University of Groningen Faculty of Economics and Business
Master Thesis: International Financial Management (I.F.M)
The impact of the Sarbanes-Oxley Act on the relationship
between U.S. stock market mispricing and capital
investments
Student Name: Charles- X.P.R.M. Sassen Student ID Number: S1584146
Student email: c.x.p.r.sassen@student.rug.nl Date: Friday, 28 June 2013
Abstract
Theoretically, this paper proclaims that the positive and significant correlation between corporate investment and mispricing is to a great extent due to compensation schemes such as the “target- based corporate budgeting system”. Moreover, this research insinuates that stock market mispricing combined with such remuneration systems separate (rather than unify) the interests of executive managers and shareholders, which generate “agency problems”. I furthermore claim that the implementation, in 2002, of the Sarbanes- Oxley Act (SOX) has improved the corporate governance and consequently has led these managers to alter their initial aggressive investment policy to a more reserved and conservative strategy. The empirical analysis on this paper however, exclusively examines the impact of the SOX on mispricing and capital investments. Using a large sample of U.S. listed companies; the results show a significant and positively relation between corporate investments and three different proxies for mispricing Tobin's Q, Share Issuance (SI) and Discretionary Accruals (DAC). Due to the introduction of the SOX, the investment- mispricing relationship has become less sensitive. Q as well as SI proxy show considerable lower mispricing-investment sensitivity during the Post-SOX period. The DAC variable provided a more rigorous picture, namely it showed a negative correlation. However, the real impact of the SOX on the direct mispricing variables (SI and DAC) and capital investments is ambiguous, since these findings are insignificant, in contrast to Q.
Introduction
Over the past few decades, extensive literature has been dedicated to the correlation between stock market mispricing and corporate investments. In general, prior literature has shown evidence that there is a significant and positive relationship between the abovementioned variables.
In this paper, I theoretically proclaim that the positive and significant correlation between corporate investments and mispricing is to a great extent due to compensation schemes based on the “target- based corporate budgeting system”. Moreover, I state that stock market mispricing combined with such remuneration systems disconnect the interests of managers and shareholders, rather than unifying them. This latter mentioned theory is better known as the “agency theory”. According to the “equity market timing” (EMT) theory, corporate managers have access to relatively cheap external capital as the market overprices firms’ fundamental core assets. Consequently, referring to the “target-based corporate budgeting system” as well as to the “EMT” theory, I suggest that executive officers will take advantage of the relatively cheap access of external capital in order to pursue an aggressive and dynamic investment policy.
Finally, this paper explores whether the introduction and implementation of the Sarbanes-Oxley Act (SOX) in 2002 has improved corporate governance of U.S. listed firms. I believe and suggest that in the Post-SOX period the interest of shareholders and managers are (re)unified, which ultimately results in conservative investment policies pursued by executive officers of U.S. listed companies.
policy ensures that executive managers obtain and receive their desired high-level remunerations.
In this paper, I will use a relatively new theory that links mispricing of company´s equity with the level of corporate investments: the so-called “Equity Market Timing (EMT)” theory. This theory asserts that managers believe they can master the timing of the market. CEOs and CFOs try to “time” the market by issuing (repurchasing) equity when their stock prices are irrationally high (low). Corporate managers will have access to relatively cheap external capital if the market overprices firms’ fundamental core assets. Consequently, executive officers have the opportunity to dedicate the inexpensive external raised funds to corporate investments.
Stock market mispricing creates forces that deviate and drift away the interest of principles (shareholders) and agents (executive managers) rather than unifying them. This conflict of interest between corporate managers and outside equity- and debt-holders is better known as the “agency theory” (Jensen, 2005). Partly due to target-based corporate budgeting systems, which initially should align the principle with the agent, give rise to CEOs and CFOs to behave differently. Namely, executive managers have a radical urge to justifying the overpriced equity as well as to satisfying the high growth expectations that is set by security markets. In order to meet these optimistic future prospects, CEOs and CFOs are prepared and willing to take drastic measures. These actions can vary from the relative innocent “earnings management” strategy (i.e. discretionary accruals) to fraudulent practices (i.e. “cooking” the financial statements). As is shown later in this paper, managers will also pursue an aggressive and dynamic investment policy to mislead the market by continuously showing the appearance of growth and value creation, whilst it remains highly questionable whether it actually does create value.
governance structures that should eventually mitigate managerial agency problem. One of the in total eleven titles of the act is called “Corporate Responsibility”, which assures that CEOs and CFOs are obliged to individually certify in any periodic financial statement the truthfulness and accurateness of these figures.
The act prescribes that under certain conditions of restatement of financials due to material non-compliance, CEOs and CFOs will be required to forfeit certain bonuses and remunerations as a result of misinforming and misleading the security markets. I am particularly interested to investigate whether the SOX improves the corporate governance of overpriced companies, which enhances the market mechanisms and especially the relationships between a company’s management, its board of directors and its shareholders. I claim that after the introduction of the SOX corporate managers stopped pursuing self-enrichment goals (gaining rewards, bonuses and other kind of remunerations), which was at the expense of shareholders. The SOX have led executive managers to alter their initial aggressive investment policy to a more reserved, cautious and conservative investment strategy.
The first part of the empirical section investigates whether stock market mispricing positively and significantly influences corporate investment. The first hypothesis states that companies with overpriced equity have higher corporate investments compared to "normal-priced" corporations. Data from U.S. listed companies during the period 1990 to 2012 clearly indicate and prove that the first hypothesis is accepted. All three different proxies that measure mispricing (Tobin's Q, Share Issuance and Discretionary Accruals) show that investment is significant and positively related.
between stock market mispricing and investments. These results suggest that high discretionary companies did not invest during the Post-SOX period; in fact, such corporations did the opposite. Nevertheless, both direct mispricing proxies (SI and DAC) show ambiguous results, since they are insignificant, suggesting that the second cannot be clearly accepted nor rejected.
Literature Review
Over the past few decades, we have seen a rush of numerous multinational corporations that disproportionately over performed. A short list of these companies includes i.a. Ahold, Enron, Computer Associates, HealthSouth, Global Crossing, Lucent, Nortel, Royal Dutch Shell, Tyco, Vodafone, WorldCom, Xerox and many others. However, the more impressive their rushing march was to the top, so ingloriously did they perish. The majority of these, seemingly financial- healthy, companies deceptively ended up in ruins or teetering on the edge of bankruptcy. We have seen on television or read in newspapers that managers of these initial extraordinary well performing companies eventually have been engaged in criminal activity, and numerous senior executives ended up in jail. Society, but in particular shareholders have suffered from value destruction that amounted to hundreds of billions of euros.
