The relationship between market signals and firm’s investment, capital structure, and compensation policies: A study of commercial banks trading on the New York stock exchange

 

 

 

 

The relationship between market signals and firm’s investment, capital structure, and compensation policies: A study of commercial banks trading on the New York stock exchange

Anahita Taghi-Ganji

Professor’s Name

Thesis proposal

Date Submitted

 

 

 

 

Introduction

Market signals are important tools in the stock market which influences the buying and investment decisions of individuals and institutions. These signals indicate investors’ confidence in specific firms, industries, or different economic sectors in many countries (O’connor 2004, p. 98). They also provide information on the behavior of various firms in the stock market and the asset prices. Changes in asset prices (equity, bond, property) are found to have significant effects on firm’s investment, capital structure and compensation policies in most parts of the world.

Economists and financial analysts have come up with different concepts which explain the relationship between market signals and firms’ investment decision. For example, Hennessy (2004, p.30) and Hovakimian (2001, p.35) claim that an increase or a decrease in equity or property prices may increase or decrease the cost of new capital in relation to existing capital. Henessy (2004, p.34) adds that the cost of investment may increase or decrease with rising or dropping of Tobin’s q (the ratio of market valuation of capital to the cost of acquiring new capital. Other studies claim that private investments are well explained by anticipated future output growth (flexible accelerator model) to the point that changes in stock prices influence upcoming GDP growth. This in turn influences current investment. Other economists claim that changes in the disposable value of the firm may have a great impact on the financing premium which would also affect the cost of capital. An increase in asset prices may improve the balance sheets of banks and other financial institutions to charge a lower premium on loans, hence reducing the cost of capital. They further claim that market signals influence investment decisions of various firms which in turn affect their dividend policies as managers seek to maximize the share holders’ wealth (international monetary fund (IMF) 2000, p. 100).

Keowns (2004, pp. 167-169) claims that the dividend payout ratio (compensation) of many organization decreases with increase in investment opportunities. If the expected compensation (dividend payout) decreases, the market price of the stock may go down since the investors may believe that the earnings of the company are not worth their investment (IMF 2000, p 103). Many individuals and firs invest in expectation of increase in prices which would enable them to make capital gains. There are others who buy stock for investment income, and they therefore rely on dividends. These investors come up with strong dividend payment policy for compensation purposes. Other firms with considerable financial resources may buy shares with a view to control a company by owning more than 50% of the issued capital (Siklos 2001, p. 42).

Baker and Wugler (2002, pp 14) and Draho (2004, p. 285) suggest that Stock prices also affect the capital structure of many firms using the market timing theory.  They claim that companies tend to issue equity when the market price of their stock is high, and purchase back or issue debt when the equity price is low. Therefore the existing capital structure of these firms is a cumulative outcome of their transactions or their past attempts to time the equity market. However, companies rarely switch between mispriced stocks or debt in an effort to reduce the cost of capital since the efficient market hypothesis is not abused by the availability of asymmetric information.

            It has on different points reported by Baker and Wugler (2002, pp 22) and Draho (2004, p. 285) that there are different models and theories which indicate that stock prices do not always influence the investment decisions of many companies. Silklos (2001, pp. 45-50) claims that market imperfections may affect the investment decisions of many firms by reducing the required cash flows from marginal projects. Market imperfections reduce the net present value of marginal projects thus depressing the investment expenditures in relation to the time when the market is perfect. This implies that some projects with positive net present value may exist but not considered or undertaken since the market imperfections make them un-attractive. The main types of market imperfections are the cost of underinvestment, the cost of information asymmetries and the cost of information asymmetries. The cost of information asymmetries crops up if a company has debs in the capital structure while firms face costly financial distress if they have a high leverage. This therefore makes it plausible that market imperfections affect the managers’ financial as well as investment decisions.

Purpose of the study

The purpose of this study is to establish if there is any relationship between market signals and firm’s investment, capital structure, and compensation policies. The researcher will conduct the study in various commercial banks trading on the New York stock exchange.

Objectives

The objectives of this study include:

1. To determine the relationship between stock prices and the investment decisions of various banks in New York.
2. To determine the relationship between stock prices and the capital structure of various commercial banks trading on the New York stock exchange
3. To determine the relationship between stock prices and dividend policies of various commercial banks trading on the New York stock exchange
4. To determine how market imperfections affect the managers financial as well as investment decisions in various commercial banks in New York.
5. To establish the policies which would help commercial banks to come up with viable investment decisions with changes in market signals and market imperfections
6. To establish whether the investment decisions employed by commercial banks respond to mispricing or private information set in the stock price.

