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The Economic Implications of Corporate Financial Reporting

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Title: Payout Policy in the 21st Century Author: Campbell Harvey Last modified by: Campbell Harvey Created Date: 12/6/2000 6:51:57 PM Document presentation format – PowerPoint PPT presentation

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Title: The Economic Implications of Corporate Financial Reporting


1
The Economic Implications of Corporate Financial
Reporting
September 28, 2004 University of Chicago
  • John R. Graham
  • Duke University, Durham, NC USA
  • Campbell R. Harvey
  • Duke University, Durham, NC USA
  • National Bureau of Economic Research, Cambridge,
    MA USA
  • Shiva Rajgopal
  • University of Washington, Seattle, WA USA

2
Graham/Harvey/Rajgopal Corporate Reporting
Background
  • In 1995, Duke and Financial Executives
    International make a deal to conduct a quarterly
    CFO survey
  • The deal allows for some special academic
    surveys outside of the quarterly survey that
    would use the FEI e-mail list

3
Graham/Harvey/Rajgopal Corporate Reporting
Background
  • 1. Graham and Harvey conduct a survey on capital
    structure and project evaluation
  • Theory and Practice of Corporate Finance
    Evidence from the Field appears in JFE 2001
  • 2. Brav, Graham, Harvey Michaely survey on
    dividend and repurchase policy
  • Payout Policy in the 21st Century forthcoming
    in JFE 2004
  • 3. Graham, Harvey and Rajgopal survey on
    corporate financial reporting

4
Graham/Harvey/Rajgopal Corporate Reporting
Methodology
  • General goals our research program
  • To examine assumptions
  • To learn what people say they believe
  • To provide a complement to the usual research
    methods archival empirical work and theory

5
Graham/Harvey/Rajgopal Corporate Reporting
Methodology
  • Approach contrasts with Friedmans (1953) The
    Methodogy of Positive Economics
  • Goals of positive science are predictive
  • Dont reject theory based on unrealistic
    assumptions
  • Also, rejects notion that all the predictions of
    a theory matter to its validity goal is narrow
    predictive success

6
Graham/Harvey/Rajgopal Corporate Reporting
Methodology
  • Alternative view, Daniel Hausman (1992)
  • No good way to know what to try when a
    prediction fails or whether to employ a theory in
    a new application without judging its
    assumptions.

7
Graham/Harvey/Rajgopal Corporate Reporting
Narrow goals
  • Insight on following issues
  • Importance of reported earnings and earnings
    benchmarks
  • Are earnings managed? How? Why?
  • Real versus accounting earnings management
  • Does missing consensus indicate deeper problems?
  • Consequences of missing earnings targets
  • Importance of earnings paths
  • Why make voluntary disclosures?

8
Graham/Harvey/Rajgopal Corporate Reporting
Strengths and limitations
  • Strengths
  • Surveys enable us to ask decision-makers specific
    qualitative questions about motivations
  • Less of a variable specification problem
  • Complements large sample analyses
  • A unique angle to confront theories with data
  • Limitations
  • Questions may be misunderstood
  • Truthful responses?
  • Non-response bias
  • Friedman (1953)

9
Graham/Harvey/Rajgopal Corporate Reporting
Comparison to archival empirical work
  • Limitations to existing research include
  • Earnings management and voluntary disclosure hard
    to measure
  • Rank ordering among various motivations difficult
  • Variable with least measurement error may
    dominate
  • Same r.h.s. variables can proxy for different
    economic motivations (e.g., size)
  • Often a narrow focus on one motivation

10
Graham/Harvey/Rajgopal Corporate Reporting
Method
  • Survey and Interview Design
  • Draft survey instrument refereed by both
    finance and accounting researchers as well as
    experts in survey design
  • Interviewed structured to adhere to best
    scientific practices of interviews, e.g. Sudman
    and Bradburn (1983)
  • IRB certification for human subject research