Jensen (2005) argues that the main cause of the abovementioned phenomena was that the multinational companies, such as Ahold, Enron, HealthSouth etc…operated in an economic and financial system that largely malfunctioned. According to his article, one of the fundamental dilemmas is that multinationals use target-based corporate budgeting systems. In this system, an employer will receive bonuses and/ or other kind of compensations, if a predetermined budget or target is reached. Therefore, an employer will not receive a reward for what he actually performs or what his capabilities are, but he will be compensated based on what it accomplishes in comparison to a previously defined target. The target-based corporate budgeting system stimulates people to maximize their proficiency and efficiency, and to reach their (personal) goals and objectives. However, meanwhile the danger of such a system is that one will see it as an obsession to reach their targets. Furthermore, employees will manipulate both the assigning of - and the way by which to meet these formulated objectives. Jensen suitably enunciates this problem as “these counterproductive target-based budget systems and compensation structures provide a fertile foundation for the damaging effects of the earning management game within capital markets”.
or other kind of bonuses. Moreover, the capital market is ruthless and merciless to punish any CEO or CFO if they are not able to meet their targets. Therefore, corporate managers will do whatever is in their power to satisfy and please the market. A well-known and utilized instrument to facilitate CEOs and CFOs to meet their targets is to make use of discretionary accruals, which is a component of earning management strategy. “When managers smooth their earnings to meet market projections, they are not creating value for the firm: they are both lying and making poor decisions that destroy value” (Jensen, 2005). In extreme cases, corporate managers will go beyond their legal limits by cooking financial statements to camouflage the disappointing and undesirable results, which is at the expense of corporate value and is ultimately borne by shareholders.
Bearing the previous mentioned reasoning in mind, Jensen (2005) particularly focuses on what he calls “overvalued” companies, which I later will define as companies that are “overpriced” by the market. Consistent with Jensen’s article, the main problem that corporate managers (of “overvalued” companies) face are high pressures to perform better according to the markets’ expectation. By definition, if stock prices are valued higher than the underlying assets, managers have to perform more efficiently to justify the increased stock price; otherwise, it would not be overvalued. In case of overvaluation, CEOs and CFOs are more tempted and inclined to move away from the traditional value creating methods and utilize earning management practises, if they do not engage themselves into illegal activities. Thus, eventually in the long- run the bubble will burst, as was the case with Enron, HealthSouth, Tyco, WorldCom and so on. According to Jensen’ words he concluded:
“To appear to be satisfying growth expectations, you use your overvalued equity to make long run value destroying acquisitions and real investments; you use your access to cheap debt and equity capital to engage in excessive internal spending and risky negative net present value investments that the market thinks will generate value; and eventually you turn to further accounting manipulation and even fraudulent practices to continue the appearance of growth and value creation.”
“CEOs and CFOs find themselves caught in a vicious bind where excessively high stock valuations releases a set of damaging organizational forces that leads to massive destruction of corporate and social value”, Jensen (2005). Including through target-based corporate budgeting systems executive managers have a radical urge to justifying the overpriced equity and satisfying growth expectations, set by security markets. However, in order to meet these optimistic future prospects, CEOs and CFOs are prepared and willing to take drastic measurements. As already mentioned, these actions can vary between the relative innocent earnings management strategy i.e. discretionary accruals and fraudulent practices i.e. cooking the financial statements. However, as we will see later in this paper, managers will also pursue an aggressive and dynamic investment policy to mislead the market and to continue the appearance of growth and value creation.
Shareholders, on the contrary perceive the highest value when managers invest in long- term projects with positive Net Present Value (henceforth, NPV), which generates and strengthens corporate core value. According to Jensen & Meckling (1973), shareholders established an executive- compensation system, (i.e. target-based corporate budgeting- and equity-based compensation- System), to minimize agency cost. Thus, the authors reasoning that on the one hand, shareholders are in favour to establishing an executive compensation system to reduce and minimize agency cost; whilst on the other hand, these reward instruments set in a motion of uncontrollable organizational forces that destroy core corporate values in the long run.
veracious investment policy, based on its real value. Ultimately, this indicates a significant decline in corporate investments, and thus in a diminution of agency costs.
Despite the fact, that Jensen’s opinion and assertion as mentioned in various articles are highly convincing and are likely to be based on the truth they are suggestive and established through his extensive experience gained throughout the years. Since, I appreciate and share Jensen’ reasoning and hypotheses, I would like to empirically investigate in a quantitative research whether his theories correspond to reality. In this paper, I would like to explore whether managers of “overvalued” firms tend to upsurge their real investments to satisfy and mislead the market expectations. Furthermore, I am keen to explore whether the implementation of federal legislation, such as SOX, reduces agency costs by means of a decrease in real investments.
Since, I want to demonstrate evidence that Jensen’s theories and hypotheses correspond to reality; this paper should be seen as an empirical extension of his work. However, let me be clear: this paper is not meant to be a summary of Jensen’s articles. I will not analyse and clarify symptoms of the malfunctioning financial system, nor will I present possible cures to improve the current security markets. The main purpose of my paper is to empirically test whether Jensen’s overvaluation theory holds in the United States. In other words, I want to explore whether executive managers of overpriced equity firms significantly increase their investments. Furthermore, I would like to investigate whether the agency cost can be reduced of means of a federal law, such as the Sarbanes- Oxley Act introduced in the United States in 2002. By means of this legislation, I expect that investment levels will diminish of overpriced companies. Therefore, this paper can better be considered as an extension of Jensen’s articles, since it represents a quantitative research based on his theory and reasoning.
Overvaluation/ Mispricing
overvalued? What is the benchmark that separates overvalued firms from “correctly-valued” firms? Since, I will not pinpoint a particular event or set another well-defined benchmark, I will henceforth make use of the terminology, “mispricing”. Mispricing is defined as a temporarily deviation of a firm’s market stock price from its true or intrinsic value, which can either be positive or negative. In my research, I will mainly focus on overpricing, meaning that the market value exceeds the fundamental asset value of a company.
