RETURN OF CAPITAL: CASH FLOW,WEALTH TRANSFER AND INFORMATION SIGNALLING EFFECTS

This paper examines the price effects of an announcement to distribute cash to shareholders via the return of capital procedure currently applying under Australian company law. The impact of such announcements on the market value of ordinary shares is analysed in terms of three hypothesised effects: the cash flow effect, the wealth transfer effect and the information signalling effect. Using data from 17 companies which announced a return of capital between 1970–1978, and applying the “comparison period” methodology, significant positive returns were observed at the time of the announcement of a return of capital. Possible explanations for this result are considered.     

Entebbe Ltd.: A Tax Case

This case is designed to integrate two major tax issues—wind‐up of a company versus sale of shares—with business valuations. Thus, it is designed to incorporate key tax and finance CPA competency areas. There are two valuations required in this case. One is the valuation of shares; the other is the valuation of an intangible asset (a patent). Students have to recognize that before they can decide whether a wind‐up or sale of shares is preferred, they first need to determine the fair market value (FMV) of the shares. However, to determine the FMV of the shares, the valuation of a patent must be done first, as its value will impact the FMV of the shares. Thus, this case requires students to sequence their analysis. Residency issues (“departure tax”) upon leaving Canada permanently are also indirectly identified in the case.     

The Icahn Manifesto

The title of this opening chapter in the author's new book on activist investors refers to Carl Icahn's solution to the “agency” problem faced by the shareholders of public companies in motivating corporate managers and boards to maximize firm value. During the 1960s and '70s, U.S. public companies tended to be run in ways designed to increase their size while minimizing their financial risk, with heavy emphasis on corporate diversification. Icahn successfully challenged corporate managers throughout the 1970s and 1980s by buying blocks of shares in companies he believed were undervalued and then demanding board seats and other changes in corporate governance and management. This article describes the evolution of Icahn as an investor. Starting by investing in undervalued, closed‐end mutual funds and then shorting shares of the stocks in the underlying portfolio, Icahn was able to get fund managers either to liquidate their funds (giving Icahn an arbitrage profit on his long mutual fund/short underlying stocks position) or take other steps to eliminate the “value gap.” After closing the value gaps within the limited universe of closed‐end mutual funds, Icahn turned his attention to the shares of companies trading for less than his perception of the value of their assets. As the author goes on to point out, the strategy that Icahn used with such powerful effect can be traced to the influence of the great value investor Benjamin Graham. Graham was a forceful advocate for the use of shareholder activism to bring about change in underperforming—and in that sense undervalued—companies. The first edition of Graham's investing classic, Security Analysis, published in 1934, devoted an entire chapter to the relationship between shareholders and management, which Graham described as “one of the strangest phenomena of American finance.”     

Close form pricing formulas for Coupon Cancellable CoCos

Contingent Convertibles (“CoCos”) are contingent capital instruments which convert into shares, or have a principal write down, if a trigger event takes place. CoCos exhibit the undesirable so-called death-spiral effect: by actively hedging the equity risk, investors can (unintentionally) force the conversion by making the share price deteriorate and eventually trigger the conversion.In this paper we introduce and analyse Coupon Cancellable CoCos (“CoCa CoCos”), a new type of CoCo where coupons can be cancelled during the lifetime of the note. We provide closed-form pricing formulas for CoCa CoCos, we study the impact of coupon cancellations in the price of the bond and we show that death-spiral effect is reduced.     

股权分置改革与股票市场价值相关性研究

本文使用剩余收益估值模型估计我国上市公司股票的内在价值,以股票内在价值为基础检验上市公司股权分置改革对股票价格和价值之间相关性的影响。选择已完成股权分置改革的上市公司为样本,研究表明股权分置改革完成后股票价格和价值之间相关性有显著的提高,业绩较差公司股价相对价值偏离程度得到一定程度的修正。股权分置改革在改善股票市场定价机制方面实现了管理层预期的效果。     

Do Investment Banks Have Incentives to Help Clients Make Value‐Creating Acquisitions?