 

Questions

The research questions of this study include:

1. What is the relationship between stock prices and the investment decisions of various banks in New York?
2. What is the relationship between stock prices and the capital structure of various commercial banks trading on the New York stock exchange?
3. What is the relationship between stock prices and dividend policies of various commercial banks trading on the New York stock exchange?
4. How do market imperfections affect the managers financial as well as investment decisions in various commercial banks in New York?
5. What policies would help commercial banks to come up with viable investment decisions with changes in market signals and market imperfections?
6. What investment decisions are employed by commercial banks respond to mispricing or private information set in the stock price?

 

 

Hypotheses

The following are the null and alternative hypotheses for each research question:

       H1₀: There is a relationship relationship between stock prices and the investment decisions of various banks in New York.

       H1_a: There is no relationship relationship between stock prices and the investment decisions of various banks in New York.

      H1₀:  There is a relationship between stock prices and the capital structure of various commercial banks trading on the New York stock exchange

 

     H1_a:  There is no relationship between stock prices and the capital structure of various commercial banks trading on the New York stock exchange

      H1₀: There is a relationship between stock prices and dividend policies of various commercial banks trading on the New York stock exchange

    H1_a: There is no relationship between stock prices and dividend policies of various commercial banks trading on the New York stock exchange

      H1₀: market imperfections affect the managers financial as well as investment decisions in various commercial banks in New York

   H1_a: market imperfections do not affect the managers financial as well as investment decisions in various commercial banks in New York

Significance of the study

1. The study will be very helpful to the management of the various commercial banks in New York in development of effective investment policies which would help them in making good decisions when trading in the capital markets.
2. The study would be important to investors who would like to invest in the market securities to have a better understanding on how market imperfections affect the stock prices and  investment decisions of many companies
3. The study would help the researcher and other academicians to have a better understanding of the relationship between market signals and the investment decisions of various commercial banks trading on New York stock exchange  

 

Theories to be used

The researcher will employ Tobin’s q (the ratio of market valuation of capital to the cost of acquiring new capital), dividend pay-out theory, market timing theory, and the flexible accelerator theory.  

 

Research methodology

This study will employ a quantitative research design with a cross-sectional descriptive correlation method or hypothesis testing. A research design is referred to as “a conceptual structure within which research is collected; it constitutes the blueprint for the collection, measurement and analysis of data” (Kothari, 2004, p. 31). This design explains the various techniques that will be used to gather data, the kind of sampling techniques, the population to be studied, methods to be used in analyzing data and how the time or cost constrains will be dealt with (Chadran, 2004; Cooper & Schindler, 2004).

A research design has several approaches among them exploratory, descriptive, a case study and hypothesis testing (Kothari, 2004; Trochin, 2006). Hypothesis testing is concerned with testing of casual relationships between two or more variables (Baker and Wugler (2002, pp 14-22) and Draho (2004, p. 287). These studies require measures which reduce bias and permit drawing of inferences about causality to increase reliability of the research (Kothari, 2004). This design involves the control of independent variables to establish their result on a dependent variable (Gravetter & Forzano, 2009; Mugenda & Mugenda, 2004; Shaughnessy & Zechmeister, 2004).The area of study will include all the commercial banks trading on the New York stock exchange. The researcher will collect data from the bank managers from each of these banks. The researcher will employ questionnaires and interviews as the primary tool of data collection. Pearson’s correlations coefficients will be used to determine if there is any correlation between market signals and investment, capital structure, or compensation policies of various commercial banks in New York.

 

 

References List

Baker, M & Wurgler, J 2002, ‘Market timing and capital structure’,  Journal of Finance, vol. 57, pp. 1–32.

 

Draho, J 2004, The IPO decision: why and how companies go public, Edward Elgar Publishing, Northampton.

 

Hennessy, C A 2004, ‘Tobin’s Q, Debt Overhang, and Investment’, Journal of Finance, vol. 59, pp. 1717– 1742.

 

Hovakimian, A T 2001, ‘The Debt-Equity Choice’, Journal of Financial and Quantitative Analysis, vol. 36, pp. 1–24.

 

International monetary fund, 2000, Asset prices and the business cycle, International monetary fund, Washington, DC.

 

Keown, A J 2004, Foundation of finance: the logic and practice of financial management, Qinghua University Press, Beijing.

 

O’connor, D E 2004, The basics of economics, Greenwood Press, Westport, Conn.

Siklos, P 2001, Money, Banking, and Financial Institutions: Canada in the Global

            Environment, McGraw-Hill, Toronto.