1. Investors’ point of view
Without going in too much detail, I briefly want to mention and explain which valuation techniques investors, analysts, executive managers and other key players in the security market use to value stock market prices. In general, there are two different kinds of valuation methods: absolute and relative valuation models. The former is predominantly based on intrinsic values of firms’ fundamentals (dividends, cash flows, growth rates etc.) Most common absolute valuation models are Discounted Cash Flow (DCF) and Dividend Discount Model (DDM). In contrast to absolute valuation model, the relative valuation model is more user-friendly, since it is an straightforward and quick analysis to perform. Moreover, this model is especially used to compare similar and competing companies. Fundamentally, the relative valuation model values companies based on calculating multiples or ratio's (e.g. Price-to-earnings).
2. Executive managers’ point of view
Executive managers, on their turn, anticipate to the estimated stock market prices set by the security market. According, to several previous scholars and empirics, market valuation is one of the main determinants of a firms’ capital structure. In other words, market mispricing influences the source of raising external finance needed and used by companies. Moreover, empirical evidences show that managers will try to take advantage of too-extreme market expectations; the so-called “equity channel” (Graham & Harvey, 2001). However, before further elaborating in detail upon this matter, I succinctly would like to mention several theories that determine managers’ choice of optimal capital structure.
In 1958, Modigliani and Miller (hereafter, M&M) introduced the “capital structure irrelevance principle”, which means that in perfect, efficient and rational markets (i.e. “Efficient Market Theory", Fama, 1965); the capital structure of a company is irrelevant. In other words, the value of a firm is unaffected by how the firm is financed (either by debt or equity), if and only if market imperfections (i.e. taxes, asymmetric information, investors' sentiment bankruptcy-, and agency- cost) do not exist. “Proposition I: “The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate r appropriate to its class”, Modigliani and Miller (1958).
Soon hereafter, proposition II was created by M&M. This model included and allowed several market imperfections as mentioned above, but retained the assumption of market inefficiency and asymmetric information. Several theories were established to explain and determine firms’ financial policies. The well known “Trade-off” and “Pecking Order" theories are, amongst many, the most widely used theories to set firms’ capital structure.
The “Trade-off theory”, initially developed by Kraus & Litzenberger (1973), indicates what the firms’ ideal capital structure is to effectively finance its operations. This theory, mainly prescribes that firms are usually financed partly by equity and partly by debt. It mentions that both financing methods have its advantages and disadvantages, and the Trade-off theory literally and figuratively balances the marginal costs (i.e. bankruptcy cost, financial distress, and agency cost) against the benefits (i.e. debt tax shield and minimizing the free cash flow problem).
information. According to this theory, executive managers dispose of the ultimate and optimal information about: future performance prospects, corporate risks and other fundamental values of a firm compared to shareholders, which eventually generates adverse selection. For example, when managers decide to issue equity instead of riskless debt, investors rationally discount the firms’ stock price. Since, managers try to avoid these unfavourable and undesirable discounts (to raise as much and as cheap capital as possible); corporate executives will therefore prevent to issue equity whenever possible. In other words, when managers want to raise external capital in the form of equity, investors suspect that the firm is overvalued and that managers take advantage of relatively cheap capital. As a result, investors will lower the value of equity issuance. Myer & Majluf (1984) argue that managers have a distinct preference in choosing what kind of source they use to raise capital; namely they prefer using internal funds first, then issuing debt is and finally resorting to equity.
Despite the Trade-off and the Pecking Order theories, recent empirical papers (Marsh (1982); Asquith & Mullins (1986); Mikkelson & Partch (1986); Jung et al., (1996); and Baker & Wurgler (2002)); have investigated and claimed a new theory that states that firms issue equity when their stock prices are high, and repurchase securities when stock prices are low. In this paper, I will use a relatively new approach to determine whether a company should issue or repurchase equity or debt; namely the “Market Timing Hypothesis” or the “Equity Market Timing”, (hereafter EMT) theory.
Baker& Wurgler (2002) have extensively articulated the EMT theory, which falls within the behavioural finance literature. Originally, this theory is derived and deviated from the revolutionary financing model established by Stein (1996). According to Baker & Wurgler (2002), the first order determinant of a company’s capital structure is market timing. In other words, managers are generally indifferent whether they generate external capital through either the equity- or debt channel. Corporate executives choose the source of financing that is at the time of issuance/ repurchasing most valuable to financial markets. The EMT- model of Baker & Wurgler (2002) consists of two different versions. Despite the fact that the approach of the two EMT-versions is similar (i.e. choosing the cheapest source of financing), the outcome may vary due to different assumptions.
Korajczyk, Lucas & McDonald, (1992) and Chloe, Masulis & Nanda, (1993), firms tend to “announce equity issues following releases of information, which may reduce information asymmetry”. From this literature, one may conclude that adverse selection results in market mispricing, whereby the manager has the finest insight of the real and intrinsic value of a firm. This correspondingly implies that the market and shareholders have limited insight and access to fundamental information to percept the true value, in contrast to executive managers.
The assumptions of the second version of EMT theory are perpendicular to the first one, as it namely assumes that managers and shareholders are irrational, consequently perceptions of mispricing are time varying. These assumptions however do not imply that the market is inefficient; it merely describes that managers believe they can master the timing of the market; hence the expression “equity market timing”. With “timing the market”, it is meant that executive managers try to time the market by issuing (repurchasing) equity when their stock prices are irrationally high (low). Corporate managers will have access to relatively cheap external capital, as the market overprices firms’ fundamental core assets. Empirical evidence by La Porta (1996), La Porta et al. (1997), Frankel & Lee (1998), and Schleifer (2000), support this theory, as they state that the market-to-book is inversely related to future equity returns, and is positively related to market expectations. “If managers are trying to exploit extreme expectations, net equity issues will be positively related to market-to-book”. When and investors “truly” value the market, there is no ideal capital structure and managers should not withdraw their issuance or repurchase decision because the cost of equity would be “normally” priced, and there will be neither loss nor profit made.
hence encourage relative cheap investments. Chirinko & Schaller (2001) classify this as “active financing mechanism”. However, according to the “classical theory”, the authors also illustrate a situation where companies do not stimulate investments in case of mispricing. When managers consider and acknowledge that share prices are disproportionately high priced, they will issue new shares. Instead of retaining external raised capital into the firm, the managers will devote the earnings to cash and securities. Chirinko & Schaller (2001) refer this to as “inactive financing mechanism”.
However, the EMT theory has limitations, as it does not technically explain why the market value firms’ fundamental assets differently. On the other hand, the theory does assume and acknowledge that adverse selection exists and it considers the mispricing of fundamental assets as an exogenous factor. Nevertheless, various empirical articles provide evidence that support the EMT theory. Graham & Harvey (2001), for example, established an anonymous survey that indicated that CFOs try to time the equity market. About 68% of the CFOs have admitted that, “the amount by which the stock is under or overvalued was an important component in issuing common stocks, if stock prices rise, the price at we can sell is “high””. Based on the abovementioned evidence, I conclude that mispricing (whether it is due to asymmetric information, market inefficiencies or irrationality of managers/ investors) is the main determinant for Equity Market Timing.
