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Executive Summaries.

CEO Ownership, Leasing, and Debt Financing

Why do corporations lease assets rather than buy them? This question has been the subject of much empirical research. Earlier studies tended to focus on the extent to which leasing and debt are substitute forms of financing or on tax considerations. More recent studies have taken a broader view of financial contracts as a means by which corporations shift risk, alter incentives, and transfer tax liabilities. Under this view, lease financing can alter the benefits and risks of asset use in ways that other financial contracts cannot.

This study also adopts the financial contracting view of lease financing. Our primary contribution is our finding of a strong positive relationship between CEO stock ownership and lease financing. In fact, corporations whose CEOs own larger fractions of the company's stock tend to use more of both conventional debt and lease financing. It is generally agreed that, for most firms, some amount of debt financing can enhance shareholder value. It thus makes sense that CEOs with large ownership stakes in their own companies have stronger incentives to use debt in order to increase shareholder value. Debt financing also makes it easier for these CEOs to maintain their control over the company. At the same time, however, debt exposes a company to financial risk, and thus the personal risk borne by CEOs with large ownership stakes increases with debt. Leasing, on the other hand, allows the company to shift some of this risk. In particular, the risk of obsolescence is shifted to the lessor, since the asset reverts to the lessor at the end of the lease contract. We interpret our empirical findings, then, as evidence that CEOs with large ownership stakes use more lease financing as a means to control their personal risk exposure.

We use a sample of 176 US manufacturing companies, with data taken from the period 1986-91. We use two measures of a company's leasing intensity. The first is the ratio of capitalized lease obligations to total assets. The second is the share of annual leasing expense in annual total capital costs. Our second measure differs from the first in that it incorporates operating leases as well as capitalized leases. This is important because an operating lease, whose term is usually shorter than an asset's useful life, affords greater opportunities for shifting obsolescence risk to the lessor than does a capitalized lease.

We first regress our measures of leasing intensity against CEO ownership and company size, as well as the squares of both variables. We include size to control for the strong negative correlation between company size and CEOs' ownership fractions. We find that, even after correcting for the negative impact of size on leasing financing, CEO ownership exerts an independent and significantly positive influence on both measures of leasing. The squared terms indicate that both ownership and size effects tend to diminish at the margin as CEO ownership and size increase.

We then estimate a more complete model that controls for other possible influences on the use of lease financing. In addition, we estimate an equation to explain companies' use of conventional debt financing, and we test for interactions between lease financing and debt. We find that CEO ownership continues to exert a significant positive influence on leasing activity. We also find that firm size is positively related to debt financing, as financial contracting theory predicts, but it is now also positively related to the share of lease payments in total capital costs. We find only weak evidence in support of investment-opportunity-set and tax effects on leasing. Other studies that have found stronger evidence of these effects have used larger samples, so the size of our sample may be insufficient to identify these effects clearly. Finally, we find evidence of a positive interaction between debt and leasing only for capitalized leases; when the lease variable includes operating leases, we find no significant interaction.

Hamid Mehran, Robert A. Taggart, and David Yermack

Tax Options, Clienteles, and Adverse Selection: The Case of Convertible Exchangeable Preferred Stock

Investors in convertible preferred stock have the option to convert the preferred into common stock. Convertible exchangeable preferred stock works the same way, but adds an option for the issuing firm to exchange the preferred shares for convertible bonds in the future. An exchange must preserve the conversion terms, and the coupon rate on the new bond must match the preferred dividend rate that it replaces.

A firm that raises capital using convertible preferred stock may find itself able to benefit from the tax deductibility of convertible debt interest in the future. Convertible exchangeable preferred lets the firm obtain additional tax deductions when it can use them, free of additional underwriting costs. This tax-timing option is valuable to an issuing firm that is in a low tax bracket when it raises capital but may face higher tax rates in the future. However, an exchange can be detrimental to investors. Corporate investors exclude the majority of a cash dividend (currently 70%) from their taxable income. An exchange would force such an investor either to endure a reduction in after-tax income or to incur the expense of selling the securities and reinvesting its funds. Thus, a potential reason for avoiding exchangeable convertible preferred is if the firm has or can attract an investor clientele that seeks stable preferred dividends. The firm can gain from serving the clientele if the investors are willing to accept a reduced yield (on non-exchangeable convertible preferred stock) in return for stability, or if being able to come back to the clientele for future offerings reduces the firm's financing costs.