11
Graham/Harvey/Rajgopal Corporate Reporting
Sample
  • 401 usable survey responses
  • response rate of 10.4
  • 25 response rate at a practitioner conference
  • 8 response rate to Internet survey
  • Interview 20 CFOs
  • 40-90 minutes in length
  • More give and take than in the survey
  • Interviewed firms are much larger, more levered
    and more profitable than the average Compustat
    firm.
  • Relative to Compustat firms
  • Surveyed firms are larger, more levered, greater
    dividend-yield, fewer firms report negative
    earnings
  • Similar B/M and positive P/E

12
Graham/Harvey/Rajgopal Corporate Reporting
Sample
  • Firm characteristics (self reported)
  • Agency
  • CEO age, tenure, education
  • Inside ownership
  • Size
  • Revenues
  • Number of employees
  • Growth opportunities
  • P/E
  • Growth in earnings

13
Graham/Harvey/Rajgopal Corporate Reporting
Sample
  • Firm characteristics (self reported)
  • Free cash flow effects
  • Profitability
  • Leverage
  • Informational effects
  • Public/private
  • Which stock exchange
  • Industry
  • Credit rating

14
Graham/Harvey/Rajgopal Corporate Reporting
Sample
  • Firm characteristics (self reported)
  • Financial reporting practices
  • Number of analysts
  • Do they give guidance?
  • Ticker symbol!
  • Demographic correlations in Table 1
  • Note positive relation between whether you give
    guidance and number of analysts (Lang and
    Lundholm TAR 1996)

15
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
16
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
17
Graham/Harvey/Rajgopal Corporate Reporting
Motivation
DeGeorge, Patel, Zeckhauser, JB 1999
18
Graham/Harvey/Rajgopal Corporate Reporting
Earnings benchmarks
Responses to the question How important are
following earnings benchmarks? based on a
survey of 401 financial executives.
19
Graham/Harvey/Rajgopal Corporate Reporting
Earnings benchmarks
  • Conditional Consensus is relatively more
    important for
  • Firms with more analysts
  • Firms that give guidance
  • Large firms
  • More levered firms
  • Table 3

20
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
21
Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
Responses to the statement Meeting earnings
benchmarks helps based on a survey of 401
financial executives.
22
Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
  • Stock price motivation
  • 86 of CFOs say builds credibility
  • 80 maintain or increase stock price

23
Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
  • Stakeholder motivations
  • Firms enhance reputation with stakeholders, such
    as customers, suppliers, creditors
  • Conditional analysis shows this is important for
    small, tech, inside dominated, young and not
    profitable

24
Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
  • Employee bonus
  • Survey evidence not significant
  • Interviews suggest that internal targets more
    important for managers (stretch and budget
    greater than consensus)

25
Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
  • Career concerns
  • External reputation very important
  • This motivation was prominent in interviews.
    Executive labor market important. Failure to
    deliver on targets inhibits intra-industry
    mobility.

26
Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks
Responses to the statement Failing to meet
benchmarks based on a survey of 401 financial
executives.
27
Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks
  • Uncertainty
  • Uncertainty about future prospects is thought to
    be priced

28
Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks
  • Cockroach problem
  • You have to start with the premise that everyone
    manages earnings
  • If you cant come up with a few cents, there must
    be some previously unknown serious problems at
    the firm
  • If you see one cockroach, you immediately assume
    there are hundreds behind the walls, even though
    you have no proof that this is the case

29
Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks
  • Mitigation of negative reaction
  • Explain miss is due to specific accounting
    accrual
  • Miss quarterly but confirm annual guidance
  • Nonfinancial indicators suggest good future
    performance
  • Other factors
  • Conference call becomes negative investors
    become defensive

30
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
31
Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
Near the end of the quarter, it looks like your
company might come in below the desired earnings
target. Within what is permitted by GAAP, which
of the following choices might your company make?
32
Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
  • Real versus accounting actions
  • 80 would reduce discretionary spending, RD,
    maintenance, advertising
  • 55.3 would delay starting a new project even if
    it entailed a small sacrifice in value
  • Not as much support for accounting actions