Investments
1. Classical Theory (or Traditional View) vs. Investments
Researchers have long known that stock market prices contain information about real investment. Perhaps the best-known description of that relation encompasses the “traditional view”, which is derived from the Tobin’s Q theory of investment (Tobin, 1969). Tobin’s Q is a ratio between the stock market value of existing capital asset and their replacement value of the same physical asset. This traditional view identifies the influence stock market prices have on investment opportunities. Brainard & Tobin (1968) and Tobin (1969) suggest that the stock prices rationally reflect the marginal product of capital and that a company will invest until Q=1.Thus, most researchers explain investments with Tobin’s Q, under the assumption of efficient capital markets, and where stock market prices fully reflect firms’ fundamental core value. The vast majority of articles based on the traditional view, found a positive cross-sectional relationship between corporate investments and mispricing at time series; implying that firms tend to (over-) invest in case the market overprices firms’ equity.
2. Alternative view vs. Investments
Keynes (1936), the founding father of the “alternative view”, was the first to argue that share prices contain an influential component of irrationality. In other words, the real cost of external financial capital can diverse from the “original” cost of capital. This means that deviations in the stock market prices influence the behaviour of equity issues, and hence corporate investment decisions. Over time, more and more researchers acknowledge that market imperfections do exist and play a vital role in financial markets. Therefore, they dissociate themselves from the “classical theory”.
Stein (1996) was one of the researchers that did not believe in the “classic and perfect world”. He reasoned that stock market prices are not solely a reflection of the shares fundamental risks, but form partially an influence of shareholders’ sentiment (Baker et al., (2003); Gilchrist et al., (2004); Baker & Wurgler, (2006)). Investors that are optimistic about a company’s future cash flow, drive up stock market prices. Furthermore, Stein (1996) assumes that executive managers do not act out of self-interest, but aim to maximize shareholders´ wealth. Consequently, when investors´ optimism increases share prices, managers “cater investors´ sentiment” by pursuing an aggressive and dynamic investment strategy (i.e. upsurge corporate investments). Several empirical papers support this reasoning; and furthermore find significant positive correlation between corporate investment and investors’ sentiment (Goyal & Yamada, (2004); Polk & Sapienza, (2009); Dong et al., (2007)).
2.a Asymmetric Information vs. Investments
This abovementioned theory relates to Jensen’s “magnum opus”: the agency theory (Jensen & Meckling, 1973). In the next section, I will elaborate on this topic in more detail. The agency theory is based on conflict of interest between corporate managers and outside equity- and debt holders. These conflicts are reinforced due to asymmetric information, namely managers have better insight in firms’ financials and growth opportunities than shareholders have. When executive officers decide to augment corporate investments, they send forth a signal to the market that the firm expects to grow and will be increasingly valuable in the near future. Thus, we may conclude that managers have the knowledge and the power to deceive and mislead the market. In such a scenario, deliberately increasing corporate investments by selfish executive managers can be at the expense of outside shareholders.
Polk & Sapienza (2002) believe that we live in a world with “semi-strong market efficiency”, meaning that solely information, which is not publicly available, is able to assist investors seeking to earn abnormal returns. All other kind of information is included in stock market prices, despite the amount of technical and fundamental analysis one carries out (Fama, 1965). Furthermore, Polk & Sapienza (2002) argue that managers operate in irrational stock markets and additionally do not act on behalf of shareholders; however, they make decisions at their own interest. In their article they claim that corporate executives with private information will invest inefficiently, which is subjected to the length of period of asymmetric information. The underlying reasoning comes from Myers & Majluf, (1984), who reason that corporate investments act as a signalling effect to the market. Generally, companies create value if they invest capital into assets, securities or other corporate investments that yield a rate-of-return being higher than its cost of capital. However, since we live in a world with “semi-strong market efficiencies”, investors do not have access to all information in the market (e.g. rates-of-return). Thus, when executive managers determine to enhance its investment levels, it sends forth a signal to the market that the firm expects growth in the future, without knowing the exact rate-of-return. An investor can only assume and trust that an executive manager acts in the interest of the shareholder, which is investing in projects with a rate-of-return higher than the cost of capital.
reason is similar as when management increases investment levels, namely signalling biased and incomplete information to the market. Managers that take advantage of the “equity channel” and overpriced stocks prefer to devote the “cheap equity” to corporate investments or to acquisitions, even though it has negative NPV. This (over)investment- strategy is beneficial for managers since it signals potential growth for a firm, which results in higher stock market value. Corporate executives who are rewarded with shares will see an increase in market value as a convenient and pleasant “incidental” circumstance. Dupable and possibly naïve investors that fully trust perfectly informed managers, expect a company to create value and long-term growth when doing acquisitions.
The second reason is if the acquiring firm is overpriced, it has access to relative cheap external capital to finance the acquisition. According to evidence of Moeller et al., (2005), “firms that make large loss deals are successful with acquisitions until they make their large loss deal”. They conclude (and I agree) that “an important component of the market’s reaction to the acquisition announcement is a reassessment of the standalone value” of the acquirer. In other words, the moment that an acquisition is completed and there is no turning back, executive managers have to disclose all relevant information about closed deal. Under the abovementioned circumstances, the obtained information will obviously be disappointing, since the positive and optimistic signals that were send forth by executives appear to be less beneficial (if not detrimental) for shareholders and other stakeholders.
2.b Short-termism vs. Investments
expense to generating value and growth opportunities on the longer run. Hence, short-termism is the “disease”, and target-based system, market imperfections and earnings (by management) are the carriers of the symptoms of the “disease”. I believe this statement needs further explanation.
Briefly and as mentioned earlier does, the “classical theory” indicate that a company creates added value when it is able to generate earnings to finance assets, which eventually should lead to growth and dividend pay-outs to shareholders. The widely accepted valuation method of financial assets, in well-functioning capital markets is the “Discounted Cash Flow” (henceforth, DCF). In addition, investors and shareholders that would like to accurately forecast and value the sustainability and potential growth of sales and cash flows must incorporate other significant factors, such as industry growth, company’s competitive position, technological change and the quality of management. Yet, investors and shareholders base their share investments on short-term earnings rather on DCF. The main issue is that in order to value a company, investors should value firms’ assets and equity, rather than assess the historical earnings.