Management should consider the firm's tax status and the target investor clientele when deciding between the conventional and exchangeable forms of convertible preferred stock. If taxable institutions are likely buyers of the issue, and the firm foresees little need for interest tax shields in the future, traditional convertible preferred stock potentially can minimize the cost of capital and smooth the way for future offerings. If there is a high likelihood that the firm can benefit from the tax shields obtainable by swapping the preferred for debt, for a sustained period before conversion can be forced, a convertible exchangeable preferred issue can make sense. This is especially true if the issue can be marketed to investors that are indifferent between dividends and interest, such as mutual funds and individuals.

The issuing firm gives up a valuable tax-timing option if it issues non-exchangeable convertible preferred. The cost of foregoing the tax-timing option can outweigh the benefits of serving a dividend-seeking clientele. The firms for which it is most costly to give up the tax-timing option - those in higher tax brackets, those that have little debt in their current capital structures, or those that are repaying debt with the proceeds of the offering - are predicted to be the most likely to issue exchangeable preferred. My empirical findings support this contention: higher marginal tax rates, lower debt ratios, and the repayment of long-term or bank debt from issue proceeds do indeed increase the likelihood that a firm chooses convertible exchangeable preferred.

The stock market tends to react unfavorably to the announcement of any convertible security offering. Desiring to limit the damage to its common stock price, management may try to signal the firm's favorable prospects through its choice of security terms. If the common stock price rises rapidly so that the preferred is converted soon, the exchange option may never be exercised. A manager who foresees this situation can try to signal that the firm will perform well by not including the exchange feature. A manager who isn't so optimistic will conclude that the tax-option value of the exchange feature is worth more than any potential signal. Thus, only issuers with comparatively poor prospects would choose convertible exchangeable preferred stock. This scenario is called the adverse selection explanation for the choice of security type.

Adverse selection implies that conventional convertible preferred issues would be called, to force conversion, earlier in their lives than exchangeable convertible preferred issues. Empirically, I find that the opposite is true, though the difference is small. Adverse selection also implies that the common stock price reaction to an exchangeable offering should be more negative than the reaction to a non-exchangeable offering. On first examination, this prediction has empirical support: the average stock price reaction evoked by exchangeable offering announcements is in fact the more negative of the two. However, after controlling for the use of proceeds, leverage, and growth opportunities, little evidence remains that the security type influences the announcement effect. The stock market seems to react to the purpose of the offering, the firm's capital structure and growth policies, and the quality of its management, not to whether the preferred is exchangeable for debt. Thus, managers would be wise to disregard the potential for influencing stock market reaction when deciding between the types of two convertible preferred.

Arnold R. Cowan

Leverage Ratios, Industry Norms, and Stock Price Reaction: An Empirical Investigation of Stock-for-Debt Transactions

In this paper, I investigate how the market reacts to managerial actions that change a firm's debt-to-equity ratio (DE) in relation to the industry DE norm. My investigation of the market response is important for those charged with the responsibility for choosing an appropriate mix of debt and equity financing for their firm.

To explore the market's response, I analyze 338 common stock offerings that raise cash to retire debt. I divide these stock-for-debt transactions into two groups. The first group includes 197 stock-for-debt transactions where the announcing firm's DE moves "away from" its industry DE norm. The second group consists of 141 transactions where the firm's DE moves "closer to" its industry norm. For each group, I look at the stock price behavior for a three-day period surrounding the announcements. For this period, I find that stock value falls less for the "closer to" group. Specifically, the fall is 1.50% less for this group as compared to the "away from" group. This 1.50% difference between groups is statistically significant. This finding implies that managers should pay attention to their industry DE norms when changing the relative amounts of equity and debt in the firm's capital structure.