33
Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
  • Real versus accounting actions
  • Little research on real actions
  • Dechow and Sloan (JAE 1991) Bartov (TAR 1993)
    Bushee (TAR 1998), RD or asset sales
  • Roychowdhury (WP 2003) over produce and sales
    discounts to meet targets

34
Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
  • Real versus accounting actions
  • Significantly more likely to say they are taking
    real rather than accounting actions
  • In contrast, most of the work on earnings
    management has focused on accruals

35
Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
  • Why real versus accounting actions?
  • Aftermath of Enron-Worldcom along with S-Ox
  • Any hint of accounting questions could have
    devastating effect on stock prices
  • More willing to admit to real actions
  • Auditors cant second guess real actions

36
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Hypothetical scenario Your companys cost of
capital is 12. Near the end of the quarter, a
new opportunity arises that offers a 16 internal
rate of return and the same risk as the firm. The
analyst consensus EPS estimate is 1.90. What is
the probability that your company will pursue
this project in each of the following scenarios?
Actual EPS if you do not pursue the project Actual EPS if you pursue the project The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row)
0 20 40 60 80 100
2.00 1.90
1.90 1.80
1.80 1.70
1.40 1.30
37
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Probability of accepting project
38
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Only 45 would take the project for sure even
if they are projected to meet consensus
Table 7
39
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
  • Reminiscent of Brav, Graham, Harvey and Michaely
  • Sacrifice positive NPV projects before cutting
    dividends

40
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Repurchases Dividends
41
Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks
  • Interviews
  • 18/20 interview mentioned trade off of short-run
    earnings and long-term optimal decisions
  • Investment banks offer products that create
    accounting income with negative cash flow
    consequences

42
Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks
  • Guidance
  • Goal of guidance is to meet or exceed consensus
    every quarter
  • Analysts complicit in game of always meeting or
    exceeding
  • Large positive surprises lead to ratchet-up
    effect
  • Asymmetric

43
Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks
  • Break out of the game
  • Why not declare that you will not play the
    earnings management game?

44
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
45
Graham/Harvey/Rajgopal Corporate Reporting
Smoothing
96.9 and 20/20 interviews prefer smooth
earnings over more volatile holding cash flows
constant
46
Graham/Harvey/Rajgopal Corporate Reporting
Smoothing
Responses to the question Do the following
factors contribute to your company preferring a
smooth earnings path?
47
Graham/Harvey/Rajgopal Corporate Reporting
Smoothing
  • Reasons
  • Lowers risk increased predictability lower
    risk premium
  • Clear from survey and interviews that CFOs
    believe that this risk is priced
  • Possible link to literature on estimation error,
    disagreement in asset pricing, information risk
    premium, and behavioral literature on risk versus
    uncertainty

48
Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing value for smoothing
Responses to the question How large a sacrifice
in value would your firm make to avoid a bumpy
earnings path?
49
Graham/Harvey/Rajgopal Corporate Reporting
Other insights on smoothing
  • Interviews
  • Volatile earnings will create trading incentives
    for speculators, hedge funds and legal vultures
  • Volatile earnings mean that you will have a
    number of misses which CFOs want to avoid
  • Smoothing example

50
Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor
Responses to the statement Rank the two most
important groups in terms of setting the stock
price for your company
51
Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor
  • Price setters
  • Institutional investors
  • Analysts have important short-term impact
  • Retail investors important because they are
    potential customers and are less likely to flip
    stock

52
Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor
  • Critique of analysts, institutions
  • Young, do not have sense of history
  • Contagion bandwagon effect important given
    relative performance measurement
  • Quantitative hedge funds issue sell signal if you
    miss irrespective of fundamental information
  • CFOs believe idiosyncratic risk is priced

53
Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
54
Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure
  • Types
  • Conference calls, meetings, press releases, and
    disclosure of more than mandated information in
    regulatory filings
  • Healy and Palepu (2001) say that motivations for
    voluntary disclosure important unresolved
    question for future research

