Two Essays On Corporate Financial Policies

This dissertation explores the extent to which managerial overconfidence affects corporate decisions. This analysis includes three essays, which address a wide range of corporate decisions including financing, investment, acquisition, innovation, liquidity management and advertising decisions. The first essay introduces a fine-tuned test of the relationship between managerial overconfidence and corporate decisions by taking the chief financial officer (CFO) overconfidence effect into account. Ex-ante, I identify financial policies and non-financial policies such as investment, innovation and acquisition as the primary managerial duties of CFOs and chief executive officers (CEOs) respectively. I construct overconfidence measures for both CEOs and CFOs and test the impact of CEO and CFO overconfidence, both on financial decisions and on nonfinancial decisions. Based on a sample of 1,173 S & P 1500 firms, I find that financial policies are primarily affected by CFO overconfidence while only CEO overconfidence affects nonfinancial decisions. My findings demonstrate that managerial biases affect corporate decisions and managerial duties shape the ways in which top managers influence corporate policies. The second essay investigates how overconfident CEOs allocate resources toward innovation activities. It argues that overconfident CEOs tend to have greater innovation input. To finance innovation, they save more cash out of the cash flow and spend more on innovation when the cash flow is high. Results from an empirical analysis of 1,015 S & P 1500 firms support this argument. Moreover, based on a series of financial constraint measurements, the effect of CEO overconfidence on liquidity management is found to be more pronounced in financially constrained firms and in highly innovative firms, but not in firms without financial constraints. With regards to innovation performance, overconfident CEOs tend to have more patents, but the overall quality of their patents is not significantly better than that of rational CEOs. The third essay introduces a simple model of firm advertising behavior in monopolistic competition industries and applies it to the situation of managerial overconfidence. The model shows that the optimal advertising to sales ratio is determined by both firm advertising competency and consumer preference. Overconfident CEOs are more willing to use advertising as a means to convey the quality of their firms and products. Such overestimation of the effects of advertising by overconfident CEOs will result in overspending on advertising. When financially constrained, an overconfident CEO's tendency to overspend will be curbed to some extent, but his amount of advertising will increase with cash flows. An empirical analysis of 654 S & P 1500 firms supports these predictions. The distorted effect of managerial overconfidence is more prominent when firms are financially constrained and when the overconfidence measure is continuous.

This dissertation contains two essays on the aggressive behavior of corporations in product market competition. In the first essay, I investigate how market structure can impact a firm's risk of facing predation by rivals, and hence, its financial policy decisions. Using a simple model, I demonstrate that a firm faces a greater predation threat when it meets the same competitor in many markets, as this competitor is able to internalize more of the benefit, degrading the firm's ability to compete in the future through aggressive actions today. I then test the predictions of the model using 2003-2011 panel data on store location across retail store chains in the US. I find that firms tend to expand more aggressively in markets shared with a competitor experiencing a substantial increase in leverage, or a decline in a credit rating, when they face that competitor in more of the other markets. The expansion relationship was found to be stronger in data from the 2008-2009 financial crisis, a period when difficulty in rolling over or obtaining new debt made it especially hard for weak firms to absorb losses. I also show that a firm facing the same competitors in many markets choose lower levels of leverage and that it decreases that leverage when a merger in the industry increases the amount of competitive overlap it has with other firms. These results suggest that firms are aware of the predation risk due to a competitive overlap and select financial policies to minimize this risk. In the second essay, I study the impact of internally generated funds on product market competition. More specifically, I investigate the idea that firms compete aggressively when their competitors face cash flow shortfalls. Testing this idea is challenging because competitor's cash flow changes are potentially endogenous with respect to firm's behavior. I address this problem in three ways. First, I investigate firm's reaction in a given market when its competitors face cash flow shortfalls outside of that market; this analysis is conducted using store location data on retail store chains. Second, I focus on the 2008-2009 financial crisis period in which retail store chains were hit by a negative demand shock which was hardly expected ex ante. Finally, I use a shock to local economic conditions which varies across markets and the different distributions of store locations across firms as instruments for the changes in competitors' cash flows. I find that a firm expands more in a given market in which it competes with rivals which face a more negative cash flow shortfall in the other markets. This relation is stronger when the competitors were highly leveraged before the crisis. Finally, I illustrate evidence that a firm responds more aggressively to competitor's cash flow shortfalls if it competes with that competitor in many of the same markets; this result is consistent with the prediction of the model in Chapter 1. These essays contribute to the literature by adding new evidence on the predatory behavior of corporations in product market competition.

