This thesis considers the impact of taxation on two problems in the theory of financial markets. The first paper deals with the optimal choice of debt made by value-maximising firms. We consider a one-period world with personal and corporate taxation and distinguish between the repayment of principal and the payment of interest on corporate debt. It is shown that at optimum, a value-maximising firm may choose to issue multiple debt contracts with differing seniorities. In addition, the impact of a change in the tax rates (corporate or personal) on the optimum level of debt is seen to be ambiguous. Unambiguous statements can, however, be made about the impact of a change in the corporate tax rate on firm value, the value of the equity and on the required rate of return on risky corporate debt. The analysis borrows heavily on a framework that we develop early in the paper which permits us to visualise the value-maximising firm's choice of an optimal capital structure, graphically. The second essay examines the impact that taxes have on the pricing of call options on corporate stock. It is demonstrated that the process of replication can be influenced by the basis of the stocks used for the replication process as a result of the capital gains taxes involved. Consequently, the equilibrium price for an option is some average of the various costs of replication that different investors face. We find that the equilibrium price for the option can be influenced by investor preferences and by the history of the stock price. The empirical findings of an apparently unpredictable strike-price bias that have been observed in the past literature is examined and duplicated numerically. In addition, one explanation is given for the rationale behind covered option positions that consist of an option position and the corresponding hedge. / Business, Sauder School of / Graduate

This dissertation presents three essays in empirical corporate finance. The essays discuss how financial markets affect the real economy. The first essay studies how a change in credit supply affects firms’ decisions to create new products or destroy the existing ones. It provides reduced form causal evidence that a reduction in credit supply reduces product creation substantially. The second essay studies the effect of less product creation on consumer welfare. I find that the effect on consumer welfare is smaller relative to a “naive” interpretation of the reduced form estimate, due to equilibrium responses. The third essay studies how financially constrained firms reduce total investment costs. It provides suggestive evidence that when reducing total investment cost, they do so by lowering the expansion of output capacity and choosing cheaper investment options.

This dissertation comprises three essays in the field of empirical corporate finance and it contributes to the literature on the financial and real effects of corporate governance. Broadly defined, corporate governance encompasses all mechanisms that remove frictions in the relationship between firm insiders and outside stakeholders with claims on the cash flows of the company. The field has focused on the relationships between concentrated equity-holders and managers, but there are many other firm claimants. I consider two that are understudied: (1) The government, which holds a claim on firm cash flows through its taxation power. This stake motivates the government to detect and punish manager expropriation. And (2) passive investors, which appear not to engage with the running of individual firms in their maximally diversified portfolios but which may have a portfolio-maximization incentive to do so. In the first two chapters I hypothesize that credible government monitoring creates firm value by reducing frictions between firms and their bank lenders, allowing them to access more and cheaper financing to fund new investments. I quantify the effect in the context of a tax audit program in Ecuador wherein a sub-group of firms were chosen to be audited every year indefinitely. In the first chapter, I show that banks lend more to firms that are known to be under higher government scrutiny, both on the intensive and extensive margins, and do so at lower interest rates and longer maturities. I control for selection bias using a regression discontinuity design based on the procedure the tax authority used to choose which firms to add to the auditing program. In the second chapter, I use the same Ecuadorian setting as in the first chapter to show that government monitoring affects the real economy: Firms subject to more government monitoring increase their employment and their investment in physical capital. This is true even though the firms increase their average tax payments. The estimated employment effects jointly estimate new employment and formalization of existing employees. Investment effects are concentrated in physical capital investments, rather than in intangibles. But what mechanism is driving these results? I determine that the financial and real effects act primarily through government monitoring reducing ``hidden action'' frictions between firms and their lenders. The corporate governance effects of tax enforcement are valuable to firm investors, which update their beliefs on firms' abilities to divert firm resources going forward, making firm actions more predictable under the monitoring regime. The combination of a larger supply of bank credit at a lower price supports this mechanism. Moreover, monitored firms became more likely to borrow from a bank that they had never borrowed from before and to attract investments from new private investors. Finally, it is those firms that appear to be most likely to divert ex ante, by both tax and accounting measures of diversion, that receive the largest decrease in their cost of borrowing once they are chosen for the program. I conclude that this government monitoring, even when it was designed to maximize tax collection, had a meaningful effect on firm access to capital and on the real economy. This evidence supports the hypothesis that predictable government enforcement of laws is an important part of a comprehensive corporate governance system, lowering frictions that are not mitigated through other means and complimenting other mechanisms, such as bank monitoring. The policy implication is that an increase in tax enforcement can benefit both the government and outside firm stakeholders by generating greater tax revenue and increasing the value of the firm to outsiders. In the third chapter I test the hypothesis that shareholder governance, the primary mechanism for inducing managers to maximize own-firm value, may in some circumstances lower manager incentives to maximize the value of their firm when to do so they would need to engage in fierce competition with other firms that their shareholders also own. One way that cross-holding shareholders could incentivize managers to internalize their competition preferences is to influence the composition of executive compensation by increasing the payouts to managers when their industry does well relative to the payouts when their own firm does well. I find no robust relationship between the cross-holdings of minority shareholders and the competition incentives embedded in the compensation of top firm executives. Rather, I find that firms with shareholders that hold relatively more cross-holdings in direct competitor firms are more likely to adopt performance pay that expressly rewards out-performing peers. This chapter contributes to the current policy debate on how to regulate diversified investors by casting doubt on the anti-competitive effects of these holdings, at least through the mechanism of executive compensation, the main way that firms align shareholder and executive incentives.

