Knowledge that Transforms

Longstaff (1992) and Edleson, Fehr, and Mason (1993) examine option values implicit in callable Treasury bonds and report a significant puzzle: implied option values are frequently negative. Using an alternative approach, we reexamine this issue and find that implied option values are generally positive, and, in contrast to previous studies, instances of option values sufficiently negative to overcome the bid-ask spread are rare. We explain the findings in other studies by showing that the method used may lead to the appearance of a negative option value when the true value is positive.

It has been previously documented that individual firms' stock return volatility rises after stock prices fall. This paper finds that this statistical relation is largely due to a positive contemporaneous relation between firm stock returns and firm stock return volatility. This positive relation is strongest for both small firms and firms with little financial leverage. At the aggregate level, the sign of this contemporaneous relation is reversed. The reasons for the difference between the aggregate- and firm-level relations are explored.

In 1991, defense contractor General Dynamics engaged a new management team which adopted an explicit corporate objective of creating shareholder value. The company tied executive compensation to shareholder wealth creation, and subsequently implemented a strategy that included downsizing, restructuring, and exit. Paying large executive cash bonuses amid layoffs ignited controversy. However, by 1993 shareholders realized gains approaching $4.5 billion, representing a dividend-reinvested return of 553%. The study shows how incentives assist in shaping strategy, illustrates the political costs and economic benefits of downsizing and demonstrates that even firms in declining industries have substantial opportunities for value creation.

This paper examines the relation between closed-end fund premia and returns. Additional evidence is provided on Thompson's (1978) finding that fund premia are negatively correlated with future returns. Funds with 20% discounts have expected twelve-month returns that are 6% greater than nondiscounted funds. This correlation is attributed to premium mean-reversion, not to anticipated future portfolio performance. Economically motivated explanations do not account for this effect.

This paper examines the relation between corporate takeovers and the board of directors as alternative control mechanisms to discipline top management. Previous research shows that CEO turnover subsequent to corporate takeovers is inversely related to pre-takeover market-related performance. We find this relation is concentrated in targets with inside-dominated boards of directors. Our results support the notion that, as an alternative control device, takeovers serve as a “substitute” for outside directors. Further, we show that the discipline associated with corporate takeovers extends beyond top management to effect restructuring of the entire board. The nature of the discipline depends on the composition of the target board prior to the takeover. Disciplinary takeovers result in two general effects: (1) for inside-dominated targets, the number of inside directorships decreases while the number of outside directorships remains about the same; and (2) for outside-dominated boards, the number of inside directorships increases while the number of outside directorships decreases. As a result, the board is recomposed toward a more even balance between inside and outside directorships.

The literature on contracts predicts that some principals will pay agents rents, that is, amounts larger than those necessary to keep the agent in the contract. We calculated the earnings of the average franchisee in seventy franchise systems in various industries to determine whether rents are paid as a solution to the agency problem in franchise contracts. We found that many but not all systems paid rents, both ex post and ex ante, to the average franchisee. The results confirm those of Kaufmann and Lafontaine (1994), who found rents associated with McDonald's, but the magnitude of rents within the systems we study was generally much lower than those of McDonald's.

This paper reviews recent research on franchising and capital structure. Several key variables that affect capital costs and are common to franchised businesses are identified. The question whether or not franchising exists because franchisees provide capital that has no close substitutes for pioneering entrepreneurs is explored and criticized because alternatives to franchisees' funds are readily available and not used by franchisers. The role of franchisee financing is also examined as a key feature of capital structure in these types of industries.

An earlier version of this paper was presented at the Conference on Franchise Contracting, Organization, and Regulation, Michigan Business School. I am indebted to the conference participants, and particularly to G. Frank Mathewson, for helpful suggestions. I also received perceptive comments from the conference organizers, Francine Lafontaine and Scott Masten. I have benefited from discussions of the subject matter of this paper with Tasneem Chipty, James Delaney, Robert Fenili, Tom Hogarty, Robert Lande, Jim Peck, and Anthony Robinson. None of the above should be implicated in the conclusions put forth below.

The empirical literature on franchising suggests that the proportion of risk borne by franchisees increases as the amount of risk to be shared goes up. This has been interpreted by some as evidence that franchisors use franchising as a way to “shed” risk. This paper argues against this conclusion. First we show that the evidence is weak given the problems associated with measuring risk in franchising. Second, we show how a model emphasizing incentive issues and informational problems can give rise to the patterns found in the data. We conclude that risk shedding need not be invoked to explain franchising.