Capital market imperfections and corporate finance

This dissertation studies how capital market imperfections affect firm behavior. The first essay, joint with Aditya V. Sunderam, studies how credit ratings and regulations tied to ratings segment capital markets and how the resulting segmentation affects firm investment. Because regulations prevent many investors from holding speculative-grade securities, shocks to capital of investors specializing in these securities, might not be immediately offset and can therefore affect the cost of capital for speculative-grade firms. Focusing on a matched sample of firms just above and just below the investment-grade cutoff, we show that flows into speculative-grade mutual funds have an economically significant effect on the investment of speculative-grade firms, especially those with limited alternative financing options. The second essay, also joint with Aditya V. Sunderam, studies how the supply of arbitrage capital, specifically capital available to convertible arbitrage hedge funds, affects firm investment. An extra $1 of flows into convertible arbitrage hedge funds increases capital expenditures of firms that depend on convertible debt for financing by $0.49. Since convertible arbitrage funds hedge their equity exposure to convertible debt issuers, we argue that changes in the supply of convertible arbitrage capital are not driven by changes in firm investment opportunities. Our results suggest that firm investment responds strongly to shocks to the supply of arbitrage capital that are unrelated to firm fundamentals. The third essay, joint with C. Fritz Foley and Robin Greenwood, studies the interaction between stock market mispricing, agency costs, and ownership structure. Standard theories of corporate ownership assume that because markets are efficient, insiders ultimately bear agency costs. We show that if equity is overvalued, however, mispricing offsets agency costs and can induce a controlling shareholder to list equity. Higher valuations support listings with greater agency costs. We test these ideas on a sample of publicly listed subsidiaries in Japan. We show that when there is greater scope for expropriation by the parent firm, minority shareholders fare poorly after listing. Parent firms often repurchase subsidiaries at large discounts to valuations at the time of listing and experience positive announcement returns.