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Macroeconomics
Financial Economics

Macroeconomics
Financial Economics
Corporate Finance

May 2001 (Written: Microeconomic Theory, Macroeconomic Theory)
May 2002 (Oral: Macroeconomics, Econometrics)

Lumpy Firm Behavior: Interactions Between Bankruptcy, Taxes, and Non-Convex Costs of Financing and Investment

Professor William Brainard (Chair)
Professor Eduardo Engel
Professor George Hall

May 2006

Ph.D. in Economics, Yale University, 2006 (Expected)
M.A. in Economics, Yale University, 2003
B.A. in Applied Math, with honors, at ITAM, Mexico, 1999

Yale University Dissertation Fellowship, September 2004
Yale University Teaching Fellowship, September 2000
Bailleres Excellence Full Scholarship, ITAM, 1995 (declined)

Intermediate Macroeconomics, Section Leader, Professor Tony Smith, Yale, Spring 2005
Theory of Income Determination, Section Leader, Professor George Hall, Yale, Fall 2003
Introductory Macroeconomics, Section Leader, Professor Ray Fair, Yale, Spring 2003
Financial Theory, Section Leader, Professor John Geanakoplos, Yale, Fall 2002
Financial Economics and Applications, Lecturer, ITAM, Mexico City, Summer 2002

Federal Reserve System, International Finance Division, Dissertation Internship, Summer 2005
Central Bank of Mexico, Economic Studies Division, Summer Research Position, Summer 2003
ITAM, Economics Research Center, Summer Research Position, Summer 2002

Central Bank of Mexico, Economic Analyst, Economic Research Department, 1998-2000

"Financing Choices as a Function of Firms Income Processes: Financing is for the Long Term"
"Investment, q and Cash Flow in a Model with Investment and Financial Fixed Costs of Adjustment"
"Plant Level Productivity and Trade Liberalization: The Case of Mexico 1994–2002"

ITAM, Gaceta de Economía, Member of the Editorial Board, 2002–2004

Federal Reserve Board, IF Seminar, July 2005
Yale, Summer Research Seminar, August 2005
Penn (University of Pennsylvania), Inter-University Conference, November 2004
Central Bank of Mexico, August 2003
ITAM Research Seminar, August 2002

Professor William Brainard
Department of Economics
Yale University
PO Box 208268
New Haven, CT 06520-8268
Telephone: (203) 432-3585
Fax: (203) 432-5779
william.brainard@yale.edu

Professor Eduardo Engel
Department of Economics
Yale University
PO Box 208268
New Haven, CT 06520-8268
Telephone: (203) 432-5595
Fax: (203) 432-2128
eduardo.engel@yale.edu

Professor George Hall
Department of Economics
Yale University
PO Box 208268
New Haven, CT 06520-8268
Telephone: (203) 432-3566
Fax: (203) 432-2128
george.hall@yale.edu

Recently, economists studying firm behavior with microeconomic data have found that investment behavior is ‘lumpy’, firms act infrequently and in large movements when they do so. This lumpy behavior is usually interpreted as the result of non-convexities in the firm’s adjustment cost function. This dissertation studies the implications of such non-convex costs of adjustment on both investment and financing decisions of firms in a model with debt, equity and retained earnings as a means of finance and where taxation and bankruptcy costs are explicit. The first chapter documents the fact that debt issuance is indeed lumpy, and shows costs of adjustment cause dynamic interactions among investment and financial variables, predicting for example that firms will issue either debt or equity, but seldom both, in order to cover their investment needs and that they will accumulate cash in anticipation of investment or debt repurchasing actions. The second chapter studies whether the large increase in dividend payments in 2003 can be attributed to that year’s tax reform. It uses to model above to compare optimal behavior with high and low dividend tax rates and derives the optimal path from one equilibrium to another. The results of this chapter suggest that tax reform has not been the driving force of the observed change in behavior, rather, the model shows firm behavior is consistent with a decrease in the rate of growth of the economy. The third chapter uses the model in chapter one to study profitability and leverage. It shows costs of adjustment over financing decisions are a robust way to explain the negative relationship between these variables observed in the data.  Overall, the issue at hand is that traditional models implying linear relationships between investment and Tobin's q or the cost of capital, or partial adjustment models of capital structure have no hope of capturing firm behavior accurately if non-convexities are indeed relevant.  This dissertation proposes a model that allows for such non-convexities to study their implications.

Chapter 1: Financial Lumpiness and Investment (Job Market Paper)

This paper shows that non-convex costs of financial adjustment are important for rationalizing observed investment and financing choices of firms.  Using the COMPUSTAT data base it first shows firm's financing activities.  The paper then presents a model which shows that, in the presence of taxes and bankruptcy costs, non-convex costs of investment and financing rationalize observed firm behavior, while non-convexities on investment alone do not.  It then shows other predictions of the model are verified empirically:  that when issuing debt or equity firms often increase their cash holdings and that when issuing debt or equity but not both, firms 'overadjust', moving beyond their financial targets.  The paper also shows financial non-convexities help rationalize the empirically documentedconvex relationship between investment and mandated investment -- the investment that would take a firm to its desired capital stock in the absence of adjustment costs.  Finally the paper uses the model to relate firm heterogeneity to the internal financing sensitivity of investment in the standard investment regression.  In the model, a firm's higher expected growth rate is associated with a higher coefficient on internal finance, consistent with the empirical relationship between growth and internal finance, consistent with the empirical relationship between growth and internal financie sensitivities.  However, unexpected differences in the rates of growth, the result of different observations of the same stochastic growth process, do not result in internal finance sensitivities consistent with the empirical evidence suggesting a big role for expected growth rates for determining the optimal sources of i nvestment financing

Chapter 2: Restructuring Firm Liabilities after The 2003 Tax Cuts: How Fast Do We Expect Firms To Adjust?

In 2003, the US congress signed into law an important change in the tax code, halving dividend taxes and deceasing personal income taxes, with the rationale of increasing investment and allowing firms to repay shareholders more easily. Chapter two of this dissertation uses the model described above to study the reaction of firms to this change in terms of financing choices, payouts and investment. While supporters of the reform view the increase in dividend payments of firms around this time as vindication for their position, it is not clear whether this change is indeed a response to the aforementioned change. This chapter characterizes the optimal reaction to this change, in terms of the new target levels of finance and investment and also in terms of the path of firms to these new targets. This experiment shows that the financial and investment incentives in the model above do not predict such a change in the tax code to have caused the increase in dividend payments that was observed. Instead the model shows that, in a high growth economy firms accumulate earnings in expectation of positive shocks to productivity that will prompt investment, but if instead bad outcomes materialize, they pay out these retained earnings to shareholders, a possible rationalization of the high dividend, high retained earnings, low investment behavior of US corporations in recent years.

Chapter 3: Financing Choices as a Function of Firms Income Processes: Financing is For the Long Term

The third chapter of this dissertation studies the dynamics of leverage. One of corporate finance most cited puzzles is the negative relationship between firms’ profitability and their leverage, which is seemingly inconsistent with the powerful income tax sheltering properties of debt. Hennessy and Whited (2005) show that this can be the result of tax schedules on corporate income, dividends, and interest payments, in a model with reversal to the mean in the firm's revenues and where debt is the only margin to store profits for future investment.  This paper shows that allowing the firm to accumulate cash for future investment or debt repayment and modeling a firm with positive long term growth produces different results.  The firm does accumulate cash when it is profitable, but the impact on overall firm leverage is negligible.