Even though the vast majority of investors acknowledge that the DCF-model is the most appropriate analysis and theoretically valid to value financial assets, yet they remain greatly committed to the reported short-term performances. Namely, shareholders and other investors have limited access to valuable information about companies´ operations and its future perspectives. Therefore, the main disadvantage of using the rational DCF-model is that forecasting the long-run cash flow is costly, time-consuming and most of all too speculative for investors. Thus, investors and shareholders prefer to utilize the (irrational) earnings analysis; hence “when the risk in going against the market’s apparent pricing model is greater than the reward, it is best to join the market” (Rappaport, 2010).
performance and earnings. Therefore, managers ensure that the short-term earnings of companies are positive and appealing, regardless the long term consequences.
As companies’ earnings are important and valuable to both investors and corporate executives, it is noteworthy to mention that there are two main drawbacks of using the (irrational) earnings-analysis to forecast future cash flows. Firstly, firms do manage their earnings because they have significant latitude in forecasting the period of time and the various different types of accruals (e.g. accounts payable, account receivable, and personnel pension costs, etc.). In the second place, and maybe more importantly, accruals disclose a relative small portion of the firms’ total cash flow, which investors need to know in order to be able to value the market stock price. Rappaport (2005) formulates this correctly in his article by stating: “Not only do revenue and expense accruals convey information about a relative small fraction of a company’s cash flow, the earnings figure- which combines realized cash flow and uncertain accruals- mask even this limited information”.
The most misleading and deceptive part of this short-termism is that corporate managers have the ability to artificially increase firms’ earnings without adding value. Either through accounting practises, (better known as “earnings management” or “creative accounting”), or through value-destroying investments (negative NPV projects), executives can mask valuable information to the investors. Corporate managers solely create companies’ value if they invest capital into assets, securities or other corporate investments that yield a rate-of-return, which is higher than the cost of capital. Regardless whether managers are engaged with creative accountings and which increases earnings, it is the rate-of-return that is the decisive and eminent factor that determines shareholders´ value.
Target-Based Corporate Budgeting System
would like to address another problem or challenge that relates to this topic, namely the measurement systems to quantity performance. Moreover, I want to focus on the reward as well as penalties to actors in an organisation who meet, exceed or fail to achieve the pre-determined target for which it is held responsible.
Numerous papers have proposed various different frameworks analysing “performance management” and “strategy implementation”, which falls under the umbrella of management control systems. Such systems are structured in relation to key issues such as objectives, target-settings, and incentive & reward structures, (Otley, 1999). The former topic concentrates on the description of objectives and the measurement of goal attainment, referring to both financial as non-financial. The classification of importance attached to various different objectives depends upon the relative control and dominance that stakeholders have in an institution. Without assessing this objective-issue, an organization cannot be evaluated either on its effectiveness or on its performance. The second issue, target-setting, refers to assessing a concrete benchmark in order to compare and measure the performance of an organization and its associated personnel. With reference to a “target-base”, one can objectively judge whether an organization is functioning according to the initial engagement. According to Kenis (1979), such targets should be “tight but attainable”. Hofstede, (1968) and Stedry & Kay, (1966) provided empirical evidence showing that objectives that are set “too tight” or “too challenging”, will have a demotivating effect on the organizations’ functioning. Finally, the incentive & reward structures- issue intends to induce and stimulate employees by suitably rewarding them for meeting or beating their internal targets. On the other hand, members of an organization will be penalised if they fail to attain their (personal) objectives for which they are held responsible.
Recapitulating, I can conclude that budgeting is a tool to help to set targets and mobilize resources referring to both human as well as non- human resources, in order to achieve the pre-specified targets (Garrison & Noreen, 2007). Once the objectives are accomplished, an organization is supposed to run effectively and efficiently. In other words, target-based budget systems can be seen as a performance-measuring tool.
into target-systems. In case workers within a company attain the pre-determined goals, they will be rewarded with bonuses and/ or other kind of compensations. Hence, there is a direct correlation between budgets and rewards.
At first sight, target-based compensation systems stimulate people to maximize their proficiency, efficiency, and to realize their personal goals. Moreover, it seems that such systems are an ideal method to align the interests of shareholder with those of corporate executives. Managers (and other employees) that effectively maximize performance will lead to profit maximization and shareholders’ maximization: in terms of growth, revenues & market shares, ameliorative reputation, and finally long-term competitive forces. In return, corporate executives will sufficiently be rewarded.
Every conceivable system has its advantages, but most certainly also its disadvantages. Hansen, Otley & Van der Stede (2003) summarized several criticisms of budgets and moreover reviewed numerous assumptions underlying the use of budgets identified from academic literature.
According to Hope & Fraser (2003a), it appears that managing and controlling the “complex budget-based contracts” is time-consuming and is therefore a costly process. The authors critically question whether the benefits exceed the costs. “The budget is a vast compendium of complex details… In 1998 a study of global companies showed that on average they invested more than 25,000 person-days per $1 billion of revenue in the planning and performance-measurement processes”.
Referring to previous sections of this paper where in detail “short-termism” is mentioned and discussed, a significant drawback of a target-based compensation system is that one can see reaching their personal targets as an obsession. Executive managers are reproached that they are “empire-builders”, and are cunning to attain status, power and control. The only path that leads to this kind of “success” is to self-transcend and deliver extraordinary performance. Welch, (2005), claims that employees will manipulate both the assigning of - and the way by which to meet these pre-specified objectives. This inevitably leads to “budgetary gaming by subordinates to increase the probability of receiving positive performance evaluations and associated pay increases”, Welch, (2005). These “gaming- activities can vary between relative innocent earnings management strategies i.e. discretionary accruals and fraudulent practises i.e. cooking the financial statements, Thomas (2002) and Karpoff et al., (2008).
Many scholars have successfully considered and examined the target-based budget systems topic. Thomas (2002), Hope & Fraser (2003), Jensen (2005), Welch (2005), and many other have made significant contributions to this discipline. The majority of the academic literature provides a convincing and evident analysis documenting the vulnerabilities of target-based budget systems. Nevertheless, Hansen et al., (2003) provide cogent evidence that the budgeting management process continues to play a key role in firm’s control and measurement systems. The authors conclude their paper with strong conviction “that most U.S. firms have no plan to abandon this management practise, although many are planning to improve their budgeting system to overcome some of the common criticisms.”
