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Synopsis

The research problem

We examined the influence of changes in CEOs’ political alignment with the White House on firms’ corporate social responsibility (CSR) performance, and the underlying reasons for this relationship.

Theoretical reasoning

Presidential elections that shift control of the White House often alter CEOs’ alignment with the presidency, influencing their motivations to invest in CSR. Firms with CEOs aligned with the newly elected president (newly aligned firms) may anticipate economic benefits, such as favorable regulation, but also face increased public scrutiny. The enhanced operating environment may reduce their incentives to use CSR to mitigate product market, litigation, and capital market pressures. Conversely, heightened scrutiny may prompt their greater CSR investment. Firms with CEOs aligned with the outgoing president (newly unaligned firms) encounter directionally opposite incentives, for example, reduced economic benefits from connection with power and lower scrutiny. Both groups of politically active firms may benefit from superior access to legislative information following the transition of power.

The test hypotheses

We state our hypotheses in the null form, predicting that there is no difference in the postelection change of CSR performance between newly aligned (newly unaligned) firms and nonpartisan firms whose CEO political alignment with the White House did not change as a result of the 2008 or 2016 elections.

Target population

Our sample consists of 12,234 firm-year observations drawn from the three-year periods immediately surrounding the 2008 and 2016 elections and includes 2086 (1935) firm-year observations with newly aligned (newly unaligned) CEOs and 8213 cases with nonpartisan CEOs.

Adopted methodology

We employed a difference-in-differences research design to examine the difference in CSR performance between the pre-election period (the election year −3 to −1) and the postelection period (the election year +1 to +3) in newly aligned (newly unaligned) firms relative to firms with nonpartisan CEOs.

Analyses and findings

We found that both newly aligned and newly unaligned firms significantly improved their CSR performance following elections where control of the White House changes, relative to nonpartisan firms. This association is more pronounced for less financially constrained firms and those in politically sensitive industries. Further analysis shows that newly aligned firms enhance CSR to mitigate public scrutiny and leverage superior legislative information, while newly unaligned firms invest in CSR to reduce their cost of capital and litigation risk.

Islamic banks are established with the mandate of conducting all their transactions in conformity with Islamic precepts which prohibit, among other things, the receipt and payment of interest. Unlike conventional (non-Islamic) commercial banks, Islamic banks mobilise funds primarily via investment accounts using profit sharing contracts. In this paper, we argue that the concept of financial risk, on which modern capital structure theories are based, is not relevant to Islamic banks. Given the contractual obligation binding the Islamic bank's shareholders and investment account holders to share profits from investments, we propose a theoretical model in which, under certain assumptions, an increase in investment accounts financing enables the Islamic bank to increase both its market value and its shareholders' rates of return at no extra financial risk to the bank. We theoretically demonstrate that such a process leads to an increase in the Islamic bank's market value but does not alter its weighted average cost of capital, i.e. the weighted average cost of capital of the Islamic bank remains constant. The evidence obtained from estimating and testing the model on annual accounts drawn from a sample of 12 Islamic banks lends support to our theoretical predictions, as do the results from counterfactual simulations and sensitivity experiments. Hence, in the context of Islamic banks both our theoretical and empirical results provide a new dimension to the theory of capital structure, which is based on a mixture of only debt and equity financing. In general, viewed against the main competing tenets of the traditional school and the MM standpoint, our results provide an encompassing paradigm on the theory of capital structure.

This paper empirically tests Kim and Verrecchia's (1994, hereafter KV) theory that bid-ask spreads may increase around earnings announcements when information asymmetry increases between the informed traders and the less informed market-makers. Despite certain limitations, prior research has used analysts' earnings forecasts as a proxy for information asymmetry. I substitute the percentage of common stocks held by institutional investors as a more precise proxy for information asymmetry. Consistent with KV's proposition, I find (1) that bid-ask spreads increase at the time of earnings announcements, and (2) that bid-ask reactions to earnings announcements are significantly positively related to information asymmetry even after controlling for the effects of other cross-sectional determinants of spreads.

This study examines the impact of covenant violations on the implied cost of equity capital and the underpricing of seasoned equity offerings (SEOs). Using a novel dataset of 1,028 first-time covenant violations from 1996–2011, we find a higher level of SEO underpricing during the period immediately following covenant violations. This suggests that creditors require violating firms to issue equity to lower leverage and that equity investors interpret the violation negatively. We also find that violating firms experience an average increase of 8.48% in the implied cost of equity capital. By comparing analysts’ earnings forecasts before and after the violations, we conclude that the negative effects on equity owe to the loss of flexibility that accompanies covenant violations, and are not simply a reflection of the deteriorating health of the firm.

This paper examines the source of the documented empirical link between measures of “accruals quality” and a firm’s cost of capital. First, we argue that when regressions include accruals quality and operating volatility as determinants, these highly correlated measures capture different underlying constructs. Second, we find that in such regressions, the accruals quality measure displays inconsistent associations, while operating volatility variables display robust associations, with various cost of capital measures. Third, we provide research design suggestions to disentangle the effect of accruals quality from operating volatility, and we show how this method leads to less noisy coefficient estimates. These findings should be useful in designing empirical tests of the hypothesized associations involving accruals quality, operating volatility, and cost of capital.

This paper addresses the following question: Are banks special firms that can achieve their goals only with high leverage, above and beyond what is considered acceptable for industrial corporations?