I perform several other tests that include time frames longer than the three-day announcement period. For tests that include a seven-day period, I offer evidence that the 141 "closer to" firms have a significant positive market reaction. This finding suggests several possibilities. First, the market recognizes that firms moving toward industry DE norms become less likely to default on their debt obligations. Second, market participant see these firms as retiring debt that hinders managers from pursuing desirable dividend and investment policies. For example, by reducing debt (that exceeds some norm or target) the firm creates enough financial slack to allow managers to undertake future projects with positive net present values. Third, firms moving "closer to" their industry DE benchmarks are viewed as signaling positive news because of their capacity to attain DEs similar to their industry competitors.

Finally, I find that large stock price run-ups precede stock-for-debt transactions. Thus, these transactions appear to be "timed" to capitalize on stock prices that have peaked. More important, I discover that a significantly greater stock price run-up is needed to induce a stock offering for "away from" firms. This discovery suggests that managers of "away from" firms are hesitant to stray from their industry DE norms. If a smaller price run-up can induce a stock offering for "closer to" firms, then it is likely that managers of these firms are motivated by a desire to correct imbalances in DEs. Investors appear to recognize this motivational factor as stock prices for "closer to" firms are not as severely penalized at the time of the announcement.

This paper examines the interplay between managerial action, industry DEs, and market reaction. I offer evidence that the market pays attention to how managers change a firm's DE in relation to its industry DE. The market's perception of an industry DE as a wealth-maximizing target enables managers to use a change in DE to influence the market's reaction to stock-offering announcements. The influence is positive when firms move toward industry DE norms and negative when firms move away from these norms.

Robert M. Hull

Does NYSE Listing Affect Firm Visibility?

Corporate managers often cite improved firm visibility as a motive for listing. This study asks whether listing on the New York Stock Exchange (NYSE) helps increase a firm's visibility, and whether firm size, as measured by market capitalization, affects visibility gains. We also investigate whether listing or earnings growth explains any changes in firm visibility.

For the purposes of this study, we define firm visibility as the extent to which analysts follow and institutions hold a firm's stock. Visibility is important because it suggests greater flow and accessibility of information about a firm. By reducing information asymmetries, visibility enhances the efficiency of the trading market in the stock.

Our sample consists of 331 firms that moved from Nasdaq to the NYSE between January 1, 1984 and December 31, 1992. Because a firm's visibility can change for reasons unrelated to listing, we use each firm as its own control match. We do this by comparing visibility changes for successive six-month periods, beginning 13 months before listing and ending five months after listing. We use three proxies to test whether firm visibility changes after NYSE listing: the number of analysts estimating the firm's next fiscal year's earnings per share (NOA), the number of institutional shareholders (NOI), and the number of shares held by institutions (NOS).

We develop three testable hypotheses. The first hypothesis is that firm visibility, as measured by the three proxies, significantly increases in the six-month period after listing on the NYSE in comparison with the two previous periods. The second hypothesis is that firm size, as measured by market capitalization, affects the visibility gains of NYSE-listing firms. We expect that small firms moving from Nasdaq to the NYSE will experience significantly greater visibility gains than medium or large firms. Our final hypothesis is that any increases in visibility are attributable primarily to listing.

Based on matched-pairs tests, our results show that changes in firm visibility are significantly positive in the post-listing period. However, the two pre-listing periods are also significantly positive. Further tests show that the change for the post-listing period is often smaller than are the changes for the two pre-listing periods. This finding suggests that post-listing visibility gains are a continuation of a pattern of gains over time and are not due specifically to the act of listing.

Our regression analysis suggests that the increases in the visibility proxies are primarily attributable to growth in market capitalization, not to listing. That is, firms often list after a period of strong growth, which leads to increased visibility. Therefore, managers are attributing visibility gains to NYSE listing erroneously

H. Kent Baker, Gary E. Powell, and Daniel G. Weaver

Open Market Stock Repurchase Signaling

Firms know more about future earnings than the market and need ways of conveying the information so that it is fully reflected in their stock price. This paper argues that firms use open market stock repurchases to transmit information to the market. The market responds to repurchases: Vermaelen (1981) finds abnormal price increases of 3.37% following their announcements and concludes that repurchases signal positive information about firm value. Their widespread use after the crash of October 1987 (over 750 revised or new offers) implies that firms believe that repurchases can change the market's perception of value. Indeed, most press releases announcing repurchases cite market undervaluation as the primary motivation. If repurchases are indeed signals, then the obvious question is, "what makes the signal believable?" This question has not been addressed adequately in the academic literature. There are no published signaling models of open market repurchases. To fill this gap, we provide a signaling model which makes two contributions: 1) it shows why repurchases are believable (how the signal works) and 2) it yields multiple implications that provide for a rigorous test of the signaling hypothesis.

