Finance
JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS doi:10.1017/S0022109009990299
Vol. 44, No. 5, Oct. 2009, pp. 1045–1079
COPYRIGHT 2009, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195
Management Quality, Financial and Investment Policies, and Asymmetric Information
Thomas J. Chemmanur, Imants Paeglis, and Karen Simonyan ∗
Abstract
We develop measures of the management quality of firms and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm’s management and its financial and investment policies, a relationship that has so far received little attention in the literature. We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managers will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, since better managers are likely to select better projects (having a larger net present value (NPV) for any given scale) and to implement them more ably, higher management quality will also be associated with higher levels of investment. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.
I.
Introduction
The determinants of the financial policies of a firm have been the subject of considerable debate in recent times (see Welch (2004) for a recent example). Surprisingly, almost 50 years after the seminal papers by Modigliani and Miller on the capital structure
Vol. 44, No. 5, Oct. 2009, pp. 1045–1079
COPYRIGHT 2009, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195
Management Quality, Financial and Investment Policies, and Asymmetric Information
Thomas J. Chemmanur, Imants Paeglis, and Karen Simonyan ∗
Abstract
We develop measures of the management quality of firms and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm’s management and its financial and investment policies, a relationship that has so far received little attention in the literature. We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managers will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, since better managers are likely to select better projects (having a larger net present value (NPV) for any given scale) and to implement them more ably, higher management quality will also be associated with higher levels of investment. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.
I.
Introduction
The determinants of the financial policies of a firm have been the subject of considerable debate in recent times (see Welch (2004) for a recent example). Surprisingly, almost 50 years after the seminal papers by Modigliani and Miller on the capital structure
References: Bertrand, M., and A. Schoar. “Managing with Style: The Effect of Managers on Firm Policies.” Quarterly Journal of Economics, 118 (2003), 1169–1208. Bhattacharya, S. “Imperfect Information, Dividend Policy, and ‘the Bird in the Hand’ Fallacy.” Bell Journal of Economics, 10 (1979), 259–270. 1078 Journal of Financial and Quantitative Analysis Borokhovich, K. A.; R. Parrino; and T. Trapani. “Outside Directors and CEO Selection.” Journal of Financial and Quantitative Analysis, 31 (1996), 337–355. Chemmanur, T. J., and P. Fulghieri. “Investment Bank Reputation, Information Production, and Financial Intermediation.” Journal of Finance, 49 (1994), 57–79. Chemmanur, T. J., and Y. Jiao. “Seasoned Equity Issues with ‘Soft’ Information: Theory and Empirical Evidence.” Working Paper, Boston College (2005). Chemmanur, T. J., and I. Paeglis. “Management Quality, Certification, and Initial Public Offerings.” Journal of Financial Economics, 76 (2005), 331–368. Chevalier, J., and G. Ellison. “Are Some Mutual Fund Managers Better Than Others? Cross-Sectional Patterns in Behavior and Performance.” Journal of Finance, 54 (1999), 875–899. Christie, A. A. “On Cross-Sectional Analysis in Accounting Research.” Journal of Accounting and Economics, 9 (1987), 231–258. Clarke, J., and K. Shastri. “On Information Asymmetry Metrics.” Working Paper, University of Pittsburgh (2001). Cotter, J. F.; A. Shivdasani; and M. Zenner. “Do Independent Directors Enhance Target Shareholder Wealth during Tender Offers?” Journal of Financial Economics, 43 (1997), 195–218. Cr´ mer, J. “Corporate Culture and Shared Knowledge.” Industrial and Corporate Change, 2 (1993), e 351–386. D’Aveni, R. A. “Top Managerial Prestige and Organizational Bankruptcy.” Organization Science, 