two essays in corporate finance

TWO ESSAYS IN CORPORATE FINANCE DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Natasha A. Burns, M.B.A. The Ohio State University 2003 Dissertation Committee: Approved by Professor René M. Stulz, Advisor _________________ Professor Jean Helwege Advisor Professor G. Andrew Karolyi Graduate Program in Business Administration Copyright by Natasha A. Burns 2003 ii ABSTRACT This dissertation analyzes restatements of financial statements and the use of cross- listed stock by foreign firms in acquisitions of U.S. firms. The first essay, presented in Chapter 2, examines the Chief Executive Officer’s (CEO’s) incentives for using aggressive accounting that might result in a restatement. Specifically, it examines how the composition of the CEO’s compensation affects these incentives. Using a logistic regression to explain misreporting in a given firm-year, this essay shows that CEO’s whose compensation depends more on options are more likely to use aggressive accounting that results in a restatement. Further, when the CEO’s option compensation deviates from its optimal level, misreporting is more likely. An increase in the equity and restricted stock component of compensation has no impact on incentives to engage in such risky accounting. The use of long-term incentive plans and restricted stock do not extend a manager’s horizon relative to the short-term focus induced by options. Finally, we examine the market reaction to the announcement of a restatement. It is more negative for those restating firms in which the exercise of options was greater during the misreported period, providing support for the idea that options provide a ‘camouflage’ for insider trading. The second essay, presented in Chapter 3, examines the role of cross-listed stock in foreign acquisitions of U.S. firms. Recent research states that there are important disclosure and legal implications for foreign firms that cross-list on a U.S. exchange. By cross-listing, a foreign firm reduces its cost of an acquisition made with equity by enhancing the rights of its minority investors and by decreasing barriers to ownership of its shares by U.S. investors. iii Cross-listed firms using equity to finance an acquisition pay, on average, 10% less than non- cross-listed firms paying with cash, as measured by the target’s premium around the announcement of the acquisition. Despite this benefit, cross-listed firms use equity less often than U.S. firms because of factors affecting foreign firms but not U.S. firms, e.g., home bias and investor protection. Using a sample of forty-four cross-listed bidders acquiring U.S. targets with equity, the essay shows that cross-listed firms from countries with poorer investor protection use equity less often than those from countries with greater investor protection. Moreover, they pay a higher premium when using equity. Thus, even after bonding to the U.S. legal regimes via its cross-listing, investors are still wary of the firm’s home country legal protections. We test Hansen’s (1987) hypothesis that equity financed acquisitions enable the bidder to share the risk with the target that the bidder overpaid. We find that acquirers are more likely to use equity in acquisitions involving targets with greater growth opportunities that are more difficult to value, supporting Hansen’s hypothesis. Finally, we find that while non-cross-listed firms use favorable exchange rate movements to bid more aggressively, cross-listed firms do not. iv ACKNOWLEDGMENTS I would like to thank my advisor René Stulz and my committee members Jean Helwege and Andrew Karolyi for their guidance and insightful feedback that helped make this dissertation possible. I also thank Craig Doidge, Jim Hsieh, Jan Jindra, Anil Makhija, Christof Stahel, Siew Hong Teoh, Karen Wruck and seminar participants at Auburn University, The Ohio State University and The University of Georgia for helpful comments and suggestions. Finally, I am grateful to W.C. Benton, Steve Buser and Jean Helwege for their words of encouragement and advice; Melanie Roy for help with data; to my family for their support; and to my precious daughter, Shefali, for keeping the joy in my life during this time. v VITA August 24, 1971 … Born – Columbus, Ohio 1993 Bachelor of Science in Computer Information Science, Ohio State University, United States. 1996 Master of Business Administration, Michigan State University, United States. FIELDS OF STUDY Major Field: Business Administration Concentration: Finance vi TABLE OF CONTENTS ABSTRACT ii ACKNOWLEDGMENTS iv VITA v LIST OF TABLES ix LIST OF FIGURES xi CHAPTER 1 1 CHAPTER 2 3 2.1. Introduction. 3 2.2. A primer on restatements 6 2.3 Literature review and development of hypotheses 8 2.3.1 The effect of option compensation. 8 2.3.2. Convexity. 12 2.4. Data and Methodology 15 2.4.1. Introduction of sample 15 2.4.2. Summary Statistics 16 2.4.3. Characteristics of restating firms 17 2.4.4. Discretionary accruals 19 2.5. Measures of CEO compensation 21 2.5.1. Option sensitivity. 21 2.5.2. Sensitivity of restricted stock and equity holdings 24 vii 2.5.3. Long term incentive plans 24 2.6. The effect of compensation. 24 2.6.1. Convexity. 30 2.6.2. Abnormal compensation. 31 2.7. Announcement reaction. 32 2.8. Conclusion 34 CHAPTER 3 37 3.1. Introduction. 37 3.2. The Determinants of financing. 40 3.2.1. Growth opportunities and the limit of debt financing 40 3.2.2. Risk sharing and signaling 41 3.2.3. Benefits of cross-listing. 41 3.2.4. The role of exchange rates 45 3.3. Data and Results. 46 3.3.1. Variables. 49 3.3.2. U.S. vs. cross-listed acquirers 52 3.3.3. Cross-listed acquirers 53 3.3.4. Premiums 56 3.4. Conclusion 61 CHAPTER 4 63 LIST OF REFERENCES 65 APPENDIX A: Tables 71 APPENDIX B: Figures 101 APPENDIX C: Estimation of discretionary accruals 104 viii APPENDIX D: Estimation of equity incentive deviation from optimal equity incentives 105 APPENDIX E: Probit used in Heckman estimation 108 ix LIST OF TABLES Table 1: Restatements for the period 1995 - 2002 71 Table 2: Measurement of variables 74 Table 3: Characteristics of restating firms 75 Table 4: Time series of discretionary accruals around the first year of alleged manipulation. 