Knowledge that Transforms

This paper examines how the trading behavior of various investors impacts the market reaction to a dividend signal. The dividend signaling model incorporates asymmetric information among traders, firm insiders, and the market. This interaction among market participants explains why not all dividend increases are viewed by the market as good news. The model predicts that the announcement day returns for a dividend increase are inversely related to measures of informed trading and decreasing in the level of buy demand relative to sell demand. Further, the model hypothesizes that more informed trading results in larger dividend increases. Empirical tests confirm these predictions.

This article provides a brief overview of the importance of market microstructure research and identifies existing areas of research that focus on links between microstructure and corporate finance. Each of the special issue articles is then summarized with particular attention given to the research contribution of the article and to the links explored between microstructure and corporate finance.

In valuing future cash flows, the standard practice is to take the current cash flow and then extrapolate at an expected growth rate, which can vary at different points in time. This practice stems from the standard way of dealing with time value of money problems under certainty. However, with uncertain cash flows, this practice underestimates the expected cash flows when the growth rates are serially correlated. As a result, both value and the equity cost, calculated as an internal rate of return, are biased low. Given the prevalence of serial correlation in the economy, this paper demonstrates how to incorporate the effects of serial correlation in a simple way and demonstrates by way of a simulation that the effects can be significant. As a result, it casts doubt on the usefulness of several standard valuation approaches and results.

This paper examines whether mandatory auctions promote the efficient restructuring of distressed firms relative to a reorganization-based bankruptcy system such as Chapter 11. Under a mandatory auction system, aggressive bidding by a coalition of incumbent management and pre-bankruptcy creditors may deter outside bidders, may result in the coalition paying more than its valuation to acquire the firm, and may result in assets remaining in a lower value use. In a reorganization-based bankruptcy system, management's voluntary choice to seek an auction conveys information about the coalition's valuation, which facilitates competition. Our model shows that a reorganization-based bankruptcy system that encourages, but does not mandate auctions, can actually increase the likelihood that an outside bidder enters and the assets of the bankrupt firm are redeployed.

This paper examines the agency conflicts between shareholders and bondholders of multinational and non-multinational firms and provides an explanation for the puzzle that multinational firms use less long-term debt, but more short-term debt than domestic firms. Using a sample of 6951 firm–year observations for multinational and domestic firms over the 1988–1994 period, we find that alternative measures of agency costs have statistically significant negative effects on the firm's long-term leverage. The results, however, also show that the negative effects of agency costs of debt on long-term leverage are significantly greater for multinational than non-multinational firms. It is documented that the effect of the agency costs of debt on leverage are increased by the firm's degree of foreign involvement. The evidence shows that firm's increasing foreign involvement exacerbates agency costs of debt leading to lower (greater) use of long-term (short-term) debt financing. This result is also confirmed using alternative measures of foreign involvement. The evidence is consistent with the view that multinational corporations (MNCs) are susceptible to higher agency costs of debt than domestic corporations because geographic diversity renders active monitoring more difficult and expensive in comparison to domestic firms. The results fail to support the view that MNCs' lower long-term debt ratios are due to the advantages of the internal capital markets.

Agency costs are a cost of production, and firms that do a better job of minimizing these costs should exhibit better performance. This paper tests this hypothesis by calculating the performance elasticity of average employee hourly compensation for U.S. manufacturing firms. This elasticity indicates the degree of alignment between employee and shareholder objectives. The estimated elasticity is indistinguishable from zero in low performance firms, and it equals 0.193 in high performance firms. While it is difficult to know whether an elevated performance sensitivity causes better firm performance, clearly the best performers in manufacturing industries link average employee pay to performance.

Small public firms in the US and elsewhere are often managed by majority owners. This paper offers the hypothesis that majority insiders have an incentive to engage in insider trading around seasoned equity offerings (SEOs), primarily for the sake of preserving control. This hypothesis is tested side-by-side with traditional hypotheses regarding insider trading, such as signaling or growth opportunities that are often considered in the context of firms with dispersed ownership. The empirical analysis in this paper utilizes data of 76 SEOs announced by firms listed on the Tel Aviv Stock Exchange (TASE) between June 1989 and December 1997, whose inside ownership exceeds 50%. The results demonstrate the strong effect of expected post-announcement share price changes on insider trading, and a weaker effect of pre-announcement insider trading on price changes. Unlike minority insiders, who may have an incentive to trade on inside information in order to extract short-term capital gains, majority insiders appear to take the long-term view by buying shares before the offering in order to preserve or increase their control over the firm. This activity does not seem to be dependent upon the firm's growth opportunities. Rather, it seems to be market-dependent; that is, the ownership ratio of majority insiders is increased in a bear market and remains the same in a bull market.

Value maximization requires either that knowledge is transferred to those with the right to make decisions, or that decision rights are transferred to those who have the knowledge. A tradeoff of knowledge transfer costs and control costs is required. Characteristics of firms' investment opportunity sets (IOSs) that affect knowledge transfer costs and control costs are identified. Testable predictions about the relations between these characteristics and firms' decentralization decisions are developed and tested. The evidence presented is consistent with our predictions and is robust to different ways of measuring variables.

We survey the recent developments in the literature on corporate diversification. This literature is voluminous, diverse, and quite old. To make the task more manageable, we focus our attention on recent contributions to that subset of the diversification literature that is in our judgment most influential in setting the agenda for financial research. The study of diversification at the corporate level can be grouped into one of two bodies of literature: cross-sectional studies of the link between corporate diversification and firm value (i.e., the diversification discount) and longitudinal studies of patterns in corporate diversification through time. The prevailing wisdom among financial economists throughout much of the last decade has been that diversified firms sell at a discount and that the level of corporate diversification has been trending downward. However, recent research questions both these tenets and a number of studies now suggest that the diversification discount is either not due to diversification at all, or may be a result of improper measurement techniques. Furthermore, some researchers are now beginning to argue that previous attempts to assess changes in the levels of corporate diversification through time is also flawed as a result of biases built into the compustat database in combination with the use of noisy proxies for corporate diversification.

We examine value creation and destruction in the tobacco industry due to the radical litigation strategy of Brooke Group CEO Bennett LeBow. Brooke Group had tiny market share, low margins, high leverage and highly concentrated management ownership. Beginning in 1996, the firm reached settlements in lawsuits brought against all cigarette companies by class action plaintiffs and US state governments. Brooke Group's actions, which included promises to cooperate in litigation against its rivals, spurred other companies to reach settlements on less favorable terms. These events led to massive wealth destruction within the industry but impressive returns for shareholders of Brooke Group.