Book‐to‐Market Equity,Asset Correlations and the Basel Capital Requirement

This paper examines the effect of book‐to‐market equity (BE/ME) on asset correlations under the Basel capital requirement. We find that BE/ME captures variations in asset correlations after controlling for firm size, default probability and industry effects from 1987 to 2011. Obligors with higher BE/ME exhibit lower asset correlations compared to those with lower BE/ME. Decomposing BE/ME into assets‐in‐place and growth options based on the asset pricing literature shows that obligors with more assets‐in‐place or more fixed assets have higher BE/ME and lower asset correlations than those with more growth options. Overall, our findings suggest that BE/ME is an additional important factor that may improve the estimates of asset correlations and thereby banks’ capital adequacy.     

Why Do European Firms Issue Convertible Debt?

We survey European managers to gain some insights into motivations of convertible issuance. Our analysis shows that a majority of firms issue convertibles as ‘delayed equity’ and as ‘debt sweetener’. Managers also use convertibles to avoid short‐term equity dilution and to signal firm's future growth opportunities. We document a large cross‐sectional variation across firms in rationales for issuing convertibles and find mixed support for most theoretical models. Our evidence suggests that the popularity of convertibles is driven primarily by their versatility in adjusting their design to fit the financing needs of individual firms, and by their increased demand among institutional investors.     

The Equity Premium: Consistent with GDP Growth and Portfolio Insurance

We find that the long‐term equity premium is consistent with both GDP growth and portfolio insurance. We use a supply‐side growth model and demonstrate that the arithmetic average stock market return and the returns on corporate assets and debt depend on GDP per capita growth. The implied equity premium matches the U.S. historical average over 1926–2001. Separately, we find that the equity premium tracks the value of a put option on the S&P 500. Our theory predicts a smaller equity premium in the future, assuming that the recent regime shifts in dividend policies, interest rates, and tax rates are permanent.     

Market's perception of deferred tax accruals

This study investigates the value relevance and incremental information content of deferred tax accruals reported under the ‘income statement method’ (AASB 1020 Accounting for Income Taxes) over the period 2001–2004. Our findings suggest that deferred tax accruals are viewed as assets and liabilities. We document a positive relation between recognized deferred tax assets and firm value using the levels model, while the results from the returns model suggest that deferred tax liabilities reflect future tax payments. The balance of unrecognized deferred tax assets provides a negative signal to the market about future profitability, particularly for companies from the materials and energy sectors and loss‐makers.     

Unexpected Inflation,Capital Structure,and Real Risk‐adjusted Firm Performance

Managers can improve real risk‐adjusted firm performance by matching nominal assets with nominal liabilities, thereby reducing the sensitivity of real risk‐adjusted returns to unexpected inflation. The net asset value of US equity real estate investment trusts (REITs) serves as a good proxy for nominal assets and, accordingly, we use a sample of US REITs to test our hypothesis. We find that for the firms in our sample: (i) their real risk‐adjusted performance, and (ii) their inflation‐hedging qualities are inversely related to deviations from this ‘matching‐nominals’ argument. In addition to providing managers with a vehicle to maximize real risk‐adjusted performance, our findings also provide investors with the tools to infer inflation‐hedging qualities of equity investments.     

Multi‐period Asset Lifetimes and Accounting‐based Equity Valuation: Take Care with Constant‐growth Terminal Value Models!

The merits of accruals in forecasting cash flows or mitigating the volatility of financials shortly after the valuation date are indisputable. However, the usefulness of accounting in equity valuation is very limited if we step beyond a certain forecasting horizon. In this paper, this limitation is emphasized by shedding new light on the accounting‐based value driver model (VDM), a widely used constant‐growth terminal value tool that uses accounting variables as input. The paper shows that, if the lifetime of a firm's assets is, on average, longer than one period, the VDM works accurately only in an idealized academic environment with an even historical corporate investment activity, a single depreciation method for all assets, and no historical inflation volatility. Artificially adjusting real‐world figures to this steady state is possible in principle, but bloats the valuation model and requires exactly the same information that is used in our cash flow‐driven benchmark model (where no adjustment phase is necessary). Beyond these theoretical shortcomings, the VDM is also prone to being misused in valuation practice due to its reliance on book (rather than economic) rates of return, and to its shortcomings in dealing adequately with the assets with an ex ante indefinite lifetime.     

Equity Financial Assets: A Tool for Earnings Management—A Case Study of a Chinese Corporation

With China’s adoption of principles-based international accounting standards and its convergence with International Accounting Standard 39 (IAS 39), Chinese companies have discretion under the original Accounting Standards for Enterprises 22 (CAS 22) as to how they account for the initial measurement, sale, and subsequent reclassification of financial assets. We use a Chinese company (‘Company A’) as a case study to illustrate how earnings are managed to exploit this discretion. We document that the company re-classifies its available for sale equity investments as long-term equity investments to decrease the volatility of the company’s apparent profits. We also make some predictions regarding how the company will handle its financial assets under the new standard, which is the same as IFRS 9. Our research contributes to the continuous improvement of China’s accounting standards and has implications for regulators of the capital market.     

