Why do managers avoid EPS dilution? Evidence from debt–equity choice

Why do managers avoid EPS dilution? Evidence from debt–equity choice Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

Why do managers avoid EPS dilution? Evidence from debt–equity choice

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Publisher
Springer Journals
Copyright
Copyright © 2013 by Springer Science+Business Media New York
Subject
Economics / Management Science; Accounting/Auditing; Finance/Investment/Banking; Public Finance & Economics
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1007/s11142-013-9266-3
Publisher site
See Article on Publisher Site

Abstract

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.

Journal

Review of Accounting StudiesSpringer Journals

Published: Dec 10, 2013

References

  • The role of information and financial reporting in corporate governance and debt contracting
    Armstrong, C; Guay, W; Weber, J
  • Investor sentiment and the cross-section of stock returns
    Baker, M; Wurgler, J
  • Incentive contracting and the value relevance of earnings and cash flows
    Banker, R; Huang, R; Natarajan, R
  • Employee stock options, EPS dilution, and stock repurchases
    Bens, D; Nagar, V; Skinner, D; Wong, F
  • Real investment implications of employee stock option exercises
    Bens, D; Nagar, V; Wong, F
  • Investor sentiment and corporate disclosure
    Bergman, NK; Roychowdhury, S

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