55
Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure
  • Drivers
  • Information asymmetry
  • Increased analyst coverage
  • Corporate control contest
  • Stock compensation
  • Management talent
  • Limitations of mandatory disclosure

56
Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure
  • Contraints
  • Litigation risk
  • Proprietary costs
  • Political costs
  • Agency costs
  • Setting a precedent that may be hard to maintain

57
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
Survey responses to the question Do these
statements describe your company's motives for
voluntarily communicating financial information?
58
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Information asymmetry Information risk
  • Diamond Verrecchia (1991) voluntary disclosure
    reduces asymmetry between informed and
    uninformed, increases liquidity.
  • 81.9 agree only 4.3 disagree
  • Related 56.2 agree that predictability of
    companys future prospects is enhanced

59
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Information asymmetry Information risk
  • Interviews distinguish between information risk
    and inherent risk
  • Believe that both command a risk premium
  • Releasing bad news quickly can be beneficial in
    reducing information risk

60
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Information asymmetry Reputation
  • 92.1 agree with reputational benefit for
    transparent reporting (scores the highest)
  • Interviews
  • Correct investors misperceptions
  • Create an environment of trust so strategic
    actions more easily taken in the future
  • Trust may be important in gaining access to
    future capital

61
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Information asymmetry Cost of capital
  • While only 39.3 point to cost of capital, the
    information risk is linked to cost of capital
  • P/E lift 42 might be similar to the cost of
    capital
  • Interviews
  • A number mentioned reducing analysts
    disagreement and linked that to cost of capital

62
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Information asymmetry Liquidity
  • Motivation especially for small firms

63
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Increased analyst coverage
  • Bhushan (1989a,b) and Lang and Lundholm (1996)
  • 50.8 agree
  • More agreement with small and insider dominated
    firms

64
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Stock price motivation
  • 48.4 use disclosure to try to correct
    undervalued stock

65
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Stock compensation
  • Managers want to reduce contracting costs with
    employees where there is information asymmetry,
    otherwise employees will demand a risk premium
  • No support, half disagree

66
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Management talent signaling
  • Trueman (1986)
  • More support for small firms plus other questions
    suggest that this is important

67
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
  • Limitations of mandatory disclosures (new)
  • 72.1 say that voluntary corrects gaps in
    mandatory
  • Interviews
  • Some mandatory confuse rather than enlighten
  • Some of our own footnotes related to off-balance
    sheet items and securitizations are so complex,
    even I dont understand them.
  • Quarterly mandatory disclosures lack timeliness
  • Mandatory ignores intangibles

68
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
Survey responses to the question Limiting voluntary communication of financial information helps
69
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
  • Precedent (new)
  • The most popular response with 69.6 agreeing
  • Most important for insider dominated firms
  • Start a practice that you might want to abandon
    later

70
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
  • Litigation costs
  • Threat of litigation makes managers disclose bad
    news quickly
  • 46.4 agree especially important for young and
    tech

71
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
  • Proprietary costs
  • Might jeopardize firms competitive position
  • 58.8 agree
  • More agreement with small firms and those with
    few analysts

72
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
  • Agency costs
  • We know that career concerns and external
    reputation important for meeting benchmarks
  • Information may be limited to reduce the chance
    of undue focus by stakeholders
  • Not much support for this agency cost angle

73
Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
  • Political costs
  • Disclosure may be limited to avoid unwanted
    attention of regulators
  • No support on average but this question, in
    particular, is difficult to interpret

74
Graham/Harvey/Rajgopal Corporate Reporting
Good news versus bad news
Survey responses to the question Based on your
company's experience, is good news or bad news
released to the public faster?
75
Graham/Harvey/Rajgopal Corporate Reporting
Good news versus bad news
Survey responses to the question Do the
following statements describe your company's
motives related to the timing of voluntary
disclosures?
76
Graham/Harvey/Rajgopal Corporate Reporting
Conclusions
  • Consensus earnings factors into decisions
  • Strong desire to meet benchmarks cockroach
    problem
  • It is routine to sacrifice long-term value to
    meet these benchmarks
  • Meeting benchmarks is important both for the
    firms stock price and managers reputation and
    mobility
  • Agents optimizing over short-term horizon