This question is related to the issue of the cost of capital and how it is affected by leverage. If we accept the Modigliani–Miller (M&M) theorem (1958), then the capital structure is irrelevant for both the cost of capital and the value of the bank. Specifically, the M&M hypothesis argues that higher levels of equity capital reduce bank leverage and risk, leading to an offsetting decline in banks’ cost of equity capital. Hence, we ask the question whether banks are special firms such that M&M theorem does not apply to banks.

We show that M&M propositions cannot be applied for banks primarily because of explicit guarantees and subsidies that provide incentives for increasing leverage. Then, some of the risk faced by the bank is transferred at no cost to the providers of these guarantees and subsidies, giving banks the incentive to increase leverage as much as they can. We show that under perfect market conditions, when risk is fairly priced, this opportunity vanishes.

We propose a possible alternative to WACC as cost of capital for a business investment decision through option theory. The cost of capital in this new definition becomes forward-looking and easy to compute with traded market information as inputs. More importantly, it is a fair value- based approach and does not depend on investors’ own expectation. An important parameter “asset characteristic value” is identified and its role is further illustrated by using Merton’s capital structure model. Asset characteristic value can be calibrated by using stock price or credit spread observed from a secondary market.

In this paper, we present a model that demonstrates the effect of debt on cost of capital and value in the case of banking firms. Using a static partial equilibrium setting, both in a steady state and steady growth scenario, we derive a bank-specific valuation metric which separately attributes value to assets and debt cash flows in the form of a liquidity premium and tax-shield. We run our model on a sample of the largest 26 European banks from 2003 to 2016 finding that the value contribution of debt benefits to enterprise value is large and persistent. Further from our model, we derived an implied cost of capital (ICC) measure finding consistent results with capital asset pricing model (CAPM). The theoretical framework we present is helpful to address bank debt benefits valuation and to reconcile equity and asset side approaches.

Specification error and measurement error are two major issues in finance research. The main purpose of this chapter is (i) to review and extend existing errors-in-variables (EIV) estimation methods, including classical method, grouping method, instrumental variable method, mathematical programming method, maximum likelihood method, LISREL method, and the Bayesian approach; (ii) to investigate how EIV estimation methods have been used to finance related studies, such as cost of capital, capital structure, investment equation, and test capital asset pricing models; and (iii) to give a more detailed explanation of the methods used by Almeida et al. (2010).

Breeden [An intertemporal asset pricing model with stochastic consumption and investment opportunities. Journal of Financial Economics 7, (1979) 265–296], Grinols [Production and risk leveling in the intertemporal capital asset pricing model. Journal of Finance 39, 5, (1984) 1571–1595] and Cox et al. [An intertemporal general equilibrium model of asset prices. Econometrica53, (1985) 363–384] have described the importance of supply side for the capital asset pricing. Black [Rational response to shocks in a dynamic model of capital asset pricing. American Economic Review 66, (1976) 767–779] derives a dynamic, multiperiod CAPM, integrating endogenous demand and supply. However, Black’s theoretically elegant model has never been empirically tested for its implications in dynamic asset pricing. We first theoretically extend Black’s CAPM. Then we use price, dividend per share and earnings per share to test the existence of supply effect with US equity data. We find the supply effect is important in US domestic stock markets. This finding holds as we break the companies listed in the S&P 500 into 10 portfolios by different level of payout ratio. It also holds consistently if we use individual stock data. A simultaneous equation system is constructed through a standard structural form of a multiperiod equation to represent the dynamic relationship between supply and demand for capital assets. The equation system is exactly identified under our specification. Then, two hypothesis related to supply effect are tested regarding the parameters in the reduced-form system. The equation system is estimated by the seemingly unrelated regression (SUR) method, since SUR allows one to estimate the presented system simultaneously while accounting for the correlated errors.

Breeden (1979), Grinols (1984 Cox et al. [Cox, J. C., Ingersoll, J. E., Jr., & Ross, S. A. (1985). An intertemporal general equilibrium model of asset prices. Econometrica 53, 363–384] have described the importance of supply side for the capital asset pricing. Black [Black, S. W. (1976). Rational response to shocks in adynamic model of capital asset pricing. American Economic Review66, 767–779] derives a dynamic, multiperiod CAPM, integrating endogenous demand and supply. However, Black’s theoretically elegant model has never been empirically tested for its implications in dynamic asset pricing. We first theoretically extend Black’s CAPM. Then we use price, dividend per share and earnings per share to test the existence of supply effect with U.S. equity data. We find the supply effect is important in U.S. domestic stock markets. This finding holds as we break the companies listed in the S&P 500 into ten portfolios by different level of payout ratio. It also holds consistently if we use individual stock data.

A simultaneous equation system is constructed through a standard structural form of a multi-period equation to represent the dynamic relationship between supply and demand for capital assets. The equation system is exactly identified under our specification. Then, two hypotheses related to supply effect are tested regarding the parameters in the reduced-form system. The equation system is estimated by the Seemingly Unrelated Regression (SUR) method, since SUR allow one to estimate the presented system simultaneously while accounting for the correlated errors.

We discuss the growth of world financial markets with common stocks, bonds, and other new financial instruments such as futures, GDRs and ETFs. We document patterns of international capital flows and discuss their related issues, which include: 1) how capital flows affect economic growth; 2) the cost of capital; and 3) increased linkages among different markets around the world. Home bias in global investment remains an issue that is not easily explained in the light of globalization.

We also discuss patterns of foreign portfolio investments and their implications for US investors. We show the importance of various types of investments in terms of maturity and asset class. The most popular industries for foreign investors are Thrifts and Mortgage Finance, Pharmaceutics, Metals and Mining, Paper and Forest Products, and Media and Insurance.