1 (1990), 121–142. Easterbrook, F. H. “Two Agency-Cost Explanations of Dividends.” American Economic Review, 74 (1984), 650–659. Eckbo, B. E., and Ø. Norli. “Liquidity Risk, Leverage, and Long-Run IPO Returns.” Journal of Corporate Finance, 11 (2005), 1–35. Gaver, J. J., and K. M. Gaver. “Additional Evidence on the Association between the Investment Opportunity Set and Corporate Financing, Dividend, and Compensation Policies.” Journal of Accounting and Economics, 16 (1993), 125–160. Giammarino, R. M., and T. Lewis. “A Theory of Negotiated Equity Financing.” Review of Financial Studies, 1 (1988), 265–288. Gompers, P. A.; J. L. Ishii; and A. Metrick. “Incentives vs. Control: An Analysis of U.S. Dual-Class Companies.” Working Paper, University of Pennsylvania (2004). Grossman, S. J., and O. D. Hart. “Corporate Financial Structure and Managerial Incentives.” In The Economics of Information and Uncertainty, J. J. McCall, ed. Chicago, IL: University of Chicago Press (1982). Guay, W. R. “The Sensitivity of CEO Wealth to Equity Risk: An Analysis of the Magnitude and Determinants.” Journal of Financial Economics, 53 (1999), 43–71. Hambrick, D. C., and R. A. D’Aveni. “Top Team Deterioration as Part of the Downward Spiral of Large Corporate Bankruptcies.” Management Science, 38 (1992), 1445–1466. Harman, H. H. Modern Factor Analysis, 3rd ed. Chicago, IL: University of Chicago Press (1976). Hermalin, B. E. “Economics and Corporate Culture.” In The International Handbook of Organizational Culture and Climate, C. L. Cooper, S. Cartwright, and P. C. Earley, eds. Chichester, UK: John Wiley & Sons, Ltd. (2001). Hodgson, G. M. “Corporate Culture and the Nature of the Firm.” In Transaction Cost Economics and Beyond, J. Groenewegen, ed. Boston, MA: Kluwer Academic Press (1996). o Holmstr¨ m, B. “Managerial Incentive Problems: A Dynamic Perspective.” Review of Economic Studies, 66 (1999), 169–182. Jensen, M. C. “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.” American Economic Review, 76 (1986), 323–329. John, K., and J. Williams. “Dividends, Dilution, and Taxes: A Signaling Equilibrium.” Journal of Finance, 40 (1985), 1053–1070. Kreps, D. M. “Corporate Culture and Economic Theory.” In Perspectives on Positive Political Economy, J. E. Alt and K. A. Shepsle, eds. Cambridge, UK: Cambridge University Press (1990). Kreps, D. M., and R. Wilson. “Reputation and Imperfect Information.” Journal of Economic Theory, 27 (1982), 253–279. Krishnaswami, S., and V. Subramaniam. “Information Asymmetry, Valuation, and the Corporate SpinOff Decision.” Journal of Financial Economics, 53 (1999), 73–112. Kyle, A. S. “Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1335. Lazear, E. P. “Corporate Culture and the Diffusion of Values.” In Trends in Business Organization, H. Siebert, ed. Tubingen, Germany: J. C. B. Mohr (1995). Loughran, T., and J. R. Ritter. “Why Has IPO Underpricing Changed Over Time?” Financial Management, 33 (2004), 5–37. Chemmanur, Paeglis, and Simonyan 1079 Michaely, R., and W. H. Shaw. “The Pricing of Initial Public Offerings: Tests of Adverse-Selection and Signaling Theories.” Review of Financial Studies, 7 (1994), 279–319. Miller, M. H., and F. Modigliani. “Dividend Policy, Growth, and the Valuation of Shares.” Journal of Business, 34 (1961), 411–433. Miller, M. H., and K. Rock. “Dividend Policy under Asymmetric Information.” Journal of Finance, 40 (1985), 1031–1051. Modigliani, F., and M. H. Miller. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 48 (1958), 261–297. Myers, S. C., and N. S. Majluf. “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have.” Journal of Financial Economics, 13 (1984), 187–221. Noe, T. H. “Capital Structure and Signaling Game Equilibria.” Review of Financial Studies, 1 (1989), 331–355. Ritter, J. R. “The ‘Hot Issue’ Market of 1980.” Journal of Business, 57 (1984), 215–240. Welch, I. “Capital Structure and Stock Returns.” Journal of Political Economy, 112 (2004), 106–131. Copyright of Journal of Financial & Quantitative Analysis is the property of Journal of Financial & Quantitative Analysis and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder 's express written permission. However, users may print, download, or email articles for individual use.