Many have long suspected that investment banks, when advising corporate clients on potential acquisitions, have strong incentives just to “get the deal done” with little if any motive for urging clients to walk away from “bad” deals. The incentive to complete deals comes from compensation arrangements in which the bulk of the bankers' fees depend upon completion of the deals. Several earlier studies have provided support for this suspicion by reporting findings that show banks' market shares of advisory services depending mainly on two variables—their previous market shares and their deal completion rate—with little if any connection to the value created (or destroyed) for their clients' shareholders. In their recently published study, the authors revisit that relationship and reach a number of different conclusions: (1) advisors in acquisitions that create more value for clients are more likely to be chosen for future deals; (2) the changes in bankers' advisory market shares are strongly related to the value created for prior clients; and (3) the changes in banks' market values are positively correlated with the value created for their acquirer clients. In sum, the findings suggest that banks have significant market‐related incentives to advise their clients to pursue value‐creating acquisitions and to avoid deals likely to reduce their market values.     

Synthetic commodity money

The conventional dichotomy of “commodity” and “fiat” base monies overlooks a third possibility that shares some features of each. This third type, which I call “synthetic commodity money,” resembles fiat money in having no nonmonetary value; but it resembles commodity money in being not just contingently but absolutely scarce. I discuss some actual examples of synthetic commodity monies, and then argue that special characteristics of synthetic commodity money are such as might allow such a money, if properly designed, to supply the foundation for a monetary regime that does not require oversight by any monetary authority, yet is able to provide for a high degree of macroeconomic stability.     

The 2007–2009 financial crisis and bank opaqueness

Doubts about the accuracy with which outside investors can assess a banking firm’s value motivate many government interventions in the banking market. Although the available empirical evidence is somewhat mixed, the recent financial crisis has reinforced a common assessment that banks are unusually opaque. This paper examines bank equity’s trading characteristics during “normal” periods and two “crisis” periods between 1993 and 2009. We find only limited (mixed) evidence that banks are unusually opaque during normal periods. However, consistent with theory, crises raise the adverse selection costs of trading bank shares relative to those of nonbank control firms. A bank’s balance sheet composition significantly affects its equity opacity, but we cannot detect specific balance sheet categories that have robust effects.     

Evaluating the impact of market reforms on Value-at-Risk forecasts of Chinese A and B shares

This paper analyses the time-varying conditional correlations between Chinese A and B share returns using the Dynamic Conditional Correlation (DCC) model of Engle [Engle, R.F. (2002), “Dynamic Conditional Correlation: A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models”, Journal of Business and Economic Statistics, 20, 339–350.]. The results show that the conditional correlations increased substantially following the B share market reform, whereby Chinese investors were permitted to purchase B shares. However, this increase in correlations was found to have begun well before the B share market reform. This result has significant implication relating to the structure of the information flow between the markets for the two classes of shares. Value-at-Risk (VaR) threshold forecasts are used to analyse the importance of accommodating dynamic conditional correlations between Chinese A and B shares, and thus reflects the impact of the changes in information flow on the risk evaluation of a diversified portfolio. The competing VaR forecasts are analysed using the Unconditional Coverage, Serial Independence and Conditional Coverage tests of Christoffersen [Christoffersen (1998), “Evaluating Interval Forecasts”, International Economic Review, 39, 841–862], and the Time Until First Failure Test of Kupiec [Kupiec, P.H., (1995), “Techniques for Verifying the Accuracy of Risk Measurements Models”, Journal of Derivatives, 73–84]. The results offer mild support for the DCC model over its constant conditional correlation counterpart.     