This dissertation contains three distinct essays in the broad area of corporate finance. The first two essays examine the role of an independent director who is also a blockholder (IDB), a potent governance mechanism, on executive compensation, and corporate financial and investment policies, respectively. The last essay examines insider trading in takeover targets. The first essay examines three issues. First, we investigate the determinants of an IDB's presence in a firm. Second, we examine the relations between IDB presence and (1) the level and structure of CEO compensation, and (2) CEO turnover-performance sensitivity. Third, we analyze if IDB presence is related to firm valuation. Our findings suggest that the presence of an independent blockholder on the board promotes better incentives and monitoring of the CEO, and consequently leads to higher firm valuation. In the second essay, we examine how the presence of an IDB affects: (1) four key financial and investment policy choices of a firm: the levels of cash holdings, dividends, investments and financial leverage, and (2) firm risk. We also examine how the market values IDB presence and changes in various policy choices associated with IDB presence in a firm. We find that firms with IDBs have significantly lower levels of cash holdings, dividend yields, repurchases, and total payout, but higher levels of capital expenditures. We also find that firms with IDBs have lower risk. Overall, IDB presence appears to reduce agency problems between managers and shareholders. The third essay brings large-sample evidence on whether the level and pattern of profitable insider trading before takeover announcements is abnormal for a broad cross-section of targets of takeovers during modern times. We find an interesting and subtle pattern in the average pre-takeover trading behavior of target insiders. While insiders reduce both their purchases and sales below normal levels, their sales reduce more than purchases, leading to an increase in net purchases. This pattern of 'passive' insider trading is confined to the six-month period before takeover announcement, holds for each insider group, for all measures of net purchases examined, and in certain sub-samples with less uncertainty about takeover completion.

Abstract: This dissertation examines two issues that are related to corporate payout policy. The first essay investigates the impact of financial development on dividend policy across countries, an issue that has largely been overlooked by the literature. The second essay investigates the relation between managerial entrenchment and firms' propensity to pay dividends in the U.S. Financial development has a positive influence on dividend policy because it improves a firm's access to external finance and it helps control the agency conflicts between corporate insiders and outside shareholders. Such influence reduces the firm's incentive to retain profits. Therefore, financial development should encourage higher dividend payouts and earlier dividend initiations. The first dissertation essay, presented in Chapter 2, tests this hypothesis. I find it to be true using a large sample of industrial firms across 44 countries. The results are robust to various measures of financial development. Moreover, I show that this effect is not driven by the difference in legal protection of minority shareholders across countries. In the second essay, presented in Chapter 3, I find that firms with entrenched managers, as measured by strong managerial power resulting from takeover protections, are more likely to pay dividends. Their high propensity to pay persists over time. While these results are surprising in light of the conventional wisdom, they support the view that firms choose a combination of governance provisions and dividend policy to maximize value. A large cash reserve can be used to deter hostile takeovers. Paying dividends reduces cash holdings, leaving the firm more vulnerable to hostile takeovers. In equilibrium, value-maximizing firms with weak investment opportunities protect managers against takeovers to induce them to distribute cash rather than build a warchest of cash against unwanted takeovers.

