Showing papers in "Financial Management in 2003"

Estimating Exchange Rate Exposures: Issues in Model Structure

Abstract: We show that both return measurement horizon and model specification have noticeable impacts on estimates of exposure from equity prices for U.S. firms. While increases in the return horizon leads to increases in the precision of the estimates, this effect is less significant than the impact of model structure. We demonstrate that the inclusion and of a market return variable and its particular construction has a dramatic influence on the sign and size of the exposures due to a strong relation between firm size and exposure for U.S. firms. We propose using CRSP cap-based portfolios as the control for market factors and show that this produces exposures with stronger relation to foreign cash flows and correlations with firm size.

Does Financial Liberalization Reduce Financing Constraints

Abstract: We use panel data on a large number of firms in 13 developing countries to find out whether financial liberalization relaxes financing constraints of firms. We find that liberalization affects small and large firms differently. Small firms are financially constrained before the start of the liberalization process, but become less so after liberalization. Financing constraints of large firms, however, are low before financial liberalization, but become higher as financial liberalization proceeds. We hypothesize that financial liberalization has adverse effects on the financing constraints of large firms, because these firms had better access to preferential directed credit during the period before financial liberalization. JEL Classification Codes: E22, E44, G31, O16

Motives for Multiple Open-Market Repurchase Programs

Abstract: We examine differences in motives, firm characteristics, market performance, andsubsequent operatingperformance offirms that repurchase shares frequently versus firms that repurchase only occasionally or infrequently. Frequent repurchasers are much larger, have significantly less variation in operating income, and higher dividend payout ratios. Infrequent repurchases are made by smaller firms with more volatile operating income, lower institutional ownership, lower market-to-book ratios and high degrees of asymmetric information. Although most repurchases are viewed favorably by the market, infrequent repurchases receive a much strongerpositive reaction. Finally, we find little evidence of improved operatingperformance following repurchase announcements. In both the academic and practitioner literature, share repurchases are viewed as relatively isolated events. It is considered to be a relatively rare set of circumstances that result in a firm repurchasing its own equity. However, in recent years it has become common for a firm to repurchase its shares on the open market on a frequent or regular basis. The reasons or motives for repurchasing shares on a frequent basis may differ from reasons to repurchase shares only occasionally or infrequently. In this paper, we examine the differences in the motives and firm characteristics for firms that repurchase frequently compared to firms that repurchase only occasionally or infrequently. Signaling or undervaluation is the motive most commonly attributed to share repurchases. Researchers view a firm's announcement of its willingness to invest in itself as a signal that the stock is undervalued. However, it is unlikely that a firm could credibly signal that its stock is undervalued on a regular basis. Therefore, there must be alternative reasons or motives for firms to frequently repurchase their stock. We use this idea to provide a distinction between differing motives for repurchases based on repurchase frequency. We find that less-frequent repurchases tend to be larger programs, that is, these firms seek to repurchase a greater percentage of their shares outstanding, than do the more frequent repurchasers. The firms that repurchase most frequently are generally larger, have higher institutional ownership, higher market-to-book ratios, more stock options, lower debt ratios, lower managerial ownership, and lower volatility of operating income. Infrequent repurchases tend to be initiated by firms with a potentially high degree of asymmetric information and preceded by relatively poor market performance. Infrequent repurchases are made by smaller firms with higher variability of operating income, higher levels of capital expenditures, lower market-to-book ratios, and lower levels of institutional ownership. Market reactions to the repurchase announcements are generally consistent with these ideas. Previous research reports abnormal returns of 2% to 3% around the announcement of openWe would like to thank Chris Anderson, Srini Krishnamurthy, Roni Michaely, Mike Weisbach, James Seward (the Editor), a particularly helpful anonymous referee, and also seminar participants at Binghamton, Case Western Reserve, Kansas, Missouri, Texas Tech, and Texas A&M for their helpful comments and suggestions. All remaining errors are ours.

