The Firm in a Changing Environment: About Investors’ Rational Pessimism and the Consequences on Corporate Financial Decision Making

The recession at the beginning of the new millennium accompanied by a series of major corporateaccounting scandals (like Enron – Arthur Andersen, WorldCom, Global Crossing, Ahold, ...) has pointed investors to the fact that (i) industry growth is apparently changing over time and (ii) the quality of signals about firms’ profitability is not necessarily perfect. Despite the fact that many indicators suggest a beginning recovery of the economy in the U.S. and in Europe, investors seem to be reluctant in gaining confidence in a prosper future. Inspired by Veronesi (1999), who gives rationale—using a general equilibrium asset pricing model— why investors underreact to good news in bad times, I develop a partial equilibrium contingent claims model of the firm in an uncertain environment. I.e., the growth rate of the cash flow generated by the firm’s productive assets is modeled to change over time and the firm’s equity and its debt are interpreted as claims contingent on this flow. To form their expectations about the firm’s future, investors have to condition their belief about the growth perspectives on signals of certain quality. It is shown (i) how to derive the risk neutral dynamics of the Bayesian belief about growth in an partial equilibrium setting (ii) that positive risk premia imply the existence of ‘rational pessimism’ about growth and how this distortion in the beliefs depends on information quality, (iii) how to value equity and debt (analytically in some special cases and on a two dimensional tree in general), (iv) how investors pessimism influences equityholders decision to default, and (iv) that—as a consequence—the value of the firm’s stakes and the debt capacity of the firm deteriorate if the information quality of signals about growth is low.