Browsing by Author "Graham, John R"

The costs and constraints to financing, and the factors that influence them, play critical roles in the determination of corporate capital structures.

Chapter 1 estimates firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company's cost of debt function varies with characteristics such as asset collateral, size, book-to-market, intangible assets, cash flows, and whether the firm pays dividends. Quantifying, the total cost of debt is on average 7.9% of asset value at observed levels, reaching as high as 17.8%. Expected default costs constitute approximately half of the total ex ante cost of debt.

Chapter 2 uses the intersection between marginal cost of debt functions and marginal benefit of debt functions to examine optimal capital structure. By integrating the area between benefit and cost functions, net benefit of debt at equilibrium levels of leverage is calculated to be 3.5% of asset value, resulting from an estimated gross benefit of debt of 10.4% of asset value and an estimated cost of debt of 6.9%. Furthermore, the cost of being overlevered is asymmetrically higher than the cost of being underlevered. Case studies of several firms reveal that, for some firms, the cost of being suboptimally levered is small while, for other firms, this cost is large, suggesting firms face differing sensitivities to the capital structure choice.

Finally, Chapter 3 examines the role of financing constraints on intertemporal capital structure choices of the firm via a structural model of capital investment. In the model, firms maximize value by choosing the amount of capital to invest and the amount of debt to issue. Firms face a dividend non-negativity constraint that restricts them from issuing equity and a debt capacity constraint that restricts them from issuing non-secured debt. The Lagrange multipliers on the two constraints capture the shadow values of being constrained from equity and debt financing, respectively. The two financing constraint measures are parameterized using firm characteristics and are estimated using GMM. The results indicate that these measures capture observed corporate financing behaviors and describe financially constrained firms. Finally, between the two financing constraints, the limiting constraint is the debt restriction, suggesting that firms care about preserving financial slack.

I study the effect of human capital on firms' leverage decisions in a structural dynamic model. Firms produce using physical capital and labor. They pay a cost per employee they hire, thus investing in human capital. In default a portion of this human capital investment is lost. The loss of human capital constitutes a significant cost of financial distress. Labor intensive firms are more heavily exposed to this cost and respond by using less leverage. Thus the model predicts a decreasing relationship between leverage and labor intensity. Consistent with this prediction, I show in the data that high labor intensity leads to significantly less use of debt. In the model a move from the lowest to the highest decile of labor intensity is accompanied by a drop in leverage of 21 percentage points, very close to the 27 percentage point drop in the data. Overall, I argue that human capital has an important effect on firm leverage and should receive more attention from capital structure researchers.

Furthermore, I study a two-period contracting problem in which entrepreneurs need financing but have limited commitment. If an entrepreneur chooses to default, he can divert a proportion of the project's output. Entrepreneurs are heterogeneous with respect to their ability to divert output. In particular, I focus on the special case with only two types of entrepreneurs. "Opportunistic'' entrepreneurs can divert output, but "dependable'' entrepreneurs cannot. I find that, if the proportion of dependable entrepreneurs is sufficiently high, it is optimal to write contracts that induce second period default by the opportunistic entrepreneurs. This critical proportion generally decreases with the severity of the agency problem. The model delivers both cross-sectional and time-series predictions about default, investment, and output.

This dissertation consists of three essays in corporate finance and corporate governance. In the first chapter, I develop a structural model of executive compensation with non- binding shareholder approval votes (“Say-on-Pay", or SOP). In the model, the Board sets compensation policy and is biased towards offering a high wage (i.e., the CEO influences compensation). Shareholders can fail the vote and punish the Board. The threat of a failed vote affects compensation policy because the Board of Directors internalizes a cost to SOP failure. I show that providing this vote to shareholders has a disciplining effect on compensation and improves firm value. This is not obvious, given that SOP votes rarely fail.The second chapter presents work with Bruce Carlin, Alan Crane and John Graham. We show theoretically that using a hurdle rate above the cost of capital conveys a bargaining advantage when negotiating with outsiders. This arises through the use of a “sacred" firm-wide hurdle rate for capital budgeting, which allows project managers to commit when negotiating. We display empirical support for our model’s predictions. The third chapter presents work with Murillo Campello, John Graham and Yueran Ma. We study the direct and interactive effects of corporate flexibility (the ability for firms to adapt to changing business conditions) on firm plans at the onset of the COVID-19 crisis. We find that financial, workplace (the ability to easily shift to a remote workplace), and in- vestment (the ability to easily modify investment plans) flexibility played a key role. The key result of the paper is that different forms of flexibility (namely, workplace and investment during the COVID crisis) interact with each other and improve corporate flexibility.