What is the Price of Hubris? Using Takeover Battles to Infer Overpayments and Synergies

Abstract: We present a framework for determining the information that can be extracted from stock prices around takeover contests. In only two types of cases is it theoretically possible to use stock price movements to infer bidder overpayment and relative synergies. Even in these two cases, we argue that it is practically difficult to extract this information. We illustrate one of these generic cases using the takeover contest for Paramount in 1994 in which Viacom overpaid by more than $2 billion. Our findings are consistent with managerial overconfidence and/or large private benefits, but not with the traditional agency-based incentive problem. When a merger is announced, three different pieces of information affect the stock prices of the target and bidder. The announcement contains information about the potential synergies arising from the combination, the stand-alone value of the firms involved in the merger, and how the value will be split between the target and the bidder(s). It is seldom possible to distinguish among these three effects in a particular takeover contest. For example, if the announcement reveals favorable (unfavorable) information about the target and bidder, the combined change in bidder and target stock values will exceed (not exceed) the synergies arising from the merger. Similarly, if the bid reveals favorable (unfavorable) news about the stand-alone value of the bidder, the change in bidder stock value will overstate (understate) the benefit of the transaction to the bidder. In this article, we develop and apply a classification scheme that identifies those situations in which it may be possible to disentangle the sources of price changes. In the first part of the paper, we identify two generic cases in which synergy, overpayment, and information effects can be disentangled to solve for the estimated overpayment by the bidder. One case occurs when the acquisition is not consummated; the other occurs when the acquisition is a takeover contest that comprises only two bidders. We also discuss the additional (information) conditions that must be satisfied in practice to enable bidders to disentangle the different effects. Even for these two generic cases, we point out that most such takeovers will not satisfy the necessary information conditions. In the second part of the article, we analyze the takeover contest for Paramount. This contest is representative of one of the generic cases and comes close to satisfying the required information conditions. The Paramount contest involved exactly two bidders: QVC, led by Barry Diller, and Viacom, led by Sumner Redstone. The unusual structure of the contest allows us to estimate

The financial and operating performance of China's newly privatized firms

Abstract: This study examines the pre- and post-privatization financial and operating performance of 208 firms privatized in China during the period 1990-97. The full sample results show significant improvements in real output, real assets, and sales efficiency, and significant declines in leverage following privatization, but no significant change in profitability. Further analysis shows that privatized firms experience significant improvements in profitability compared to fully state- owned enterprises during the same period. Firms in which more than 50% voting control is conveyed to private investors via privatization experience significantly greater improvements in profitability, employment, and sales efficiency compared to those that remain under the state’s control. Privatization seems to work in China, especially the more private firms become.

Does Long-Term Performance of Mergers Match Market Expectations? Evidence from the US Banking Industry

Abstract: There is a paradox in bank mergers. On average, bank mergers do not create value, yet they continue to occur. Using cross-sectional analysis to examine 54 bank mergers announced between 1991 and 1995, I test several facets of focus and diversification. Upon announcement, the market rewards the mergers of partners that focus their geography and activities and earnings streams. Only one of these facets, focusing earnings streams, enhances long-term performance. Two other circumstances improve long-term performance: 1) when a merger involves a relatively inefficient acquirer and 2) when partners reduce bankruptcy costs.

Infrastructure Investment as a Real Options Game: The Case of European Airport Expansion

Abstract: This article analyzes the optional and strategic features of infrastructure investment. Infrastructure investments generate other investment opportunities, and in so doing change the strategic position of the enterprise. A combination of real options theory and game theory can capture the elusive value of a strategic modification of a firm’s position in its industry. My model focuses in particular on an analysis of European airport expansion. Airports with infrastructures that are less constrained by growth regulations capture more value, because they are in a better position to exercise growth options available in the airport industry.

Further Evidence on Compensation Committee Composition as a Determinant of CEO Compensation

Abstract: I use more than 1,500 firm-year observations for 271 US firms between 1991-1997 to examine the relation between insider membership in compensation committees and CEO pay. I find a steady decline in the number of committees with insider participation during the sample period, and uncover some opportunism by insiders in setting pay prior to the compensation disclosure and tax reforms. Finally, I document changes in pay practices that would be consistent with the intent of these reforms. Based on this evidence, however, I cannot definitively conclude whether the reforms were efficient.

The Paradox of Priority

Abstract: There is a paradox in bank mergers. On average, bank mergers do not create value, yet they continue to occur. Using cross-sectional analysis to examine 54 bank mergers announced between 1991 and 1995, I test several facets of focus and diversification. Upon announcement, the market rewards the mergers of partners that focus their geography and activities and earnings streams. Only one of these facets, focusing earnings streams, enhances long-term performance. Two other circumstances improve long-term performance: when a merger involves a relatively inefficient acquirer and when partners reduce bankruptcy costs.