This paper extends the scope of Earnings per share ("EPS") studies by incorporating Bushman et al. (2004)'s conceptual framework of corporate transparency to illustrate how the disclosure requirement of an accounting rule governing EPS could have far-reaching effects on the information environment in US. Informed participants are having a keener edger over average investors in using EPS as a guide to investment value. EPS signals a summary measure of firm performance to market participants. The market reactions to EPS and change in per share earnings provide a distinct opportunity to gauge the informativeness of earnings. The information role will nevertheless derail whenever there is an equity change. The accounting rule stipulates the use of a theoretical construct, the weighted average number of shares, in the denominator for EPS, which the average investor is unable to interpret as the number of shares at the reporting date is the actual, not average number of shares. Relative to the actual-share EPS, the average-share EPS will either inflate or deflate the per share earnings. The informed investors, who can substitute actual number of shares for the theoretical construct, are hence bestowed by the accounting rule an information advantage over the average investors. Earnings response coefficient is significant with denominator of EPS substituted while the explanatory power of theoretical-denominator EPS abates when it is contemporary with the denominator substituted EPS. Financial analysts' expertise in the provision of idiosyncratic information to the market has been compromised by the average-share EPS, which is reflected heretofore in proforma earnings forecasts errors. Proforma earnings use a numerator different from accounting rules and to further temper the denominator with the actual number of shares will make pro-forma EPS forecast unintelligible to users. The unintended consequence of inflating or deflating the per share earnings misleads average investors in their decision-making process. Analysts should not issue proforma earnings forecast while researchers should abstain from using theoretical-denominator EPS for sample firms with equity change as their policy prescriptions may further aggravate the problem. A simple remedy to change the accounting rule, SFAS No. 128 is eminently anticipated, if not warranted.

The dissertation deals with the allocation of resources, among profit producing elements within a company, to achieve satisfactory results over a planning horizon. The company is viewed as a confederation of profit making elements called Strategic Business Units (SBU) which are independent of each other and held together by a central authority. The dissertation uses a computerized simulation model of the deterministic type in a timesharing mode. The model is deterministic with some limited probabilistic The model is deterministic with some limited probabilistic effects. It is used to develop projected balance sheets and profit and loss statements for each period in a predetermined planning horizon and to evaluate the success of a set of alternative futures of the SBU. The set of SBU alternatives to be evaluated as the "company" may be arbitrarily chosen by the operator or chosen through the use of a near-optimal, integer programming algorithm for a variety of measurement criteria and subject to various restraints on the balance sheet. The research uses data generated by the long-range planning process at an intermediate sized, multinational corporation listed on the New York Stock Exchange. The data consist of assets, liabilities, and profit and loss statement items for each period in a planning horizon and for each of three alternatives of each SBU in the study. In addition, a beginning corporate balance sheet is required as are planned corporate expense items and the specification of operating restrictions. Research into the effect of several strategic policies, including dividend rate and debt to equity ratio, on the future prospects of the company in accordance with the optimal value of five different measurement criteria, is reported. The five measurement criteria are present value of shareholder equity, growth in earnings per share, growth in total assets, total assets and growth in sales. The appendix material contains listings of computer programs used in the model (written in the Basic computer language), the research data used, numerous computer printouts, and technical discussions on the model. Several tentative conclusions are listed, many areas for further research are suggested, and strengths and constraints of the model are discussed. It is concluded that the techniques developed have good potential for increasing cash generation and the efficiency of the investment process in a company; the dividend rate has a significant effect on how fast a company can grow; and the model is flexible and can be used for a number of investigative purposes to support company decision-makers. An interesting area for further research is the tentative conclusion that return on assets, when used as an optimization criterion, produces a significantly different set of SBU alternatives from the one which results from using the other measurement criteria.

