Knowledge that Transforms

We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. A surprising number of firms use firm risk rather than project risk in evaluating new investments. Firms are concerned about financial flexibility and credit ratings when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes.

We study the proposal of manager-sponsored compensation plans linking pay to performance by S&P 500 firms in the 1990s. We examine the market perception of these proposals and the characteristics of the firms that propose them. Shareholders gain at the announcement of the plans, especially when the plans are directed toward the firm's top executives. Proposing firms are those that can most benefit from the plans, given their asset type and agency considerations. Firms with more potential agency costs have the highest vote-for percentages for the plans. However, shareholders are less approving of plans with negative features such as high dilution levels. Our work suggests that stock-based compensation plans are helpful in improving managerial efforts to increase shareholder wealth.

We investigate the timing of open market share repurchases and the resultant impact on firm liquidity. Using the Stock Exchange of Hong Kong's unique disclosure environment, we identify the exact implementation dates for more than five thousand equity buybacks. We find that managers exhibit substantial timing ability. Consistent with the information-asymmetry hypothesis, bid–ask spreads widen and depths narrow during repurchase periods. We decompose bid–ask spreads and show that adverse selection costs increase substantially as market participants respond to the presence of informed managerial trading. Our findings provide additional insight into how markets process information and have significant implications for corporate payout and disclosure policies.

The purpose of the Harvard Business School-Journal of Financial Economics conference was to reexamine the role of clinical work in our profession. Clinical research–empirical work that examines a relatively small number of events intensively–accounts for a very small fraction of published work in the field. The pieces in this conference volume are case studies of different “clinical” research techniques that are used to develop, test, apply and communicate theory.

This study examines the effect of real exchange rate changes on multinational firms and incorporates the effect of intra-industry competition on the relation between exchange rates and firm value. To test the relation more effectively, tests are conducted using a sample of automotive firms from the United States and Japan. Consistent with theoretical predictions, there is significant exposure to exchange rate shocks. Moreover, there is evidence of time-variation in exchange rate exposure, which is consistent with changes in the competitive environment within the industry. Finally, evidence is presented that is consistent with foreign sales being a major determinant of exposure and the effectiveness of operational hedging through foreign production.

Given the evidence that the level of liquidity affects asset returns, a reasonable hypothesis is that the second moment of liquidity should be positively related to asset returns, provided agents care about the risk associated with fluctuations in liquidity. Motivated by this observation, we analyze the relation between expected equity returns and the level as well as the volatility of trading activity, a proxy for liquidity. We document a result contrary to our initial hypothesis, namely, a negative and surprisingly strong cross-sectional relationship between stock returns and the variability of dollar trading volume and share turnover, after controlling for size, book-to-market ratio, momentum, and the level of dollar volume or share turnover. This effect survives a number of robustness checks, and is statistically and economically significant. Our analysis demonstrates the importance of trading activity-related variables in the cross-section of expected stock returns.

CalFed Bancorp is one of 126 S&Ls suing the U.S. government for breach of contract related to supervisory goodwill, a form of goodwill created by the acquisition of insolvent thrifts during the early 1980s. Before a determination of damages in its lawsuit, CalFed announced and issued a litigation participation security giving shareholders a proportional claim on recovered damages, if any. This announcement generated a positive excess return in part because it made CalFed a more likely acquisition target. Trading in the security also reveals important, yet previously unavailable, information about CalFed's lawsuit: its price reveals a market-based estimate of damages while its beta reveals information regarding expected returns and trial duration. In a broader context, this paper identifies acquisition facilitation as a benefit of issuing targeted stock and highlights a series of lawsuits that will set important precedents regarding the determination of liability and the estimation of damages in breach of contract cases.

Conventional wisdom suggests that lockup options are granted by self-interested target managers to discourage competition and hand-select an acquirer, thus harming target shareholder wealth. Evidence from 2,067 deals announced during 1988–1995 suggests that lockup options inhibit competition, but on average, deals with lockup options have higher target announcement and overall returns and lower bidder announcement returns, even after controlling for shareholder anticipation and other factors. An examination of 100 merger proxies suggests lockup options are no more prevalent in privately negotiated, preemptive deals, and average target returns are higher when such deals include a lockup option. The overall evidence is more consistent with managers using lockup options to enhance bargaining power than with lockup options harming shareholder wealth.

In 1992–1993, the SEC required enhanced disclosure on executive compensation and Congress enacted tax legislation limiting the deductibility of non-performance related compensation over one million dollars, i.e. Internal Revenue Code Section 162(m). We examine the effects of these regulatory changes and report small and large sample evidence that many million-dollar firms have reduced salaries in response to 162(m) and that salary growth rates have declined post-1993 for the firms most likely to be affected by the regulations. We further document that bonus and total compensation payouts are increasingly sensitive to stock returns after 1993, especially for firms with million-dollar pay packages. We also document that, once we control for other factors affecting CEO incentives, the sensitivity of the CEO's wealth to changes in shareholder wealth has increased from 1993 to 1996 for firms with CEOs near or above the million dollar compensation level. Overall, our results suggest that some firms have reduced salaries in response to 162(m). More importantly, the pay for performance sensitivity, measured using total annual compensation and firm-related CEO wealth, has increased for firms likely to be affected by 162(m).

We examine determinants of non-executive employee stock option holdings, grants, and exercises for 756 firms during 1994–1997. We find that firms use greater stock option compensation when facing capital requirements and financing constraints. Our results are also consistent with firms using options to attract and retain certain types of employees as well as to create incentives to increase firm value. After controlling for economic determinants and stock returns, option exercises are greater (less) when the firm's stock price hits 52-week highs (lows), which confirms in a broad sample the psychological bias documented by Heath et al. (Quarterly Journal of Economics 114 (1999) 601–628).