This thesis presents two essays in Corporate Finance. In the first essay, I use the August 2007 crisis episode to gauge the effect of financial contracting on real firm behavior. I identify heterogeneity in financial contracting at the onset of the crisis by exploiting ex-ante variation in long-term debt maturity structure. Using a difference-in-differences matching estimator approach, I find that firms whose long-term debt was largely maturing right after the third quarter of 2007 cut their investment-to-capital ratio by 2.5 percentage points more (on a quarterly basis) than otherwise similar firms whose debt was scheduled to mature after 2008. This drop in investment is statistically and economically significant, representing one-third of pre-crisis investment levels. A number of falsification and placebo tests suggest that my inferences are not confounded with other factors. For example, in the absence of a credit contraction, the maturity composition of long-term debt has no effect on investment. Moreover, long-term debt maturity composition had no impact on investment during the crisis for firms for which long-term debt was not a major source of funding. Our analysis highlights the importance of debt maturity for corporate financial policy. More than showing a general association between credit markets and real activity, my analysis shows how the credit channel operates through a specific feature of financial contracting. In the second essay, I analyze how institutional investors choose which Initial Public Offering to invest. Using a sample of IPOs from 1980 to 2004, I show that the reputation of the lead underwriter is the most significant variable in this decision process. Using Carter-Manaster rankings of underwriter reputation, I report that a one point increase in the reputation ranking leads to a 2% increase in institutional investors` holding. Moreover, I test hypotheses about what kind of certification the underwriter is providing. I provide evidence that underwriters certify un-measurable characteristics, in contrast to measurable characteristics, such as those provided in the financial statements of the issuer.

This dissertation contains three chapters on topics related to corporate finance and banking. The first two chapters explore how fiscal policy and bank branching deregulation can impact firms’ liquidity and credit constraints, while the third chapter looks at the relationships between executive status, compensation, masculinity, and language complexity. In the first chapter, I shed light on the complexity of liquidity injection programs by providing evidence on unintended consequences that arise when governments and central banks do not consider firm heterogeneity. Utilizing hand-collected, firm-level data from the Paycheck Protection Program, I show that government lending effectively reduced closures (the ultimate consequence of a liquidity shortfall), especially when received during the first two weeks of the program. However, I find that there was significant heterogeneity in the effectiveness of funds, resulting from the government’s broad-brush eligibility guidelines and differences in how firms process policy information. The implementation heavily relied on the banking system, which exacerbated the distributional effects by favoring firms with stronger customer capital. Overall, this chapter highlights the importance of the design of liquidity distribution to maximize its benefits. In the second chapter, I quantify the extent to which financial constraints limit the scope of activity of small firms, influence their labor decisions, and impact their ultimate survival. To study this, I first document how markets with bank branching deregulation experienced an increase in branches, driven by the entry of larger out-of-state banks with a decrease in existing branches. Consequently, small businesses were affected disproportionally. In the treated markets, the overall lending to small businesses declined by 5.4% and remained lower for several years. The decline in credit supply led to a decrease in the number of small businesses; however, many firms were able to stay open by decreasing their demand for labor. Specifically, I document decreases in employment, hours worked, and wages in treated markets. Overall, the results demonstrate the critical dependence of small businesses on relationship lending by local banks and show how temporary negative credit supply shocks can have persistent adverse effects on labor. In the third chapter, I use novel measures of CEO and CFO vocal masculinity and language complexity to gain insight into how these individual-level traits influence executive status and compensation both within and across genders. I find that vocal masculinity, within females, positively impacts their likelihood of becoming a CEO while the opposite is true for males. Furthermore, I find heterogeneity in these relationships depending on the gender composition of the board, the gender of the CFO, and the entrenchment level of a firm. When it comes to communication, CEOs speak with greater complexity than CFOs while both female CEOs and CFOs use more complex language and speak longer during earnings calls than their male counterparts. Finally, for both male and female CEOs, compensation is positively related to masculinity, while increased language complexity only matters for females. These results help provide insight into the determinants of CEO status and compensation and may help explain how boards view and reward perceived competency across genders.

ABSTRACT: Firms have many risk management tools at their disposal. How a firm uses these choices alone and as part of a choice set is less well understood. I examine two major risk management decisions in the corporate finance arena. First, I address the use of operational hedging (corporate finance activity that reduces firm risk). I document that acquisitions are operational hedges and that firms substitute operational and financial hedging. Next, I explore the speed of capital structure adjustment. Capital structure decisions are an important part of risk management and I document that the costs and benefits of adjustment are significant factors in determining leverage. Collectively, my research presents new information on how firms use two major risk management tools: operational hedges and capital structure adjustment.