This paper studies foreign currency adjustments in executive compensation (i.e. exclusionof foreign currency impacts from accounting-based performance metrics). In light of recent debates on the pros and cons of using non-GAAP adjustments in compensation, I propose a rational explanation for adjusting foreign currency concerning firm’s operating decisions. I employ real options theory to study foreign currency fluctuations in decision making. I show, both analytically and empirically, that Integration Level, the extent of coordinated activities or cross-border transactions between the parent and its foreign subsidiaries, can serve as an explanation. Firms with a high level of integration are less likely to adopt foreign currency adjustments. On average, firms consider foreign currency fluctuations to make corporate decisions; the usage of foreign currency adjustments in executive compensation is less likely to be a result of managerial opportunism.

I develop a general equilibrium model to examine the innovation and welfare effects of expanding mandatory financial disclosure to a broader set of firms. In the model, disclosure by relatively small firms reveals proprietary information about their local markets, which helps larger firms enter and compete. Consistent with previous empirical findings, the model predicts that mandatory disclosure encourages (discourages) innovation by larger (smaller) firms. More importantly, I identify conditions for when expanding the scope of disclosure regulation increases aggregate innovation and/or welfare. I structurally estimate the model using innovation data and plausibly exogenous variation in the extent of disclosure regulation in Europe. My estimates suggest that subjecting 15% more firms to full reporting requirements decreases aggregate innovation by around -0.26% but increases welfare by around 1%. This disparity is driven by the fact that production shifts to larger firms that innovate less but are more efficient in exploiting the fruits of innovations.

The literature on agency theory has generally modelled and tested the firm’s dividend and capital structure decisions separately. In this dissertation, a model is developed based on agency cost considerations and dividends as a means of controlling equity agency costs, which simultaneously determines the optimal capital structure and payout rate for firms. However, to the extent that alternative, non-dividend mechanisms exist across industries and industry groups that may either diminish or nullify the effect of dividends in controlling equity agency costs, simultaneity is not predicted to be universal but a function of industry characteristics. This central hypothesis is tested on three industry groups: industrial firms, banks and electric utilities. Banks and utilities are regulated. Industrials are not regulated but are subject to other equity agency cost controlling mechanisms like the threat of takeover and incentive-based compensation packages. As hypothesized, the results for industrials show no simultaneity in the subsample where these other mechanisms are present, and simultaneity in the subsample where dividends are the dominant mechanism. For banks and utilities no simultaneity is found since regulation, through its effect on the debt agency cost curve of firms in these industries effectively precludes its occurrence. / Ph. D.

This dissertation examines the role of insider trading activity in explaining announcement price effects of seasoned debt and equity issues for investment. As has been widely discussed in the finance literature, the announcement of new financing for investment purposes can convey good or bad news depending on the motivation behind the issue, the profitability of the investment, and the stage of firm development. If insider trading can effectively reduce information asymmetry about investment opportunities at the time of corporate financing announcements, markets can be expected to react less negatively to these announcements. Corporate insiders know more about the expected impact of current earnings and future investments than anyone else. Consequently, the value and direction of their personal trading should reflect, to some extent, their expectation of the value of the firm in the future. John and Mishra’s [1990] signaling model explains how insider trading can act as a joint signal along with a corporate announcement in sending information to the market efficiently. A cross-sectional analysis is conducted to test the hypothesis that announcements of new financing (debt or equity) for investment that are preceded by insider buying are accompanied by a less negative stock price response than issues that are preceded by insider selling. This analysis is followed by several tests designed to examine the robustness of this relationship. The results of this study suggest a correlation between trading and announcement period price effects for equity issues that is consistent with this hypothesis, though the effect is more pronounced for smaller firms. There appears to be no connection between insider trading and the announcement period reaction to debt issues, however. / Ph. D.

In this study the irrelevance school of issue price is challenged and a theoretical model of optimal allocation ratio which explicitly takes into account various costs associated with rights offerings is developed. The empirical results reveal the importance of owners' subscription cost, the issuing firm's dividend policy, as well as the cost of administering share transfers in the determination of allocation ratio. The entirety of these results points, therefore, to the rejection of the irrelevance school of issue price and lend support to the three relevance school theories: the dividend policy cost theory of Levy and Sarnat, the transfer cost hypothesis of Beranek, and the cost of owner subscription hypothesis developed in this study. / Ph. D.