This dissertation examines whether investors’ cognitive limitations can influence market prices and, if so, how this affects corporate decisions. In the first chapter, I investigate whether and how investors’ cognitive limitations influence market prices. I study this issue in the context of an accounting rule that enabled firms to avoid recognition of a compensation expense against reported earnings. I begin by noting that, because of the high cost associated to processing information, it is reasonable for an individual investor to make buy or sell decisions based on a few salient signals, such as front-page earnings. Following this premise, I argue, overstated earnings that lead investors to form over-optimistic views of a firm should result in the overvaluation of the firm’s stock under the presence of conditions that limit arbitrage.

In this chapter, I provide evidence in support that market prices did not incorporate this compensation expense, which did not lead to a reduction in reported earnings but needed to be disclosed in a footnote to the financial statements. Consistent with the argument that this result is driven by investors’ cognitive limitations, I find that firms’ use of employee option grants –the form of compensation in question– and abnormal return performance are associated to the composition of firms’ investor base. Specifically, I find that these two are positively related to the presence of individual investors. Furthermore, I find that these are positively correlated to the presence of institutional investors with a short-term investment horizon, or transient investors, according to the classification developed in Bushee (1998). These results challenge the widespread notion that prices incorporate all publicly available information not only in the absence of well-funded rational investors, or arbitrageurs, but also in their presence.

The results in Chapter 1, however, are subject to potential criticisms. Measuring market efficiency is a treacherous endeavor, being the “bad model problem” the chief challenge. As noted in Fama (1970), market efficiency can only be tested jointly with an equilibrium asset-pricing model characterizing normal returns. Therefore, the presence of abnormal return performance can be interpreted either as evidence against the hypothesis that market prices incorporate all publicly available information, the inappropriateness of the equilibrium pricing model under consideration, or a combination of these two. To mitigate concerns related to this issue, I propose three complementary methods to assess the informational efficiency of market prices: a calendar-time portfolio strategy, a regression analysis of abnormal returns, and an event-study around earnings announcements. Although the results of these analyses are all consistent with the behavioral view, it is not possible to fully reject the alternative that the “bad model problem” can at least partially explain the evidence here documented.

After showing that due to the favorable accounting treatment of option grants firms had a stock-price motivation to use this form of compensation, in Chapter 2, I examine whether this affects firms’ behavior. Specifically, I explore whether it shaped CEO option-based compensation during the period under study and provide evidence that sustains that this is the case.

These findings help explain the sudden shift away from executive option grants observed in 2002, and by doing so they contribute to fill in a void in the literature, which has so far not been able to determine the causes of this phenomenon (Frydman and Jenter, 2010). Existing studies have examined how the change in the accounting for options affected CEO compensation. Differently, in this chapter, I provide evidence that the most significant changes in firms’ CEO option-based compensation took place in 2002 –following the string of accounting and corporate scandals that rocked corporate America– well in advance of the mentioned change in the accounting rule. This finding is particularly important for studies that examine the effect that rules and laws have on corporate policies. As this dissertation demonstrates, in these studies, it is of first order importance to consider the events that lead to the implementation of any rule or law because the actions of lawmakers and rule-setters are rarely exogenous or unanticipated.

This dissertation investigates how variation in trade credit standards play a role in firm maturation. In Chapter 1, I survey existing research in trade credit. Following this, I identify lifecycle trends in supplier trade credit policy in Chapter 2. Young suppliers assume greater risks in trade credit provision early in their lifecycles in order to advance growth and product market agendas. There is a peak around a supplier's IPO in the riskiness of trade credit supplied, measured by doubtful receivables and the length of credit provided (receivables length). I find that young firms in industries where customer-supplier relationships are more significant have higher doubtful receivables, consistent with suppliers varying trade credit standards to build relationships. Additionally, young suppliers with more complex products (as measured by R&D intensity) offer longer duration loans compared to suppliers of similar age. Offering riskier trade credit terms affects economic outcomes. In Chapter 3, I study if varying trade credit standards for the purpose of relationship building is a viable strategy for all firm maturities. I use the incidence of a major free trade agreement to study firm responses to a major disruption in existing supplier-customer relationships. Chapter 3 posits both supplier driven as well as customer driven explanations for the observed responses, finding evidence consistent with older suppliers have a reduced incentive as well as capacity to engage in relationship building.

Health care costs for U.S. employers have tripled in the past twenty years. By constructing a novel dataset with firm-specific health care expenses, I show that firms negatively adjust both capital expenditures and R&D expenses in response to changes in health care costs. I estimate that, on average, a 1% increase in health care costs is associated with a 0.7% decrease in total investment. The effects are stronger for financially constrained firms, firms employing more high-skilled workers, and firms working with fewer insurers. Additional tests confirm that hiring fewer workers and reducing wages do not offset rising health costs enough to counteract this lower investment channel. Overall, my findings suggest that rising health care costs limit firms’ ability to expand either physically or via innovation.

