Knowledge that Transforms

This paper tests for changes in firms' production and pricing decisions in four industries in which firms have sharply increased their financial leverage. The analysis of product price and quantity data shows that industry product market decisions are associated with capital structure. In three industries, output is negatively associated with the average industry debt ratio. In the one industry which shows a positive association between output and debt ratios, rival firms have low financial leverage and entry barriers are relatively low. Analysis of executive compensation data supports the hypothesis that managers' incentives to maximize shareholders' wealth increase following recapitalization.

We estimate diversification's effect on firm value by imputing stand-alone values for individual business segments. Comparing the sum of these stand-alone values to the firm's actual value implies a 13% to 15% average value loss from diversification during 1986–1991. The value loss is smaller when the segments of the diversified firm are in the same two-digit SIC code. We find that overinvestment and cross-subsidization contribute to the value loss. The loss is reduced modestly by tax benefits of diversification.

This paper examines the relation between management turnover and divestitures of recently acquired divisions. The empirical results indicate that at the time of a management change, there is an increased probability of divesting an acquisition at a loss or one considered unprofitable by the press. The probability increases by about the same amount regardless of whether the change is an apparent age-65 retirement or a resignation. Overall, the results are consistent with a variety of agency-based theories of corporate investment and suggest that management changes are important events for corporations because they lead to reversals of poor prior decisions.

We report that 31% of the firms completing leveraged recapitalizations between 1985 and 1988 subsequently encounter financial distress. Following their recaps, the distressed firms exhibit (1) poor operating performance due largely to industry-wide problems, (2) surprisingly low proceeds from asset sales, and (3) negative stock price reactions to economic and regulatory events associated with the demise of the market for highly-leveraged transactions. The incidence of distress is not related to several characteristics that have previously been linked with poorly-structured deals. We thus attribute the high rate of distress primarily to unexpected macroeconomic and regulatory developments.

AT&T's 7.5 billion acquisition of NCR decreased the wealth of AT&T shareholders by between 3.9 billion and 6.5 billion and resulted in negative synergies of 1.3 to 3.0 billion. We find that AT&T paid a documented 50 million and possibly as much as $500 million to satisfy pooling accounting, thus boosting EPS by roughly 17% but leaving cash flows unchanged. We conclude that AT&T's decision to acquire NCR in what the market perceived as a value-destroying transaction was related at least in part to the 1984 consent decree with the Department of Justice that led to the break-up of AT&T.

We argue that management sells assets when doing so provides the cheapest funds to pursue its objectives rather than for operating efficiency reasons alone. This hypothesis suggests that (1) firms selling assets have high leverage and/or poor performance, (2) a successful asset sale is good news, and (3) the stock market discounts asset sale proceeds retained by the selling firm. In support of this hypothesis, we find that the typical firm in our sample performs poorly before the sale and that the average stock-price reaction to asset sales is positive only when the proceeds are paid out.

We examine investor communication issues using the experience of CUC International. CUC had difficulty convincing investors that its marketing outlays were profitable investments, leading to stock misvaluation over an extended period. To resolve this problem, CUC adopted an accounting change and then underwent a leveraged recapitalization. Subsequently, it accelerated recap debt repayments and initiated a stock repurchase. CUC's experience suggests that accounting reports are not always effective in investor communication. While financial signals are more effective, their impact is not as immediate as predicted by prior research. The CUC case suggests that investor communications is a rich area for future research.

Previous research suggests that offering costs are higher when warrants are used to compensate underwriters. This finding potentially arises from a failure to account for self-selection in estimating offering cost relations. Using methods that account for self-selection, I find that underpricing and total offering costs are reduced for firms using warrants as underwriter compensation, consistent with the hypothesis that issuers choose compensation contracts which minimize costs.

This paper evaluates the influence of financial contracting costs on public corporations' incentives to lease fixed capital. We argue that firms facing high costs of external funds can economize on the cost of funding by leasing. We construct several measures of leasing propensity, plus some a priori indicators of the severity of financial constraints facing firms. We find that the share of total annual fixed capital costs attributable to either capital or operating leases is substantially higher at lower-rated, non-dividend-paying, cash-poor firms — those likely to face relatively high premiums for external funds.

We examine whether sample selection bias explains the difference in returns between ‘value’ stocks (high book-to-market ratios) and ‘glamour’ stocks (low book-to-market ratios). Selection bias on Compustat is not a severe problem: for CRSP primary domestic firms, the proportion missing from Compustat is not large and the average return is not very different from the Compustat sample. Mechanical problems with matching Cusip identifiers account for much of the discrepancy between CRSP and Compustat. The superior performance of value stocks is confirmed for the top quintile of NYSE-Amex stocks, using a sample free from selection bias.