The Agency Theory
Almost five decades ago, scholars have observed conflicts that arose between two (or more) individuals, organisations or other cooperating parties that have dissimilar opinions towards risk (Eisenhardt, 1989); this became known as the “risk-sharing” problem. This theory evolved and extended over time and scholars continuously associated this theory with the already existing “agency” problem. The fundamental definition of the latter concept is when cooperating parties have different interests, objectives and divisions of labour (Jensen & Meckling, 1976). Eventually, the outgrowth of these two abovementioned problems became known as the “agency theory”.
that can occur in a relationship between agent and principle. Agency problems arise in twofold situations, firstly (i) the actual conflict of interest between an agent and a principle, and secondly (ii) expenses that are made to verify and monitor what the agent is doing on behalf of the principle. The latter problem contributes to the risk-sharing problem, which arises when the principle and agent have dissimilar opinions and attitudes toward risk. The dilemma here is that the principle and the agent pursue to and strive for different objectives due to differences in risk preferences. Agency costs arise when the interest and risk sharing of an agent collide with those of a principle and vice versa. These clashes can debouch into various different costs, for example: monitoring, contracting, bonding, and residual loss. The agency cost is defined as the sum of all these abovementioned costs.
During the 70’s and 80’s various different scholars have extensively contributed to the development of the agency theory, and applied the concept to several economical and business fields. E.g. accounting (Demski & Feltham, 1978), economics (Spence & Zeckhauser, 1971), finance (Fama, 1980), marketing (Basu, Lal, Srinivasan & Staelin, 1985), ownership and financing structures (Argawal & Mandelker, 1987; Jensen & Meckling, 1976) political science (Mitnick, 1986), organizational behaviour (Eisenhardt, 1985, 1988; Kosnik, 1987), and sociology (Eccles, 1985; White, 1985). However, in this paper I will particularly focus on agency costs that arise in “finance” and “ownership and financing structure”. I will specifically make use of various articles written by Jensen, who has continually developed and adjusted the agency theory as it is today. Therefore, his concept of that theory will be used and seen as the benchmark of this paper.
Various different strategies are applicable for shareholders to monitor agency cost and control related problems to it, which aligns agents’ activities with owners’ preferences. The U.S. Securities and Exchange Commission (SEC) is responsible for implementing federal security laws as well as for regulating the U.S. security industry. The SEC has enforced numerous practises to control executive managers’ behaviour with the intent to enhance shareholders value. “The principal strategies used include: 1) incentive pay, 2) debt financing, 3) equity ownership structure (by CEOs, by large outside block-holders or by institutional investors), 4) dividends, and 5) independent directors on the board”, Kay & Vojtech, (2011).
In this paper, I explicitly look at agency costs that arise in security markets. More specifically, will I focus on how market inefficiencies can create and aggravate agency costs between agents and principles. As previously mentioned, various different factors can cause market disequilibria such as, asymmetric information, investors’ sentiment and short-termism. I am particularly interested in situations where security markets are in disequilibrium as the market (i.e. investors, analysts etc.) overprice firms’ equity compared to the intrinsic value of its fundamentals.
Sarbanes Oxley Act
relationship between a company’s shareholder, directors and management as defined by the corporate charter, bylaws, formal policy and rule of law” (Gallegos, 2004).
The SOX is the most comprehensive reform of security laws since the “Security Act” of 1933 and its replacement in 1934 the “Security Act”, both being legislations enacted by U.S. Congress in the aftermath of the U.S. stock market crash of 1929 and during the ensuing Great Depression (Koehn & Vecchio, 2004). The Security Act of 1933 was the first major federal legal code to regulate both the offer and sale of securities. According to Green & Greogory (2005) the major provisions of the SOX included: “(1) the principle executive officer and the principle financial officer must certify the financial statements of the company, (2) the company must document its internal control system, (3) the audit committee of the Boards of Directors must be composed of independent directors and establish ‘whistleblowers’ policies to allow questionable accounting practises to be anonymously reported and (4) public companies are to adopt and disclose a code of ethics for its key executives”. With these new regulations and codes of conduct, U.S. Congress tried to improve corporate governance and restore future access to capital markets by demonstrating more transparency in a company and the availability of more trustworthy financial information (Bealing & Baker, 2006). Moreover, SOX requires; tighter monitoring and supervision, imposes harsh punishments in case of transgression, and in addition it deals with potential conflicts of interest with the aims of counteracting deceit and fraudulent financial reporting and management misbehaviour.
In the knowledge that SOX had an extensive impact on various different companies, I will particularly focus on how agency cost was affected by SOX and, moreover, whether the introduction and implementation of SOX influenced corporate investment in general.
A considerable amount of literature has been dedicated to the correlation between corporate governance and -investment. The majority of papers that found empirical evidence on the relation between corporate governance and investment are of larger scale and more significant when treating about investments related to acquisitions (Lewellen et al., (1985)). In contrast, the evidence is less suggestive and of a smaller magnitude when it comes to investments regarding “hard” corporate investment. The main problem by establishing the accurate correlation between corporate governance and the efficiency of “hard” investments is that companies do not need to announce internal investments, this in contrast to acquisitions. Nevertheless, there is sufficient literature that investigates the relation between corporate governance and large internal investments (Mayer & Sussman, 2005; White, 2006). Indeed, these papers provide evidence of which the overall conclusion is coherent with the notion that poor corporate governance associates with overinvestment and vice versa (Richardson, (2006); Harford et al., (2008); Billet et al., (2011)).
1. Corporate Investment
Kang et al., (2010), created a model that is based on “terms of intertemporal investment substitutions where the stochastic discount factor is related to the manager’s risk factor or preference – a lower discount factor (a higher discount rate) corresponds to a more cautious and reticent attitude towards corporate investment”. Their findings, according to their hypotheses, are suggesting that SOX has a significant influence on managers’ risk factor or preference. Namely, during the post- SOX period, the models´ “stochastic discount factor” decreased considerably compared to the pre-SOX period. Therefore, since the introduction and implementation of SOX, managers’ incentives altered from an aggressive investment policy to a more reserved, cautious and conservative investment strategy. Furthermore, they investigate and compare the inferred discount rates (i.e. the investment levels) of U.S. with U.K. firms. Their findings, once again, suggest that SOX has considerable impact on investment levels. Kang et al., (2010) contribute to the literature by lucidly stating and concluding that the SOX-act has remarkably influenced managerial investment decisions.