76 Table 5: Firm-year characteristics 77 Table 6: Logit regressions of determinants of restated year 78 Table 7: The effect of Gamma 82 Table 8: Deviations from optimal compensation 84 Table 9: Announcement reactions 85 Table 10: Distribution of sample by year and country 87 Table 11. Description of financing. 90 Table 12: Probit regressions of factors affecting method of payment for cross-listed and U.S. bidders of U.S. firms 91 Table 13: Probit regressions on the use of equity in acquisitions by cross-listed firms 92 Table 14: Cumulative abnormal returns 95 Table 15: Cross-sectional weighted least-square regression results of premiums to shareholders of US targets of cross-listed and non-cross listed foreign acquirers 96 Table 16: Cross-sectional weighted least-square regression of premiums to target shareholders of U.S. and cross-listed acquirers 97 Table 17: U.S. Target Premiums of cross-listed acquirers 98 [...]... encouraging management to focus on the short-term, especially in periods of speculation (Bolton, Scheinkman, and Xiong (2003)) We compare restating firms and non-restating firms in the S&P 1500, over the period from 1994-2002 Our contribution is in examining the personal incentives that CEOs have in relation to their compensation to make aggressive accounting choices In particular, we examine equity-linked... wealth, increasing manager’s utility, and sometimes offering collateral for debt.32 Baker and Hall (2001) argue that the first measure (change in wealth for a percentage change in price) is more useful when examining incentives to change entire firm value, for instance, a change in the accounting system They suggest that percentage ownership (the second measure) is more important in explaining incentives... concentrated in computer equipment, electrical and measuring instruments industries as well as services The industries in which restatements are more prevalent are growth industries that seemed to be affected by investor optimism regarding technology Financial firms are not included (SIC 60-69) due to data that is inappropriate for calculating leverage and market-tobook; variables that we use as controls in. .. (2002) find restating firms to be growth firms, and that restating firms are more likely to have accessed external capital during their restated years We examine proxies of firm growth opportunities: Earnings to price and market-to-book We also examine factors that have been associated with motivations for aggressive accounting 17 related to financing Restating firms might be manipulating accounting numbers... and stock incentives as the deviation of the firm equity incentives from optimal incentives We find significantly abnormal incentives from option compensation in restated years We test the implication from the Bolton, et al (2003), that managers are more likely to use aggressive accounting in periods in which it is most profitable to do so We find weak evidence consistent with this, finding that restated... restating firms have higher leverage and greater market valuations than non-restating firms in the S&P 1500 We find that restating firms use discretionary accruals more aggressively than non-restating firms in the first year that had to be restated, confirming similar results in Richardson, Tuna and Wu (2002) However, we do not find that their use of accruals is significantly greater in the years leading... personal incentives because managers face personal risks for making these choices In the first essay, presented in Chapter 2, we examine the CEO’s personal incentives to make such choices We examine the role played by the different components of the CEO’s compensation package, with a focus on options We focus on options because the increase in restatements has coincided with the increase in the use... Characteristics of restating firms Previous literature concentrates on market based pressures as causes for executive’s management of financial statements resulting in restatement For instance, Dechow, Sloan and Sweeney (1996) find that significantly more firms engaging in fraudulent accounting are in violation of debt covenants However, Beneish (1999), by contrast, finds that earnings overstatements do... trying to look like a “hot company” in order to earn those “megabucks” while in a bull market? Is the recent increase in the number of restatements coinciding with the increased use of large option grants evidence of what these men said? In this paper, we examine restatements that are due to ‘purposeful’ accounting choices in order to understand whether and how management’s incentives, through their compensation... the firm Finally, we examine Earnings per Share as well as Fully Diluted EPS We are interested in the incentives in place during the years restated as opposed to at the time of announcement Therefore, we measure the firm’s characteristics relative to the violation period as in Table 2 Table 3 presents univariate characteristics of restating firms compared to non-restating firms Data for restating firms . 3.1. Introduction. 37 3.2. The Determinants of financing. 40 3.2.1. Growth opportunities and the limit of debt financing 40 3.2.2. Risk sharing and signaling 41 3.2.3. Benefits of cross-listing contribution is in examining the personal incentives that CEOs have in relation to their compensation to make aggressive accounting choices. In particular, we examine equity-linked compensation:. speaking motivated by firms trying to look like a “hot company” in order to earn those “megabucks” while in a bull market? Is the recent increase in the number of restatements coinciding with