Introduction to Empirical Research in (Corporate) Finance

Question 1

firm valuation / performance

Answer 1

Tobin’s Q

Question 2

Tobin’s Q: definition

Answer 2

defined as the ratio of the market value of a company
to its replacement (or recorded asset) value

Question 3

Tobin’s Q: empirical (finance) setup

Answer 3

Q = Market Value of Equity + Book value of Debt / Total Assets

Question 4

Tobin’s Q would be 1.0

Answer 4

If the market valuation reflected solely the recorded assets of a company

Question 5

If Q is greater than 1.0

Answer 5

the market value is greater than the value
of the company’s recorded assets, suggesting that the market value reflects some unrecorded assets of the company

Question 6

How is corporate governance reflected in Tobin’s Q?

Answer 6

• In better governed firms, less assets, profits, etc. are expected to be diverted by self-serving managers as compared to poorly governed companies
• In an efficient market (and due to transparency requirements), the market should realize this and hence be willing to pay more for well-governed
  companies leading to higher share prices
• the numerator in the Q formula increases while the denominator remains unchanged (see governance class on why the denominator may change as well) leading to higher Q-values

Question 7

An alternative are stock returns, but they are associated with several problems

Answer 7

• we would expect that only changes in corporate
  governance affect stock returns (at announcement): Changes vs. levels
• if governance matters but is not incorporated immediately into stock prices, then realized returns on the stock would differ systematically from equivalent securities

Question 8

Accounting-based measures

Answer 8

• Return on assets (e.g., EBIT / total assets)
• Return on equity (e.g., net income / book value of equity)
• Sales growth, asset growth, et

–> Major problem: These measures are all backward-looking

Question 9

Other measures of company performance

Answer 9

• Value destroying (or increasing) acquisitions and value-increasing (or destroying) divestitures
• More valuable (e.g., R&D) investments, more patents, etc.
• Positive news and press coverages (measured using text analysis)

Question 10

Earlier studies investigate the effect of individual and “simple” corporate governance attributes

Answer 10

• managerial ownership is related to firm value in a non-linear way
• controlling for manager ownership, the percentage of outside directors on the board is not significantly related to firm value
• board size is negatively related to firm
  value (and controls for manager ownership and the percentage of outside directors on the board)

Question 11

More recent studies attempt to use more comprehensive measures of corporate governance

Answer 11

• 24 different corporate governance attributes that are related to anti-takeover provisions (G-Index)
• six out of the 24 attributes with the
  empirically strongest relation to firm value and returns (E-Index)
• 64 corporate governance attributes from the Governance Metrics International (GMI) database

Question 12

Reliable / usable data is available for the following countries / firms

Answer 12

• Managerial compensation and ownership data is available for US firms (S&P 1500) from S&P’s ExecuComp database for the years 1992 onwards
• Detailed data on board characteristics is available from the ISS (formerly RiskMetrics) Directors database for S&P 1500 firms since 1996
• Data to calculate the Gompers, Ishii, and Metrick (2003) index are available from the
  ISS Governance database for the years 1990 to today

Question 13

BoardEx (as of 2000)

Answer 13

Detailed data on virtually all directors in listed US firms and many directors worldwide is available

Question 14

Governance Metrics International provides about..

Answer 14

400 corporate governance attributes on thousands of international companies

Question 15

ISS Voting Analytics

Answer 15

Shareholder voting data (on say-on-pay, director elections, etc.)

Question 16

Thomson Financial’s CDA/Spectrum database

Answer 16

Data on block shareholdings (holdings exceeding 5%) are available

Question 17

Thomson’s Insider Trading database includes..

Answer 17

information on stock and option trades of top executives and directors since 1986

Question 18

Most of these datasets are available on..

Answer 18

WRDS (Wharton Research Data Services) and thus widely available to researchers

Question 19

Only very limited data on non-US
countries:

Answer 19

• For a long time, most papers used hand-collected data from annual reports and/or survey data
• The emergence of ISS and GMI (and a few others) made large-scale international studies possible. But these databases do not include detailed information on managerial ownership and remuneration and are very expensive
• Thomson Financial started to collect and report a
  number of board characteristics (board size, % of independent directors on the board, etc.) on international firms as well
• BoardEx also added more and more countries and firms

Question 20

Most data is available in …

Answer 20

yearly intervals only

Question 21

The exact date of changes in governance is in general not reported..

Answer 21

in databases and the announcement often coincides with other major events that are reported on the same day

Question 22

to be able to investigate the announcement effects of
important changes in..

Answer 22

governance, a detailed news search for
example in LexisNexis or in Dow Jones Factiva is necessary

Question 23

Basically all older empirical studies use either..

Answer 23

cross-sectional or panel datasets including yearly observations

Question 24

More recent research looks at changes in…

Answer 24

corporate governance (and their announcement effects), changes in regulation

Question 25

McConnell and Servaes (1990) estimate the following regression

Answer 25

voir page 18

Question 26

To assess the statistical significance of results, we use?