those who could delay the compliance of SOX. After 2002, when the federal law was established and implemented by U.S. Congress, section 404 of the SOX act required public listed firms to declare and include an “Accelerator Filer Status” in their annual financial reports (10-K). This status is based on the size of their “Public Float” of the second quarter of a fiscal year. Qian et al., (2010) define public float as “the fraction of the equity that is not held by insiders such as managers, employees and board members”, and this should be reported on the front page of a company's annual financial report. Those floats over the $75 million threshold would become “Accelerator filers”. Results of Qian, Strohan & Zhu´s research, show that the accelerator filers group of companies significantly cut CEO compensation and financial slack, increased pay-outs to shareholders and pursued an mild and prudent investment policy that decreased firms’ real investments. The authors acknowledged that during the pre-SOX period corporate executives had incentives to act in their own interest, rather than the shareholders´. This implies that managers “enjoy private benefits of control and thus have an inducement to pursue ‘empire building’ (i.e. more corporate investment and high growth) and accumulate and consume free cash flows (more balance-sheet cash, lower leverage and lower pay-outs to shareholders)”. However, Qian, Strohan & Zhu's (2010) results demonstrated that the SOX act curbs reduced the desire and eagerness of executives- and board members to pursuing their “empire building”, whilst favouring the value for shareholders.
2. Diminishing discretionary accrual earnings
Besides the fact that corporate investment levels are tempered by the ratification of the SOX regulation, evidence shows also that accrual-based earning management were suppressed and substituted for real earnings management methods. Cohen et al., (2008), provide significant data showing that accrual-based earnings practises steeply increased from 1987 until the enactment of SOX in 2002, which was followed by a considerable decrease after the ratification. Contrariwise, in the period preceding the SOX, real earnings management shrank significantly, and these activities augmented considerably during the post- SOX period.
stock option rewards are assigned to the managers, they will have an incentive to minimize the value of the currents stock price. On the other hand, for un-exercised options approaching the exercise-date, executive officers will try to maximize their earnings by increasing current stock prices, allowing them to take full advantage of their compensation reward. According to Cohen et al., (2008), they discovered and concluded that, “new options granted during the current periods are negatively associated with income-increasing discretionary accruals; while un-exercised options are positively associated with income-increasing discretionary accruals”. In both cases, corporate managers try to increase the difference or latitude between the stock option reward and the stock price at exercise date, to maximize and exploit their personal profits.
Zang (2006) did a more or less similar research investigating whether executive managers use real- and accrual earnings management as substitutes. According to the model she designed, Zang presented evidence that is coherent with Cohen et al., (2008) finding that managers employ real and accrual manipulations as substitutes.
Furthermore, there are several previous studies (Greenspan, 2002; Coffee, 2003; Cheng & Warfield, 2005; Bergstresser & Philippon, 2006), which demonstrate qualitative evidence that there is a positive and significant correlation between the level of accrual- based earnings management activities and the option- based compensation of managers. Field et al. (2001) claimed that executive officers who get rewarded corresponding to high stock- and option-based compensation are more attentive and focused on term stock prices (i.e. short-termism), and that they can use their discretion to influence annual financial earnings in the knowledge that it’s difficult for capital markets to discover earnings management.
Consistent with the results of the survey developed by Graham et al. (2005), their conclusion is that they “acknowledge that the aftermath of accounting scandals at Enron and WorldCom and the certification requirements imposed by the Sarbanes-Oxley Act may have changed managers’ preferences for the mix between taking accounting versus real actions to manage earnings”.
Hypothesis
meet and preferably exceed their internal and pre-determined targets and analysts’ forecasts. Since, executive managers are reproached to be “empire-builders” and thus ambitious to gain more status, power, and rewards, they create an uncontrollable obsession to perform better according to the markets’ expectation. This self-glorification tendency of managers is often at the expense of shareholders.
According to the equity-financing channel, executive managers have relative cheap access to external capital when they issue additional share at times investors misprice stock market prices. If the market overprices companies’ equity, CEOs and CFOs are tempted to artificially keep the stock prices abnormally high and consequently mislead the market expectations. Executive managers do this by increasing corporate investments, which signals positive cash flows and growth forecasts to both the market and other stakeholders. I, therefore claim that managers of mispriced companies will pursue an aggressive and dynamic investment policy to mislead the market and to continue the appearance of growth and value-creation.
Thus, I propose the following hypothesis:
Hypothesis I: Companies with overpriced equity have higher corporate investments, compared to “normal-priced” corporations.
U.S. listed companies that are forced to act in accordance with SOX are exposed to high compliance costs and to reduced earnings due to more transparent and conservative accounting methods. Nonetheless, the intention of SOX was not to alter accounting practises, but rather to enhance financial information disclosure to stakeholders in order to ameliorate the general corporate governance structures. In this context, I believe that if the SOX truly and effectively altered the managers’ philosophy from being egocentric to altruistic. Therefore, top-management and Board of Directors have the incentive to act in the interest of shareholders, which should have lead to improved corporate investments and finance activities. In other words after 2002, when the SOX was established and implemented, corporate managers stopped pursuing self-enrichment goals (i.e. gaining rewards, bonuses and other kind of remunerations), which was at the expense of shareholders. Nowadays, corporate managers have a (investment) policy that is in favour of shareholders and other stakeholders, which creates value on the long run. The SOX have led executive managers to alter their initial aggressive investment policy to a more reserved, cautious and conservative investment strategy. This brings me to the second hypothesis:
Empirical analysis
MethodologyIn this section, I would like to empirically test and prove my substantiated and motivated hypotheses. With reference to the aforementioned literature, I claim that companies’ investment decisions are influenced by market (mis)valuations of a corporation. Namely, firms that are mispriced by the market will invest more. To be more precise, I believe that the influence of market mispricing of firms’ equity and real investments drives through the equity-financing channel. In a cross-sectional analysis, I will investigate the relationship between stock mispricing across firms and real investment. Furthermore, I want to explore whether the introduction of the U.S. federal law, Sarbanes-Oxley Act (SOX), has a significant influence on the relationship between mispricing and investment. Firstly, I will elaborate on the linear model of firm investment, which is mainly based on Stein’s (1996) model. Secondly, I will discuss several definitions of the direct proxies for stock market mispricing. The challenging part of this research is to find a good proxy for mispricing that contains both a fundamental and non-fundamental components of companies´ stock prices.
