TAILIEUCHUNG - VALUE-ENHANCING CAPITAL BUDGETING AND FIRM-SPECIFIC STOCK RETURN VARIATION

When interest rates rise, amortizing securities may also lose value at an increasing rate, as their average lives extend. For example, a mortgage security may, at current interest rates, have an estimated average life of five years. Average life refers to the average length of time a dollar of principal remains outstanding. However, as rates rise and fewer homeowners prepay, the security may then have an average life of seven years. Its price sensitivity will consequently become similar to a seven-year security, rather than a five-year security. It is helpful. | THE JOURNAL OF FINANCE VOL. LIX NO. 1 FEBRUARY 2004 Value-Enhancing Capital Budgeting and Firm-specific Stock Return Variation ART DURNEV RANDALL MORCK and BERNARD YEUNG ABSTRACT We document a robust cross-sectional positive association across industries between a measure of the economic efficiency of corporate investment and the magnitude of firmspecific variation in stock returns. This finding is interesting for two reasons neither of which is a priori obvious. First it adds further support to the view that firm-specific return variation gauges the extent to which information about the firm is quickly and accurately ref lected in share prices. Second it can be interpreted as evidence that more informative stock prices facilitate more efficient corporate investment. Corporate capital investment should be more efficient where stock prices are more informative. Informed stock prices convey meaningful signals to management about the quality of their decisions. They also convey meaningful signals to the financial markets about the need to intervene when management decisions are poor. Corporate governance mechanisms such as shareholder lawsuits executive options institutional investor pressure and the market for corporate control depend on stock prices. Where stock prices are more informative these mechanisms induce better corporate governance which includes more efficient capital investment decisions. Our objective in this paper is to examine empirically whether capital investment decisions are indeed more efficient where stock prices are more informative. To do this we require a measure of the efficiency of investment and a measure of the informativeness of stock prices. Durnev is from the Department of Finance University of Miami Morck is the Stephen A. Jarislowsky Distinguished Professor of Finance at the School of Business University of Alberta and Yeung is the Abraham Krasnoff Professor of International Business Professor of Economics and Professor of Management

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