Answer 26

t- statistics, defined as the coefficient estimate divided by the standard deviation of the estimate

Question 27

The empirical setup: Heterogeneity

Answer 27

The relation between a specific firm-attribute (e.g., board size) and firm performance / value

Question 28

The optimization problem of the two firms

Answer 28

For both firms there is a concave relation between the governance attribute and firm value. * In the graph, both firms are at their maximum! * Firm 2 would prefer to be on Firm 1’s curve, but it isn’t. * But: by decreasing board size, Firm 2 would do worse than it does with the current board size. * A simple linear regression as in the first graph is misleading

Question 29

The empirical setup: Endogeneity

Answer 29

- firms may adopt good corporate governance to signal that firm insiders behave well, but governance is only a proxy for an omitted variable (for example, management quality) that simultaneously determines governance and performance - firms with lower firm valuation may attempt to limit shareholders’ rights by adopting more G-Index provisions in order to insulate the firm from hostile takeovers

Question 30

How can researchers mitigate such endogeneity concerns?

Answer 30

1) Econometric approaches 2 ) Natural experiments

Question 31

Econometric approaches:

Answer 31

* Firm fixed effects * Instrumental variables regressions * Heckman selection models * Dynamic panel GMM models

Question 32

Natural experiments

Answer 32

Changes in regulation, e.g., Business Combination Laws, which protect firms from hostile takeovers and thereby increase the CEO’s power

Question 33

CEO turnover and director reputation – Motivation : Two conflicting views

Answer 33

1) Firing a poorly performing CEO may be a sign of effective monitoring by the board. --> Directors are expected to gain reputation 2) Firing a poorly performing CEO may cause disruption and/or indicate that the board did not replace the CEO before the negative performance became observable --> This view is consistent with work in the management literature and theoretical work in financial economics --> Directors are expected to lose reputation = Answering the question whether directors gain or lose reputation from forcing out a CEO, allows us to shed light on the corporat governance signal transmitted by a forced CEO turnover

Question 34

CEO turnover and director reputation – Empirical challenges

Answer 34

1. Turnover decisions are endogenous 2. Widely used measures of director reputation are subject to endogenous selection

Question 35

Turnover decisions are endogenous

Answer 35

→ We study directors with multiple directorships who are interlocked to a forced CEO turnover: − Interlocked firms, and the directors sitting on their boards, are largely unaffected by characteristics of the turnover firm, including factors that led to the forced CEO turnover

Question 36

Widely used measures of director reputation are subject to endogenous selection

Answer 36

→ We use changes in withheld votes as a measure of director reputation: − Votes are not under directors’ direct control. − Investors use withheld votes to evaluate directors’ actions and directors respond to changes in withheld votes

Question 37

Difference-in-difference regressions at the director-firm-year level

Answer 37

voir page 30

Question 38

CEO turnover and director reputation – Cross- sectional results

Answer 38

- Forced CEO turnovers without a full replacement announced. – Forced CEO turnovers that are performance induced. – Forced CEO turnovers taking place at CEOs’ most productive tenure range of 3-13 years (Brochet et al., 2021, TAR). – Forced CEO turnovers in which the interlocked director has a committee-based monitoring role towards the CEO. – Forced CEO turnovers where the turnover interlocked director is affiliated with the CEO (Coles et al., 2014, RFS). – Directors who did not leave the turnover firm prior to the forced CEO turnover.

Question 39

Forced CEO turnovers and increases in withheld votes could result from poor performance of the turnover firms

Answer 39

idea : Obtain balanced treatment and control samples of directors interlocked to firms that are similar in terms of the likelihood of firing the CEO but differ only in the effective turnover decision Covariates: Company financial (valuation, stock returns, volatility,…), CEO characteristics, board characteristics, governance characteristics (compensation, G-Index, etc.). --> Performance of the turnover firm does not constitute an omitted variable

Question 40

Is there an unknown reason why, in two firms with equally bad performance, one chooses to fire its CEO and the other does not?

Answer 40

– If a management failure drives the bad performance, this may cause both CEO turnover and a negative updating about director ability. – If bad performance is due to bad luck, this may not convey any signal about directors’ ability.

Question 41

Augment PSM analysis with a newspaper-based sentiment index

Answer 41

– Mistakes of the leadership team trigger more negative newspaper coverage than bad luck. – This matched sample is balanced in terms of managers’ involvement in negative events → Results remain unchanged: An unobservable variable related to management failures versus bad luck does not cause an OVB

Question 42

Alternative explanation: Director distraction (e.g., Masulis & Zhang, 2019, JFE)

Answer 42

A forced CEO turnover demands significant time from involved directors and directors may neglect duties at interlocked firms

Question 43

Results are not driven by director distraction:

Answer 43

1. No increase in withheld votes following sudden CEO deaths at interlocked firms. 2. No reduction in board meeting attendance for turnover- interlocked directors.

Question 44

CEO turnover and director reputation – Labor market

Answer 44

- Outside directors involved in a forced CEO turnover on average do not lose board seats five years after the turnover - Initially lost directorships at the turnover firms are offset by newly acquired board seats in the subsequent four years - Lost board seats are replaced by new board seats at smaller firms - Smaller companies are associated with smaller compensation packages, less power and prestige and reduced networking benefits