned peer firms. The model acknowledges this fact but also shows that asymmetric information and heterogeneity in beliefs regarding the relationship between corporate social and financial performance can dampen and even reverse the cost of capital gap between shunned and non-shunned firms. As such the model in the paper delivers a richer set of predictions which help explain the mixed empirical support for a link between SRI screening and equity cost of capital.

Finally, the third chapter outlines a new reason for why firms may finance themselves through financial contracts which provide explicit incentives to generate a social alongside a financial return on investment. The argument developed in this chapter does not rely on investor altruism nor on an explicit link between financial and corporate social performance. Instead it argues that social financial contracts can emerge naturally as the solution to a credit constraint problem in a common agency moral hazard setting. The paper predicts an inverted U-shape relationship between the use of social financial contracts and financial strength.

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