1. The Investment Model
An extensive amount of literature has been dedicated to the relationship between firms’ real investment and to stock market mispricing. The traditional view is articulated in Tobin’s Q-theory, which accentuates the influence of stock prices as significant indicators of investment opportunities. Stein (1996) was a proponent of an alternative model, which he believed was more suitable and applicable. Therefore, he established a theoretical model, which predicts that companies use the equity-financing channel to finance their “legitimate” investment opportunities. The main implication of Steins’ model is that over-pricing (under-pricing) decreases (increases) the effective cost of external capital and therefore stimulates (tempers) companies to invest. In his model, Stein makes a distinction between equity-dependent and non-equity-dependent firms. This however, is irrelevant for this research.
A shortcoming of this study is that solely Tobin’s Q is used as the proxy of mispricing. Usually Tobin’s Q is used as a main variable among the determinants of investments in the finance literature. Additionally it is used to indicate growth opportunities in most of the cases rather than measuring mispricing. As stated by Baker et al. (2003), Tobin’s Q contains both a fundamental and non-fundamental component that can influence the “difference in the sensitivity of investment to Q”. In this research, I am interested in the equity-financing channel (i.e. non-fundamental component), but the fundamental component can create problems and may lead to biased results. Therefore, the challenge is to find good and suitable proxies for mispricing, assuming that firms’ investment levels will indicate greater sensitivity to these proxies.
Chang et al., (2007) did a similar investigation as Baker et al. (2003) did, and likewise they based their empirical framework on Stein’s model. Chang et al. explored whether mispricing in the stock market influenced corporate investments. They find that firms’ investment level is positively related to their proxies of mispricing. Using a sample of Australian firms, this evidence implies that companies that are overpriced by the market appear to overinvest. Above all, the most interesting feature of this study was that Chang et al. (2007) created two different investment equations with two different direct proxies for mispricing: “discretionary accruals” and “composite share issuance”. Following the methodology of Baker et al. (2003) and Chang et al., (2007), the paper will use their baseline empirical model. (See Appendix A for detailed information on the financial variables).
inclusion of the “Year” dummy- variables is to ensure that business-cycles influence and other unspecified time effects have an independent impact on my research. The standard errors used in the calculation of the t-statistics are founded on the heteroskedastic-consistent Huber–White sandwich (robust) estimator.
Devereux & Schiantarelli (1989) and Mill, Morling & Tease (1994) proclaim that financial leverage (the variable Leverage), cash holding (Cash), and net sales (Sales) all have influence on corporate investment decision-making. Therefore, I utilize an enhanced empirical investment model to verify the robustness of my findings.
(2) Similarly, to Chang et al., (2007), I include sales to control for the influence of “product demand on capital investment”. To take into account the influence companies’ liquidity has on investments, cash holdings (Cash) are included in the extended empirical model. According to Lang, Ofek, & Stulz (1996) corporate investment is negatively related to leverage and to companies with low Tobin’s Q values. The authors recommend therefore to including companies’ leverage (Leverage) into the investment model.
2. Proxies for Mispricing
This research paper explores situations where the market overvalues firms’ share price. The first problem that can arise is the so-called “classic joint hypothesis problem”, established by Fama (1970). He argued that expected fluctuations in share prices might just well have an effect of compensation for risk because of investors’ sentiment. “The model of market equilibrium is what distinguishes two possibilities: one researcher’s anomaly is another’s risk factor”, Polk & Sapienza (2004).
As mentioned above, the second challenge of this research is to capture suitable proxies for stock market mispricing, or equivalently the non-fundamental component of share prices. Similarly as Chang et al. (2007), I will use two different direct proxies for mispricing namely, “discretionary accruals” and “composite share issuance”.
2.a Discretionary Accruals
cash sales in the same reporting period in which sales occurs. However, many scholars provide evidence that executive managers use the “grey area” in the accounting regulations to modify accruals with the purpose of manipulating earnings and hence increase stock market prices. For example, corporate accountants may increase their accruals boosting their revenues with credit sales without receiving hard cash. Similarly, executive managers may postpone payments when cash is paid to suppliers.
Teoh et al., (1998); Polk & Sapienza (2002, 2004); and Chang et al., (2007) utilized in their research an extension of the cross-sectional model, which was originally established by Jones (1991). In this empirical framework, Jones distinguishes accruals into discretionary and non-discretionary components. Non-non-discretionary accruals (NDAC) is defined as the obligatory and appropriate level of expense that has been correctly recorded according to the accounting conventions, but that has yet to be realized. Discretionary accruals (DAC), on the contrary, “capture the unusual part of accruals given the underlying timing of cash flows, and so deemed to be under managerial discretion”, Chang et al. (2007). (A detailed derivation of the nondiscretionary accruals and discretionary accruals are outlined in Appendix B.)
Theoretically, in a perfectly- efficient world when investors discover earnings management abnormal high accruals should not influence the stock market prices. However, extensive evidence (Hand, 1990; And Maines & Hand (1996) demonstrates that by means of investors' obsession and desire on earnings (i.e. short-termism) they are blinded and unable to differentiate accruals from cash flow components. Prior literature has been dedicated to investigate the correlation between discretionary accruals and successive stock market returns. The majority of literature shows a negative relationship, suggesting that companies with high discretionary accruals are overpriced compared to equivalent counterparts operating in a similar industry.
abovementioned evidence, I believe I may conclude that it is justified to use discretionary accruals as a proxy for mispricing.
2.b Share Issuance
The definition of Share issuance (SI) is the value of equity of a firm under consideration during the last two years, in exchange for cash and services. As mentioned in the “mispricing” section, executive managers endeavour to time the market by issuing (repurchasing) equity when their company's stock prices are irrationally high (low). Corporate managers will have access to relatively cheap external capital, as the market overprices firms’ fundamental core assets. Hence, this evidence suggests that previously issued equity by a corporation should capture the level of mispricing of a share. Daniel & Titman (2004) established a measurement of share issuance that combines a company’s equity issuance, repurchasing activity and dividends initiation (omission). The authors provide evidence that proves that firms with high share issuance in the past have subsequent low stock returns in the next years, hereby suggesting that the companies are overpriced at the time of equity issuance.
Following Daniel & Titman (2004); Polk & Sapienza (2002, 2004); and Chang et al., (2007), I construct a measure of a company’s equity issuance over a two year period.
SI will be defined as the log of the inverse of the percentage ownership in the corporation one would have at time t, given a one percent ownership of the firm at time t-2, assuming full reinvestment of all cash flows. ME is the market value of equity that equals the year-end share price multiplied by the number of shares outstanding. is the log stock return from year t-2 to t.
After, having defined the two different proxies for mispricing, these variables will be included separately into the extended investment equation (2) and assess the subsequent equations (3) and (4).
(3)