Price Pressure on the NYSE and Nasdaq: Evidence from S&P 500 Index Changes

Abstract: Using additions of NYSE- and Nasdaq-listed firms to the S&P 500, between 1989 and 2000, we explore the price effects of noninformation related demand shocks. After controlling for various firm characteristics, index fund growth, and arbitrage risk, we find that NYSE stocks suffer less pronounced price effects than do Nasdaq stocks on the day stocks are added to the Index. For NYSE stocks, this effect is reversed immediately, but Nasdaq stocks, show a partial reversal taking place over several days. We interpret this result as evidence of the superiority of the specialist system over the dealer system in mitigating price pressures. An important facet of any stock market is its ability to absorb large demand shocks for stocks while minimizing any resulting change in price. In this article, we compare the price effects for Nasdaq and NYSE stocks added to the S&P 500 Index. Our experiment allows us to study the impact of exchange listing on the effects of large demand shocks that are relatively clean of confounding information. This issue is more than an academic curiosity, since both the NYSE and the Nasdaq claim that their respective systems are better able to absorb such shocks (Wall Street Journal, July 26, 2000). The arguments of both sides have validity. The NYSE argues that the centralized specialist can see the big picture and manage supply more effectively than can a dispersed network of dealers. The NYSE also has the benefit of investor-supplied liquidity in the form of the limit order book (Cochrane, 1993), and the specialist is committed to taking offsetting positions in each stock he is assigned. Nasdaq claims that its dispersed dealer system is better able to minimize the price impact of additions for several reasons (see Groth and Dubofsky, 1987). First, there is greater competition

Does the Sequence of Seasoned Equity Offerings Matter

Abstract: We investigate the relation between announcement period returns and the sequence of seasoned equity offerings (SEOs) for industrial, financial, and utility firms making multiple offerings. For industrial firms, there is a monotonically positive relation between the returns and the sequence of issues. Further, the stock price reactions to the fourth and subsequent issues by industrial firms are insignificant. For firms that conduct at least two SEOs, there is no difference in returns between industrial firms and utilities or financial institutions. The lower negative returns for later announcements by industrial firms can be explained by reduced adverse selection costs.

Efficient Labor and Capital Markets: Evidence from CEO Appointments

Abstract: An examination of268 CEO appointments in USfirms indicates that, on average, appointment ofa better-quality CEO (a CEO who receives a pay premium ex-ante) is accompanied by an immediate positive revaluation of stock prices, and is followed by an improvement infirm performance. This evidence supports the notion ofjointly efficient and integrated labor and capital markets. The findings are particularly strong in non-regulated industries. The managerial labor market appears somewhat less efficient in internal successions, and the stock market appears less efficient or only relatively weakly integrated with the labor market in smallfirm appointments. This study examines the hypothesis that the managerial labor market and the capital market are jointly efficient and integrated with respect to Chief Executive Officer appointments. In an efficient labor market, the firm hires a new CEO from a slate of internal and external candidates, and offers a compensation contract commensurate with the person's quality and potential contribution to firm value. Further, if labor and capital markets are linked and jointly efficient, the stock market would respond positively to appointments of new CEOs who receive a pay premium in the labor market, indicating they are of better quality. Finding evidence of joint efficiency is a non-trivial task. First, there are doubts about the rationality or efficiency of the managerial labor market. This is because CEO compensation

Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between Global and Domestic CAPM

Abstract: We estimate ex ante expected returns for a sample of S&P 500 firms over the period 1983-98. The exante estimates show a better overall fit with the domestic version of the single-factor CAPM than with the global version, but the difference is small. This finding has no trend in time and is consistent across groups formed on the basis of relative foreign sales. The findings suggest that, for estimating the cost of equity, the choice between the domestic and global CAPMs may not be a material issue for many large U.S. firms.

