The Persistence and Pricing of the Cash Component of Earnings

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments.     

The Volatility of Return Revisions and Financial Statement Literacy in Emerging Markets: The Case of Cross‐listed Chinese Firms

Are foreign investors in emerging markets more financial statement literate than domestic investors? If so, this conjecture implies that foreign (domestic) investors are more likely to revise their return expectations to cash flow (discount rate) news. It also implies that cash flow news and discount rate news are likely to be uncorrelated when evaluating return revisions by domestic investors, whereas cash flow news and discount rate news are likely to be negatively correlated when evaluating return revisions by foreign investors. The Chinese equity markets yield robust empirical results that are consistent with both hypotheses.     

Wealth transfer through private placements: Evidence from China

We examine private issuance of public equity (PIPE) in China, and our results suggest that PIPE investors benefit from the price manipulation before and after issuance. These investors tend to cash out after lockup expiration and make large profits. We also find evidence that the trading of PIPE investors after lockup expiration is informed. Tests about the abnormal returns in the 3 years after lockup expiration suggest that at least part of the benefits PIPE investors receive come from wealth transfer from outside investors. Overall, PIPE issuers in China seem to use an opaque mechanism to compensate PIPE investors.     

Outside Equity

Equity financing is modeled when cash flows and asset values are not verifiable. Investors have enforceable property rights to the firm's assets, but cannot prevent insiders (managers or entrepreneurs) from capturing cash flow. Insiders must coinvest and pay in each period a dividend sufficient to ensure outside investors' participation for at least one more period. Intervention by the investors must be limited by an agreement with insiders or by costs of collective action. Basic models are extended to show why firms go public and why agency costs necessarily arise when the act of investment is not immediately verifiable.     

Climate risk: The price of drought

We document a significant positive relation between drought risk and the cost of equity capital. Our estimation shows that the cost of equity capital is 92 basis points higher for firms affected by severe drought conditions. We provide evidence that when firms are affected by droughts, firms with higher local institutional holdings exhibit a higher cost of equity capital. This result supports the well-known local bias of institutional investors, and suggests that diversification cannot fully eliminate the loss in wealth caused by droughts. Consistent with theoretical predictions, we find that drought duration and drought intensity further increase a firm's risk premium. However, for firms with diversified cash flows/investments, geographically dispersed business operations, and high cash holdings, the impact of drought on the expected return is significantly lessened. Overall, our findings show that investors require a higher rate of returns on firms affected by droughts and offer implications on how firms can mitigate the impact of droughts on their cost of capital.     

A theory of equity carve-outs and negative stub values under heterogeneous beliefs

We develop a theory of new-project financing and equity carve-outs under heterogeneous beliefs. In our model, an employee of a firm generates an idea for a new project that can be financed either by issuing equity against the cash flows of the entire firm (“integration”), or by undertaking an equity carve-out of the new project alone (“non-integration”). While the patent underlying the new project is owned by the firm, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The firm's choice between integration and non-integration is driven primarily by heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders: if the marginal outsider financing the new project is more optimistic about the prospects of the project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding new-project cash flows than that about assets-in-place cash flows, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the firm's financing choice are the cost of motivating the employee to exert optimal effort, and the potential synergies between the new project and assets in place. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the “negative stub values” documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values.     

Institutional Investment in Listed Private Equity

This paper examines institutional investors’ propensity to invest in a relatively unknown asset class of listed private equity. Based on data provided by LPEQ, Preqin and Scorpio Partnership covering 171 institutional investors in Europe in 2008–2010, we find allocations are primarily a function of size, type, location, decision‐making authority and liquidity preferences. Investment in listed private equity is more commonly made by institutions that are smaller, private (not public) pension institutions, institutions that have a preference for liquidity, quick access, and administrative and cash flow management simplicity, and institutions that are based in the UK, Switzerland, Sweden and the Netherlands. As well, institutions are less likely to invest in listed private equity when investment decision‐making is empowered to an alternative asset class team.     

分析师为什么选择性的发布现金流预测?——基于信息需求理论的实证研究

分析师在对公司发布盈余预测的同时,还对一些公司发布了现金流预测。分析师为什么仅针对某些公司发布现金流预测?其动因何在?本文基于信息需求理论对上述问题进行了研究,研究发现,分析师针对现金流信息需求高的公司发布现金流预测的可能性更大。进一步发现,分析师更可能对非国有控股的公司发布现金流预测。本文首次基于我国独特的制度背景,研究分析师选择性发布现金流预测的动因问题。本文的结论有助于加深对分析师行为的理解,并对投资者决策具有一定的参考价值。     

The adverse selection effect of corporate cash reserve: Evidence from acquisitions solely financed by stock