77
Graham/Harvey/Rajgopal Corporate Reporting
Conclusions
  • Having predictable smooth earnings is thought to
    both reduce the cost of capital and enhance
    manager reputation
  • Voluntary disclosure is an important tool in
    managers arsenal
  • Disclosure can potentially reduce information
    risk and enhance a managers reputation

78
Graham/Harvey/Rajgopal Corporate Reporting
Future research
  • Last survey instrument!
  • We are thinking of administering the identical
    survey before it is published to non-management
    members of Boards of Directors.
  • Also
  • Detection of Financial Earnings Management
  • Detection of Real Earnings Management
  • We have the tickers for 107 firms many of which
    admit to both financial and real earnings
    management

79
Payout Policy in the 21st Century
Alon Brav Duke University, Durham, NC USA John
R. Graham Duke University, Durham, NC
USA Campbell R. Harvey Duke University, Durham,
NC USA National Bureau of Economic Research,
Cambridge, MA USA Roni Michaely Cornell
University, Ithaca, NY USA IDC, Israel
80
Brav/Graham/Harvey/Michaely Payout Policy
Introduction
  • In 1956, John Lintner laid the foundation for the
    modern understanding of dividend policy
  • He conducted detailed interviews with 28
    companies
  • His research helped set the agenda for
    theoretical and empirical research on dividend
    policy
  • Much has changed in the last 50 years.
  • Possibly different payout policy goals
  • Repurchases
  • More insights from theory that may help direct
    the spotlight in the right direction
  • We revisit this path-breaking study at the
    beginning of the 21st century

81
Brav/Graham/Harvey/Michaely Payout Policy
Introduction
  • We survey 384 financial executives with an
    instrument that focuses on both dividends and
    repurchases
  • 256 public, 128 private
  • Most presented results are based on the public
    firms
  • We conduct one-on-one interviews with 23 CFOs or
    Treasurers of prominent corporations
  • Interviews last between 40 minutes and two hours

82
Brav/Graham/Harvey/Michaely Payout Policy
Methodology
  • Survey and Interview Design
  • Draft survey instrument refereed by both
    finance researchers and experts in survey design
  • Interviewed structured to adhere to best
    scientific practices of interviews, e.g. Sudman
    and Bradburn (1983)

83
Brav/Graham/Harvey/Michaely Payout Policy
Methodology
  • Survey Delivery
  • Survey CFOs, Treasurers, Finance VPs
  • Primarily members of Financial Executives
    International
  • Two 500 random winners
  • Three surveys
  • FEI CFO Forum (April 23, 2002, Co. Springs CO)
  • Dave Ikenberry NFCF (May 1, 2002, Houston TX)
  • Mass emailing to 2200 FEI members
  • Overall 16 response rate

84
Brav/Graham/Harvey/Michaely Payout Policy How
are payout decisions made?
  • Goals of Treasury department
  • Fund investment
  • MM
  • Liquidity and possible contingencies
  • Payout decisions are second-order
  • Except...
  • DO NOT CUT DIVIDENDS ranks equal to or above all
    of these items

85
Brav/Graham/Harvey/Michaely Payout Policy
Payout vs. Investment Decisions
Repurchases Dividends
86
Brav/Graham/Harvey/Michaely Payout Policy
Dividends vs. Repurchases (Fig. 2)
87
Brav/Graham/Harvey/Michaely Payout Policy
Complements or Substitutes?
  • Level of dividend fixed
  • Substitute repurchases for change in dividends
  • One way substitution
  • Would use even more repurchases if they were free
    of constraint of dividend history