Operating Performance and Free Cash Flow of Asset Buyers

Abstract: We examine a sample of 552 firms that announce asset purchases. We find that the announcement period returns are negatively related to the amount of free cash flow for buyers with fewer growth opportunities. Compared to the year prior to the purchase, the mean long-run operating performance of asset buyers worsens in each of the three years following the transaction. Operating performance changes are negatively related to the amount of free cash flow, and the relationship is stronger for buyers with fewer growth opportunities. We also find that buyer firms experience a decline in the return on assets and asset turnover ratios. These findings are consistent with Jensen’s (1986) free cash flow theory. Asset sales have become increasingly common in recent years. Two recent examples are the Fuji Xerox purchase of Xerox’s Chinese operations for $550 million and the Univision Communications purchase of USA’s television stations for $1.1 billion. John and Ofek (1995) and Lang, Poulsen, and Stulz (1995) examine stock price reactions to the announcement of changes in the ownership of assets. They find that the announcement period stock returns are positive on average for the seller and positive or zero for the buyer of the asset. Most researchers concentrate on the seller’s stock price reaction to the announcement of the asset sales. We focus primarily on the buyer’s operating performance following the purchase. We examine the operating performance of the asset buyers during a seven-year period around the asset purchase, measuring performance in terms of pretax operating cash flow scaled by the book value of assets. Two other measures are an industry-adjusted measure, which adjusts raw performance by a matched portfolio based on industry, and a matched-firm-adjusted method, which is based on a portfolio matched by firm size and performance. By all three measures, compared to the year prior to the purchase, operating performance worsens during the three-year period following the asset purchase. We also find that the asset buyers experience a decline in the return on assets and asset turnover ratios during the three years following the purchase. The cross-sectional regressions show a significant relationship between the changes in operating performance and growth opportunities and free cash flow of the asset buyers. On average, operating performance changes are negatively related to free cash flow for buyers with fewer growth opportunities. Although the coefficient of free cash flow is also negative for highgrowth firms, free cash flow has lower economic and statistical significance than in the case of low-growth firms. Changes in focus or the method of payment for the purchased assets have no effect on the long-run performance of the buyers. Like several other authors, we find the average stock price reaction is positive for the asset buyers. Our univariate results show that announcement period returns are positive and significant for buyers with low free cash flow. The cross-sectional regressions control for other factors

An Investigation of the Gains from Specialized Equity Claims

Abstract: We investigate whether operating performance improves when a firm creates traded equity claims on a subsidiary without relinquishing control. We find that the change in a parent firm’s operating performance following an equity carve-out is negatively related to the fraction of subsidiary shares that the parent firm retains after a carve-out. Operating performance of parent firms improves only when the parent completely divests its ownership of the subsidiary. We also find no improvement in operating performance following the creation of tracking stock. We conclude that corporate restructuring without relinquishing control of assets does not enhance operating performance.

The Long-Term Risks of Global Stock Markets

Abstract: This research investigates the persistence of investment risk across time horizon, a crucial issue in asset allocation decisions. Previous empirical results have focused mainly on US data and suffer from limited sample size in the analysis of long-horizon returns. Investigation of a long

Government Support of Investment Projects in the Private Sector: A Microeconomic Approach

Abstract: We examine government decisions on subsidizing investments in the private sector and discriminating among firms in its support programs. By taxing corporate profits, the government may affect corporate investment decisions, causing firms to invest less than what would be socially optimal. Investments that are desirable from the standpoint of social welfare may be rejected by shareholders, which may ultimately lead to the collection of fewer taxes. We analyze the conditions for optimal subsidies for investments carried out by the private sector. We find that high-risk ventures that generate substantial spillover activity are prime candidates for government incentive schemes. In this article, we conduct a theoretical analysis of government incentives for private investment activity. We focus on two major questions: First, under what conditions is a government justified, from an economic viewpoint, in supporting investment activities undertaken by private firms? Second, under which conditions is supporting an investment in R&D projects more economically justifiable than support of an investment in a traditional low-tech project? In our analysis, we focus on the microeconomic interaction between the government and a specific pure-equity firm. Our approach is based on a partial equilibrium solution, within the framework of Modigliani and Miller’s (1958, 1963) (M&M) modeling of corporate valuation. We assume that there are no taxes other than corporate taxes, and that within this framework all markets are in equilibrium. Following Modigliani and Miller (1958, 1963), we let governments “negotiate” with firms to maximize the total net value to all stakeholders. We view the government as an economic agent that collects taxes from corporations based on simple, uniform tax rules, and which provides a basket of services to the entire population. Unlike the majority of academic papers in the public finance area, we assume that a government acts as an economic agent. Its objective is to enhance public welfare and in order to jointly achieve a higher level of public welfare, it “negotiates” with private firms. Therefore, the government takes into consideration the present value of its net tax collection from each new investment made in the private sector. Through its traditional tax rules, governments may affect and alter the investment decisions of the firm, causing a distortion in the allocation of resources throughout the economy. We examine the conditions under which the government may provide investment subsidies to an individual company to generate economic benefits and enhance the public welfare. In this article, we analyze the welfare effect of subsidies extended differentially to specific projects, rather than as an across-the-board tax break. We find that subsidizing industrial R&D is not necessarily inefficient and can benefit individual firms, industries and the economy as a whole. We adopt a microeconomic approach, looking mainly at the firm’s level and modeling the We have benefited from the helpful comments of the Editors, anonymous referees, Zvi Griliches, Eugene Kandel, Itzhak Venezia, and Shlomo Yitzhaki. We acknowledge partial funding from the Krueger and Zagagi Centers of the School of Business, The Hebrew University of Jerusalem, and from the Samuel Neaman Institute for Advanced Studies in Science and Technology.

