Knowledge that Transforms

Taxes represent a significant cost to the firm and shareholders, and it is generally expected that shareholders prefer tax aggressiveness. However, this argument ignores potential non-tax costs that can accompany tax aggressiveness, especially those arising from agency problems. Firms owned/run by founding family members are characterized by a unique agency conflict between dominant and small shareholders. Using multiple measures to capture tax aggressiveness and founding family presence, we find that family firms are less tax aggressive than their non-family counterparts, ceteris paribus. This result suggests that family owners are willing to forgo tax benefits to avoid the non-tax cost of a potential price discount, which can arise from minority shareholders’ concern with family rent-seeking masked by tax avoidance activities [Desai and Dharmapala, 2006. Corporate tax avoidance and high-powered incentives. Journal of Financial Economics 79, 145–179]. Our result is also consistent with family owners being more concerned with the potential penalty and reputation damage from an IRS audit than non-family firms. We obtain similar inferences when using a small sample of tax shelter cases.

Deregulation significantly affects the firms’ operating environment and leverage decisions. Firms experience a significant decline in profitability, asset tangibility and a significant increase in growth opportunities following deregulation. Firms respond by reducing leverage. Deregulation also significantly affects the cross-sectional relation between leverage and its determinants. Leverage is much less negatively correlated with profitability and market-to-book and much more positively (negatively) correlated with firm size (earnings volatility) following deregulation. These results are consistent with the dynamic tradeoff theory of capital structure. Also consistent with the dynamic tradeoff theory, those firms that are more likely to be above their target capital structure issue significantly more equity in the first few years following deregulation.

In this paper, we show that the existence of a large, negative wealth shock and insufficient insurance against such a shock could explain both the limited stock market participation puzzle and the low-consumption–high-savings puzzle. We then conduct an empirical analysis on the relation between household portfolio choices and access to private insurance and various types of government safety nets. The empirical results demonstrate that a lack of insurance against large, negative wealth shocks is positively correlated with lower participation rates and higher saving rates. Overall, the evidence suggests an important role of insurance in household investment and savings decisions.

It has become standard practice in the cross-sectional asset pricing literature to evaluate models based on how well they explain average returns on size-B/M portfolios, something many models seem to do remarkably well. In this paper, we review and critique the empirical methods used in the literature. We argue that asset pricing tests are often highly misleading, in the sense that apparently strong explanatory power (high cross-sectional R2s and small pricing errors) can provide quite weak support for a model. We offer a number of suggestions for improving empirical tests and evidence that several proposed models do not work as well as originally advertised.

We survey chief financial officers from 29 countries to examine whether and why firms use lines of credit versus non-operational (excess) cash for their corporate liquidity. We find that these two liquidity sources are employed to hedge against different risks. Non-operational cash guards against future cash flow shocks in bad times, while credit lines give firms the option to exploit future business opportunities available in good times. Lines of credit are the dominant source of liquidity for companies around the world, comprising about 15% of assets, while less than half of the cash held by companies is held for non-operational purposes, comprising about 2% of assets. Across countries, firms make greater use of lines of credit when external credit markets are poorly developed.

We analyze the impact of sovereign wealth fund (SWF) investments on firm values and provide evidence consistent with the tradeoff between the monitoring and lobbying benefits versus tunneling and expropriation costs of SWFs as blockholders. The data show significant positive (negative) returns to announcements of SWF investments (divestments). The returns are non-monotonic, first rising (falling) and then falling (rising) with the share sought (sold) for investments (divestments). Moreover, we find that SWFs are often active investors. Slightly more than half of the target firms experience one or more events indicative of SWF monitoring activity or influence.

This paper considers the features of the newly disclosed compensation peer groups and demonstrates their significant role in explaining variations in chief executive officer (CEO) compensation beyond that of other benchmarks such as the industry-size peers. After controlling for industry, size, visibility, CEO responsibility, and talent flows, we find that firms appear to select highly paid peers to justify their CEO compensation and this effect is stronger in firms where the compensation peer group is smaller, where the CEO is the chairman of the board of directors, where the CEO has longer tenure, and where directors are busier serving on multiple boards.

A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to “walk away.” I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as “flight to quality.”

We use the founding of the Federal Reserve to identify the effects of a lender of last resort. We examine stock return and interest rate volatility during September and October, when markets were vulnerable because of financial stringency from the harvest. Stock volatility fell by 40% and interest rate volatility by more than 70% following the monetary regime change. The drop is insignificant if major panic years are omitted from the analysis, however. Because business cycle downturns occurred in the same year as financial crises, our results suggest that the existence of the Federal Reserve reduced liquidity risk.

This paper uses recent regulations that have required some companies to increase the number of outside directors on their boards to generate estimates of the effect of board independence on performance that are largely free from endogeneity problems. Our main finding is that the effectiveness of outside directors depends on the cost of acquiring information about the firm: when the cost of acquiring information is low, performance increases when outsiders are added to the board, and when the cost of information is high, performance worsens when outsiders are added to the board. The estimates provide some of the cleanest estimates to date that board independence matters, and the finding that board effectiveness depends on information cost supports a nascent theoretical literature emphasizing information asymmetry. We also find that firms compose their boards as if they understand that outsider effectiveness varies with information costs.