The model simulates the effects of a repurchase on the utility of the inside shareholders and yields three testable implications: the market's valuation of the firm increases with 1) the quantity of shares repurchased, 2) the riskiness of the firm's earnings, and 3) the level of insider shareholdings. We test these relationships with a sample of over 700 US repurchases and find a significant relationship between all three variables and the market's announcement-period price reaction. The positive results imply that shareholders should view repurchases as mechanisms for conveying their estimate of the firm's value to the market. Our estimates suggest that an additional 1% in the repurchase proportion adds approximately 0.26% to the announcement-period return over and above the concurrent market return. Firms that have more volatile earnings or where insiders have a larger proportionate ownership position can repurchase smaller proportions to achieve a given increase in market value, or, equivalently, will receive a greater announcement-period return for any given target repurchase proportion.

The model's implications provide a theoretical underpinning for the main results in the empirical literature. Comment and Jarrell (1991) find a significant, positive relationship between the repurchase quantity and the announcement-period stock return, which is consistent with the first signaling implication. Consistent with the first two implications, Ikenberry and Vermaelen (1996) find that the announcement-period return is positively related to both the repurchase quantity and the firm's risk (volatility).

The reasoning behind our signaling model is similar to Leland and Pyle's (1977), because a repurchase increases the risk exposure of non-tendering inside shareholders. Depending on how it is financed, the repurchase either decreases the cash holdings of the firm (its least risky asset) or increases its leverage. Either way, if insiders do not tender (an important assumption), they end up owning a greater proportion of a riskier package of assets. Assuming risk aversion, owners of firms with larger earnings derive less disutility from that added risk and should optimally repurchase more than owners of low-earnings firms. Since the cost of signaling is the increased exposure to risk, we would expect insiders of high-risk firms or insiders with larger initial stakes in their firms to repurchase less. The market can draw three inferences from a repurchase: high-earnings firms repurchase more, high-risk firms repurchase less, and firms where insiders own a large proportion of shares repurchase less.

We test the implications using Comment and Jarrell's (1991) sample of 1,197 open market repurchase announcements between 1984 and 1988. To the event data, we added stock price data from CRSP, accounting variables from COMPUSTAT, and prior insider holdings data from SEC records (direct shareholdings of officers, directors, and 10% holders from CDA Spectrum 6). The resulting sample has 702 repurchase announcements.

We also test, but find no support for, four alternative explanations of the announcement-period return: the insider-trading option model, Jensen's free-cash-flow hypothesis, the personal-tax hypothesis, and the corporate-tax-shield hypothesis.

William J. McNally

Assessing Post-Bankruptcy Performance: An Analysis of Reorganized Firms' Cash Flows

It has been difficult to understand how well companies perform after they emerge from a Chapter 11 bankruptcy reorganization because, until recently, the issue has only been addressed indirectly. In this study, we analyze the post-bankruptcy cash flows of a sample of firms that emerged from Chapter 11 reorganizations between 1983 and 1993.

We evaluate the asset performance of those companies by examining the rate of return available to investors who owned all the debt and equity claims on the firm as it emerged from bankruptcy. On average, this return matches the performance of benchmark portfolios during the five years following bankruptcy reorganization. In short, firms emerging from bankruptcy neither overperform or underperform - their returns are, on average, what you would expect from other companies with similar characteristics. Across the sample, companies with (1) good investment opportunities that (2) invest heavily perform the best. Firms that are acquired after reorganization post better results, while companies that require additional debt restructuring perform worse.