Informational Feedback,Adverse Selection,and Optimal Disclosure Policy

Faceless trading in a secondary stock market not only redistributes wealth among investors but also generates information that feeds back to real decisions. Using this observation we re‐evaluate the “leveling‐the‐playing‐field” rationale for disclosure to secondary stock markets. By partially preempting traders' information advantage established from information acquisition, disclosure reduces private incentives to acquire information, resulting in two opposite effects on firm value. On one hand, this narrows the information gap between informed and uninformed traders and improves liquidity of firm shares. On the other hand, this reduces the informational feedback from the stock market to real decisions. This tradeoff determines the optimal disclosure policy. The model explains why firm value can be higher in an environment that simultaneously promotes disclosure and private information production and why growth firms are endogenously more opaque than value firms.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

BEHIND THE CORPORATE HEDGE: INFORMATION AND THE LIMITS OF "SHAREHOLDER WEALTH MAXIMIZATION"

The article begins by setting out three alternative conceptions of the corporate objective function. Relying on this framework, it shows that legal analyses tend to neglect conflicts between the interests of the corporate entity and the interests of shareholders over the amount of corporate risk-taking. Financial analyses tend to ignore both constraints on managerial discretion imposed by law and a fundamental ambiguity the author identifies in the “shareholder wealth maximization” assumption that underlies such analyses. This ambiguity arises in part from market “frictions”–particularly, the investor uncertainty and heightened price volatility that stem from informational “asymmetry.” Such an information gap between management and outside investors (along with market “irrationality”) can cause material disparities between the actual trading price and the intrinsic value (or what the author calls the “blissful price”) of a company's shares. As a consequence, corporate hedging that maximizes actual share values may not maximize intrinsic values (and vice versa), thus giving rise to a managerial dilemma. Previous analyses have also failed to give adequate consideration to the expectations of shareholders. If, for example, the shareholders of a natural resource company are seeking a relatively “pure play” on that resource–in part because they believe the company's management has no comparative advantage in managing price risks–corporate hedging that increases shareholder wealth may re-duceshareholder welfare. In this sense, the usual “shareholder wealth maximization” directive is not only ambiguous, but also incomplete. These problems stem not only from informational asymmetry, but from other institutional realities (such as the “political” taint associated with reported derivative losses of any kind) that raise the information costs of using derivatives. The article concludes with some suggestions for improving disclosure of corporate risk management “philosophy.” Better disclosure may not only help reduce such information costs, but could also encourage corporations to find–and stick to–their derivatives niche.     

IPO Pricing and Share Allocation: The Importance of Being Ignorant

Since an underwriter sets an IPO's offer price without knowing its market value, investors can acquire information about its value and avoid overpriced deals (“lemon‐dodge”). To mitigate this well‐known risk, the bank enters into a repeat game with a coalition of investors who do not lemon‐dodge in exchange for on‐average underpriced shares. We (i) derive and test a quantitative IPO pricing rule (showing that tech IPOs were not excessively underpriced during the boom of the 1990s); and (ii) analyzing a unique multibank data set, find strong support for the conjecture that a bank preferentially allocates shares to its coalition.     

Disclosure “Bunching”

This paper studies managers' preferences among information acquisition and disclosure policies when their firms are required to engage in “real‐time” or “continuous” financial reporting. The paper predicts that for many, but not all, processes describing the distribution of their firms' cash flows, when subject to such reporting requirements, managers will engage in disclosure “bunching,” that is, they will bunch the discretionary component of the information they acquire and disclose into a single point in time rather than spread the acquisition and disclosure of that information over time. We show that managers' preferred bunching period depends on managers' strategy for trading in their firms' shares, managers' risk aversion, the risk premium the capital market attaches to firms' shares, and the size of managers' initial ownership stakes in their firms. We also study and characterize how the equilibrium prices of firms' shares vary over time and also how managers' optimal trading strategies vary with their most preferred “bunching” strategies. Several extensions confirm the robustness of the optimality of disclosure “bunching.”     