Discretionary accounting choices: the case of IAS 19 pension accounting

Based on a sample of 3207 firm-year observations for the years 2005–2013, we investigate how stock-listed companies in France, Germany and the UK use two discretionary choices in their accounting for defined benefit pension plans under International Accounting Standard (IAS) 19 Employee Benefits. We first analyse companies’ decision whether to voluntarily early adopt the equity method of accounting for actuarial gains and losses. Second, we analyse companies’ choice to present pension interest cost and expected return on plan assets, or, in 2013, net pension interest cost, in operating or financial income. Our findings provide evidence that companies’ decisions to early adopt the equity method in 2005, the first year this accounting choice was available, were motivated by short-term effects on equity. Our analyses also indicate that the choice regarding where to present interest cost and expected return on plan assets in the income statement is associated with the resulting effect on Earnings before Interest and Tax. Finally, we document country-specific differences in the use of the discretion provided under IAS 19, suggesting that discretionary pension accounting choices may impede comparability.     

How Do Financing Constraints Affect Firms’ Equity Volatility?

Theory suggests that financing frictions can have significant implications for equity volatility by shaping firms’ exposure to economic risks. This paper provides evidence that an important determinant of higher equity volatility among research and development (R&D)‐intensive firms is fewer financing constraints on firms’ ability to access growth options. I provide evidence for this effect by studying how persistent shocks to the value of firms’ tangible assets (real estate) affect their subsequent equity volatility. The analysis addresses concerns about the identification of these balance sheet effects and shows that these effects are consistent with broader patterns on the equity volatility of R&D‐intensive firms.     

Growth Opportunities,Technology Shocks,and Asset Prices

We explore the impact of investment‐specific technology (IST) shocks on the cross section of stock returns. Using a structural model, we show that IST shocks have a differential effect on the value of assets in place and the value of growth opportunities. This differential sensitivity to IST shocks has two main implications. First, firm risk premia depend on the contribution of growth opportunities to firm value. Second, firms with similar levels of growth opportunities comove with each other, giving rise to the value factor in stock returns and the failure of the conditional CAPM. Our empirical tests confirm the model's predictions.     

THE RELATION BETWEEN THE MAGNITUDE OF GROWTH OPPORTUNITIES AND THE DURATION OF EQUITY

I examine the relation between the magnitude of growth opportunities in a firm and the duration of the firm's equity. Conventional wisdom holds that because cash flows from growth opportunities occur late relative to cash flows from existing projects, firms that can be characterized as growth firms have a higher duration. I adopt the real option approach to the valuation of growth opportunities and show that under certain circumstances the opposite can be true; equity duration can be lower for growth firms. I further show that the relation between equity duration and the magnitude of growth opportunities depends on (a) the magnitude of the duration of assets in place, (b) dominance of the firm in its industry, (c) the magnitude of R&D expenditure, and (d) the volatility of expected cash flows generated by the investment project underlying the growth opportunity. I empirically test these predictions and find the predictions are not rejected, particularly for the utility and banking industries. JEL classification: G31, G12.     

Corporate Commitment to Sustainability – Is it All Hot Air? An Australian Review of the Linkage between Executive Pay and Sustainable Performance

Across time, companies have increasingly made public commitments to sustainable development and to reducing their impacts on climate change. Management remuneration plans (MRPs) are a key mechanism to motivate managers to achieve corporate goals. We review the MRPs negotiated with key management personnel in a sample of large Australian carbon‐intensive companies. Our results show that, as in past decades, the companies in our sample have MRPs in place that continue to fixate on financial performance. We argue that this provides evidence of a disconnection, or ‘decoupling’, between the sustainability‐related rhetoric of the sample companies, and their ‘real’ organisational practices and priorities.     

Tangibility and investment irreversibility in asset pricing

Zhang (2005) and Cooper (2006) provide a theoretical risk‐based explanation for the value premium by suggesting a nexus between firms’ book‐to‐market ratio and investment irreversibility. They argue that unproductive physical capacity is costly in contracting conditions but provides growth opportunities during economic expansions, resulting in covariant risk between firms’ investment in tangible assets and market‐wide returns. This article uses the Australian accounting environment to empirically test this theory – a test that is not possible using US data. Consistent with the theoretical argument, tangibility is priced in equity returns, and augmenting the Fama and French three‐factor model with a tangibility factor increases model explanatory power.     