The results contained in this article contrast with the results of previous studies, which either infer underperformance from post-bankruptcy characteristics or establish evidence of overperformance based on an analysis of market returns. A number of past studies infer that post-bankruptcy performance is poor because operating margins are weak, post-reorganization debt ratios are high, and further debt restructuring following Chapter 11 reorganizations is frequently required. A contemporaneous study finds that publicly traded reorganized firms produce abnormally high returns for the common stockholders.

Evaluating the post-bankruptcy performance of reorganized firms is complicated by two features common to distressed or recently distressed companies: the unavailability of market prices for weaker companies and the tendency for only strong firms to survive the reorganization process. These features imply that an examination of reorganized firms will likely find that market returns are superior, perhaps because they are initially underpriced, but also perhaps because the sample excludes the companies that performed poorly and disappeared from the public markets, before reorganizing or shortly thereafter.

Our study attempts to control for this survivorship bias by examining the factors that influence the performance of our sample firms after they emerge from Chapter 11. If performance varies in the cross-section in an economically reasonable fashion, concern over the influence of survivorship bias is mitigated. Using a multivariate regression model, we examine the relation between post-bankruptcy performance and capital expenditures. We find that performance is best among companies with both superior growth opportunities and high industry-adjusted capital expenditures. In contrast, firms with poor investment opportunities that invest heavily do not perform better than others. These findings are consistent with the hypothesis that superior performance among the sample of reorganized firms is linked to the exercise of valuable growth options.

Our study also examines the relation between post-bankruptcy asset performance and other variables that have traditionally been thought either to influence or to reflect how well firms perform after they reorganize. The regression analysis shows that companies perform better if they are acquired after emergence, and that their returns are abnormally poor if they require further debt restructuring after emerging from Chapter 11. Perhaps surprisingly, post-bankruptcy performance does not show any statistical relation to operating margins (EBITDA/Sales) or to management changes.

Michael J. Alderson and Brian L. Betker

Are Leases and Debt Substitutes? Evidence from Belgian Firms

Finance theory suggests that leases and debt are substitutes, as both are fixed, contractual obligations that reduce the firm's debt capacity. However, some empirical evidence indicates that leases and debt are complements rather than substitutes.

A possible explanation for these results is that under the American tax law, the lessor is considered the fiscal owner of the leased assets. Thus, the lessor can deduct depreciation charges for the leased assets from taxable income, whereas for the lessee the rental payments are operating expenses. Tax differences between lessor and lessee can then influence the lease-buy decision. If the lessee pays little or no corporate tax, leasing makes it possible to pass on the depreciation charges to the lessor, in exchange for lower rental payments. The possibility of selling excess tax shields increases the tax benefit associated with debt financing. Thus, firms that use (more) lease financing might have higher debt ratios.

In the Belgian leasing system, however, the lessee is considered to be the fiscal owner of the assets, and may thus write these off for tax purposes. As the lessee cannot sell excess tax shields to the lessor, tax differences between lessor and lessee do not influence the lease-buy decision. It should also be pointed out that Belgian capital markets are notoriously underdeveloped, and that bank loans and intra-group financing are the main forms of long-term external financing.

In this paper, we use a sample of 1,066 non-financial Belgian firms to examine whether these institutional differences have an impact on the lease-buy decision. Although the lease rates of these firms seem to be quite low, they are comparable to figures for American and British firms, which indicates that even without tax differences between lessor and lessee, leasing still is a valuable financing alternative.

We find that those Belgian firms that make greater use of lease financing use less non-lease debt financing. Leases seem to be an alternative to long-term bank debt and intra-group debt. However, leases and non-leasing debt are imperfect substitutes. This might result from the tighter collateral arrangements associated with lease financing. In case of default, it is easier for a lessor (who remains the legal owner of the asset) to regain possession of the leased asset than for a secured debtholder to acquire the pledged asset. This is confirmed by our finding that firms with more volatile earnings have higher lease ratios.

We also find that larger firms have higher lease ratios, whereas firms with more current assets and more fixed financial assets (that cannot be leased) make less use of lease financing. Small firms with very volatile earnings make great use of leasing. Furthermore, for smaller firms, leases and non-leasing debt do not seem to act as substitutes.

Marc Deloof and Ilse Verschueren
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Publication:Financial Management
Date:Jun 22, 1999
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