88
Brav/Graham/Harvey/Michaely Payout Policy
Lintner (1956)
  • Three main points
  • Target payout ratio (dividend/earnings)
  • Dividend policy set conservatively
  • partial adjustment to target payout
  • smooth through time
  • sticky (history important)
  • Level given, focus on changes
  • tied to long-run sustainable earnings
  • do not increase now if you might have to cut
    later
  • No repurchases

89
Brav/Graham/Harvey/Michaely Payout Policy
Compare to Lintner (1956)
  • Dividend policy still conservative?
  • Yes
  • Perceived big penalty for cut, small reward for
    increase
  • So, smooth, to avoid future cuts
  • Path dependence of dividend policy
  • BUT
  • stealth dividend cut if possible
  • holding dividend constant OK

90
Brav/Graham/Harvey/Michaely Payout Policy
Payout Decisions Still Made Conservatively? vs.
Lintner (1956)
Repurchases No, flexible Dividends Yes, still
conservative
91
Brav/Graham/Harvey/Michaely Payout Policy
Conservatively increase payout? Similar to
Lintner (1956)?
Repurchases Dividends
92
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
93
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
94
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
  • Extension of Fama-Babiak (1968), Choe (1990)
  • The SOA and TP .
  • Both SOA and TP have declined through time using
    both matching sample to our survey and broader
    Compustat sample

95
Brav/Graham/Harvey/Michaely Payout Policy
Summary vs. Lintner (1956)
  • Dividend policy still very conservative
  • Modern cash cows live in (close to) Lintner world
  • Repurchase policy is not (i.e., it is more
    flexible)
  • Payout ratio no longer target
  • Targets very flexible
  • Repurchases now very important

96
Brav/Graham/Harvey/Michaely Payout Policy
Miller and Modigliani (1961)
  • Payout Policy irrelevant if capital markets
    perfect
  • Imperfections that could explain payout policy
  • Taxes
  • Managerial agency conflict
  • Information/signaling
  • Other factors (EPS, float, credit ratings, etc)
  • Clienteles could result from imperfections

97
Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes
  • Theory At least for individual investors,
    dividends are taxed move heavily than capital
    gains.
  • Therefore
  • Firms should consider investors taxation when
    deciding about payout policy
  • Relative taxation should affect the amount of
    dividends they pay

98
Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes
  • Interviews repurchases are efficient way to
    return capital
  • taxes (2nd order) important
  • Surveys modest support

Repurchases Dividends
99
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles
  • Investors that pay (relatively) more taxes on
    dividends should hold stocks that pay out through
    repurchases.
  • Translation Individual investors should have an
    aversion to dividend paying stocks. By
    implications, institutions should be more
    attracted to such stocks.
  • Prudent man
  • Institutions as monitors

100
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles
  • Retail investors
  • Prefer dividends, in spite of tax disadvantage
  • Firms like because loyal
  • Institutions
  • If anything, prefer repurchases
  • Some can not invest in zero dividend stocks
  • 42 say pay dividends because of prudent man
    rules
  • Tax advantage not an issue to institutions
  • Firms like because they have the money

101
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles
  • Companies do not think that dividends attract
    institutions more so than do repurchases
  • Companies do not use dividends or repurchases
    attract institutions to monitor
  • Inconsistent with Allen, Bernardo, and Welch
    (2000) idea that firms use dividends to attract
    institutional investors

Repurchases Dividends
102
Brav/Graham/Harvey/Michaely Payout Policy C.
Agency Stories
  • Firms pay dividends to impose discipline on
    managers

103
Brav/Graham/Harvey/Michaely Payout Policy C
Free Cash Flow
  • Interviews some say money can burn hole in
    pocket
  • But payout not the way to fix the problem
  • Surveys (1) no support in general, (2)
    repurchases work as well as dividends but (3)
    Cash cows are much more likely to pay more
    reluctant to cut more likely to keep dividend
    growth as earnings growth