Morgan Stanley Roundtable on Private Equity and Its Import for Public Companies

The role of private equity in global capital markets appears to be expanding at an extraordinary rate. Morgan Stanley estimates that there are now some 2,700 private equity funds that either have raised, or are in the process of raising, a total of $500 billion. With this abundance of available equity capital, the willingness of private equity firms to participate in “club” deals, and the leverage that can be put on top of the equity, private equity buyers now appear able and willing to pay higher prices for assets than ever before. And thanks in part to this new purchasing power, private equity transactions reportedly account for a quarter of all global M&A activity as well as a third of the high yield and IPO markets. The stock of capital now devoted to private equity reflects the demonstrated ability of at least the most reputable buyout firms to produce consistently high rates of returns for their limited partners. Although a talent for identifying and purchasing undervalued assets may be part of the story, the ability to produce such returns on a consistent basis implies an ability to add value, to improve the performance of the operating companies they invest in and control. And in this round‐table, a small group of academics and practitioners address two main questions: How does private equity add value? And are there lessons for public companies in the success of private companies? According to the panelists, the answer to the first question appears to have changed somewhat over time. The consensus was that most of the value added by the LBO firms of the‘80s was created during the initial structuring of the deals, a process described by Steve Kaplan as “financial and governance engineering,” which includes not only aggressive use of leverage and powerful equity incentives for operating managements, but active oversight by a small, intensely interested board of directors. In the past ten years, however, these standard LBO features have been complemented by increased attention to “operational engineering,” to the point where today's buyout firms feel obligated, like classic venture capitalists, to acquire and tout their own operating expertise. In response to the second of the two questions, Michael Jensen argues that much of the approach and benefits of private equity‐particularly the adjustments of financial policies and stronger managerial incentives‐can be replicated by public companies. And although some of these benefits have already been realized, much more remains to be done. Perhaps the biggest challenge, however, is finding a way to transfer to public companies the board‐level expertise, incentives, and degree of engagement that characterize companies run by private equity investors.     

Corporate Climate Change‐Related Governance Practices and Related Disclosures: Evidence from Australia

This paper investigates the climate change‐related corporate governance disclosure practices of five major Australian energy‐intensive companies over a 16‐year period. In doing so, a content analysis instrument is developed to identify disclosures made in relation to various policies and procedures the organisations have in place for addressing the issues associated with climate change. This instrument is applied to the respective companies’ annual reports and sustainability reports. An increasing trend is found in companies’ climate change‐related corporate governance disclosures over time; however, in many instances the disclosures provide limited insights into the climate change‐related risks and opportunities confronting the sample companies.     

An Investor Perspective on the Black Box of Corporate Social Responsibility

In summarizing the findings of their recent study, the authors report findings that suggest that not all socially responsible corporate policies are likely to have the same effect on a company's ownership and value. Using environmental policy as their proxy for CSR activities, the authors classify corporate environmental practices into two categories: (1) actions that reduce the likelihood of harmful outcomes by reducing the corporate exposure to environmental risk; and (2) actions that enhance companies' perceived ‘greenness’ through investments that go beyond both legal requirements and any conceivable risk management rationale. Although both groups of environmental practices are likely to be viewed as socially beneficial, corporate expenditures that reduce a firm's environmental risk exposure are more likely to benefit shareholders by limiting the risk of losses arising from environmental accidents, lawsuits, and fines—and possibly thereby reducing the firm's cost of capital. By contrast, corporate expenditures that enhance the firm's perceived greenness by going beyond legal requirements and risk management rationales could actually reduce shareholder value. Consistent with this hypothesis, the authors find that institutional investors tend to own smaller than average percentages of both companies the authors identify as ‘toxic’ and make limited efforts to manage their environmental risk, and companies they label ‘green’ with low environmental risk exposure but relatively high CSR spending on the environment. At the same time, such investors hold larger‐than‐average positions in ‘neutral’ companies with relatively low, or effectively managed, environmental risk exposures and limited investment in ‘greenness’ programs. The authors also find that both toxic and green companies have lower (Tobin's Q) valuations than neutral companies, and that otherwise toxic companies that effectively manage their environmental risk exposures have higher valuations.     

Private equity and Covid-19

We survey more than 200 private equity (PE) managers from firms with $1.9 trillion of assets under management (AUM) about their portfolio performance, decision-making and activities during the Covid-19 pandemic. Given that PE managers have significant incentives to maximize value, their actions during the pandemic should indicate what they perceive as being important for both the preservation and creation of value. PE managers believe that 40% of their portfolio companies are moderately negatively affected and 10% are very negatively affected by the pandemic. The private equity managers—both investment and operating partners—are actively engaged in the operations, governance, and financing in all of their current portfolio companies. These activities are more intensively pursued in those companies that have been more severely affected by the Covid-19 pandemic. As a result of the pandemic, they expect the performance of their existing funds to decline. They are more pessimistic about that decline than the venture capitalists (VCs) surveyed in Gompers et al. (2021). Despite the pandemic, private equity managers are seeking new investments. Rather than focusing on cost cutting, PE investors place a much greater weight on revenue growth for value creation. Relative to the 2012 survey results reported in Gompers, Kaplan, and Mukharlyamov (2016), they appear to give a larger equity stake to management teams and target somewhat lower returns.     

