1 The Economic Implications of Corporate Financial Reporting 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 September 17, 2004 University of Southern California

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 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 Brav, Graham, Harvey & Michaely survey on dividend and repurchase policy –“Payout Policy in the 21 st Century” forthcoming in JFE 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 Friedman’s (1953) “The Methodogy of Positive Economics” Goals of positive science are predictive Don’t 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 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 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 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 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 EPS focus Fig. 2. Responses to the question: “Rank the three most important measures report to outsiders” based on a survey of 401 financial executives.

19 Graham/Harvey/Rajgopal: Corporate Reporting EPS focus Conditional analysis Unprofitable and younger firms, earnings less important Cash flows more important when less guidance Private firms put more emphasis on cash flows than earnings (suggesting capital market motivations drive focus on earnings) [Table 2]

20 Graham/Harvey/Rajgopal: Corporate Reporting EPS focus Interviews: Why focus on earnings? 1.Complex world need simple, comparable number 2.EPS gets broadest coverage in media 3.By focusing on one number, simplifies the analyst’s job 4.Investment banks can assess the performance of analysts by looking at forecast and actual EPS

21 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.

22 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]

23 Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

24 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.

25 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Stock price motivation Barth, Eliot and Finn (TAR 1999) firms with continuous growth in earnings priced at premium Skinner and Sloan (RAS 2002) growth firms missing benchmarks are severely punished 86% of CFOs say “builds credibility” 80% maintain or increase stock price

26 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Stakeholder motivations Bowen, Ducharme and Shores (JAE 1995) by managing earnings, 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

27 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Employee bonus Healy (JAE 1986) accounting discretion to maximize bonus Matsunaga and Part (TAR 2001) failure to make consensus leads to CEO pay cuts Survey evidence not significant Interviews suggest that internal targets more important for managers (“stretch” and “budget” greater than consensus)

28 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. Recent papers: Farrell and Whidbee (JAE 2003); Feng (WP 2004); Francis, Huang, Rajgopal and Zhang (WP 2004);

29 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.

30 Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks Uncertainty Uncertainty about future prospects is thought to be priced

31 Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks Cockroach problem “You have to start with the premise that everyone manages earnings” If you can’t 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”

32 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

33 Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

34 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?”

35 Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks Real versus accounting actions 80% would reduce discretionary spending, R&D, 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”

36 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), R&D or asset sales –Mittelstaedt, Nichols, Regeir (TAR 1995) cut health care –Penman and Zhang (TAR 2002) cutting investments in presence of conservative accounting –Roychowdhury (WP 2003) over produce and sales discounts to meet targets

37 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

38 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 can’t second guess real actions

39 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Hypothetical scenario: Your company’s 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) 0%20%40%60%80%100% $2.00$1.90 $1.80 $1.70 $1.40$1.30

40 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Probability of accepting project

41 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]

42 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Reminiscent of Brav, Graham, Harvey and Michaely Sacrifice positive NPV projects before cutting dividends

43 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Repurchases Dividends

44 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

45 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

46 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?

47 Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

48 Graham/Harvey/Rajgopal: Corporate Reporting Smoothing 96.9% and 20/20 interviews prefer smooth earnings over more volatile holding cash flows constant

49 Graham/Harvey/Rajgopal: Corporate Reporting Smoothing Responses to the question: “Do the following factors contribute to your company preferring a smooth earnings path?”

50 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

51 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?”

52 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

53 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”

54 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

55 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

56 Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Why smooth earnings? Sec 5.1, Table 8 Value sacrifice for smooth earnings Sec 5.2, Table 9 Why disclose? Sec 6.1,Table 11 Why not disclose? Sec 6.2, Table 12 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

57 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 (JAE 2001) say that motivations for voluntary disclosure “important unresolved question for future research”

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

59 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

60 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?

61 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 company’s future prospects is enhanced

62 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

63 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

64 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% is similar to the cost of capital Interviews: –A number mentioned “reducing analysts disagreement” and linked that to cost of capital

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

66 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

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

68 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

69 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Management talent signaling: Trueman (1986) Little support but more support for small firms

70 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 don’t understand them.” –Quarterly mandatory disclosures lack timeliness –Mandatory ignores intangibles

71 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure Survey responses to the question: Limiting voluntary communication of financial information helps…

72 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

73 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

74 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure Proprietary costs Might jeopardize firm’s competitive position 58.8% agree More agreement with small firms and those with few analysts

75 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

76 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

77 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?

78 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?

79 Graham/Harvey/Rajgopal: Corporate Reporting Conclusions Managers focused on earnings not cash flows 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 firm’s stock price and managers reputation and mobility

80 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 manager’s arsenal Disclosure can potentially reduce information risk and enhance a manager’s reputation

81 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

82 Payout Policy in the 21 st 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

83 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 21 st century

84 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

85 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)

86 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 ing to 2200 FEI members –Overall ~16% response rate

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

88 Brav/Graham/Harvey/Michaely: Payout Policy Payout vs. Investment Decisions Repurchases Dividends

89 Brav/Graham/Harvey/Michaely: Payout Policy Dividends vs. Repurchases (Fig. 2)

90 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

91 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

92 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

93 Brav/Graham/Harvey/Michaely: Payout Policy Payout Decisions Still Made Conservatively? vs. Lintner (1956) Repurchases: No, flexible Dividends: Yes, still conservative

94 Brav/Graham/Harvey/Michaely: Payout Policy Conservatively increase payout? Similar to Lintner (1956)? Repurchases Dividends

95 Brav/Graham/Harvey/Michaely: Payout Policy Payout ratio still target? vs. Lintner (1956)

96 Brav/Graham/Harvey/Michaely: Payout Policy Payout ratio still target? vs. Lintner (1956)

97 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

98 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

99 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

100 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

101 Brav/Graham/Harvey/Michaely: Payout Policy A. Taxes Interviews: repurchases are “efficient way to return capital” –taxes (2 nd order) important Surveys: modest support Repurchases Dividends

102 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

103 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”

104 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

105 Brav/Graham/Harvey/Michaely: Payout Policy C. Agency Stories Firms pay dividends to impose discipline on managers

106 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

107 Brav/Graham/Harvey/Michaely: Payout Policy D. Asymmetric Information Conveying information Costly self-imposed action—Signaling Adverse selection –Do informed investors benefit from repurchase programs, at expense of uninformed? Stock undervaluation

108 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

109 Brav/Graham/Harvey/Michaely: Payout Policy Information: Signaling Repurchases Dividends

110 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 – can’t explain dividend policy for most firms Does not explain why firms pay dividends in the first place

111 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, it’s a conditional objective Surveys: repurchases, stock good investment Repurchases Dividends

112 Brav/Graham/Harvey/Michaely: Payout Policy E. Other factors: EPS Interviews: managers are concerned about EPS –Some think it’s automatic that repurchases increase EPS –Other believe that it depends on alternative use of funds Surveys: EPS important Repurchase questions

113 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

114 Brav/Graham/Harvey/Michaely: Payout Policy Initiate with repurchases or dividends?

115 Brav/Graham/Harvey/Michaely: Payout Policy Why initiate payout? Repurchases Dividends

116 Brav/Graham/Harvey/Michaely: Payout Policy Conclusions Payout policy is not first-order important* (M&M) Repurchases: decided de novo Dividends: level very important Managers prefer repurchases over dividends because they are more flexible. –Not because of taxes.

117 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

118 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.

119 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, don’t ever cut dividends unless you have an amazing investment opportunity smaller penalty if competitors cut Think very carefully before initiating dividends

120 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 quarter’s target! 78% would knowingly sacrifice value to smooth earnings