Corporate cash reserve has an adverse selection effect. Specifically, if investors know a company does not have to issue to invest, an attempt to do so sends a strong signal of overvaluation. This notion has not been explicitly studied in the extant empirical literature, despite its intuitiveness. Using a sample of acquisitions solely financed by stock to exclude the potential complications of free cash flow, I find that announcement returns are lower for a bidder with a higher excess cash reserve. This effect is stronger in hot equity market years or when a bidder's standalone value is more difficult to evaluate. I also find evidence supporting the idea that targets request cash payment to remove “lemon” bidders in normal (non-hot equity market) years, but accept too many stock offers in hot equity market years. After acquisitions, high-excess-cash-reserve bidders operationally outperform low-excess-cash-reserve bidders. Further, they spend more funds on reducing debt but not more on investments, compared with low-excess-cash-reserve bidders. Combined, these results show that cash reserve has information costs. Further, they highlight the importance of the two-sided information asymmetry framework of Rhodes-Kropf and Viswanathan (2004) in describing merger outcomes without resorting to behavioral or agency explanations.     

Does financial reporting regulation influence the value of cash holdings?

We investigate how the value of cash holdings changes following the mandatory adoption of International Financial Reporting Standards (IFRS), which is viewed as an exogenous shock to information asymmetry between firms and outside investors. Using firm-level data from 47 countries, we find that mandatory IFRS adoption has a negative and significant impact on the value of cash holdings. This result suggests that investors reduce their valuation of cash holdings when firms can have access to external financing at a lower cost under IFRS. The negative effect of IFRS is concentrated among financially constrained firms. Furthermore, we show that the effect is more pronounced in countries with strong legal enforcement. Overall, our evidence highlights that financial reporting regulation can have a significant effect on how outside investors value corporate cash holdings across countries.     

More Evidence That Corporate R&D Investment (and Effective Boards) Can Increase Firm Value

The authors find that higher R&D expenditures generally lead to both higher expected future cash flow and a lower cost of equity. In addition, they find that the positive connections between R&D spending and higher expected future cash flow and lower cost of equity are stronger in companies with more effective boards (as indicated by measures of director independence and experience). Such findings should help senior executives overcome any concern that investors may not give full credit to R&D investments because they are fully expensed and lead to lower reported earnings in the short term.     

LEVERAGING THE UNDERINVESTMENT PROBLEM: HOW HIGH DEBT AND MANAGEMENT SHAREHOLDINGS SOLVE THE AGENCY COSTS OF FREE CASH FLOW

It is argued that leveraged buyouts (LBOs) provide managers with a powerful incentive to release excess cash rather than invest in negative net present value projects. This incentive is attributed to the large debt obligations associated with “junk” bond financing and to an increase in the shareholdings of top management. In this paper I explore the conditions under which leverage and management shareholdings complement one another in resolving the agency costs of free cash flow and would therefore optimally be used “together” as in an LBO. Complementarity is shown to obtain under plausible conditions, essentially because increased leverage reduces equityholders' share of investment returns. Increased management shareholdings then leverage this underinvestment effect. My analysis also helps explain why top managers who participate in an LBO receive a highly leveraged equity claim rather than a share of the “strip” that is generally provided to outside investors.     

Canada's Dual Class Shares: Further Evidence on the Market Value of Cash Dividends

The Canada Income Tax Act of 1971 permitted Canadian corporations to create two classes of equity, one paying ordinary cash income and the other paying capital gains income. Cash-paying shares have often sold at a premium. Empirical results indicate that the premium is largely explained by the relative value of the dividends paid and by costs imposed on investors by stock dividend payment and share conversion procedures. Premiums for a few firms also reflect the relative liquidity of the two classes of shares. No evidence exists that investors prefer cash income to equal amounts of capital gains.     

Sources of Corporate Financing and Operating Performance: The effects of strategic ownership and financial restatements

Using a sample from European markets this study documents that changes in external financing, both in the form of equity and debt, can predict future operating performance (profitability and cash flows). In terms of future profitability, increases in equity (debt) financing particularly benefit large-size growth firms (large-size value firms). It is notable that a firm environment of low information quality, indicated by the presence of accounting restatements, intensifies the association between external financing and operating performance, due to the heightened scrutiny investors/lenders apply to firms that have recently restated their financials. In addition, strategic ownership in the firm has no significant effect on the financing – operating profitability association but may amplify the positive effects of equity financing on future operating cash flows. Moreover, financial analysts' forecasts of operating profitability and operating cash flows reflect the impact of external financing changes on future operating performance but exhibit a financing-related systematic inefficiency particularly for firms that have recently announced a material restatement of their prior financial results. Finally, controlling for information contained in analyst forecast surprises, the market is efficient overall and incorporates the effects of equity and debt financing changes into stock prices.     