Re‐equitizing Corporate Balance Sheets: Choosing Among the Alternatives

Companies are generally reluctant to issue new equity because it can be expensive capital. Among the largest costs of an equity offering are so‐called “market‐impact” costs. To the extent the typically negative market reaction to a stock offering causes an issue to be underpriced, such underpricing dilutes the value of current shareholders. Despite such costs, many companies—particularly financial institutions—are raising equity capital to “delever” balance sheets that have been squeezed by the credit crunch and economic slowdown. And far from transferring value from existing shareholders, these offerings can preserve and even increase the value of highly leveraged companies by shoring up their capital bases and providing the flexibility to get through a difficult period. According to recent studies, announcements of equity offerings by distressed companies have been accompanied by positive stock returns in excess of 5 %. The challenge for CFOs is to determine why and when issuing equity is the value‐maximizing strategy. The kinds of companies that are most likely to benefit from equity offerings are those that score low on credit metrics, have experienced cyclical declines in operating performance, and have growth opportunities as part of their recovery. There are a number of options for raising equity capital, but no set rules for identifying the optimal one. Nevertheless, the author offers a number of suggestions designed to help CFOs make smarter decisions: Communicate clearly to investors the intended uses of the proceeds from the equity offering and how they are expected to create value; Consider judicious cuts to the dividend to preserve capital; Involve current shareholders to minimize dilution, perhaps by considering a rights offering, and strengthen their commitment; Seek out “smart money” such as private equity or SWFs as long‐term investors; Get the offer size right the first time so a second offering can be avoided; and Monetize volatility in uncertain markets by issuing convertible securities.     

Do Board Characteristics Influence the Shareholders' Assessment of Risk for Small and Large Firms?

This paper investigates the association between board characteristics and shareholders' assessment of their exposure to economic and agency risks as reflected in the volatility of stock returns. Our hypotheses incorporate prior evidence that small and large firms have ‘dramatically’ different board structures, reflecting the firms' different monitoring and advising needs. We hypothesize and find evidence that only the shareholders of well‐established large firms are able to generate positive net benefits, in the form of lower equity risk, from independent boards and well‐connected independent directors with multiple directorships. We also find professional and formal industry degree qualifications on the board are associated with shareholders' risk assessment for some small firms consistent with the focus of small firms on building growth and scale. While we find evidence that formal industry professional affiliations (weak evidence) and MBAs provide benefits for the shareholders of large firms, there is limited evidence that financial expertise on the board systematically influences shareholders' risk assessments for small or large companies. The key conclusion from the evidence in this paper is that a ‘one size fits all’ approach to governance in relation to the board of directors may not meet the diverse needs of companies at different stages of economic development.     

CONVERTIBLE BONDS: MATCHING FINANCIAL AND REAL OPTIONS

For companies whose value consists in large part of “real options”‐ growth opportunities that may (or may not) materialize‐convertible bonds may offer the ideal financing vehicle because of the matching financial options built into the securities. This paper proposes that convertible debt can be a key element in a financing strategy that aims not only to fund current activities, but to give companies access to low‐cost capital if and when their real investment options turn out to be valuable. In this sense, convertibles can be seen as the most cost‐effective solution to a sequential financing problem‐how to fund not only today's activities, but also tomorrow's growth opportunities (some of them not yet even foreseeable). For companies with real options, the ability of convertibles to match capital inflows with corporate outlays adds value by minimizing two sets of costs: those associated with having too much (particularly equity) capital (known as “agency costs of free cash flow”) and those associated with having too little (“new issue” costs). The key to the cost‐effectiveness of convertibles in funding real options is the call provision. Provided the stock price is “in the money” (and the call protection period is over), the call gives managers the option to force conversion of the bonds into equity. If and when the company's investment opportunity materializes, exercise of the call feature gives the firm an infusion of new equity (while eliminating the debt service burden associated with the convertible) that enables it to carry out its new investment plan. Consistent with this argument, the author's recent study of the investment and financing activities of 289 companies around the time of convertible calls reports significant increases in capital expenditures starting in the year of the call and extending three years after. The companies also showed increased financing activity following the call, mainly new long‐term debt issues (many of them also convertibles) in the year of the call.