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  Professors Robert Korajczyk and Janice Eberly
© Nathan Mandell
Professors Robert Korajczyk, an asset pricing expert, and Janice Eberly, an expert in real options theory.

Capital motivations
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Entrepreneurship and the business cycle
The incentives of managers to reveal bad news early is not the only aspect of financial decision making affected by aggregate economic conditions. Attitudes toward risk are also affected, and this is reflected in the entrepreneurs' decisions to invest at different times in the business cycle.

Whether entrepreneurs are more or less risk averse depends on how the overall economy is doing. When the economy is doing poorly, entrepreneurs are less well off and hence more risk averse than when the economy is doing well.

Moreover, their motivation depends on how diversified their entire portfolio of assets is.

As it turns out, most entrepreneurial risk is not diversified away—seemingly surprising, given that everyone involved in entrepreneurial pursuits tends to understand that these ventures are inherently risky and that the risk is in large part idiosyncratic.

"The lenders know it, the investors know it, the entrepreneurs know it. Why don't people then diversify the risk?" asks Rampini.

His answer involves the motivation and incentives surrounding entrepreneurship.

"If you have perfectly diversified the risk of your new venture, the odds are that you won't succeed," explains Rampini. "Because by insuring your venture, there is no upside for you anymore, so there's no need to work as hard. The steep incentives are gone."

Somewhat similar to the dynamics that discourage capital reallocation during recessions, when capital could typically be redeployed quite productively, entrepreneurship tends to drop precipitously during economic busts and rise during good times.

During boom times, says Rampini, everyone is generally better off which tends to make people less risk averse and more inclined to launch entrepreneurial activities. If the projects do poorly, the entrepreneurs won't likely suffer as much, because the aggregate market is relatively forgiving when overall productivity is up and capital relatively inexpensive.

When times are tough and capital tight, however, risk aversion goes up.

"So in good times, entrepreneurs are happier to hold risk and start ventures," Rampini notes. "Moreover, they may also be more able to sell risky claims on their ventures. Thus, the amount of idiosyncratic risk that you can diversify varies over the business cycle."

This means that holding on to a smaller stake in the firm during good times still provides sufficient incentives. In bad times, though, the situation is reversed and managers have to hold a larger fraction of the project's risk— which is a disincentive to entrepreneurial activity.

"Incentives and risk aversion move together, making booms that much better since both aspects make it more attractive to start entrepreneurial activities," says Rampini.

In a very uncertain environment, the real options strategy can have a significant negative impact on overall investment, notes Prof. Janice Eberly.  

This way of thinking about entrepreneurial activity and the associated incentives and risk is applicable to dynamics within a firm too, suggests Rampini. Though his research has not explicitly considered this context, he says that there appears to be analogous incentives inside firms that launch new divisions. Starting a new division is clearly associated with considerable risk.

"How steep must the incentives be so that the manager of a new division will work hard?" asks Rampini. "How much of the new division's risk must we leave with the divisional management, and how much can we transfer to headquarters, which may care less about the idiosyncratic risk and hence may be more willing and able to absorb that risk?"

In principle, all the risk should go to headquarters. It doesn't, of course, precisely because of the incentives necessary to motivate the divisional management team. The question for the firm's finance experts is how much risk must reside with the division compared to headquarters.

This is a simplification, admits Rampini, but it does work to illustrate how the internal capital market may be understood as somewhat similar to the larger capital markets in terms of risk and incentives.

Real options and capital assets: adding complexity
Behind all investment decisions, including the ones Rampini and Eisfeldt have considered, rests the literature of asset pricing and, more recently, real options. For more than two decades, CAPM has become well defined around the core assumption that markets prohibit the chance for investors to make large-scale riskless profits.

"Asset pricing models examine what kinds of risks are important," explains Korajczyk, adding that a central consideration for the model involves a portfolio selection that is efficient—generating high expected return and low standard deviation. He says that the intuition for a lot of people is that high individual asset volatility must correlate with a high risk premium—something that is not true, given the insights of portfolio theory which say that assets cannot be viewed in isolation from one another.