Canadian Business Trusts: A New Organizational Structure

The focus of this paper is a subset of income trusts called business trusts, a Canadian financial innovation that has experienced remarkable success in the Canadian market, but not in the U.S. At theendof2005, there were more than 170 business trusts (most of them in Canada, but a handful in the U.S.) with an aggregate market value of over $90 billion. Like income trusts generally, which include REITs and oil & gas trusts, business trusts are designed in large part to avoid taxation at the corporate level by distributing a substantial proportion of a business's operating cash flow. The business trust structure provides investors (called “unit holders”) with what amounts to a combination of subordinated, high‐yield debt and high‐yielding equity. But unlike the subordinated debt in most highly leveraged transactions (HLTs), the “internal” debt in a business trust unit is effectively “stapled” to the equity part of the security. And this kind of “strip financing” (which was a common practice in U.S. LBOs during the‘80s) means that, besides providing stable cash‐generating companies with a tax‐minimizing way of paying out excess cash, the business unit structure also limits the “financial distress costs” associated with HLTs. In the event of financial trouble, the unit holders are likely to be much more cooperative than ordinary subordinated debt holders in restructuring interest payments since the benefits of so doing accrue to the equity portion of their units. The original income trust structure has also been used by a number of U.S.‐based companies that listed their shares on the TSX. But, in the attempt to make the securities suitable for listing on the AM EX, and in response to auditor demands intended to address potential IRS concerns, the instruments were modified in ways that sacrificed one of the important benefits of the original structure. The changes were designed to make the subordinated debt issued as part of a package with equity look more like external, third‐party debt. And in so doing, the low‐cost restructuring feature built into the Canadian version was lost, and the U.S. trusts failed to gain acceptance.     

Save the Buyback,Save Jobs

In response to a recent New York Times op‐ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job‐creating investments. But as the authors argue, well‐run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long‐run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs. But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors' firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013‐2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management's effectiveness in “timing” its stock repurchases. Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value‐adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.     

Accounting For Conversion Of Convertibles

Accounting policy-makers continue to confront problems that arise from ambiguities in the value of some types of transaction. For example, AAS21 was put in place partially to ensure that assets of a business acquired are accounted for at fair market value, rather than at the values recorded in the books of the acquired business. One related question that has not been clarified is the value to be attributed to shares issued as a result of convertible note-holders exercising conversion options. Convertible notes and convertible preference shares feature regularly in the capital structures of Australian firms. This paper discusses the economic nature of the conversion option, outlines alternative ways of accounting for conversion in the context of tax and other economic implications, and reports a brief survey of current practice.     

Financial Distress Costs and Delayed Calls of Convertible Bonds: An Empirical Analysis

Theoretical analysis implies that optimal call policy would be to call the bonds as soon as the conversion value equals the call price. Empirical studies, however, report that firms appear to systematically delay the call and the difference between the conversion value and the call price is large at the time of the call. This study examines convertible bond calls between 1977 and 1993, with a view to explain the large difference between the conversion value and the call-price at the time of the call. A large majority of the firms calling the bonds have cash-flow incentive to call the bonds in that the after-tax interest payments are higher than the dividends on the converted shares. The large difference between the conversion value and the call price is positively related to the risk characteristics of the firm. Evidence seems to support the view that risk aversion and fear of potential financial distress may explain the large difference at the time of call between the conversion value and the call price.     

Trust in a High‐concern Risk Controversy: A Comparison of Three Concepts

A community survey examined factors affecting the trust of four groups involved in a high concern controversy over the risks posed by motor boats to the quality of a municipal water supply. In an effort at conceptual integration the survey results were used to examine the relationships between three concepts of trust. Perceived agreement in values between self and four controversy‐involved groups was found to be the most powerful predictor of trust of all four groups, as expected by the salient value similarity perspective. “Fairness” and “competency,” as expected by the “dimensions” of trust perspective were also found to be significant predictors of trust. However, judgments of “fairness” and “competency” were context specific as indicated by significant correlations with judgments of salient value similarity and self interests. This violates the assumption of universality of the “dimensions” of trust perspective. Judgments of similarity of values between self and the controversy‐involved groups were significantly correlated to self interests. This indicates a conceptual overlap between the salient values similarities perspective and the encapsulated trust perspective.     

Contingent capital with a dual price trigger

This paper evaluates a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure potentially protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation, whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; uniqueness of the share price when contingent capital is outstanding; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present an illustrative pricing example.