Repurchases Dividends
104
Brav/Graham/Harvey/Michaely Payout Policy D.
Asymmetric Information
  • Conveying information
  • Costly self-imposed actionSignaling
  • Adverse selection
  • Do informed investors benefit from repurchase
    programs, at expense of uninformed?
  • Stock undervaluation

105
Brav/Graham/Harvey/Michaely Payout Policy D
Do payout decisions convey information?
  • Interviews Yes, punctuation mark at end of
    sentence
  • Need to be consistent with other forms of
    communication
  • Repurchases convey as much as dividends
  • Surveys Yes, convey info in general

Repurchases Dividends
106
Brav/Graham/Harvey/Michaely Payout Policy
Information Signaling
Repurchases Dividends
107
Brav/Graham/Harvey/Michaely Payout Policy D.
Information Signaling
  • Surveys
  • No supporting evidence
  • Scores are even lower for growth/risky firms
  • 39 (16) say keep div (repurchase) policy of
    peers
  • Interviews
  • Spent hours on this issue
  • Generally try to group selves with peers (not
    separate)
  • No evidence of
  • increasing dividend to show market that firm is
    strong
  • viewing dividend as self-imposed cost
  • Avoiding dividend cut
  • Possibly a signal (costly for bad firms, separate
    from bad)
  • Cuts are rare cant explain dividend policy for
    most firms
  • Does not explain why firms pay dividends in the
    first place

108
Brav/Graham/Harvey/Michaely Payout Policy D.
Information Stock Price
  • Interviews Would like to buy when price low, but
  • often want to maintain liquidity at this time
  • do not want credit rating downgrade
  • So, its a conditional objective
  • Surveys repurchases, stock good investment

Repurchases Dividends
109
Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors EPS
  • Interviews managers are concerned about EPS
  • Some think its automatic that repurchases
    increase EPS
  • Other believe that it depends on alternative use
    of funds
  • Surveys EPS important

Repurchase questions
110
Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors Float and credit ratings
  • Interviews Float very important
  • Execs think they need to have a large number of
    shareholders
  • Interviews credit rating important
  • Hoard cash to improve rating
  • Especially for financial firms or firms with
    financial divisions

Repurchases Dividends
111
Brav/Graham/Harvey/Michaely Payout Policy
Initiate with repurchases or dividends?
112
Brav/Graham/Harvey/Michaely Payout Policy Why
initiate payout?
Repurchases Dividends
113
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions
  • Payout policy is not first-order important (MM)
  • Repurchases decided de novo
  • Dividends level very important
  • Managers prefer repurchases over dividends
    because they are more flexible.
  • Not because of taxes.

114
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions
  • According to managers, payout
  • convey information
  • NOT being used as a costly signal
  • NOT being used to attract institutions
  • Managers do not use dividends over repurchases to
    attract institutions
  • Institutions do not push for more dividends

115
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions
  • Managers of cash cows believe more strongly that
  • Dividends should be stable
  • Keeping dividend growth rate with earnings growth
  • But all managers reject the notion that they need
    dividends so that they will not spend cash
    unwisely.

116










Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game How payout policies are determined

  • Make investment plans first
  • Take care of cash/liquidity needs
  • BUT, remember, level of dividends fixed
  • Only reduce dividends in extraordinary
    circumstances
  • Severe penalty for cutting dividend because the
    market believes that cuts precede bad news
  • So, dont ever cut dividends
  • unless you have an amazing investment opportunity
  • smaller penalty if competitors cut
  • Think very carefully before initiating dividends





















117










Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game

  • Desire to maintain the level of dividend at any
    cost consistent with findings in Graham, Harvey
    and Rajgopal, 2004, The Economic Implications
    of Corporate Financial Reporting
  • Here managers desire to hit consensus EPS at any
    cost
  • 55 would knowingly sacrifice value (not pursue a
    very positive NPV project) if it would cause the
    firm to miss next quarters target!
  • 78 would knowingly sacrifice value to smooth
    earnings




















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