I examine how employing workers with specific human capital affects capital structure decisions by employers. Based on plant-level data from the U.S. Census Bureau, I use the opening of new plants as an exogenous reduction in human capital specificity-- the inability to transfer specific skill sets across employers--for incumbent workers in a local labor market. My results indicate that the opening of a new manufacturing plant in a given county leads to a 2.6-3.9% increase in the leverage of existing manufacturing firms in the county, relative to the leverage of manufacturing firms in an otherwise comparable county. Moreover, plant openings have a larger impact on firms that are more likely to share labor with the new plant, that have high labor intensity, and that have high marginal tax benefits of debt. Alternative explanations concerning productivity spillovers, product market competition, and county-wide shocks do not appear to account for the results. I find consistent evidence in a separate sample that contains a broad panel of firms. Overall, these results suggest that human capital specificity raises the cost of debt and thus decreases optimal leverage.

This dissertation explores the effects of private equity (PE) investment on product quality among healthcare providers. In the first essay, I study the determinants of PE manager behavior, focusing on the role of product market competition. Using the nursing home setting as a backdrop, I consider the broader question of whether and how product market competition shapes the impact of PE acquisitions on consumers. By studying acquisitions of skilled nursing facilities by PE firms, I find that PE-owned providers exhibit greater competitive sensitivity—in that they compete more aggressively when competitive incentives are comparatively strong, and exploit market power more aggressively when competitive incentives are comparatively weak.

To investigate whether PE managers respond differently than non-PE managers to competition, I consider two sources of variation in competitive incentives facing nursing homes. First, I exploit the fact that nursing homes compete with one another in geographically segmented markets to contrast facilities according to the levels of local competition they face. I find significant heterogeneity in the effect of PE ownership according to levels of local market concentration. In highly competitive markets, PE owners increase staffing by $101,783 worth of care annually (enough to increase registered nurse (RN) hours by 20.8% of the mean), while actually reducing staffing in less competitive markets. Second, I show that PE-owned nursing homes respond more strongly to policies intended to spur competition. I study the introduction of the Five-Star Quality Rating System, a policy that increased the salience of staffing for consumers. Following its introduction, PE-owned facilities increased their staffing by an average of $39,118 worth of care more than their non-PE counterparts. Moreover, PE managers more aggressively shift their staffing composition towards RNs in response to the rating system's specific emphasis on RN staffing (RN expenditure increasing by 14.7% of the mean, with licensed practical nurse (LPN) expenditure decreasing by 4.9% of the mean): in total, the share of RN staffing increased by 1.9 percentage points (17.3% of the mean) more than non-PE facilities.

In the second essay, I assess how PE acquisitions influenced the readiness and outcomes of nursing facilities during the onset of the COVID-19 pandemic. With over 40% of U.S. COVID-19 deaths occurring in nursing homes, long-term care is a critical setting in which we must better understand the impact of PE ownership during the coronavirus pandemic. I find PE ownership to be associated with a mean decrease in the probability of confirmed COVID-19 cases among residents by 7.1 percentage points and confirmed staff cases by 5.4 percentage points. PE was also associated with a decreased probability of PPE shortages—including N95 masks, surgical masks, eyewear, gowns, gloves, and hand sanitizer. However, facilities previously (but not presently) owned by PE firms did not fare similarly well. I observe that prior PE ownership may result in increased PPE shortages and a potentially greater likelihood of resident outbreaks. This suggests that the contribution of PE ownership to improved COVID-19 outcomes is a result of active management during the pandemic, rather than the legacy of interventions undertaken beforehand.

This paper establishes the life-cycle dynamics of Corporate Venture Capital (CVC) to explore the information acquisition role of CVC investment in the process of corporate innovation. I exploit an identification strategy that allows me to isolate exogenous shocks to a firm's ability to innovate. Using this strategy, I first find that the CVC life cycle typically begins following a period of deteriorated corporate innovation and increasingly valuable external information, lending support to the hypothesis that firms conduct CVC investment to acquire information and innovation knowledge from startups. Building on this analysis, I show that CVCs acquire information by investing in companies with similar technological focus but have a different knowledge base. Following CVC investment, parent firms internalize the newly acquired knowledge into internal R&D and external acquisition decisions. Human capital renewal, such as hiring inventors who can integrate new innovation knowledge, is integral in this step. The CVC life cycle lasts about four years, terminating as innovation in the parent firm rebounds. These findings shed new light on discussions about firm boundaries, managing innovation, and corporate information choices.