Collusion and Financial Leverage: An Analysis of the Integrated Mill Steel Industry

Abstract: We show that firms can design their capital structure to provide a publicly observable indication of compliance with a collusive agreement. We develop two empirically testable hypotheses based on this argument and test these propositions on data for seven integrated mill steel firms. Our study period covers years when prices were overtly coordinated under the basing point pricing system and after the demise of the system. Empirical tests confirm the hypotheses that leverage is positively related to both price elasticity of demand and the level of convertibles outstanding during the years after the collapse of the basing point pricing system.

Analyst underreaction in the United Kingdom.

Abstract: We revisit the debate on the interpretation given to prior-year earnings changes in predicting analysts' future forecast errors. We advance a new specification of this relation that distinguishes between earnings reversion and momentum. For a large UK dataset for the years 1990-1996, we find substantial underreaction, particularly in situations of earnings momentum. We find that underreaction is further increased for cases of downward earnings momentum when the analyst's merchant bank acts as a broker to the company. We interpret this as a reporting bias caused by an analyst's response to bad news being compromised.

Survival and Default of Original Issue High-Yield Bonds

Abstract: We study the default behavior of original issue high-yield bonds to answer the open question of how the probability of default changes over time. We use a flexible econometric method, the Cox proportional hazard, to model the default behavior of junk bonds over their life. The method allows us to include the impact of issue and issuer characteristics on the probability of and the time to, default in the estimation. Using a large comprehensive sample, we find that the bonds face a constantly increasing default risk over time, with the most significant increase beyond four years after issuance. Due to the higher costs of high-yield bonds, issuers will refinance their debt as their prospects improve. Only nonperforming issuers will keep their junk bonds outstanding over the medium to long run. Therefore, the default rate of high-yield bonds should exhibit an increasing pattern over time. In this paper, we suggest a new application for a semi-parametric proportional hazard model. This new application allows us to extract default probabilities of original-issue high yield (junk) bonds. This method largely avoids the estimation problems caused by the changing population of outstanding junk bonds, and we can use it to account for the impact of issue and issuer characteristics on the probability of, and the time to, default in the estimation. In contrast to earlier studies, we find strong evidence for default probabilities that increase monotonically as junk bonds age, with the most significant increase coming four years after issuance. We analyze several issue-years together without distortions through changing populations. To do so, we first identify several characteristics at the issue date that have an impact on the default of bonds. We use these variables to estimate a semi-parametric Cox proportional hazard model. Using the coefficient estimates, we can recover the baseline hazard functions and the instantaneous default probabilities over time. We also estimate a time-varying Cox proportional hazard model, using the time-varying spread between interest rates at the bond's issue date and current interest rates as an explanatory variable. This specification removes the impact of the general level of interest rates from our hazard estimations. The fact that we also observe the increasing risk of default in this setup suggests that our results would still hold in a period of stable interest rates. As junk bonds age, the increasing risk of default can be explained by the nature of this method of corporate financing. As with any kind of borrowing, higher-risk borrowers have to

Managerial Discretion Costs and the Acquisition of Capital: Evidence from Forced Warrant Exercise

Abstract: Forced warrant exercise should elicit a stock price reaction only in response to inventory adjustments or unanticipated increases in agency costs. We find evidence of both effects. Firms calling warrants for redemption experience negative abnormal returns on the announcement date. Negative returns are concentrated among firms whose characteristics suggest that the call should have been deferred. We find lower announcement returns among inefficient firms with low leverage-firms for which the agency costs of managerial discretion may be high. All else equal, announcement returns are lower among inefficient firms that invested heavily in the year after forced exercise.