Using data from “non-bubble firms”—that is, old economy firms—during the technology bubble, the authors present evidence that market misvaluations can affect corporate investment, issuance, and savings policies. They find that the issuance of overvalued stock does not always lead to a transfer of wealth from new to old shareholders. The run-up in equity can ease financing difficulties, which allows credit-constrained firms to engage in profitable investments that otherwise would not be available. They also discover evidence that bubble (technology) firms did not allocate issuance funds to cash savings, whereas credit-constrained non-bubble firms did allocate issuance funds to investments and cash savings.

The authors report at least two results that are useful for practitioners. First, they provide evidence that contradicts prior research indicating that the issuance of overvalued equity benefits old shareholders at the expense of new shareholders. The authors find that a run-up in equity prices can ease credit constraints of firms that would otherwise not be able to borrow and fund profitable projects. This access to capital can then lead to an increase in shareholder value and result in a benefit to both new and old shareholders. Although the insight may not be new, the evidence provided by the authors is interesting and has significant implications in corporate finance.

Second, they find that financially constrained firms use issuance funds for both investments and cash savings, whereas unconstrained firms use issuance funds for investments. This result is interesting because it provides new insights into corporate investment and savings policies.

Using sectors whose business fundamentals were probably not directly affected by advances in telecommunications and data processing, the authors identify non-bubble sectors during the tech bubble period. They use SIC codes and data from Compustat’s P/S/T, Full Coverage, and Research annual files from 1971 to 2003. They focus primarily on data from 1992 to 2003 and use pre-1992 data to benchmark tests. Next, they identify financially constrained and unconstrained firms using ex ante sorting based on such observables as payout policy, size, and debt ratings.

The authors’ baseline model regresses a proxy for investments on proxies for market valuation and cash flow. This simple model isolates the amount of investment that is unexplained by firm fundamentals, and the result indicates that market valuation is a strong driver of investments for financially constrained firms.

To continue their research and perform robustness tests, the authors modify the baseline model. For example, in one specification, they include a proxy for the profitability of the firm’s capital as an additional independent variable, which causes the market valuation proxy to become insignificant. From this result, they infer that it is optimal for both constrained and unconstrained firms to increase their investments if changes to the fundamentals result in more investments becoming profitable and if market prices have not systematically driven corporate investment spending beyond its relationship with fundamentals.

The authors find that the issuance of overvalued equity can benefit both new and old shareholders. But this result seems to be relevant only for credit-constrained firms prior to an equity price run-up. Moreover, even in such a situation, we still need to analyze the magnitude of the benefit to new shareholders and compare this benefit with the harm of buying overvalued equity. In addition, for firms that are not credit constrained, the issuance of overvalued equity seems to benefit only old shareholders.