This chapter discusses how applied researchers in corporate finance can address endogeneity concerns. We begin by reviewing the sources of endogeneity—omitted variables, simultaneity, and measurement error—and their implications for inference. We then discuss in detail a number of econometric techniques aimed at addressing endogeneity problems, including instrumental variables, difference-in-differences estimators, regression discontinuity design, matching methods, panel data methods, and higher order moments estimators. The unifying themes of our discussion are the emphasis on intuition and the applications to corporate finance.

/pdf/endogeneity-in-empirical-corporate-finance1-obm7n5t71j.pdf

Endogeneity in Empirical Corporate Finance1

Why and how do corporations accumulate liquid assets? We show theoretically that intertemporal trade-offs between interest income taxation and the cost of external finance determine optimal savings. We find the striking result that, controlling for Tobin's q, saving and cash flow are negatively related because firms lower cash reserves to invest after receiving positive cash-flow shocks, and vice versa. Consistent with theory, we estimate negative propensities to save out of cash flow. We also find that income uncertainty affects saving more than do external finance constraints. Therefore, contrary to previous evidence, saving propensities reflect too many individual forces to be used to measure external finance constraints.

The Corporate Propensity to Save

States were granted authority to limit interstate branching following passage of Federal legislation in 1994 relaxing restrictions on geographical expansion by banks. We show that differences in state's branching restrictions affected credit supply. In states more open to branching, small firms borrow at interest rates 25 to 45 basis points lower than firms operating in less open states. Firms in open states also are more likely to borrow from banks. Despite this evidence that interstate branch openness expands credit supply, we find no effect of variation in state restrictions on branching on small-firm borrowing or other indicators of credit constraints.

Does Credit Competition Affect Small-Firm Finance?

http://apps.olin.wustl.edu/faculty/milbourn/BeckerMilbournApril2010.pdf

How did increased competition affect credit ratings

The credit rating industry has historically been dominated by just two agencies, Moody’s and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how in fact increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.

How Did Increased Competition Affect Credit Ratings

I exploit Moody's 1982 credit rating refinement to examine the impact of more refined rating information on firms' credit market access, financing decisions, and investment policies. First, I decompose the information content of the rating refinement into predictable and unpredictable components. While firms' ex ante cost of borrowing can partially predict the direction of refinement changes, firms with rating refinement upgrades as a result of additional rating gradations still experience a significant decrease in their ex post cost of borrowing compared to firms with rating refinement downgrades. The former subsequently also issue more debt and rely more on debt financing over equity than the latter. These effects remain both economically and statistically significant even when controlling for the heterogeneity in firms' ex ante cost of borrowing. Lastly, rating refinement is associated with more capital investments, less cash accumulation, and faster asset growth for the upgraded firms than the downgraded firms. These findings suggest that third-party rating agencies help to reduce credit market information asymmetry through disclosure of new information and thereby significantly affect firms' credit market access as well as their real outcomes.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID943947_code451833.pdf?abstractid=909269&mirid=1&type=2

Information Asymmetry and Firms' Credit Market Access: Evidence from Moody's Credit Rating Format Refinement

We analyze whether the organizational structure of firms (i.e., whether a firm is diversified or focused) affects their cash holdings. Using Compustat firm level and segment level data, we find that diversified firms hold significantly less cash than their focused counterparts. Our results are robust to industry adjustments at the segment level and to different factors previously found to be important determinants of cash holdings. Using time-series, cross-sectional, and additional robustness tests we are able to attribute the lower cash holdings among diversified firms to complementary growth opportunities across the different segments of these firms and the availability of active internal capital markets. We find that the other theories that rely on the potentially effective use of asset sales of non-core segments of diversified firms to generate cash, and the increased agency/influence costs in diversified firms do not offer an economically significant explanation for the lower cash holdings among diversified firms.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1672692_code21937.pdf?abstractid=1672692&rulid=4446459&mirid=1

Firm Structure and Corporate Cash Holdings

Information asymmetry and firms??? credit market access: Evidence from Moody's credit rating format refinement

Firm structure and corporate cash holdings

This paper documents two stylized facts related to firms' credit ratings and their capital structure decisions. First, firms' dependence on debt financing is positively related to their credit ratings. Firms with higher credit ratings issue more debt and less equity than firms with lower credit ratings. Second, the effects of potential credit rating changes on firms' capital structure decisions are asymmetric. When they face potential rating downgrades, firms issue more debt and have an increased reliance on debt issuance as their external finance. In contrast, when firms face potential rating upgrades, there is no significant change in their choice of external finance. Lastly, in an attempt to provide a theoretical interpretation of the empirical results, the paper also proposes a "last call" model, which predicts a pooling equilibrium among firms that face potential rating downgrades and a separating equilibrium among firms face potential rating upgrades.

Tony T. Tang

Papers

Information Asymmetry and Firms' Credit Market Access: Evidence from Moody's Credit Rating Format Refinement

Firm Structure and Corporate Cash Holdings

Information asymmetry and firms??? credit market access: Evidence from Moody's credit rating format refinement

Firm structure and corporate cash holdings

The Effects of Credit Ratings on Firms' Financing Decisions