Optimal Financial Instruments

Debt and equity are developed as optimal financial instruments in a model where cash flows and control rights are allocated to investors endogenously. When investment decisions must be made by a single party, the debtholder's cash flows are fixed in order to provide the equityholder with efficient incentives for investment. Ownership of control may be transferred to the debtholder to attenuate the impact of asymmetric information, concerning the investment opportunity, on the efficiency of the decision making.     

Is Financial Reporting Still Useful? Australian Evidence

There has been recent and growing criticism of the usefulness of financial reporting for investors, particularly the annual financial statements. In response, the IASB is pursuing several projects aimed at improving the relevance of financial information. To inform the IASB’s work, we investigate, using a mixed-method approach, the extent and nature of the use of annual financial statements by equity investors. We examine the relevance of financial reporting for equity valuation in Australia across time. We find that financial reporting (specifically, reported net income, shareholders’ equity, and operating cash flows) remains relevant for investment decisions. We further support this finding with evidence from field interviews that provide insight into how and why financial statements are used by equity investors. The field evidence also demonstrates that no one financial statement dominates in investor decision making. Given the increasing availability of more timely, forward-looking information from alternative sources, we examine the relevance of non-GAAP financial information and other non-financial information for investor decision making. We find that non-GAAP financial information (as proxied by EBIT and EBITDA) is more value relevant than statutory measures. We further find a broad range of non-financial information is utilized by investors in making investment decisions both as a ‘screen’ and for valuation purposes. Our findings inform regulators and other stakeholders as we provide evidence of the continuing relevance of financial statements and the complementary role of non-GAAP financial and other information. Our evidence provides a rebuttal to the recent criticism.     

An Empirical Examination of Cash Flow Measures

In recent years in the United States and Canada, there has been an increasing interest in cash flow reporting and a strengthening belief that information on cash flows is valued in the marketplace. However, little research has been devoted to the issue. Regulatory bodies in the U.S. (Financial Accounting Standards Board) and Canada(Canadian Institute of Chartered Accountants) require that an enterprise should disclose separately cash flows from operating, financing and investing activities in their cash flow statements. The data in the cash flow statements are expected to help investors assess the firm's liquidity, financial flexibility and risk. On the other hand, the British Accounting Standards Committee (ASC) does not require a statement of cash flows. This study employs a cross-sectional equity valuation model to examine the association of cash flows from operating, financing and investing activities with security prices. A sample of 403 U.S. firms is used for the ten-year period of 1976–85. The results of this study indicate that there exists a strong association between the various cash flow components included in the cash flow statements and the market value of the firm.     

Corporate Cash Holdings and Acquisitions

We find that acquirers’ announcement returns decline with their cash holdings, but only when at least part of the payment is in the form of stock. We further find evidence that acquirers that use stock payment are overvalued, especially when they have excess cash that they could have used instead. Collectively, our results suggest that investors interpret announcements of stock acquisitions as a signal that the acquirers’ equity is overvalued and that high cash holdings intensify this signal. However, our results are inconsistent with the common belief that cash holdings induce value‐destroying acquisitions.     

Blockholding and market reactions to equity offerings in China

We examine the impact of blockholding on shareholders' wealth in equity offerings in China. We find that investors generally react negatively to equity-offering announcements by firms with high blockholding. A one-standard-deviation (12%) increase in blockholding leads to a 0.59% reduction in firm valuation over a seven-day window and a 5.50% reduction over a 2-year period surrounding the announcement. Private (non-governmental) blockholding is associated with a more negative valuation effect than governmental blockholding over the long-term event window. The above result holds only for financially constrained firms but not unconstrained firms. Further analysis shows that firms with private blockholding have greater positive cash–cash flow sensitivity than firms with governmental blockholding, and again, the result holds for financial constrained firms only. Collectively, the findings suggest that equity offerings in China signal the issuers' future financial constraints, but the findings do not support the agency hypothesis of state ownership.     

Privatization under incomplete information and bankruptcy risk

We study privatization under moral hazard and adverse selection. We show that if the fraction of efficient investors is either insignificant or productivity differences between efficient and inefficient investors are negligible, the government would offer a pooling contract and sell the same fraction of equity to both types of investors. The lower the productivity difference, the greater the equity stake offered to investors. On the other hand, if the fraction of efficient investors is significant or productivity differentials are large, the optimal policy consists of a dual method of privatization in which it offers two methods of privatization to outside investors. The first method consists of a sale of 100% equity together with a subsidy and charges higher price. Under the second option, the investor pays a smaller price but buys less than 100% equity without any subsidy. Efficient investors opt for the first method while inefficient investors prefer the second. The dual privatization method screens investors and provides them with maximum incentives to invest while minimizing the risk of post-privatization bankruptcy.