"If you think about the world in a portfolio context, something with a high volatility could increase the risk of the portfolio or actually decrease the risk of the portfolio, depending upon how it is correlated with the other assets in the overall portfolio," says Korajczyk.

"The next step in the asset pricing literature, given this insight, is to determine what sort of risk is going to command a risk premium," he explains. "It's going to be risks correlated with the assets we hold in a diversified portfolio—the risk that is undiversifiable."

A stock's sensitivity to the overall marketplace is defined as its beta. According to CAPM, if the aggregate investment community holds the entire market portfolio, and if beta indicates each stock's contribution to the portfolio risk, then investors will require that the risk premium be aligned with beta.

Korajczyk notes that the more recent asset pricing literature seeks to gain more subtle insights into risk and risk premiums. For instance, newer capital asset pricing models try to take into account how investors think about transaction costs and illiqidity.

The subtleties of risk are also being explored in the real options literature, an area that Kellogg School Professor Janice Eberly knows well.

In an effort to develop a more refined framework to analyze investment, Eberly has turned to real options, an area of financial thinking that treats assets in a more sophisticated way, comparing them to options that may or may not be exercised along a temporal continuum. Options, in financial terms, are defined as having a choice to invest in the future using terms that are fixed in the present.

"Some investment decisions act like options, in that you not only have the choice to exercise them, but you can also choose when to exercise them," says Eberly. The valuation is done exactly like an option, she notes, so idiosyncratic risk is relevant.

"The intuitive part of this is that in an environment with a lot of uncertainty, that option to delay and wait to see what happens becomes more valuable," she explains.

As a result, firms often delay projects until some of the uncertainty is resolved. Consequently, notes Eberly, in a very uncertain environment, the real options strategy can have a significant negative impact on overall investment, because companies are just waiting.

The real options approach to capital investing tries to generalize a narrow assumption associated with calculating net present value. Textbooks assume that investments are "take it or leave it" propositions that must be undertaken now or never. In reality, Eberly says, things are not so straightforward.

A firm frequently has a number of investment opportunities, she says, including growth options that influence the company's value in complex ways depending on whether and when the options are exercised.

Eberly and her colleague Andrew B. Abel from the Wharton School have developed a model in which a firm's opportunity to upgrade its technology results in growth options in the value of the firm.

"A firm's value is the sum of value generated by its current technology plus the value of the option to upgrade," they write in their paper "Investment, Valuation, and Growth Options."

The authors reveal that "variation in the technological frontier leads to variation in firm value that is unrelated to current cash flow and investment, though variation in firm value anticipates future upgrades and investment."

What real options attempts to do, Eberly says, is provide a more dynamic way of thinking about investment decisions, refining the textbook models in light of real-world practices.

Similarly, Korajczyk points out that developments in the microstructure literature over the last two decades have also tried to assess investment more realistically, in part by taking a closer look at trading costs.

"Costs are more than simply transactions associated with brokerage commissions," says Korajczyk. "That's really just part of the costs. There's also a bid-ask spread that you pay." And with larger, institutional trades, he says, not only must you pay the bid-ask spread, but you are likely to move the price adversely against you.

"What the microstructure literature does is think about how we're going to influence price when we start trading, and how we measure these kinds of effects," says Korajczyk.

All these finance tools continue to evolve in ways that seek to account for the real financial world in increasingly accurate ways. As they do so, their complexity increases too, until they can seem esoteric.

But Eisfeldt still remembers what initially attracted her to finance: a desire to make the world a better place. Though she doesn't use the word "utopian" to describe her underlying scholarly motivations, the term seems to fit.

"I'm really interested in learning how we can get the most out of the resources we have," she says. "The issues most compelling to me include how we design securities so that financing goes to the right places; how we minimize information asymmetry to get capital into the optimal hands. The advances we have made in finance are making it less costly to get resources to the right places.

"Solving these questions has great implications for how happy everyone can be."

And that's an attitude you can take to the bank.

©2002 Kellogg School of Management, Northwestern University